PLEASE COMPLETE NO LATER THAN 10/14 @3:30PM

Each question(1,2,& 3) must be a minimum of 200 words. Please EXPLAIN answers in FULL detail and make answers knowledgeable based off the attached reading, also using outside scholarly sources.

ARE YOU ABLE TO COMPLETE THIS FOR ME? 20.00

ATC 5-1 (Pg. 246)

(Using ABC to improve product pricing) Answer the four questions posed in the case. Include in your answer the basic differences between volume based (traditional) overhead application procedures and the ABC method.

Describe the production characteristics (for example, high-volume, specialty, etc.) of the three products manufactured by Drilling Innovations, Inc. in our case study.

Describe the characteristics of products which would suggest it would be better to use ABC as an indirect cost allocation method over a traditional method such as direct labor hours.

This discussion must be a minimum of 100 words:

Define and discuss the difference between indirect and direct cost. Provide an example of each. In your initial response, please do not use citations to convey your understanding. Based on your reading, please communicate your own understanding of the requirements. Students are allowed to use one citation in each response to their peers.

edm10890_ch04_150-201.indd Page 150 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd CHAPTER 4 Cost Accumulation, Tracing, and Allocation LEARNING OBJECTIVES W I L S O N , After you have mastered the material in this chapter, you will be able to: 1 2 3 4 5 6 7 8 9 Q U Distinguish direct costs from indirect costs. A Allocate indirect costs to cost objects. S Select appropriate cost drivers for allocating indirect costs. H Allocate costs to solve timing problems. E Explain the benefits and detriments of allocating pooled costs. Identify cost objects and cost drivers. Allocate joint product costs. 1 9 Allocate service department costs to operating departments (Appendix). 9 7 B CHAPTER OPENING U Recognize the effects of cost allocation on employee motivation. What does it cost? This is one of the questions most frequently asked by business managers. Managers must have reliable cost estimates to price products, evaluate performance, control operations, and prepare financial statements. As this discussion implies, managers need to know the cost of many different things. The things we are trying to determine the cost of are commonly called cost objects. For example, if we are trying to determine the cost of operating a department, that department is the cost object. Cost objects may be products, processes, departments, services, activities, and so on. This chapter explains techniques managerial accountants use to determine the cost of a variety of cost objects. 150 edm10890_ch04_150-201.indd Page 151 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd The Curious Accountant A former patient of a California hospital complained about being charged $7 for a single aspirin tablet. After all, an entire bottle of 100 aspirins can be purchased at the local pharmacy store for around $2. Can you think of any reasons, other than shameless profiteering, that a hospital would need to charge $7 for an aspirin? Remember that the hospital is not just selling the aspirin; it is also delivering it to the patient. (Answer on page 159.) W I L S O N , Q U A S H E 1 9 9 7 B U 151 edm10890_ch04_150-201.indd Page 152 152 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 4 DETERMINE THE COST OF COST OBJECTS LO 1 Identify cost objects and cost drivers. Accountants use cost accumulation to determine the cost of a particular object. Suppose the Atlanta Braves advertising manager wants to promote a Tuesday night ball game by offering free baseball caps to all children who attend. What would be the promotion cost? The team's accountant must accumulate many individual costs and add them together. For simplicity consider only three cost components: (1) the cost of the caps, (2) the cost of advertising the promotion, and (3) the cost of an employee to work on the promotion. Cost accumulation begins with identifying the cost objects. The primary cost object is the cost of the promotion. Three secondary cost objects are (1) the cost of caps, (2) the cost of advertising, and (3) the cost of labor. The costs of the secondary cost objects are combined to determine the cost of the primary cost object. Determining the costs of the secondary cost objects requires identifying what drives those costs. A cost driver has a cause-and-effect relationW ship with a cost object. For example, the number of caps (cost driver) has an effect on the cost of caps (cost object). The number of advertisements is I a cost driver for the advertising cost (cost object); the number of labor hours worked is a L driver for the labor cost (cost object). Using the folcost lowing assumptions about unit costs and cost drivers, the accumulated S cost of the primary cost object (cost of the cap promotion) is: Cost Object Cost of caps Cost of advertising Cost of labor Cost of cap promotion O N Cost Per Unit , $2.50 $100.00 $8.00 3 Cost Driver 5 Total Cost of Object 3 3 3 4,000 Caps 50 Advertisements 100 Hours 5 5 5 $10,000 5,000 800 $15,800 Q U A The Atlanta Braves should run the promotion if management expects it to produce S additional revenues exceeding $15,800. H Estimated versus Actual Cost E The accumulated cost of the promotion$15,800is an estimate. Management cannot know actual costs and revenues until after running the promotion. While actual information is more accurate, it is not relevant for deciding whether to run the promotion 1 because the decision must be made before the actual cost is known. Managers must ac9 cept a degree of inaccuracy in exchange for the relevance of timely information. Many business decisions are based on9 estimated rather than actual costs. Managers use cost estimates to set prices, bid on contracts, evaluate proposals, 7 distribute resources, plan production, and set goals. Certain circumstances, however, require actual cost data. For B example, published financial reports and managerial performance evaluations use actual cost data. Managers frequently accumulate both U estimated and actual cost data for the same cost object. For example, companies use cost estimates to establish goals and use actual costs to evaluate management performance in meeting those goals. The following discussion provides a number of business examples that use estimated data, actual data, or a combination of both. ASSIGNMENT OF COSTS TO OBJECTS IN A RETAIL BUSINESS Exhibit 4.1 displays the January income statement for In Style, Inc. (ISI), a retail clothing store. ISI subdivides its operations into women's, men's, and children's departments. To encourage the departmental managers to maximize sales, ISI began edm10890_ch04_150-201.indd Page 153 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Cost Accumulation, Tracing, and Allocation 153 paying the manager of each department a bonus based on a percentage of departmental sales revenue. Although the bonus incentive increased sales revenue, it also provoked negative consequences. The departmental managers began to argue over floor space; each manager wanted more space to display merchandise. The managers reduced prices; they increased sales commissions. In the drive to maximize sales, the managers ignored the need to control costs. To improve the situation, the store manager decided to base future bonuses on each department's contribution to profitability rather than its sales revenue. IDENTIFYING DIRECT AND INDIRECT COSTS The new bonus strategy requires determining the cost of operating each department. LO 2 Each department is a separate cost object. Assigning costs