Additional Slides for Chapter 4 - Cost

# Additional Slides for Chapter 4 - Cost - 1 Mechanics of...

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1 Mechanics of Cost Allocation

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2 Main complication: Shared capacity costs RIP Mattress Company makes mattresses. It has two product lines, Standard and Deluxe. Its contribution margin statement for last year is as follows: Shared capacity costs: can’ t be traced to individual product lines. a large fraction of total costs (40%) => we want to know: (1) how to divide them among the two products lines?
3 Cost Allocations Capacity resources are shared by multiple product lines, cannot be traced to a specific product line => use cost allocation to estimate what fraction of the total capacity costs (fixed costs) is used by each product line, and how capacity costs will change with long-term decisions. General idea of cost allocation: find a cost driver that has a clear cause-and-effect relation with the capacity costs: e.g., if most of your capacity resources (machines, supervisors, floor space) are used to support direct labor, then direct labor hours drive the amount of resources you need and the associated capacity costs. % capacity costs used by each product line is roughly proportional to its % use of the cost driver in the long term, capacity costs change roughly in proportion to changes in the cost driver amounts

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4 Mechanics of Cost Allocation First, choose the cost driver , and determine the total costs in the cost pool (cost pool = total fixed costs you want to allocate) After that, use the 2-step cost allocation procedure: 1) calculate allocation rate (aka overhead rate ) allocation rate = = cost in cost pool / denominator volume * denominator volume = total amount of cost driver units for all product lines combined 2) cost allocated to each product line = = # cost driver units for that product line × allocation rate
5 Example: Cost Allocation Question: Allocate the shared capacity costs (fixed costs) between the 2 product lines. Use direct labor \$ (DL\$) as the cost driver (allocation basis). cos t poo l denominat or volume cost driv er

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6 The choice of cost driver can make a difference Suppose we use a different cost driver - the number of units (instead of DL\$). What are the amount allocated to Standard and Deluxe now? Cost pool = total fixed costs = \$50,000 + \$30,000 = \$80,000 Denominator volume = total # units = 200 + 100 = 300 units Allocation rate = \$80,000/300 = \$266.67 per unit Amount allocated to Standard = \$266.67 x 200 units = \$53,333 (vs \$16,000) Amount allocated to Deluxe = \$266.67 x 100 units = \$26,667 (vs \$64,000) cos t poo l denominat or volume cost driv er
7 Refining the Allocation: Multiple cost pools, multiple cost drivers To get more accurate estimates:

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