Management Accounting: Cost Allocation and Job Costing Lecture Notes

Management Accounting: Cost Allocation and Job Costing

• Lecture Topic: AYB202 Lecture 6

• University: QUT (Queensland University of Technology)

• Subject: Management Accounting

• Main Themes: Cost Allocation, Job Costing, and Support Department Costing Methods

Week 6 Learning Objectives

• Describe the meaning of the term "cost object."

• Explain and distinguish between direct and indirect costs.

• Understand why indirect costs require allocation to cost objects and apply cost drivers to perform basic allocations.

• Compare alternative methods for allocating support department costs including direct, step-down (sequential), and reciprocal methods.

• Distinguish between job costing and process costing and identify the appropriate scenarios for each.

• Apply job costing to calculate the inventoriable cost of a customized product or service.

Textbook Reading References

• Eldenburg et al., 5th Edition:

  • Chapter 3: A costing framework and cost allocation.

  • Chapter 7: Job costing systems.

Importance of Cost Allocation: The "Success Failure" of Forrest Gump

• Cost allocation matters because it directly influences reported profitability, even for commercially successful projects.

• Case Study: Forrest Gump (1994), produced by Paramount Pictures.

  • The film was a massive commercial success, winning 6 Academy Awards.

  • It earned over $677 \times 10^{6}$ worldwide on a budget of $55 \times 10^{6}$.

  • Despite this, the studio reported a financial loss of $62 \times 10^{6}$.

• Reasoning for loss reporting: Many shared costs exist between different movie projects. The specific methods used to allocate these shared costs drastically affect the final reported profit or loss of an individual project.

Understanding Cost Objects and Cost Types

• Cost Object: Anything for which a separate measurement of cost is desired. Examples include:

  • Geographic regions.

  • Business units.

  • Services.

  • Customers.

  • Products.

  • Business processes.

  • Departments.

• Direct Costs: Costs that can be traced to a specific cost object in an economically feasible way.

• Indirect Costs: Costs related to a cost object that cannot be traced in an economically feasible way. These are often pooled as "overheads."

• Example: Custom-Made Table:

  • Direct Costs: Timber used for the table, wages paid to the carpenter for specific hours worked on that table, special hardware or fittings for that table.

  • Indirect Costs: Workshop rent, electricity for lighting and machinery, depreciation of tools and machinery, salary of the workshop supervisor.

Mechanism of Cost Allocation

• Indirect costs are assigned to cost objects through allocation rather than direct tracing.

• Cost Drivers: An input or activity that causes a change in the total cost for a cost object.

  • Volume Drivers: Metrics that measure output at the unit level (e.g., units produced, machine hours).

  • Activity Drivers: Related to attributes of individual activities and recognize the actual amount of activity consumed by cost objects.

• Support Departments: These are non-producing units (e.g., Information Systems, Maintenance) that provide necessary services to operating/producing departments. Their costs are part of manufacturing overhead and must be allocated to operating departments and then to products.

• Challenges in Allocation:

  • Allocation involves estimation and introduces potential imprecision.

  • It is a frequent area of internal conflict, as managers often question the amount of indirect costs assigned to their specific divisions or departments.

Activity 1: Forber Bakery Allocation Exercise

• Scenario: Forber Bakery has three divisions (Bread, Cake, Doughnuts) and a Headquarters (HQ). HQ costs are $510,000$.

• Option 1: Equal Allocation

  • Calculation: \frac{510,000}{3} = $170,000

  • Result: Bread ($170,000$), Cake ($170,000$), Doughnuts ($170,000$).

• Option 2: Allocation based on Number of Employees

  • Data: Bread (400), Cake (100), Doughnuts (300). Total = 800 employees.

  • Rate: $\frac{510,000}{800} = 637.5$

  • Bread: $637.5 \times 400 = 255,000$

  • Cake: $637.5 \times 100 = 63,750$

  • Doughnuts: $637.5 \times 300 = 191,250$

• Option 3: Allocation based on Revenue

  • Data: Bread ($4,200,000$), Cake ($2,100,000$), Doughnuts ($700,000$). Total = $7,000,000$.

  • Bread: $(\frac{4.2}{7}) \times 510,000 = 306,000$

  • Cake: $(\frac{2.1}{7}) \times 510,000 = 153,000$

  • Doughnuts: $(\frac{0.7}{7}) \times 510,000 = 51,000$

Support Department Classification and Allocation Methods

• Operating (Production) Departments: Directly add value to a product or service (e.g., Machining, Assembly, Packaging).

• Support (Service) Departments: Provide services to other internal departments (e.g., Material Handling, IT, Power Supply, Purchasing).

1. Direct Method

• Allocates support costs only to operating departments.

• Completely ignores any interaction or services provided between support departments.