to the departments (cost objects) requires cost tracing and cost allocation. Direct costs can be easily traced to a cost object. Indirect costs cannot be easily traced to a cost object. Whether or not a cost Distinguish direct costs from W is easily traceable requires cost/benefit analysis. indirect costs. I Some of ISI's costs can be easily traced to the cost EXHIBIT 4.1 L objects (specific departments). The cost of goods sold is an example of an easily traced cost. Price tags on merchandise S Income Statement can be coded so cash register scanners capture the departO mental code for each sale. The cost of goods sold is not only IN STYLE, INC. easily traceable but also very useful information. Companies N Income Statement need cost of goods sold information for financial reporting , (income statement and balance sheet) and for management For the Month Ended January 31 decisions (determining inventory reorder points, pricing Sales $360,000 strategies, and cost control). Because the cost of tracing cost Cost of goods sold (216,000) Q of goods sold is small relative to the benefits obtained, cost Gross margin 144,000 of goods sold is a direct cost. U Sales commissions (18,000) In contrast, the cost of supplies (shopping bags, sales Dept. managers' salaries (12,000) A is slips, pens, staples, price tags) used by each department Store manager's salary (9,360) much more difficult to trace. How could the number of S staDepreciation (16,000) ples used to seal shopping bags be traced to any particular Rental fee for store (18,400) department? The sales staff could count the number of H staUtilities (2,300) ples used, but doing so would be silly for the benefitsE obAdvertising (7,200) tained. Although tracing the cost of supplies to each Supplies (900) department may be possible, it is not worth the effort of doNet income $ 59,840 1 ing so. The cost of supplies is therefore an indirect cost. Indirect costs are also called overhead costs. 9 Direct and indirect costs can be described as follows: 9 7 Direct costs can be traced to cost objects in a cost-effective manner. Indirect costs cannot be traced to objects in a cost-effective manner. B U By analyzing the accounting records, ISI's accountant classified the costs from the income statement in Exhibit 4.1 as direct or indirect, as shown in Exhibit 4.2. The next paragraph explains the classifications. All figures represent January costs. Items 1 though 4 are direct costs, traceable to the cost objects in a cost-effective manner. Cost of goods sold is traced to departments at the point of sale using cash register scanners. Sales commissions are based on a percentage of departmental sales and are therefore easy to trace to the departments. Departmental managers' salaries are also easily traceable to the departments. Equipment, furniture, and fixtures are tagged with department codes that permit tracing depreciation charges directly to specific departments. Items 5 through 8 are incurred on behalf of the company as a whole and are therefore not directly traceable to a specific department. edm10890_ch04_150-201.indd Page 154 154 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 4 EXHIBIT 4.2 Income Statement Classification of Costs Direct Costs Cost Item 1. Cost of goods sold$216,000 2. Sales commissions$18,000 3. Dept. managers' salaries$12,000 4. Depreciation$16,000 5. Store manager's salary 6. Rental fee for store 7. Utilities 8. Advertising 9. Supplies W Totals Women's Men's Children's $120,000 9,500 5,000 7,000 $58,000 5,500 4,200 5,000 Indirect Costs $38,000 3,000 2,800 4,000 $141,500 $72,700 $47,800 $ 9,360 18,400 2,300 7,200 900 $38,160 I L S Although Item 9 could be traced to specific departments, the cost of doing so would exceed the benefits. The cost of O supplies is therefore also classified as indirect. N Cost ClassificationsIndependent and Context Sensitive , Whether a cost is direct or indirect is independent of whether it is fixed or variable. In the ISI example, both cost of goods sold and the cost of supplies vary relative to sales volume (both are variable costs), but cost of goods sold is direct and the cost of supQ plies is indirect. Furthermore, the cost of rent and the cost of depreciation are both U fixed relative to sales volume, but the cost of rent is indirect and the cost of depreciation is direct. In fact, the very same cost can be classified as direct or indirect, dependA ing on the cost object. The store manager's salary is not directly traceable to a specific department, but it is traceableS a particular store. As these examples demonstrate, to cost classification depends on the context in which the costs occur. H LO 3 Allocate indirect costs to cost objects. E ALLOCATING INDIRECT COSTS TO OBJECTS 1 Common costs support multiple cost objects, but cannot be directly traced to any specific object. In the case of In Style, Inc., the cost of renting the store (common cost) 9 supports the women's, men's, and children's departments (cost objects). The depart9 mental managers may shirk responsibility for the rental cost by claiming that others higher up the chain of command are responsible. Responsibility can be motivated at 7 the departmental level by assigning (allocating) a portion of the total rental cost to B each department. To accomplish appropriateU motivation, authority must accompany responsibility. In other words, the departmental managers should be held responsible for a portion of rental cost only if they are able to exercise some degree of control over that cost. For example, if managers are assigned a certain amount of the rental cost for each square foot of space they use, they should have the authority to establish the size of the space used by their departments. Controllable costs are costs that can be influenced by a manager's decisions and actions. The controllability concept is discussed in more detail in Chapter 9. Cost allocation involves dividing a total cost into parts and assigning the parts to designated cost objects. How should ISI allocate the $38,160 of indirect costs to each of the three departments? First, identify a cost driver for each cost to be allocated. For example, there is a cause-and-effect relationship between store size and rent cost; edm10890_ch04_150-201.indd Page 155 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Cost Accumulation, Tracing, and Allocation 155 REALITY BYTES How does Southwest Airlines know the cost of flying a passenger from Houston, Texas, to Los Angeles, California? The fact is that Southwest does not know the actual cost of flying particular passengers anywhere. There are many indirect costs associated with flying passengers. Some of these include the cost of planes, fuel, pilots, office buildings, and ground personnel. Indeed, besides insignificant food and beverage costs, there are few costs that could be traced directly to customers. Southwest and other airlines are forced to use allocation and averaging to determine the estimated cost of providing transportation services to customers. Estimated rather than actual cost is used for decision-making purposes. Consider that in its 2008 annual report Southwest reported W the average operating expenses of flying one passenger one I mile (called a passenger mile) were 10.2. However, this number was based on 103.3 billion \"available passenger miles.