SMG AC 222 Lecture Notes - Lecture 3: Cost Driver, Finished Good, Income Statement

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5 Aug 2016

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Distinguish between the direct and indirect costs of products and services, and learn the benefits and drawbacks of different methods of charging / allocating / applying indirect costs to the objectives those costs help to achieve. Job order costing is a method of organizing the work in process account so that the costs of different products, or different batches of the same product, can be traced. Overhead is the indirect cost of making a product or doing a service. Since it cannot be traced directly to cost objects, it is usually charged to cost objects using a predetermined rate: estimated total overhead cost. Estimated units of activity / cost driver predetermined oh rate. Manufacturing costs versus cost of goods manufactured. Absorption costing: all manufacturing costs both fixed and variable are charged to products. Job order costing: production of many different, unique products; also used by service companies; products not made continuously, but rather in batches.

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Blueprint Problem: Support Department Cost Allocation TheDifference Between Support Departments and Producing DepartmentsWhen a firm decides that a plant wide overhead rate is notsufficient (perhaps it makes multiple products and the variousproducts go through some processes but not all), it may decide todepartmentalise. The factory is divided into departments and costsare accumulated within the departments. When that is done, thereare basically two types of departments: producing departments thatactually make units of product, and support departments that do notmake the product but assist or support the producing departments.Costs of support departments are allocated to producing departmentsfor the following reasons: inventory valuation, product-lineprofitability, pricing, and planning and control. From the listbelow, determine which of the following are producing departments:Departments Is it a producing department? Assembly Yes HumanResources No Industrial engineering (in a bread factory) No Baking(in a bread factory) Yes Packaging Yes Accounting (in a paintfactory) No Welding (in a auto manufacture) Yes Maintenance NoMixing (in a food factory) Yes Some costs are hard to associatewith a single department, so a final catch-all department may becreated called General Factory. This department includes alloverhead costs that could not be traced to the other departments.For example, the salary of the plant superintendent and the cost oflandscaping and grounds keeping may be included in General Factory.Once the factory is departmentalized, the costs of each departmentare traced to that department. All costs in the support departmentsare overhead costs. Costs in the producing departments can includedirect overhead. For example, overhead cost directly traced to aproducing department may include depreciation on machinery and thesalary of the departmental supervisor. Feedback Correct Single andDual Charging Rates A support department may develop a chargingrate that is used to charge other departments that use the service.This is similar to an overhead rate. For example, Davis Company'sinformation technology (IT) department is in charge of purchasing,installing and assisting other departments with computers and otherforms of information technology. The IT department may develop asingle charging rate by determining all budgeted costs for the yearand dividing by the budgeted hours of IT personnel usage. Supposethe budgeted costs of the Davis Company IT Department for thecoming year equal $240,000 and budgeted hours of service providedequal 5,000. What is the charging rate for the coming year? $/service hour. If the Payroll Department uses 30 hours of ITservice next year, how much is that department charged by IT? $Notice that the charging rate is computed using budgeted numbers,but that the actual charge is the predetermined rate times actualusage of IT service hours. At the end of the year, the total amountcharged out is compared to the total actual cost of the ITdepartment to determine its efficiency/inefficiency. Dual chargingrates require the department to separate fixed from variable costsand develop charging rates for each. In this way, the userdepartments are charged for their original capacity requirementthrough the fixed allocation and then charged for their actualusage of variable costs through the variable rate. Suppose that theDavis Company IT Department serves four other departments: Payroll,Factory, Human Resources, and Engineering. When the IT Departmentwas organized, those using departments said they would need thefollowing hours of IT service in a year: Estimated Hours of ITService Percentage of IT Service Payroll 100 2.00% Factory 2,00040.00% Human Resources 1,500 30.00% Engineering 1,400 28.00% Total5,000 100.00% Davis' IT Department estimated that it would requirebudgeted fixed cost of $120,000 and variable costs of $20 perservice hour. Calculate the fixed cost to be allocated to each ofthe four using departments and the variable costs to be assignedusing the variable rate. What is the total amount charged to eachdepartment using these dual rates? (Fill in the following table.)Estimated Hours of IT Service Percentage of IT Service Fixed ITCost Allocated Actual Hours of IT Service Used Variable CostAllocated Using $20 Rate Total IT Cost Allocated Payroll 100 % $ 30$ $ Factory 2,000 % 2,200 Human Resources 1,500 % 1,200 Engineering1,400 % 1,400 Total 5,000 % $ 4,830 $ $ Why was less charged intotal than the budgeted amount of $240,000? Less variable cost wascharged because total actual hours were less than total budgetedhours. Is it possible to allocate more IT cost to the four userdepartments than budgeted? Yes, because increased actual hours willlead to more variable cost allocated to the user departments.Feedback Partially correct Support Department Cost Allocation Usingthe Direct Method Factory accountants usually allocate supportdepartment costs to the producing departments using one of threemethods: the direct method, the sequential (or step) method, or thealgebraic (or reciprocal) method. The objective is simple - to getall factory costs into the producing departments in order tocalculate overhead rates and apply them to units produced. Whycan't support departments allocate overhead costs to unitsproduced? Support departments don't make the product that thecompany is in business to produce and sell - only producingdepartments do that. The direct method involves allocating overheadcost from the support departments to the producing departments. Thedirect method never allocates cost from one support department toanother support department. As a result, it is the easiest of thethree methods. Let's use Porter Company, as an example. Porter hastwo producing departments - Fabricating and Assembly - and threesupport departments - Maintenance, Human Resources (HR) and GeneralFactory (GF). Porter provided the following