# Allocation of Fixed Costs

## Introduction

Segmented income statement is an important component in a firm’s financial reporting. This is mainly so with regard to firms which have diversified their operation (Kieso, Weygandt & Warfield, 2011, p. 13). This arises from the fact that it enables an organization’s management team to gain useful information regarding the businesses segments (Edwards, Hermanson & Invacevich, 2007, p.37). This means that the management teams can be able to make optimal investment decisions. This can be enhanced by integration of activity-based-costing method.

## Analysis of Herrestad Company segment income statement

In its operation Herrestad Company produces and sells two products, product A and product B. The following is the firm’s segmented income statement.

 Herrestad Company Segmented Income Statement For the period ending 31st December 2011 Amount in \$ Amount in \$ Amount in \$ Product A Product B Total Sales 1,080,000 1,320,000 2,400,000 Variable cost: Direct material cost 540,000 420,000 960,000 Direct labour cost 120,000 360,000 480,000 Variable overhead 170,000 150,000 320,000 Variable selling and 26,000 54,000 80,000 administrative cost Total variable expense 856,000 984,000 1,840,000 Contribution margin 224,000 336,000 560,000 Less traceable fixed cost Fixed manufacturing overhead 187,500 62,500 250,000 Fixed selling and administrative 66,666.66 33,333.33 100,000 350,000 cost Net operating income 210,000

## Computations for product A

Sales =Units sold *selling price per unit

=2000 units x \$540= \$ 1,080,000

Direct material cost of goods sold =2000 units x\$270=\$ 540,000

Direct labor cost =2000 units x\$ 60= \$ 120,000

Variable overhead cost =2000 units x \$ 85= \$ 170,000

Variable selling and administrative expense =2000 units x\$13= \$26,000

## Computations of product B

### Computations for product A

Sales =Units sold *selling price per unit =6000 units x \$220= \$ 1,320,000

Direct material cost of goods sold =6000 units x\$70=\$ 420,000

Direct labor cost =6000 units x\$ 60= \$ 360,000

Variable overhead cost =6000 units x \$ 25= \$ 150,000

Variable selling and administrative expense =6000 units x\$9= \$54,000

### Allocation of fixed costs using activity based costing

According to Martin (n.d, para. 15), it is possible to trace fixed and variable activity costs to individual products. This makes it possible to trace idle capacity. Martin (n.d, para. 16), asserts that activity basting costing enables managerial accountants to generate actual product costs. In its production, Herrestad incurs a fixed manufacturing overhead of \$250,000. Its production of the two products is undertaken through 100 production runs. Seventy five of the production runs are for producing product A while 25 production runs are used in producing product B. Using the activity –based-costing method; the total fixed manufacturing overhead can be allocated to the two products. The cost of one production run can be calculated by dividing the total production runs by the number of runs.

Cost per production run=\$250,000/100= \$2,500 per unit

Therefore cost allocation for the fixed manufacturing overhead is illustrated below.

Product A =\$ 2,500 x 75 production runs = \$187,500

Product B = \$ 2,500 x25 production runs = \$ 62,500

## Cost allocation for the fixed selling and administrative activities for the two products

According to Walter (2011, para. 17), it is possible to determine per-activity allocation rates used in the production process. Herrestad Company incurs a fixed selling and administrative cost of \$ 100,000. To execute its selling activities, the firm has 30 sales representatives. Twenty of the representatives are engaged in the sale of product A while the other 10 are involved in marketing product B. Using this information, the fixed cost of one sales representative can be calculated by dividing the total fixed selling and administrative cost by the total number of sales representative.

Fixed selling and administrative cost per sales representative = \$ 100,000/ 30 = \$3,333.33 per representative

Therefore, total fixed selling and administrative cost for product A is equal to = \$ 3,333.33 x20= \$ 66,666.6

Total fixed selling and administrative cost for product B is equal to \$3,333.33 x 10= \$ 33,333.3

Adding up the fixed selling and administrative cost for the two products will amount to approximately \$ 100,000.

## Conclusion

Segmented income statement enables organizations to be effective in evaluating their performance, for example their profitability. This arises from the fact that an organization is able to focus on a particular segment. In their operation most businesses make their decisions on the basis of their profitability. Determination of profitability can be achieved by comparing the sales price and the cost.

Activity-based-costing can enable firms’ management accountants to identify the organization activities that consume a lot of resources. This arises from the fact that the costs are analyzed individually. Additionally, it is also possible for management accountants to analyze the cost drivers. By analyzing the individual activities within the organization, managers become effective in their decision making. From the analysis, Product B is relatively profitable compared to product A. This is evidenced by the size of the contribution margin of the two products. Product A has a contribution margin of \$ 224,000 while that of Product A is \$ 336, 000.

## Reference List

Edwards, J.D., Hermanson, R.H. & Invacevich, S.D. (2007). Accounting principles: a business perspective. Managerial. Georgia: University of Georgia.

Kieso, D., Weygandt, J. & Warfield, T. (2011). Intermediate accounting. Hoboken, N.J: Wiley.

Walter, L.M. (2011). Principles of accounting. Utah: Utah State University.

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BusinessEssay. (2022) 'Allocation of Fixed Costs'. 16 December.

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