\" In L 2008 Southwest operated at 71.2 percent of capacity, not 100 percent, so it was only able to charge passengers for 73.5 billion S passenger miles. Thus, its average operating expenses were closer to 14.4 for each mile for which they were able to charge. Had they operated at a higher capacity, their average costs would have been lower. O N , the larger the building, the higher the rent cost. This relationship suggests that the more floor space a department occupies, the more rent cost that department should Q bear. To illustrate, assume ISI's store capacity is 23,000 square feet and the women's, U men's, and children's departments occupy 12,000, 7,000, and 4,000 square feet, reA spectively. ISI can achieve a rational allocation of the rent cost using the following two-step process.1 S Step 1. Compute the allocation rate by dividing the total cost to be allocated ($18,400 H rental fee) by the cost driver (23,000 square feet of store space). The cost driver E is also called the allocation base. This computation produces the allocation rate, as follows: Total cost to be allocated 4 Cost driver (allocation base) 5 Allocation rate 1 $18,400 rental fee Step 2. 23,000 square feet 9 5 9 $0.80 per square foot Multiply the allocation rate by the weight of the cost driver (weight of the 7 base) to determine the allocation per cost object, as follows: Cost Object Women's department Men's department Children's department Total 1 4 B Number U of Allocation Rate 3 Square Feet 5 $0.80 0.80 0.80 3 3 3 12,000 7,000 4,000 23,000 5 5 5 Allocation per Cost Object $ 9,600 5,600 3,200 $18,400 Other mathematical approaches achieve the same result. This text consistently uses the two-step method described here. Specifically, the text determines allocations by (1) computing a rate and (2) multiplying the rate by the weight of the base (cost driver). edm10890_ch04_150-201.indd Page 156 156 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 4 It is also plausible to presume utilities cost is related to the amount of floor space a department occupies. Larger departments will consume more heating, lighting, air conditioning, and so on than smaller departments. Floor space is a reasonable cost driver for utility cost. Based on square footage, ISI can allocate utility cost to each department as follows: Step 1. Compute the allocation rate by dividing the total cost to be allocated ($2,300 utility cost) by the cost driver (23,000 square feet of store space): Total cost to be allocated 4 $2,300 utility cost Step 2. Cost driver 5 Allocation rate 4 23,000 square feet 5 $0.10 per square foot Multiply the allocation rate by the weight of the cost driver to determine the allocation per cost object: Cost Object Women's department Men's department Children's department Total Allocation W Rate I $0.10 0.10 L 0.10 S O N , 3 3 3 3 Number of Square Feet 12,000 7,000 4,000 23,000 5 Allocation per Cost Object 5 5 5 $1,200 700 400 $2,300 CHECK YOURSELF 4.1 HealthCare, Inc., wants to estimateQ cost of operating the three departments (Dermatology, the Gynecology, and Pediatrics) that serve patients in its Health Center. Each department perU formed the following number of patient treatments during the most recent year of operation: A Dermatology, 2,600; Gynecology, 3,500; and Pediatrics, 6,200. The annual salary of the Health Center's program administrator is $172,200. How much of the salary cost should HealthCare S allocate to the Pediatrics Department? Answer Step 1 H E Compute the allocation rate. Total cost to be allocated 4 Cost driver (patient treatments) 5 Allocation rate 1(2,600 1 3,500 1 6,200) 5 $14 per patient treatment $172,200 salary cost 4 9 Step 2 Multiply the allocation rate by the weight of the cost driver (weight of the base) to 9 determine the allocation per cost object. 7 Allocation No. of Allocation per B Cost Object Rate 3 Treatments 5 Cost Object U Pediatrics department $14 3 6,200 5 $86,800 SELECTING A COST DRIVER LO 4 Select appropriate cost drivers for allocating indirect costs. Companies can frequently identify more than one cost driver for a particular indirect cost. For example, ISI's shopping bag cost is related to both the number of sales transactions and the volume of sales dollars. As either of these potential cost drivers increases, shopping bag usage also increases. The most useful cost driver is the one with the strongest cause-and-effect relationship. edm10890_ch04_150-201.indd Page 157 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Cost Accumulation, Tracing, and Allocation Consider shopping bag usage for T-shirts sold in the children's department versus T-shirts sold in the men's department. Assume ISI studied T-shirt sales during the first week of June and found the following: Department Children's Men's 120 $1,440 92 $1,612 Number of sales transactions Volume of sales dollars Given that every sales transaction uses a shopping bag, the children's department uses far more shopping bags than the men's department even though it has a lower volume of sales dollars. A reasonable explanation for this circumstance is that children's T-shirts sell for less than men's T-shirts. The number of sales transactions is the better cost driver because it has a stronger cause-and-effect relationship W with shopping bag usage than does the volume of sales dollars. Should ISI therefore use the number of sales transactions to allocate supply cost to the departments? I Not necessarily. L The availability of information also influences cost driver selection. While the numS ber of sales transactions is the more accurate cost driver, ISI could not use this allocation base unless it maintains records of the number of sales transactions per department. O If the store tracks the volume of sales dollars but not the number of transactions, it N must use dollar volume even if the number of transactions is the better cost driver. For ISI, sales volume in dollars appears to be the best available cost driver for allocating , supply cost. Assuming that sales volume for the women's, men's, and children's departments was $190,000, $110,000, and $60,000, respectively, ISI can allocate the supplies cost as follows: Q Step 1. Compute the allocation rate by dividing the total cost to be allocated ($900 U supplies cost) by the cost driver ($360,000 total sales volume): A 5 Allocation rate S $900 supplies cost 4 $360,000 sales volume H $0.0025 per sales dollar 5 E Multiply the allocation rate by the weight of the cost driver to determine the Total cost to be allocated 4 Step 2. Cost driver allocation per cost object: Cost Object Women's department Men's department Children's department Total Allocation Rate 3 $0.0025 0.0025 0.0025 3 3 3 1 Sales 9 Volume 9 $190,000 7 110,000 60,000 B $360,000 U 5 5 5 5 Allocation per Cost Object $475 275 150 $900 ISI believes sales volume is also the appropriate allocation base for advertising cost. The sales generated in each department were likely influenced by the general advertising campaign. ISI can allocate advertising cost as follows: Step 1. Compute the allocation rate by dividing the total cost to be allocated ($7,200 advertising cost) by the cost driver ($360,000 total sales volume): Total cost to be allocated 4 Cost driver 5 Allocation rate $7,200 advertising cost 4 $360,000 sales volume 5 $0.02 per sales dollar 157 edm10890_ch04_150-201.indd Page 158 158 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 4 Step 2. Multiply the allocation rate by the weight of the cost driver to determine the allocation per cost object: Cost Object Allocation Rate 3 $0.02 0.02 0.02 3 3 3 Women's department Men's department Children's department Total Sales Volume $190,000 110,000 60,000 $360,000 Allocation per Cost Object 5 $3,800 2,200 1,200 $7,200 5 5 5 There is no strong cause-and-effect relationship between the store manager's salary and the departments. ISI pays the store manager the same salary regardless of sales level, square footage of store space, number of labor hours, or any other identifiable W variable. Because no plausible cost driver exists, ISI must allocate the store