Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 11 th Edition Chapter 8

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-Based Costing: A Tool to Aid Decision Making Chapter Eight

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect fixed as well as variable costs. ABC is a good supplement to our traditional cost system I agree!

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Manufacturing costs Nonmanufacturing costs  ABC assigns both types of costs to products. Traditional product costing ABC product costing

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing  ABC does not assign all manufacturing costs to products. Manufacturing costs Nonmanufacturing costs “Best practice” ABC differs from traditional costing in five ways. Traditional product costing ABC product costing All Most, but not all Some

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing Plantwide Overhead Rate Plantwide Overhead Rate Departmental Overhead Rates Departmental Overhead Rates Activity–Based Costing Activity–Based Costing Number of cost pools Level of complexity “Best practice” ABC differs from traditional costing in five ways.  ABC uses more cost pools.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways.  ABC uses more allocation bases. Traditional Costing Number of Allocation Bases ABC Bases usually rely solely on volume measures. Volume measures plus other bases.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways.  ABC uses more allocation bases. The most commonly used allocation base in traditional costing is direct labor hours. Direct labor hours work well when overhead increases as direct labor hours increase.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing Problems:  In many processes, overhead is increasing while direct labor is decreasing.  Variety and complexity of products is increasing. The most commonly used allocation base in traditional costing is direct labor hours. “Best practice” ABC differs from traditional costing in five ways.  ABC uses more allocation bases.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways.  ABC uses more allocation bases. All overhead costs are not related to volume measures like direct labor hours. ABC uses volume as well as other allocation bases not related to the volume of production.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses.  ABC bases level of activity on capacity.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Characteristics of Successful ABC Implementations Strong top management support Cross-functional involvement Link to evaluations and rewards

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Designing an ABC System Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers) ActivitiesActivities Consumption of Resources Consumption CostCost

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Designing an ABC System Steps for Implementing ABC  Identify and define activities and activity cost pools.  Trace costs to activities and cost objects.  Assign costs to activity cost pools.  Calculate activity rates.  Assign costs to cost objects.  Prepare management reports.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Manufacturing companies typically combine their activities into five classifications. Unit-LevelActivityBatch-LevelActivityProduct-LevelActivityCustomer-LevelActivity Organization- sustaining Activity

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing  Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment would be a unit-level activity.  Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities.  Product-level activities relate to specific products and must be carried out regardless of how many batches are run or units produced and sold. For example, designing or advertising a product would be product-level activities.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing 4. Customer-level activities relate to specific customers and are not tied to any specific product. For example, sales calls and catalog mailings would be customer-level activities. 5. Organization-sustaining activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are organization-sustaining activities.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Activities should only be combined within a level if they are highly correlated. When combining activities, they should be grouped together only at the appropriate level.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Activity Cost Pool An Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system. $ $ $ $ $ $

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Simple count of the number of times an activity occurs. Transaction driver A measure of the amount of time needed for an activity. Duration driver Two types of activity measures:

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product Designs - assigned all costs of resources consumed by designing products. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations – assigned all costs associated with maintaining relations with customers. Other – assigned all overhead costs that are not associated with the other cost pools. Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product Designs - assigned all costs of resources consumed by designing products. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations – assigned all costs associated with maintaining relations with customers. Other – assigned all overhead costs that are not associated with the other cost pools.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   When Possible, Directly Trace Overhead Costs to Activities and Cost Objects

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Assign Costs to Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity cost pools is determined. ** Not included because they are directly traced to customer orders.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000   Assign Costs to Activity Cost Pools

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000   Assign Costs to Activity Cost Pools

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Assign Costs to Activity Cost Pools

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool...  1,000 customer orders,  200 new designs,  20,000 machine-hours,  100 customer relations activities. Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Calculate Activity Rates

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Traced Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers OrderSizeOrderSizeCustomerOrdersCustomerOrdersProductDesignProductDesignCustomerRelationsCustomerRelationsOtherOther Overhead Costs First-Stage Allocation

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers OrderSizeOrderSizeCustomerOrdersCustomerOrdersProductDesignProductDesignCustomerRelationsCustomerRelationsOtherOther Overhead Costs First-Stage Allocation Second-Stage Allocations $/MH $/Order $/Design $/Customer Unallocated

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer – Windward Yachts. Standard Stanchions (no design required) units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours. 3. Selling price is $34 each. 4. Direct materials total $2, Direct labor totals $1, Shipping costs total $180. Custom Compass Housing (requires new design) 1. One order during the year. 2. Each housing required 4 machine-hours. 3. Selling price is $650 each. 4. Direct materials total $ Direct labor totals $ Shipping costs total $25.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Prepare Management Reports

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Prepare Management Reports Customer Profitability Analysis