information on the fivedepartments: Maintenance HR GF Fabricating Assembly Direct overheadcost $80,000 $120,000 $260,000 $93,400 $56,700 Machine hours 1,0003,000 5,000 12,000 3,000 Direct labor hours 4,000 5,000 8,00010,000 30,000 Square footage 500 2,500 10,000 12,000 18,000 Porteruses the direct method of support department cost allocation.Maintenance is allocated based on machine hours, HR on the basis ofdirect labor hours, and GF on the basis of square footage. TheFabricating overhead rate is based on machine hours and theAssembly overhead rate is based on direct labor hours. Fill in thefollowing table to allocate support department costs to theproducing departments. (Round all allocation ratios to foursignificant digits and all allocated amounts to the nearest dollar.If an amount box does not require an entry, leave it blank or enter"0".) Maintenance HR GF Fabricating Assembly Direct overhead cost$80,000 $120,000 $260,000 $93,400 $56,700 Allocate: MaintenanceHuman Resources General Factory Total after allocation $ $ $ $ $Notice that after allocation, zero dollars remain in the supportdepartments and all overhead cost has been allocated to theproducing departments. As a check on your work, add up all directoverhead costs from the first line - it equals $610,100. Then addthe totals after allocation - again, it equals $610,100. Finally,calculate the overhead rates (rounded to the nearest cent) forFabricating and Assembly. Fabricating overhead rate $ per machinehour Assembly overhead rate $ per direct labor hour Suppose thatthe square footage for Fabricating and Assembly were equal at12,000 each. How would that affect the allocation of the following:Maintenance: there would be no change Human Resources: there wouldbe no change General Factory: increase amount allocated toFabricating and decrease amount allocated to Assembly FeedbackPartially correct Support Department Cost Allocation Using the Stepor Sequential Method The step or sequential method requires thatsupport departments be ranked and that the highest ranking supportdepartment be allocated first to all lower ranking supportdepartments and the producing departments. Then the highest rankingsupport department is closed and the second-highest ranking supportdepartment is allocated to lower ranking support departments andthe producing departments. This continues until all supportdepartment cost has been allocated to the producing departments.The sequential method takes partial account of support departmentreciprocity. Reciprocity occurs when one support department usesthe services of another support department. For example,Maintenance uses HR and HR may use the services of Maintenance. Thesequential method does not take full account of reciprocity becauselower ranking support department costs are never allocated tohigher ranking support departments. Let's use Porter Company, as anexample. Porter has two producing departments (Fabricating andAssembly) and three support departments (Maintenance, HumanResources (HR) and General Factory (GF)). Porter provided thefollowing information on the five departments: Maintenance HR GFFabricating Assembly Direct overhead cost $80,000 $120,000 $260,000$93,400 $56,700 Machine hours 1,000 3,000 5,000 12,000 3,000 Directlabor hours 4,000 5,000 8,000 10,000 30,000 Square footage 5002,500 10,000 12,000 18,000 Porter uses the sequential method ofsupport department cost allocation, and support departments areranked in order of direct overhead cost (from high to low).Maintenance is allocated based on machine hours, HR on direct laborhours, and GF on the basis of square footage. The Fabricatingoverhead rate is based on machine hours and the Assembly overheadrate is based on direct labor hours. Calculate the allocationratios to five significant digits and fill them into the followingtable (If an amount box does not require an entry, leave it blankor enter "0".) : Maintenance HR GF Fabricating Assembly GeneralFactory Human Resources Maintenance Using the allocation ratios,fill in the following table to allocate support department costs tothe producing departments. (Round all allocated amounts to thenearest dollar. Leave cells blank that do not require an entry.)Maintenance HR GF Fabricating Assembly Direct overhead cost $80,000$120,000 $260,000 $93,400 $56,700 Allocate: Maintenance HumanResources General Factory Total after allocation Notice that afterallocation, zero dollars remain in the support departments and alloverhead cost has been allocated to the producing departments. As acheck on your work, add all direct overhead costs from the firstline - it equals $610,100. Then add the totals after allocation -again, it equals $610,100. Finally, calculate the overhead rates(rounded to the nearest cent) for Fabricating and Assembly.Fabricating overhead rate $ per machine hour Assembly overhead rate$ per direct labor hour Feedback Partially correct SupportDepartment Cost Allocation Using the Algebraic or Reciprocal MethodThe algebraic or reciprocal method takes full account of supportdepartment reciprocity. This method requires the solution of asystem of simultaneous equations to determine the total supportdepartment costs to be allocated. In practice, relatively fewcompanies use the reciprocal method. Let's use Anders Company, asan example. Anders has two producing departments - Cutting andSewing - and two support departments - Maintenance and GeneralFactory (GF). Anders provided the following information on the fourdepartments: Maintenance GF Cutting Sewing Direct overhead cost$10,000 $270,000 $56,400 $75,000 Machine hours 459 2,000 9,0009,000 Square footage 2,500 3,418 5,000 8,500 Anders uses thealgebraic method of support department cost allocation. Maintenanceis allocated based on machine hours, and GF on the basis of squarefootage. Calculate the allocation ratios to five significant digitsand fill them into the following table (Leave cells blank that donot require an entry.): Maintenance GF Cutting Sewing GeneralFactory Maintenance Using the allocation ratios, solve a system ofsimultaneous equations for support department cost as follows.Maintenance = $100,000 + 0.15625 GF GF = $270,000 + 0.1 MaintenanceSubstituting Maintenance into the equation for GF and solving forGF: GF = $270,000 + 0.1 ($100,000 + 0.15625 GF) GF = $270,000 +$10,000 + 0.015625 GF 0.984375 GF = $280,000 GF = $284,444 Then,Maintenance = $100,000 + 0.15625 ($284,444) = $144,444 Using thenewly calculated amounts for GF and Maintenance and the allocationratios, fill in the following table to allocate support departmentcosts to the producing departments. (Round all allocated amounts tothe nearest dollar. Leave cells blank that do not require anentry.) Maintenance GF Cutting Sewing Direct overhead cost $100,000$270,000 $56,400 $75,000 Allocate: General Factory MaintenanceTotal after allocation Notice that after allocation, zero dollarsremain in the support departments and all overhead cost has beenallocated to the producing departments. As a check on your work,add all direct overhead costs from the first line - it equals$501,400. Then add the totals after allocation - again, it equals$501,400.