manager's I salary arbitrarily. Here the manager's salary is simply divided equally among the departments as follows: L Step 1. S Compute the allocation rate by dividing the total cost to be allocated ($9,360 manager's monthly salary) by the allocation base (number of O departments): N , Total cost to be allocated 4 Cost driver 5 Allocation rate $9,360 store manager's salary 4 3 departments 5 $3,120 per department Step 2. Multiply the allocation rate by the weight of the cost driver to determine the Q allocation per cost object: Cost Object Women's department Men's department Children's department Total U A Allocation S Rate H $3,120 E 3,120 3,120 3 3 3 3 Number of Departments 1 1 1 3 5 5 5 5 Allocation per Cost Object $3,120 3,120 3,120 $9,360 1 9 9 As the allocation of the store manager's salary demonstrates, many allocations are arbitrary or based on a weak relationship between the allocated cost and the 7 allocation base (cost driver). Managers must use care when making decisions using B allocated costs. U Behavioral Implications Using the indirect cost allocations just discussed, Exhibit 4.4 shows the profit each department generated in January. ISI paid the three departmental managers bonuses based on each department's contribution to profitability. The store manager noticed an immediate change in the behavior of the departmental managers. For example, the manager of the women's department offered to give up 1,000 square feet of floor space because she believed reducing the selection of available products would not reduce sales significantly. Customers would simply buy different brands. Although sales would not decline dramatically, rent and utility cost allocations to the women's department would decline, increasing the profitability of the department. edm10890_ch04_150-201.indd Page 159 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Cost Accumulation, Tracing, and Allocation 159 W When we compare the cost that a hospital charges for an aspirin to the price Answers to The Curious Accountant we pay for an aspirin, we are probably w not considering the full cost that we incur to purchase aspirin. If someone asks you what you pay for an aspirin, you would probably take the price of a bottle, say $2, and divide it by the number of pills in the bottle, say 100. This would suggest their cost is $0.02 each. Now, consider what it cost to buy the aspirins when all costs are considered. First, there is your time to drive to the store; what do you get paid per hour? Then, there is the cost of operating your automobile. You get the idea; in reality, the cost of an aspirin, from a business perspective, is much more than just the cost of the pills themselves. Exhibit 4.3 shows the income statement of Hospital Corporation of America (HCA) for three recent years. W I ated 271 facilities in 20 states and England. As you can see, while it generated over $28 billion in revenue, it also L incurred a lot of expenses. Look at its first two expense categories. Although it incurred $4.6 billion in supplies S expenses, it incurred almost two and a half times this amount in compensation expense. In other words, it cost a O lot more to have someone deliver the aspirin to your bed than the aspirin itself costs. N In 2008 HCA earned $673 million from its $28.4 billion in revenues. This is a return on sales percentage of , HCA claims to be \" . . . one of the leading health care services companies in the United States.\" In 2008 it oper- 2.4 percent ($.673 4 $28.4). Therefore, on a $7 aspirin, HCA would earn 17 cents of profit, which is still not a bad profit for selling one aspirin. As a comparison, in 2008, Walgreens return on sales was 3.7 percent. Q U EXHIBIT 4.3 A HCA, INC. S Consolidated Income Statements H for the Years Ended December 31, 2008, 2007, and 2006 (Dollars in millions, except per share amounts) E 2008 1 Revenues Salaries and benefits 9 Supplies 9 Other operating expenses Provision for doubtful accounts 7 Gains on investments Equity in earnings of affiliates B Depreciation and amortization U Interest expense Gains on sales of facilities Transaction costs Impairment of long-lived assets Total expenses Income before minority interests and income taxes Minority interests in earnings of consolidated entities Income before income taxes Provision for income taxes Net income 2007 2006 $28,374 11,440 4,620 4,554 3,409 (223) 1,416 2,021 (97) $26,858 10,714 4,395 4,241 3,130 (8) (206) 1,426 2,215 (471) 64 27,204 1,170 229 941 268 $ 673 24 25,460 1,398 208 1,190 316 $ 874 $25,477 10,409 4,322 4,056 2,660 (243) (197) 1,391 955 (205) 442 24 23,614 1,863 201 1,662 626 $ 1,036 edm10890_ch04_150-201.indd Page 160 160 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 4 EXHIBIT 4.4 Profit Analysis by Department Department Women's Sales Cost of goods sold Sales commissions Dept. managers' salary Depreciation Store manager's salary Rental fee for store Utilities Advertising Supplies Departmental profit Men's Children's Total $190,000 (120,000) (9,500) (5,000) (7,000) (3,120) (9,600) (1,200) (3,800) (475) W $ 30,305 $110,000 (58,000) (5,500) (4,200) (5,000) (3,120) (5,600) (700) (2,200) (275) $ 25,405 $60,000 (38,000) (3,000) (2,800) (4,000) (3,120) (3,200) (400) (1,200) (150) $ 4,130 $360,000 (216,000) (18,000) (12,000) (16,000) (9,360) (18,400) (2,300) (7,200) (900) $ 59,840 I L S In contrast, the manager of the children's department wanted the extra space. He O believed the children's department was losing sales because it did not have enough N floor space to display a competitive variety of merchandise. Customers came to the store to shop at the women's department, but they did not come specifically for chil, dren's wear. With additional space, the children's department could carry items that would draw customers to the store specifically to buy children's clothing. He believed the extra space would increase sales enough to cover the additional rent and utility Q cost allocations. U The store manager was pleased with the emphasis on profitability that resulted from tracing and assigning costs to specific departments. A S EFFECTS OF COSTH BEHAVIOR ON SELECTING E THE MOST APPROPRIATE COST DRIVER LO 4 Select appropriate cost drivers for allocating indirect costs. As previously mentioned, indirect costs may exhibit variable or fixed cost behavior 1 patterns. Failing to consider the effects of cost behavior when allocating indirect costs can lead to significant distortions in product cost measurement. We examine 9 the critical relationships between cost behavior and cost allocation in the next 9 section of the text. 7 B Using Volume Measures to Allocate Variable Overhead Costs U A causal relationship exists between variable overhead product costs (indirect materials, indirect labor, inspection costs, utilities, etc.) and the volume of production. For example, the cost of indirect materials such as glue, staples, screws, nails, and varnish will increase or decrease in proportion to the number of desks a furniture manufacturing company makes. Volume measures are good cost drivers for allocating variable overhead costs. Volume can be expressed by such measures as the number of units produced, the number of labor hours worked, or the amount of direct materials used in production. Given the variety of possible volume measures, how does management identify the most appropriate cost driver (allocation base) for assigning particular overhead costs? Consider the case of Filmier Furniture Company. edm10890_ch04_150-201.indd Page 161 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Cost Accumulation, Tracing, and Allocation Using Units as the Cost Driver During the most recent year, Filmier Furniture Company produced 4,000 chairs