Fundamental Managerial Accounting Concepts Chapter Five Cost Accumulation, Tracing and Allocation Edmonds, Edmonds, Tsay, Olds, Schneider Prepared by:

Fundamental Managerial Accounting Concepts

Chapter Five

Cost Accumulation, Tracing and Allocation

Edmonds, Edmonds, Tsay, Olds, SchneiderPrepared by: Md. Tapan

Mahmud

Learning Objectives:1.Describe the relationships among cost driver, cost object, and cost accumulation?2.Distinguish direct cost from indirect cost.3.Use basic mathematics to compute indirect cost allocation.4.Select appropriate cost drivers for allocating indirect costs in a variety of different circumstances.5.Use allocation to solve problems that emerge in the process of making cost-plus pricing decisions.6.Explain why companies use indirect cost pools.7.Explain the nature and allocation of joint product and by product common costs.8.Recognize human motivation as a key variable in the allocation process.9.Allocation of service center costs to operating departments by using direct and step methods.

Prepared by: Md. Tapan Mahmud

Use of cost driver to accumulate cost

Accountants use cost accumulation to determine the cost of a particular object.

For example: imagine that the advertising manager of Coca-cola company wants to promote his company in the Mirpur Stadium in an international cricket game. For this three cost components may emerge: a)Cost of the capsb)Cost of advertisingc)Cost of labor.



Cost accumulation always starts with the identification cost objects. There might be two types of cost objects:

a)Primary: The cost of the promotionb)Secondary: Cost of the caps

Cost of advertisingCost of labor.



To determine the cost of the secondary cost objects we have to identify what actually drives each cost component. (we have to find cost drivers)A cost driver has a cause-and-effect relationship with a cost object.


Cost Object Cost DriverCost of the caps The number of capsCost of advertising The number of

advertisingCost of labor The number of labor

hours



Cost object

Cost Driver

Cost per unit

Total cost of object

Cost of the caps

4000 caps $2.50 $10,000

Cost of advertising

50 Advertisements

$100 $5000

Cost of labor

100 Hours $8.00 $800

Total Cost of Coca-Cola promotion

$15,800

Estimated Vs Actual Cost

At the last example we saw the promotion would require $15,800 (which is an estimate, not an actual cost). Though, actual information is more accurate than the estimated information, in this case the estimated information is relevant to the decision making and actual information is irrelevant to the decision making. Before making decision one can’t know for sure what would be the actual cost.



Situations at where cost estimates are used:

a)Price setting,b)Bidding on contracts,c)Evaluating proposals,d)Distributing resource,e)Planning production and inf)Setting goals.



Situations at where actual costs are used:

a)Financial Statements Preparation,b)Managerial Performance Evaluation,c)Segment Reporting.



Situations at where both actual and estimated cost information are used:

a) Variance Analysis.


Assignment of cost to objects in a Retail Business (A classic case in reference to the importance of cost allocation)In Style Inc. is a fashion house and it has three operational departments (three cost objects); namely: Women’s . Men’s and Children's.

ISI began to pay the department mangers a bonus based on the sales revenue, then the managers argued on the floor space, gave more sales commission, reduced prices; as a result the overall profit declined. In the end, the ISI paid bonus on profitability rather than sales revenue.


Assignment of cost to objects in a Retail Business

Assignment is divided into two parts:

a)Cost Tracingi. Identifying Direct &

Indirect Costii. Automatic allocation of direct

costb)Cost Allocationi. Selecting a cost driverii.Allocation of indirect Cost


Assignment of cost to objects in a Retail Business (Cost Tracing)(Traceability requires cost-benefit analysis)

Direct Cost: Can be traced to cost object in a cost-effective / economically convenient manner.

Ex: Cost of good sold / cost of sales. The ISI can trace cost of goods sole directly to the sales, just by the tracking transaction automatically. It requires very little effort and time, which justifies the cost-benefit test of tracing.


Assignment of cost to objects in a Retail Business (Cost Tracing)(Traceability requires cost-benefit analysis)

Indirect Cost: Can’t be traced to cost object in a cost-effective / economically convenient manner.

Ex: Cost of supplies (such as; shopping bag, pens, staples, price tags). The resource and time requirement to trace these cost (say how much staple was used by women’s dept.) would be very cumbersome, and wouldn’t justify the cost-benefit analysis).


Assignment of cost to objects in a Retail Business (Automatic allocation of direct cost with unallocated indirect cost)


Cost Item Direct Costs Indirect Costs Women Men Children COGS (216000) 120000 58000 38000 Sales Commission (18000) 9500 5500 3000 Dept. Managers' Salaries (12000) 5000 4200 2800 Depreciation (16000) 7000 5000 4000 Store Manager's Salary 9360Store Rental 18400Utilities 2300Advertising 7200Suppllies 900Total 141500 72700 47800 38160

Assignment of cost to objects in a Retail Business (Cost Classifications : Independent & context sensitive)

Whether a cost is direct or indirect is independent of whether it is fixed or variable. The very same cost can be classified as direct or indirect depending on the cost object. Ex: Store Manager’s salary.

When trying to identify costs as to type or behavior, you must consider the context in which the costs occur.


Assignment of cost to objects in a Retail Business (Cost Allocation) (Selecting a cost driver)

Most of the time a company may identify more than one cost driver or activity base to allocate indirect cost to a particular cost object. When a company has more than one cost driver, then the company may choose the optimum cost drive based on the following two criterion:

a)Cause-and- effect relationship,b)Availability of information.


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Fundamental Managerial Accounting Concepts Chapter Five Cost Accumulation, Tracing and Allocation Edmonds, Edmonds, Tsay, Olds, Schneider Prepared by: