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COST ALLOCATION

• Do you still remember?


• Fixed vs Variable Cost
• Direct and Indirect Cost
• Prime Costs (Direct material and direct labor) are usually
traced directly to cost objects
• The most obvious and important cost object in organizations
are the products and services sold by the organization
TRACKING PRIME COSTS TO COST
OBJECTS

• Direct Material through:

material requisition form


• Direct Labour through:

time ticket
MFG. OVERHEADS

Direct Material
Product/Job A

Direct Labour

Product/Job B
Allocation
Basis

Mfg. Overheads
CAGED BIRDS FARM: CASE I

• A poultry farm owner worried about low profitability of his small-sized farm is
considering to radically re-design his manufacturing operation.
• The price of eggs are subject to huge variations in Pakistan and are considered
outside the control of poultry owners.
• He has heard about ‘caged farming’, a relatively new technology available in
the West.
• Rather than letting the bird move around in the controlled shed, in the new
technology, it is placed in a cage.
• The advantage of the cage is that feed is not wasted. The ‘running around’ of
the bird in the farm results in precious energy being wasted. Placing the birds in
the cage significantly increase the egg yield of a bird.
• Due to certain regulation changes, the entire cage plants can be imported from
some Western countries. These are used plants but are in very good condition.
The total cost of a 120,000 birds cage plant is around 100M Rs.
CAGED BIRDS FARM: CASE I

• Since the firm only produces one (class of) product, cost
allocation will not be a major issue here.
• Fixed and variable cost classification, and attendant analysis,
however, will be an important consideration
COSTS

• Costs • Variable Costs:


• Food medicine and vaccination of • FM&V
chicken • DOC
• Cost of heating/cooling the shed • Culling
• Salary of Staff • Fixed Costs:
• Depreciation • Salary
• DOC • Cost of Heating/Cooling
• Culling • Depreciation
OPEN VS CAGED FARM

• Open Farm • Caged Farm


• Variable cost/egg: 7 • Variable cost/egg: 5.54
• Revenue/egg: 7.78 • Revenue/egg: 7.78
• Fixed Costs: 0.6M Rs • Fixed Cost: 12M Rs
• Number of birds: 20,000 • Number of birds: 120,000
• Number of eggs: 6M • Number of eggs: 42M
Chicken, Managing Costs/Increasing
Profits
Open Farming Caged Farming
(Rs) (Rs)
Revenue /Egg 7.78 7.78
V.Cost /Egg 7 5.54
C.M./Egg 0.78 2.24
Number of Eggs 6M 42M
CM 4,680,000 94,000,000
Fixed Costs 600,000 12,000,000
Profit 4,080,000 82,000,000
CM Ratio .78/7.78=10% 2.24/7.78=30%
ROI ?
Caged Chicken
Case II: Pakistan Railways
• PR has three functional units; the Operations Unit, the Manufacturing and Services Unit, and the Welfare and
Special Initiative Unit
• In 2014, PR had, on papers, 421 locomotives but in reality more than half of these locomotives were inoperative.
• Poor financial performance was leading to reduced resources for repair and replacement, which in turn was reducing the
number of operational locomotives thus creating a vicious downward financial spiral.
• Manufacturing and Service includes 4 workshops: Carriage, Locomotive, Steel, and Power House.
• The Workshops Division was capable of generating substantial revenues through selling the products of its individual
workshops to outside customers, while providing services to PR Operations Unit as well.
• The Steel Shop, for example, could generate revenue by manufacturing and selling various foundry products through steel
melting, casting, and steel rolling.
• With capacity utilization of around 25%, during 2013, Steel Mill didn’t provide any product to outside customers.
• Costing System of Steel Mill a matter of concern?
Pakistan Railways Overall Financial
Position
Particulars 2010-2011 2011-2012 2012-2013 2013-2014

Gross Earnings 18,612,068 15,444,393 18,069,546 22,800,217

Operating Expenses 31,464,910 31,443,343 35,123,742 39,795,937

Capital Outlay 8,084,889 8,814,707 11,897,393 13,380,697

Interest Charges 4,956,742 1,234,420 47,016 3,716

Gain/(Loss) (31,090,555) (30,360,859) (32,661,824) (31,355,122)


Costing Method
• Cost determination of individual jobs involved estimation of three major components of costs: direct material, direct labour, and
overheads
• Direct material: Issued from the workshop stores and charged directly to the job
• Direct labour: hours of ‘skilled labour’ required to complete a job x rate per hour.
• (Per hour rate determined by dividing the fixed monthly salary with the number of working hours in a month).
• Overhead consist of the following:
• Labour: Unskilled, supervisory and idle hours of skilled labour (all labour on fixed monthly salary contract)
• Shop overhead: included other shop specific costs such as electricity and gas, required primarily to run the furnace.
• General overheads were incurred by PR Workshops as a whole and were common among the various shops. These included, for
example, yard lighting, any wages of staff not directly allocated to shops such as guards, printing, and stationery.
• Pro forma overheads were charged to a job when that job was undertaken for outside customers. These included, for example,
general administrative expenses of PR such as managerial salaries, facilities costs etc.
• Allocation Basis: The allocation of these overheads to particular jobs, works, or products was done mostly on the basis of direct
labour hours.
• Pricing: According to the Code for the Mechanical Department, a product could not be sold in the market at a price which was less
than its total cost i.e. the cost of material, direct labour as well as all three categories of overheads. In exceptional cases,
management could ignore general and proforma overheads but never the shop overheads.
• For every job query (from internal or external customers), Steel Mill will calculate the cost of the job and will then quote its price. If
the customer will find the cost too high, it will go somewhere else!
Steel Shop (16,000 tons capacity)