and 1,000 desks. It incurred $60,000 of indirect materials cost during the period. How much of this cost should Filmier allocate to chairs versus desks? Using number of units as the cost driver produces the following allocation: Step 1. Compute the allocation rate. Total cost to be allocated 4 Cost driver 5 Allocation rate $60,000 indirect materials cost 4 5,000 units 5 $12 per unit Step 2. Multiply the allocation rate by the weight of the cost driver to determine the allocation per cost object. Product Allocation Rate Number of Units Produced 3 5 Allocated Cost W 5 $12,000 5 48,000 I 5 $60,000 L S Using Direct Labor Hours as the Cost Driver O Using the number of units as the cost driver assigns an equal amount ($12) of indirect N materials cost to each piece of furniture. However, if Filmier uses more indirect materials to make a desk than to make a chair, assigning the same amount of indirect materi, Desks Chairs Total $12 12 1,000 4,000 5,000 3 3 als cost to each is inaccurate. Assume Filmier incurs the following direct costs to make chairs and desks: Q Total U Direct labor hours 3,500 hrs. 2,500 hrs. 6,000 hrs. A Direct materials cost $1,000,000 $500,000 $1,500,000 S H Both direct labor hours and direct materials cost are volume measures that indicate Filmier uses more indirect materials to make a desk than a chair. It makes sense E Desks Chairs that the amount of direct labor used is related to the amount of indirect materials used. Because production workers use materials to make furniture, it is plausible to assume that the more hours they work, the more materials they use. Using this reason1 ing, Filmier could assign the indirect materials cost to the chairs and desks as follows: Step 1. Step 2. 9 9 Total cost to be allocated 4 Cost driver 5 Allocation rate 7 $60,000 indirect materials cost 4 6,000 hours 5 $10 per hour B Multiply the allocation rate by the weight of the cost driver. U Compute the allocation rate. Product Desks Chairs Total Allocation Rate 3 $10.00 10.00 3 3 Number of Labor Hours 5 Allocated Cost 3,500 2,500 6,000 5 5 5 $35,000 25,000 $60,000 Basing the allocation on labor hours rather than number of units assigns a significantly larger portion of the indirect materials cost to desks ($35,000 versus $12,000). Is this allocation more accurate? Suppose the desks, but not the chairs, require elaborate, 161 edm10890_ch04_150-201.indd Page 162 162 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 4 labor-intensive carvings. A significant portion of the labor is then not related to consuming indirect materials (glue, staples, screws, nails, and varnish). It would therefore be inappropriate to allocate the indirect materials cost based on direct labor hours. Using Direct Material Dollars as the Cost Driver If labor hours is an inappropriate allocation base, Filmier can consider direct material usage, measured in material dollars, as the allocation base. It is likely that the more lumber (direct material) Filmier uses, the more glue, nails, and so forth (indirect materials) it uses. It is reasonable to presume direct materials usage drives indirect materials usage. Using direct materials dollars as the cost driver for indirect materials produces the following allocation: Step 1. Compute the allocation rate. Total cost to be allocated 4 $60,000 indirect materials costW Step 2. 4 Cost driver 5 Allocation rate $1,500,000 direct $0.04 per direct 5 material dollars material dollar I Multiply the allocation rate by the weight of the cost driver. Product Desks Chairs Total L Allocation S Rate O $0.04 N 0.04 , 3 Number of Direct Material Dollars 5 Allocated Cost $1,000,000 500,000 $1,500,000 5 5 5 $40,000 20,000 $60,000 3 3 Q Selecting the Best Cost Driver U Which of the three volume-based cost drivers (units, labor hours, or direct material A dollars) results in the most accurate allocation of the overhead cost? Management S must use judgment to decide. In this case, direct material dollars appears to have the most convincing relationship H indirect materials usage. If the cost Filmier was to allocating were fringe benefits, however, direct labor hours would be a more approE priate cost driver. If the cost Filmier was allocating were machine maintenance cost, a different volume-based cost driver, machine hours, would be an appropriate base. The most accurate allocations of indirect costs may actually require using multiple 1 cost drivers. One candy bar, two kidshow should we divide it? 9 9 7 B should U Iget more because I'm bigger. You don't need more; you're too big as it is. I should get more. Choosing the right allocation base. Now that's a serious problem. edm10890_ch04_150-201.indd Page 163 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Cost Accumulation, Tracing, and Allocation CHECK YOURSELF 4.2 Boston Boat Company builds custom sailboats for customers. During the current accounting period, the company built five different-sized boats that ranged in cost from $35,000 to $185,000. The company's manufacturing overhead cost for the period was $118,000. Would you recommend using the number of units (boats) or direct labor hours as the base for allocating the overhead cost to the five boats? Why? Using the number of units as the allocation base would assign the same amount of overhead cost to each boat. Since larger boats require more overhead cost (supplies, utilities, equipment, etc.) than smaller boats, there is no logical link between the number of boats and the amount of overhead cost required to build a particular boat. In contrast, there is a logical link between direct labor hours used and overhead cost incurred. The more labor used, the more supplies, utilities, equipment, and so on used. Since larger boats require more direct labor than smaller boats, using direct labor hours as the allocation base W would allocate more overhead cost to larger boats and less overhead cost to smaller boats, producing a logical overhead allocation. Therefore, Boston should use direct labor hours as I the allocation base. Answer L S O Allocating Fixed Overhead Costs N Fixed costs present a different cost allocation problem. By definition, the volume of production does not drive fixed , costs. Suppose Lednicky Bottling Company rents its manufacturing facility for $28,000 per year. The rental cost is fixed regardless of how much product Lednicky bottles. Q However, Lednicky may still use a volume-based cost driver U as the allocation base. The object of allocating fixed costs to products is to distribute a rational share of the overhead A cost to each product. Selecting an allocation base that S spreads total overhead cost equally over total production H often produces a rational distribution. For example, assume Lednicky produced 2,000,000 bottles of apple juice during E 2011. If it sold 1,800,000 bottles of the juice during 2011, how much of the $28,000 of rental cost should Lednicky allocate to ending inventory and how much to cost of goods 1 sold? A rational allocation follows: 9 9 Total cost to be allocated 4 Allocation base (cost driver) 5 Allocation rate 7 $28,000 rental cost 4 2,000,000 units 5 $0.014 per bottle of juice B Because the base (number of units) used to allocate the cost does not drive the cost, it U is sometimes called an allocation base instead of a cost driver. However, many managers Step 1. Compute the allocation rate. use the term cost driver in conjunction with fixed cost even though that usage is technically inaccurate. The terms allocation base and cost driver are frequently used interchangeably. Step 2. Multiply the allocation rate by the weight of the cost driver. Financial Statement Item Inventory Cost of goods sold Allocation Rate 3 Number of Bottles 5 Allocated Cost $0.014 0.014 3 3 200,000 1,800,000 5 5 $ 2,800 25,200 163 edm10890_ch04_150-201.indd Page 164 164 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 4 Using number of units as the allocation base assigns equal amounts of the rental cost to each unit of product. Equal allocation is appropriate so long as the units are homogeneous. If the units are not identical, however, Lednicky may need to choose a different allocation base to rationally distribute the rental cost. For example, if some of the bottles are significantly larger than others, Lednicky may find using some physical measure, like liters of direct material used, to be a more appropriate allocation base. Whether an indirect cost is fixed or variable, selecting the most appropriate allocation base requires sound reasoning and judgment. ALLOCATING COSTS TO SOLVE TIMING PROBLEMS LO 5 Allocate costs to solve timing problems. Under certain circumstances products may be made before or after the costs associated with making them have been incurred. Suppose, for example, premiums for an annual insurance policy are paid in March. The insurance cost benefits the products made in the months before and after March as well as those produced in March. Allocation can be used to spread the insurance cost over products made during the entire accounting W period rather than charging the total cost only to products made in March. I Monthly fluctuations in production volume complicate fixed cost allocations. To L illustrate, assume Grave Manufacturing pays its production supervisor a monthly salary of $3,000. Furthermore, assume Grave makes 800 units of product in January and 1,875 S in February. How much salary cost should Grave assign to the products made in January and February, respectively? TheO allocation seems simple. Just divide the $3,000 monthly salary cost by the number of units of product made each month as follows: N January $3,000 4 , 800 units 5 $3.75 cost per unit February $3,000 4 1,875 units 5 $1.60 cost per unit If Grave Manufacturing based a cost-plus pricing decision on these results, it would Q price products made in January significantly higher than products made in February. It U is likely such price fluctuations would puzzle and drive away customers. Grave needs an allocation base that will spread A annual salary cost evenly over annual production. A the timing problem exists, however, because Grave must allocate the salary cost before the S end of the year. In order to price its products, Grave needs to know the allocated amount before the actual cost H information is available. Grave can manage the timing problem by using estimated rather than actual costs. E Grave Manufacturing can estimate the annual cost of the supervisor's salary (indirect labor) as $36,000 ($3,000 3 12 months). The actual cost of indirect labor may differ because the supervisor might receive a pay raise or be replaced with a person who earns 1 less. Based on current information, however, $36,000 is a reasonable estimate of the 9 annual indirect labor cost. Grave must also estimate total annual production volume. Suppose Grave produced 18,000 units last year and expects no significant change in the 9 current year. It can allocate indirect labor cost for January and February as follows: Step 1. 7 B Total cost to be allocated U Compute the allocation rate. $36,000 Step 2. 4 Allocation base 5 Allocation rate (cost driver) 4 18,000 units 5 $2.00 per unit Multiply the rate by the weight of the base (number of units per month) to determine how much of the salary cost to allocate to each month's production. Month January February Allocation Rate 3 Number of Units Produced 5 Allocation per Month $2.00 2.00 3 3 800 1,875 5 5 $1,600 3,750 edm10890_ch04_150-201.indd Page 165 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Cost Accumulation, Tracing, and Allocation 165 Grave Manufacturing will add these indirect cost allocations to other product costs to determine the total estimated product cost to use in cost-plus pricing or other managerial decisions. Because the overhead allocation rate is determined before actual cost and volume data are available, it is called the predetermined overhead rate. Companies use predetermined overhead rates for product costing estimates and pricing decisions during a year, but they must use actual costs in published year-end financial statements. If necessary, companies adjust their accounting records at year-end when they have used estimated data on an interim basis. The procedures for making such adjustments are discussed in a later chapter. AGGREGATING AND DISAGGREGATING INDIVIDUAL COSTS INTO COST POOLS Allocating individually every single indirect cost a company incurs would be tedious and W not particularly useful relative to the benefit obtained. Instead, companies frequently I accumulate many individual costs into a single cost pool. The total of the pooled cost is then allocated to the cost objects. For example, a company may accumulate costs for L gas, water, electricity, and telephone service into a single utilities cost pool. It would S then allocate the total cost in the utilities cost pool to the cost objects rather than indiO vidually allocating each of the four types of utility costs. How far should pooling costs go? Why not pool utility costs with indirect labor N costs? If the forces driving the utility costs are different from the forces driving the , labor costs, pooling the costs will likely reduce the reliability of any associated cost allocations. To promote accuracy, pooling should be limited to costs with common cost drivers. Q Costs that have been pooled for one purpose may require disaggregation for a different purpose. Suppose all overhead costs are pooled for the purpose of determining U the cost of making a product. Further, suppose that making the product requires two A processes that are performed in different departments. A cutting department makes heavy use of machinery to cut raw materials into product parts. An assembly departS ment uses human labor to assemble the parts into a finished product. Now suppose the objective changes from determining the cost of making H product to determining the the cost of operating each department. Under these circumstances, it may be necessary to E disaggregate the total overhead cost into smaller pools such as a utility cost pool, an indirect labor cost pool, and so on so that different drivers can be used to allocate these costs to the two departments. 1 9 9 ALLOCATING JOINT COSTS 7 Joint costs are common costs incurred in the process of making two or more joint B products. The cost of raw milk is a joint cost of producing the joint products cream, U whole milk, 2 percent milk, and skim milk. Joint costs include not only materials costs but also the labor and overhead costs of converting the materials into separate products. The point in the production process at which products become separate and identifiable is the split-off point. For financial reporting of inventory and cost of goods sold, companies must allocate the joint costs to the separate joint products. Some joint products require additional processing after the split-off point. Any additional materials, labor, or overhead costs incurred after the split-off point are assigned to the specific products to which they relate. To illustrate, assume Westar Chemical Company produces from common raw materials the joint products Compound AK and Compound AL. Compound AL requires further processing before Westar can sell it. The diagram in Exhibit 4.5 illustrates the joint product costs. LO 6 Explain the benefits and detriments of allocating pooled costs. LO 7 Allocate joint product costs. edm10890_ch04_150-201.indd Page 166 166 7/12/10 9:03 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 4 EXHIBIT 4.5 Allocation of Joint Cost Joint materials $27,000 Joint processing $21,000 Sales Split-off point Compound AL $12,000 $50,000 COGS Compound AK $36,000 (36,000) Gross margin $14,000 Joint products Sales $13,000 COGS (20,000) Gross margin Additional processing $8,000 $(7,000) Total joint costs $48,000 The joint costs of producing a batch of the two compounds are $48,000, represenW ting $27,000 of materials cost and $21,000 of processing cost. A batch results in 3,000 gallons of Compound AK and I1,000 gallons of Compound AL. Westar allocates joint costs to the products based on the number of gallons produced, as follows: L Step 1. Compute the allocation rate. S Total cost to be allocated 4 Allocation base 5 Allocation rate O $48,000 joint costs N Step 2. 