Accounting Business Reporting for Decision Making

482 Accounting: Business Reporting for Decision Making

(continued)

For products passing through Department A, indirect costs will be allocated based on the use of

machine hours. In Department B, the indirect costs will be allocated to the individual products based on

the use of labour hours. The accuracy of the cost assignment will depend on the strength of the cost

driver to explain resource consumption.

Department A Department B

$60 000machine hours

60 000

$62 500labour hours

10 000

$1.00 per machine hour $6.25 per labour hour

Step 3: Allocate indirect costs

Multiplying the products’ use of the cost driver by the indirect cost rate will complete the allocation pro-

cess. For example, the soap product uses 1 hour of machine time per unit and, given the total output

of 30 000 units, would have used 30 000 machine hours. Overhead will be applied at the rate of $1 per

machine hour. Therefore, 30 000 machine hours at $1 per hour will result in $30 000 being applied to the

soap product. These calculations are summarised below.

Soaps

(30 000 units)

Candles

(20 000 units)

Department A $30 000

($1 × 1 machine hour) × 30 000 units

$30 000

($1 × 1.5 machine hour) × 20 000)

Department B $46 875

($6.25 × .25 labour hours) × 30 000 units

$15 625

($6.25 × .125 labour hours) × 20 000 units

Total indirect costs $76 875 $45 625

Does a variance need to be identified? No, because actual indirect costs incurred and actual usage of

the cost driver were used for cost determination. Variances need to be identified only if budgeted costs

are used in the allocation process and they differ from actual costs. (A detailed look at the calculation of

variances can be found in management accounting texts.)

Step 4: Determine inventoriable product cost

The determination of the inventoriable cost for each product is now possible by adding the direct

cost and the allocated indirect cost. The unit cost can be calculated by dividing the total inventoriable

product cost by the number of units of output. The total cost of the soap product is $690 000 (direct

material plus direct labour plus allocated indirect costs) divided by 30 000 units, giving a unit cost of

$23.00 per unit of soap. The unit cost for candles is $16.125. These costs are summarised below.

Cost category

Soaps

(30 000 units)

Candles

(20 000 units)

Total indirect costs

Direct costs

$76 875

613 125

$45 625

276 875

Inventoriable product cost

(direct costs + indirect costs)

Unit cost

(inventoriable product cost / # units)

$ 690 000 $ 322 500

$ 23.00 $16.125

The degree of accuracy of the inventoriable product cost is influenced by the use of a cost driver that

explains resource consumption. If we look at the soap product, we can see that in illustrative example 11.3

the unit cost was $22.00 per unit in 2016, yet in illustrative example 11.4 the unit cost has changed

to $23.00. The difference relates to the introduction of a new product, changes in input prices or pro-

duction efficiencies, and the change in the design of the cost system. This difference could indicate that