Cost-Based Pricing

Companies use various strategies to set price. Since cost is animportant determinant of supply and is known to the producer, manycompanies base price on cost. Still other companies use atarget-costing strategy, or strategies based on the initialconditions in the market.

A cost-based pricing approach starts with product cost and thendesired profit is added. Usually, there is some cost base and amarkup. The markup is a percentage applied to base cost; itincludes desired profit and any costs not included in the basecost. Companies that bid for jobs routinely base bid price oncost.

Example: Linder Company makes and sells vitaminsupplements. The following information from last year's accountingrecords showed:


Cost of Goods Sold	$254,000
Selling and administrativeexpense	86,360
Operating income	111,760

The markup percentage must include all costs that are not a partof cost of goods sold plus the desired profit. For Linder Company,the markup on COGS is found as follows:

Markup on COGS	= (Selling and administrativeexpenses + Operating income)/COGS
	= ($86,360 + $111,760)/$254,000 =0.78 or 78%

Now, if Linder Company produces a new product with manufacturingcost of $2 per unit, the unit price at this markup is:

Price = $2 + (0.78 Ã $2) = $2.00 +$1.56 = $3.56

A Company does not have to use Cost of Goods Sold as the basisof the markup. For example, a job-order firm might decide to usethe markup on prime costs (direct materials and direct labor) tocost jobs. Suppose that Carl's Custom Cabinetry wants to price jobsbased on prime costs plus a markup on prime cost. Last year'sincome statement revealed the following information:


Prime costs	$134,000
Overhead	73,700
Selling and administrativeexpense	38,860
Operating income	50,920

Markup on Prime Cost	= (Overhead + Selling andadministrative expenses + Operating income)/Prime cost
	= ($73,700 + $38,860 +$50,920)/$134,000 = 1.22 or 122%

Carl is pricing a new job with estimated direct materials of$4,300 and direct labor of $1,800. The estimated price is:

Price = ($4,300 + $1,800) + (1.22 Ã$6,100) = $6,100 + $7,442 = $13,542

Neither Linder Company nor Carl's Custom Cabinets must use theprice figured according to the markup. This is just a firstapproximation. Carl, for example, may want to set a lower price inhopes of getting more business from this particular customer.Linder Company may want to charge a higher price based on marketconsiderations.