4 4,000 gallons 5 $12 per gallon Multiply the allocation rate by the weight of the base. , Joint Product Allocation Q Rate Compound AK Compound AL U $12 12 A 3 Number of Gallons Produced 5 Allocated Cost 3 3 3,000 1,000 5 5 $36,000 12,000 S Westar sells 3,000 gallons of Compound AK for $50,000, and 1,000 gallons of Compound H AL for $13,000. Exhibit 4.5 shows the gross margins for each product using the joint cost E allocations computed above. Relative Sales Value as 1 Allocation Base the Because Compound AL shows a $7,000 loss, a manager might mistakenly conclude that 9 Westar should stop making and selling this product. If Westar stops making Com9 pound AL, the total joint cost ($48,000) would be assigned to Compound AK and total gross margin would decline as shown below. 7 B U Sales Cost of goods sold Gross margin $63,000 (56,000) $ 7,000 With Compound AL Without Compound AL ($50,000 1 $13,000) ($36,000 1 $20,000) $50,000 (48,000) $ 2,000 To avoid the appearance that a product such as Compound AL is producing losses, many companies allocate joint cost to products based on the relative sales value of each product at the split-off point. Westar Chemical would allocate all of the joint costs to Compound AK because Compound AL has no market value at the split-off point. The resulting gross margins follow. edm10890_ch04_150-201.indd Page 167 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Cost Accumulation, Tracing, and Allocation Compound AK Sales Cost of goods sold Gross margin Compound AL $50,000 (48,000) $ 2,000 167 $13,000 (8,000) $ 5,000 Westar's total profit on the joint products is $7,000 whether it allocates the joint costs using gallons or relative market value. However, using market value as the allocation base produces a positive gross margin for both products, reducing the likelihood that a manager will mistakenly eliminate a product that is contributing to profitability. CHECK YOURSELF 4.3 W What are some logical split-off points for a meat processing company engaged in butcherI ing beef? L The first logical split-off point occurs when processing separates the hide (used S to produce leather) from the carcass. Other split-off points occur as further processing produces different cuts of meat (T-bone and New York strip steaks, various roasts, chops, O ground chuck, etc.). Answer N , COST ALLOCATION: THE HUMAN FACTOR Q Cost allocations significantly affect individuals. They may influence managers' perforU mance evaluations and compensation. They may dictate the amount of resources A various departments, divisions, and other organizational subunits receive. Control over resources usually offers managers prestige and influence over organization operaS tions. The following scenario illustrates the emotional impact and perceptions of fairH ness of cost allocation decisions. E Using Cost Allocations in a Budgeting Decision Sharon Southport, dean of the School of Business at a major state university, is in dire 1 need of a budgeting plan. Because of cuts in state funding, the money available to the 9 School of Business for copying costs next year will be reduced substantially. Dean Southport supervises four departments: management, marketing, finance, and ac9 counting. The Dean knows the individual department chairpersons will be unhappy 7 and frustrated with the deep cuts they face. B Using Cost Drivers to Make Allocations U To address the allocation of copying resources, Dean Southport decided to meet with the department chairs. She explained that the total budgeted for copying costs will be $36,000. Based on past usage, department allocations would be as follows: $12,000 for management, $10,000 for accounting, $8,000 for finance, and $6,000 for marketing. Dr. Bill Thompson, the management department chair, immediately protested that his department could not operate on a $12,000 budget for copy costs. Management has more faculty members than any other department. Dr. Thompson argued that copy costs are directly related to the number of faculty members, so copy funds should be allocated based on the number of faculty members. Dr. Thompson suggested that number of faculty members rather than past usage should be used as the allocation base. LO 8 Recognize the effects of cost allocation on employee motivation. edm10890_ch04_150-201.indd Page 168 168 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 4 Is it fair to divide the copy cost budget equally among the departments? Using the number of students as the cost driver would definitely work to the advantage of my department. I think we should allocate based on the number of faculty. W I L S O N , Since the School of Business has 72 faculty members (29 in management, 16 in accounting, 12 in finance, and 15 in marketing), the allocation should be as follows: Step 1. Step 2. Q U Total cost to be allocated 4 Cost driver 5 Allocation rate A $36,000 4 72 5 $500 per faculty member S Multiply the rate by the weight of the driver (the number of faculty per H department) to determine the allocation per object (department). E Compute the allocation rate. Department Management Accounting Finance Marketing Total Allocation Rate $500 500 500 500 3 1 3 39 39 3 Number of Faculty 29 16 12 15 5 Allocation per Department Allocation Based on Past Usage $14,500 8,000 6,000 7,500 $36,000 $12,000 10,000 8,000 6,000 $36,000 7 B U Seeing these figures, Dr. Bob Smethers, chair of the accounting department, ques- tioned the accuracy of using the number of faculty members as the cost driver. Dr. Smethers suggested the number of students rather than the number of faculty members drives the cost of copying. He argued that most copying results from duplicating syllabi, exams, and handouts. The accounting department teaches mass sections of introductory accounting that have extremely high student/teacher ratios. Because his department teaches more students, it spends more on copying costs even though it has fewer faculty members. Dr. Smethers recomputed the copy cost allocation as follows: Step 1. Compute the allocation rate based on number of students. University records indicate that the School of Business taught 1,200 students during the most recent academic year. The allocation rate (copy cost per student) follows. edm10890_ch04_150-201.indd Page 169 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Cost Accumulation, Tracing, and Allocation Total cost to be allocated 4 Cost driver 5 Allocation rate $36,000 Step 2. 