• Example: Northshore Mechanical (Direct Method):

  • Support: Facilities (Budget: $6,400,000$), IT Services (Budget: $1,440,000$).

  • Operating: Fabrication, Final Assembly.

  • Allocation of Facilities (3/8 to Fab, 5/8 to Assembly):

    • Fabrication: $6,400,000 \times \frac{3}{8} = 2,400,000$

    • Assembly: $6,400,000 \times \frac{5}{8} = 4,000,000$

  • Allocation of IT (8/9 to Fab, 1/9 to Assembly):

    • Fabrication: $1,440,000 \times \frac{8}{9} = 1,280,000$

    • Assembly: $1,440,000 \times \frac{1}{9} = 160,000$

2. Step-Down (Sequential) Method

• Allocates support-department costs in a prescribed sequence to other support departments and operating departments.

• Provides partial recognition of mutual services between support departments.

• Once a department's costs are allocated out, no costs are allocated back to it.

• Sequence typically starts with the department providing the highest percentage or dollar amount of services to other support departments.

• Example: Northshore Mechanical (Step-Down):

  • Facilities is allocated first (1/5 to IT, 3/10 to Fab, 1/2 to Assembly).

    • IT receives: $6,400,000 \times 0.20 = 1,280,000$

  • IT's new total to allocate: $1,440,000 + 1,280,000 = 2,720,000$.

  • IT then allocates to Fab (8/9) and Assembly (1/9).

3. Reciprocal Method

• Fully recognizes mutual services provided among all support departments.

• Requires setting up and solving linear equations.

• Example Equations for Northshore Mechanical:

  • Let $F = \text{Facilities Maintenance costs}$ and $I = \text{IT Services costs}$.

  • $F = 6,400,000 + \frac{1}{10} I$

  • $I = 1,440,000 + \frac{1}{5} F$

  • Solution: $F = 6,677,551.02$ and $I = 2,775,510.20$.

• Theoretical advantage: Most precise. Practical disadvantage: Difficult to implement without software.

Job Costing vs. Process Costing

• Process Costing: Appropriate for masses of identical or similar products (e.g., Oil refineries, Tyre manufacturers, Water balance manufacturers, Pharmaceutical companies, Textbook publishers).

• Job Costing: Appropriate for highly customized products or services where every job is distinct (e.g., Landscaping companies, Movie studios, Car repair shops, Management consulting firms, Construction companies).

Normal Costing Framework

Cost Flows in Job Costing

• Product Costs (Inventoriable Costs): Consist of Direct Materials (traced), Direct Labour (traced), and Overhead (allocated). These accumulate in "Work in Process Inventory" on the Balance Sheet, then move to "Finished Goods Inventory," and finally to "Cost of Sales" on the Profit or Loss statement when sold.

• Period Costs: Costs not directly related to production (e.g., Selling, Administrative). These are expensed directly to the Statement of Profit or Loss in the period they occur.

7 Steps to Calculate Job Costs

1. Identify the job (cost object).

2. Identify direct costs (Materials-requisition and Labour-time records).

3. Select cost-allocation bases for indirect costs.

4. Identify indirect costs associated with each base (cost pools).

5. Calculate the rate per unit of each allocation base.

6. Calculate indirect costs allocated to the job (Rate $\times$ Actual Activity).

7. Calculate total job costs (Direct + Indirect).

• Documentation for Tiling Job Example:

  • Materials Requisition Record: Lists items like ceramic tiles ($1,980$), adhesive ($270$), grout ($310$), and waterproofing ($200$). Total Materials = $2,760$.

  • Labour-time Record: Surface prep (8 hrs), Tile laying (22 hrs), Finishing (8 hrs). Total Hours = 38. Rate = $45.00/h$. Total Labour = $1,710$.

  • Overhead Allocation: Direct Labour hours as driver. Rate = $30.00/h$. Allocated Overhead = $38 \times 30 = 1,140$.

  • Total Job Cost: $2,760 + 1,710 + 1,140 = 5,610$.

Activity 5: BMF Constructions Comprehensive Exercise

• Scenario (2025 Data for Rates):

  • DL Hours: 4,000; DL Costs: $200,000$; Direct Materials: $2,450,000$.

  • Building Support: $250,000$; Logistics: $196,000$.

• Rate Calculations:

  • Building Support Rate: $\frac{250,000}{4,000} = 62.5$ per DL hour.

  • Logistics Rate: $\frac{196,000}{2,450,000} = 0.08$ (or 8%) of Direct Materials cost.

• 2026 Job Calculation:

  • Direct Material: $110,000$

  • Direct Labour: $40,000$ (800 hours)

  • Allocated Building Support: $800 \times 62.5 = 50,000$

  • Allocated Logistics: $110,000 \times 0.08 = 8,800$

  • Total Job Cost: $110,000 + 40,000 + 50,000 + 8,800 = 208,800$