Target Costing

Another approach to pricing a product or service is targetcosting. The target cost is based on the price (target price) thatcustomers are willing to pay. The Marketing Department determineswhat characteristics and price for a product are most acceptable toconsumers. Then, it is the job of the company's engineers to designand develop the product such that cost and profit can be covered bythat price. Japanese firms have been doing this for years; Americancompanies are beginning to use target costing. So first the targetprice is set. Then the desired profit is deducted, and theremaining amount is the target cost.

Target cost = Target price -Desired profit

Determining the target cost is relatively easy. Actuallydesigning and manufacturing a product that will achieve the targetcost and sell for the target price is more difficult. As a result,target costing is an iterative process as the firm works to refinethe proposed product to meet the cost and price targets.

Price Discrimination

Price discrimination refers to the charging of different pricesto different customers for essentially the same product. TheRobinson-Patman Act was passed in 1936 as a means of outlawingprice discrimination by manufacturers or suppliers; services andintangibles are not included under the act.

The Robinson-Patman Act does allow price discrimination undercertain specified conditions: (1) if the competitive situationdemands it and (2) if costs (including costs of manufacture, sale,or delivery) can justify the lower price. According to the secondcondition, a lower price offered to one customer must be justifiedby identifiable cost savings and the amount of the discount must beat least equaled by the amount of cost saved.

To compute a cost differential, the company creates classes ofcustomers based on the average costs of selling to those customers.Then all customers in each group are charged a cost-justifiableprice.

Example: Raul Company manufactures specializedelastic bandages used to reinforce athletes' wrists or ankles. Raulsells to a number of individual physical therapists and athletictrainers as well as to Medallion Gym, a national chain of physicalfitness facilities. The average manufacturing cost is $169 per case(a case contains 100 plastic-wrapped elastic bandages). RaulCompany sold 350,000 cases last year to the following two classesof customer.

	Price	Quantity
Medallion Gym	$235	175,000
Individual trainers and physicaltherapists	$241	175,000

Medallion Gym requires that the bandages be individuallypackaged in boxes with the Medallion name on the label. This boxand special labelling costs $0.34 per unit. Raul also pays allshipping costs, which amounted to $1,400,000 last year.

The individual trainers and physical therapists order in smalllots that require special picking and packing in the factory; thespecial handling adds $20 to the cost of each case sold. Salescommissions to the independent jobbers who sell Raul products tothe trainers and physical therapists average 10 percent of sales.Bad debts expense amounts to 1 percent of sales.

The cost per case for each customer category can be computed asfollows:

Medallion Gym:
Manufacturing cost per case	$169.00
Box and special labelling ($0.34 Ã100)	34.00
Shipping ($1,400,000/175,000cases)	8.00
Total cost per case	$211.00

Individual Trainers and PhysicalTherapists:
Manufacturing cost per case	$169.00
Special handling	20.00
Sales commission ($241 x 0.10)	24.10
Bad debts expense ($241 x0.01)	2.41
Total cost per case	$215.51

Profit and profit percentages are as follows:

	Medallion Gym	Trainers and Physical Therapists
Price per case	$235.00	$241.00
Less: cost per case	211.00	215.51
Profit per case	$24.00	$25.49
Profit percentage	10.21%	10.58%

The company will need to see if the profit percentages range areclose to one another; if so, there would be a cost justificationfor the price differential. If not, the company may need toconsider potential price discrimination and change its price forthe customer group that it considers to be "out of line."

For each of the following situations, determine whether or notthere is price discrimination according to the Robinson-PatmanAct.

1.	Dr. Jeffrey Lowman, M.D., chargesless to patients who he feels cannot afford his usual fee.- Selectyour answer -YesNoItem 1

2.	Damian Company manufacturesspecialty jams and jellies. Damian is located in Amarillo, Texas,and sells only to stores in the Amarillo area. Sometimes Damianoffers a price break to store owners whose children attend the sameschools as Damian's children. - Select your answer -YesNoItem2

3.	A national manufacturer of hairproducts charges a significantly lower price to large chain storesthan to smaller stores. The price differential is not supported bycost differences. - Select your answer -YesNo

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SMG AC 222 Lecture Notes - Lecture 3: Cost Driver, Finished Good, Income Statement

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