4 1,200 5 $30 per student Multiply the rate by the weight of the driver (number of students taught by each department) to determine the allocation per object (department). Department Management Accounting Finance Marketing Total Allocation Rate 3 Number of Students $30 30 30 30 3 3 3 3 330 360 290 220 5 Allocation per Department Allocation Based on Past Usage $ 9,900 10,800 8,700 6,600 $36,000 $12,000 10,000 8,000 6,000 $36,000 W I Dr. Thompson objected vigorously to using the number of students as the cost driver. L He continued to argue that the size of the faculty is a more appropriate allocation base. The chair of the finance department sided with Dr. Smethers, the chair of the marketS ing department kept quiet, and the dean had to settle the dispute. O Dean Southport recognized that the views of the chairpersons were influenced by self-interest. The allocation base affects the amount of resources available to each N department. Furthermore, the dean recognized that the size of the faculty does drive , some of the copying costs. For example, the cost of copying manuscripts that faculty Choosing the Best Cost Driver submit for publication relates to faculty size. The more articles faculty submit, the higher the copying cost. Nevertheless, the dean decided Q number of students has the the most significant impact on copying costs. She also wanted to encourage faculty memU bers to minimize the impact of funding cuts on student services. Dean Southport therefore decided to allocate copying costs based on the number of students taught by each A department. Dr. Thompson stormed angrily out of the meeting. The dean developed S a budget by assigning the available funds to each department using the number of students as the allocation base. H Controlling Emotions E Dr. Thompson's behavior may relieve his frustration but it doesn't indicate clear think1 ing. Dean Southport recognized that Dr. Thompson's contention that copy costs were related to faculty size had some merit. Had Dr. Thompson offered a compromise rather 9 than an emotional outburst, he might have increased his department's share of the 9 funds. Perhaps a portion of the allocation could have been based on the number of faculty members with the balance allocated based on7 number of students. Had the Dr. Thompson controlled his anger, the others might have agreed to compromise. TechB nical expertise in computing numbers is of little use without the interpersonal skills to U persuade others. Accountants may provide numerical measurements, but they should never forget the impact of their reports on the people in the organization. A Look Back > A Look Forward 1 The failure to accurately allocate indirect costs to cost objects can result in misinforma9 tion that impairs decision making. The next chapter explains how increased use of automation in production has 9 caused distortion in allocations determined using traditional approaches. The chapter introduces the allocation of indirect costs using 7 more recently developed activity-based costing and explains how activity-based management can improve efficiency and productivity. Finally, the chapter introduces total B quality management, a strategy that seeks to minimize the costs of conforming to a U designated standard of quality. APPENDIX Allocating Service Center Costs LO 9 Allocate service department costs to operating departments. Most organizations establish departments responsible for accomplishing specific tasks. Departments that are assigned tasks leading to the accomplishment of the primary objectives of the organization are called operating departments. Those that provide support to operating departments are called service departments. For example, the department of edm10890_ch04_150-201.indd Page 171 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Cost Accumulation, Tracing, and Allocation accounting at a university is classified as an operating department because its faculty perform the university's primary functions of teaching, research, and service. In contrast, the maintenance department is classified as a service department because its employees provide janitorial services that support primary university functions. Professors are more likely to be motivated to perform university functions when facilities are clean, but the university's primary purpose is not to clean buildings. Similarly, the lending department in a bank is an operating department and the personnel department is a service department. The bank is in the business of making loans. Hiring employees is a secondary function that assists the lending activity. The costs to produce a product (or a service) include both operating and service department costs. Therefore, service department costs must somehow be allocated to the products produced (or services provided). Service department costs are frequently distributed to products through a two-stage allocation process. First-stage allocations involve the distribution of costs from service center cost pools to operating department cost pools. In the second stage, costs in the operating cost pools are allocated to products. Three different approaches can be used to allocate costs in the first stage of the two-stage costing process: the directW method, the step method, and the reciprocal method. I L S Direct Method O The direct method is the simplest allocation approach. It allocates service department costs directly to operating department cost pools. To illustrate, assume that Candler & N Associates is a law firm that desires to determine the cost of handling each case. The , firm has two operating departments, one that represents clients in civil suits and the other that defends clients in criminal cases. The two operating departments are supported by two service departments, personnel and secretarial support. Candler uses a Q two-stage allocation system to allocate the service centers' costs to the firm's legal cases. In the first stage, the costs to operate each service department are accumulated U in separate cost pools. For example, the costs to operate the personnel department are A $80,000 in salary, $18,000 in office rental, $12,000 in depreciation, $3,000 in supplies, and $4,000 in miscellaneous costs. These costs are added together in a single services S department cost pool amounting to $117,000. Similarly, the costs incurred by the secretarial department are accumulated in a cost pool.H assume that this cost pool We contains $156,800 of accumulated costs. The amounts in these cost pools are then E allocated to the operating departments' cost pools. The appropriate allocations are described in the following paragraphs. Assume that Candler's accountant decides that the1 number of attorneys working in the two operating departments constitutes a rational cost driver for the allocation of 9 the personnel department cost pool and that the number of request forms submitted 9 to the secretarial department constitutes a rational cost driver for the allocation of costs accumulated in the secretarial department cost pool. The total number of attor7 neys working in the two operating departments is 18, 11 in the civil department and 7 B in the criminal department. The secretarial department received 980 work request forms with 380 from the civil department and 600 from the criminal department. U Using these cost drivers as the allocation bases, the accountant made the following first-stage allocations. Determination of Allocation Rates Allocation rate for personnel $117,000 5 $6,500 per attorney 5 department cost pool 18 Allocation rate for secretarial $156,800 5 $160 per request form 5 department cost pool 980 171 edm10890_ch04_150-201.indd Page 172 172 7/10/10 5:21 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 4 EXHIBIT 4.6 First-Stage Allocations for Candler & AssociatesDirect Method Allocated Service Department Overhead Allocation Rate 3 Personnel $6,500 6,500 Total cost of personnel department Secretarial Weight of Base 3 11 attorneys 3 7 attorneys Civil Criminal 5 Department Department 5 5 $ 71,500 3 380 requests 5 3 600 requests 5 Total Service Department Cost Pool 60,800 $ 45,500