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Product Margins Traditional Cost Accounting System Predetermined manufacturing overhead rate $1,000,000 20,000 MH = $50/MH= 400 units x 0.5 MH/unit x $50/MH = $10,000

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Differences Between ABC and Traditional Product Costs Product margins are different for four reasons:  Traditional costing assigns design costs to both products based on machine hours. ABC assigns product design costs to a product only if product design work is required.  Traditional costing assigns customer order costs, a batch- level cost, using a unit-level allocation base, machine hours. ABC assigns these batch-level costs using a batch-level activity measure.  Traditional costing assigns only manufacturing costs to products. ABC also assigns nonmanufacturing costs to products.  Traditional costing assigns all manufacturing costs to products. The ABC system does not assign organization- sustaining manufacturing costs to the products.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Differences Between ABC and Traditional Product Costs When batch-level and product-level costs are present, ABC will usually shift costs from high volume products, produced in large batches, to low volume products produced in small batches. This cost shifting will usually have its greatest impact on the per unit cost of the low volume products.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Targeting Process Improvement Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements. While the theory of constraints approach discussed in Chapter 1 is a powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on where to focus improvement efforts.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because... 1.External reports are less detailed than internal reports. 2.It may be difficult to make changes to the company’s accounting system. 3.ABC does not conform to GAAP. 4.Auditors may be suspect of the subjective allocation process based on interviews with employees. 1.External reports are less detailed than internal reports. 2.It may be difficult to make changes to the company’s accounting system. 3.ABC does not conform to GAAP. 4.Auditors may be suspect of the subjective allocation process based on interviews with employees.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin ABC Limitations Substantial resources required to implement and maintain. Resistance to unfamiliar numbers and reports. Desire to fully allocate all costs to products. Potential misinterpretation of unfamiliar numbers. Does not conform to GAAP. Two costing systems may be needed.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Review Problem Ferris Corporation makes a single product-afire resistant commercial filing cabinet. The company has a simple ABC system. The company has two overheads departments whose costs are listed below: Manufacturing Overhead$ Selling & Administration Overhead Total Overhead Cost The company's ABC system has the following activity cost pools and activity measures: Activity Cost PoolsActivity Measures Assembling UnitNo. of Units Processing OrdersNo. of Orders Supporting CustomersNo. of Customers OtherNot Applicable Cost assigned to the “Other” activity cost pool have no activity measure; they consist of the costs of unused capacity and organizational sustaining costs– neither of which are assigned to product, orders, or customers.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Review Problem Ferris Corporation distributes the cost of manufacturing overhead and of selling & administrative overhead to the activity cost pools based on employee interviews, the result of which are reported below: Distribution of resource consumption across activity cost pools Assemblin g Units Processin g Orders Supporting Customers OtherTotal Manufacturing Overhead50%35%5%10%100% Selling & Administrative Overhead10%45%25%20%100% Total Activity1000 Units 250 Orders 100 Customers

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Review Problem Requirements: 1.Perform the first-stage allocation of overhead costs to the activity cost pools. 2.Compute activity rates for the activity cost pools. 3.Office-Mart is one of the Ferris’ customers. Last year Office-Mart ordered file cabinet four different times. Office-Mart ordered a total of 80 filing cabinets during that year. Construct a table showing the overhead cost of these 80 units and four orders. 4.The selling price of a filing cabinet is $595. The cost of direct material is $180 per filing cabinet, and direct labor is $50 per filing cabinet. What is the product margin on the 80 filing cabinets ordered by Office-Mart? How profitable is Office-Mart as a customer?

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Review Problem Activity Cost Pools Assembling Units Processing Orders Supporting Customers OtherTotal Manufacturing Overhead$ Selling & Administrative Overhead Total Cost$ The first stage allocation of cost to the activity cost pools appears below:

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Review Problem 2. The activity rates for the activity cost pools are: Activity Cost PoolsTotal Cost (a)Total Activity (b)Activity Rate (a / b) Assembling Unit$ Units$280 Per unit Processing Orders$ Orders$1240 Per Order Supporting Customers$ Customers$1000 per customers

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Review Problem 3. The overhead cost for the four orders of a total of 80 filling cabinets would be computed as follows: Activity Cost PoolsActivity Rates (a)Activity (b)(a X b) ABC Cost Assembling Unit$280 Per unit80 Units22400 Processing Orders$1240 Per order4 Orders4960 Supporting Customers$1000 per customerNot applicable

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Review Problem 4. The product and customer margins can be computed as follows Filing Cabinet Product Margin Sales (595 X 80)47600 Cost: DM (180 X 80)14400 DL (50 x 80)4000 Unit related OH Cost22400 Order related OH Cost4960(45760) Product Margin 1840

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Review Problem 4. Customer Profitability Analysis Customer Profitability Analysis Product Margin1840 Less: Customer Related OH1000 Customer Margin840

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin End of Chapter 8