Total Total
Production Production
Month (Tons) Month (Tons)
Jan-13 170.720 Jul-13 540.060
Feb-13 323.380 Aug-13 353.640
Mar-13 478.700 Sep-13 336.220
Apr-13 523.380 Oct-13 325.180
May-13 294.520 Nov-13 356.820
Jun-13 455.160 Dec-13 479.520
Grand Total 4637.3
Cost for the Year 2013
Is Overhead Allocation an Important Issue?
• There are multiple product categories
• Overheads are a large chunk of overall costs
• Hence cost allocation (and determining full cost of product) will be an
important issue
• However, allocating overhead costs to products to determine their full cost
and making the full cost a basis of pricing are two separate things.
• If a firm has extremely low capacity utilization; and fixed costs cannot be
reduced, making full costs the basis of pricing will result in firm becoming
further uncompetitive.
• Since fixed costs are uncontrollable, firm should try and sell products that
provide greatest contribution margin (sales price less variable cost). In case
of PR, the variable cost is that of materials alone.
Cost of a “star product”: MS Round that
sells for Rs 85/KG
Particulars Cost/kg

Direct Labour 6

Direct Material 42

Prime Cost 48

Shop Overheads 222

   

   

Total Cost of Product 270


Selling MS Round will result in a net
economic benefit
• Revenue/KG : 85 Rs
• Variable Cost/KG: 42 Rs
• C.M./KG: :43Rs
• CM for 12,000 tons (if entire excess capacity is produced
and sold):?
• 43Rs/KGx12M KG:???
• Utility Costs: 19 Rs/KG
• If Utility costs are also variable,
Case III: A Furniture Firm
• A Market leader in Furniture Business
• Established since 1970’s as a Family Firm
• Dealing in Office Furniture, Home Furniture, Kids
Furniture, Kitchens, Doors, Wardrobes, Floors.
• Fragmented Industry that consists of large
number of small players (100-200 in Lhr., 3000-
4000 in Chiniot, 300 in Gujrat, 6,000-7,500 in
Kchi)
The Case Organization: Manufacturing
• Manufacturing takes place in 6 shops.
The Case Organization: Manufacturing
• The metal shop: consists of general purpose machines for cutting, grinding, welding and painting of
furniture metal parts.
• The board shop: provides boards for furniture items that are designed with veneer and laminate boards.
This section contains highly automated machines which are able to process boards. The only labor
intensive part is the application of veneer sheets to the boards.
• The Wood Shop: The sheets are marked and cut by hand and the pressing on the boards is done by
the machines. After all pieces are cut, they are sanded, polished and dried
• Assembly Shop
• Upholstery
• Polishing: 2 automated polishing lines in which pieces of wood are given a uniform coating in a
controlled environment.
The Case Organization: Marketing and
Sales
• 700 SKU’s
• Historically been charging premium prices, for high end customers (at least
15% above the ‘market’.)
• In recent years, for some product categories, it has also introduced the
econo-range
• 6 company owned and 20 franchised stores (mostly opened in recent years
to cater to demand in semi-urban areas and are mostly focused on econo-
range)
The Case Organization: Market
Segmentation
The Case Organization: Problem
• In the last few years, 4 things have happened:
• Revenues have gone up (25%)
• Profits have gone down (45%)
• Inventory has gone up
• Management feels that costing system is responsible for
this.
The Case Firm: Costing Methodology
• Material Cost is directly traced to the products
• Other costs are allocated to a product on the basis of
direct material costs of a product (using last year’s other
costs to material costs ratio as a basis)
The Case Firm: Last Year’s Cost Break-Up
Cost of Sales
RM consumed 74.4%
Salaries 8.0%
Fuel & Power 4.5%
Maintenance 2.1%
Stores & spares 4.2%
Insurance 0.3%
Freight 0.7%
Others 0.2%
Research 0.4%
Misc 0.1%
Depreciation 5.1%
100.0%
The Case Firm: Is Cost Allocation
Important
• For cost allocation system to be of relevance for decision-
making, following 3 questions are important:
• Is Overhead a large proportion of total cost (like in PR)?
• Is the firm making a number of varied products?
• Are we operating in a cost competitive environment,
where a slight error in full cost determination make a big
difference to the competitiveness of the firm?
Design a Costing System
Allocation Basis
Cost Items Shop or Facility Allocation Basis
Direct Material Related to product N/A
Labor Related to shop ?
Depreciation Related to shop ?
Electricity in Related to shop ?
shops
Maintenance Related to shop ?
Supervisors Related to shop ?
Salary
Facility Electricity Related to facility ?
Managerial salary Related to facility ?
Building Related to facility ?
Depreciation
Allocation Basis
Cost Items Shop or Facility Allocation Basis to Products
Direct Material Related to product N/A
Labor Related to shop Time Spent on the Product
Depreciation Related to shop Time Spent on the Product
Electricity in Related to shop Time Spent on the Product
shops
Maintenance Related to shop Time Spent on the Product
Supervisors Related to shop Time Spent on the Product
Salary
Facility Electricity Related to facility Total hours on the product
Managerial salary Related to facility Total hours on the product
Building Related to facility Total hours on the product
Depreciation
Ideal Allocation Base
• Cause-effect relationship
• Ease of measurement
Sample Costing for Har…. Bed
Cost of Har Bed
• Overhead Cost: 2,104
• Raw Material Cost: 14,275
• Total Cost: 16,379
• Is this a better costing system?
• Old system would have given us a total cost of around Rs
19,000 (14,275 plus 33% of DM cost as labor and
overhead cost allocation)
• The firm sells the bed for Rs 43,000