3-1 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2016 by McGraw-Hill Education. All rights reserved. Activity-Based Costing Chapter 3

3-2 Learning Objective 3-1 Understand the basic approach in activity- based costing and how it differs from conventional costing.

3-3 When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. Assigning Overhead Costs to Products

3-4 Plantwide Overhead Rate Plantwide Overhead Rate A single overhead rate used throughout an entire factory. Direct labor has often been used as the allocation base for overhead because: 1. Direct labor information was already being recorded. 2. Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated. Direct labor has often been used as the allocation base for overhead because: 1. Direct labor information was already being recorded. 2. Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated.

3-5 Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1.Most companies sell a large variety of products that consume differing amounts of overhead. 2.As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of these growing overhead costs may not be correlated with direct labor. 3.Technology advancements have reduced the cost and complexity of gathering diverse sources of data. Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1.Most companies sell a large variety of products that consume differing amounts of overhead. 2.As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of these growing overhead costs may not be correlated with direct labor. 3.Technology advancements have reduced the cost and complexity of gathering diverse sources of data. Plantwide Overhead Rate A plantwide overhead allocation system may not be optimal for many companies in today’s business environment.

3-6 Departmental Overhead Rates Machining Department Shipping Department Assembly Department Many companies have a system in which each department has its own overhead rate. The allocation base depends on the nature of the work performed in each department. In the machining department, overhead may be based on machine-hours, but in the assembly department, overhead may be based on direct labor-hours.

3-7 Activity-based costing is required to account for these other factors. The departmental approach relies exclusively on volume-related allocation bases while some overhead costs may be caused by factors that are not related to the volume of production. Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs. Departmental Overhead Rates

3-8 A number of allocation bases are used for assigning costs to products. Activity-Based Costing (ABC)

3-9CostCost Activity-Based Costing (ABC) Consumption of Resources ActivitiesActivities Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers)

3-10 Activity An event that causes the consumption of overhead resources. Setting up machines Examples of Activities Admitting hospital patients Opening a bank account Billing customers Activity-Based Costing (ABC)

3-11 Activity Cost Pool A “cost bucket” in which costs related to a particular activity are accumulated. Activity Measure Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs. Activity-Based Costing (ABC) Activity Rate A predetermined overhead rate for each activity cost pool.

3-12 Activity-Based Costing (ABC) For each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2. A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product.

3-13 Designing an Activity-Based Costing System The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources.

3-14 An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured. For example, several actions may be involved in handling and moving raw materials, but these may be combined into a single activity titled material handling. Designing an Activity-Based Costing System Related activities are frequently combined to reduce the amount of detail and record-keeping costs.

3-15 Hierarchy of Activities

3-16 Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment

3-17 Unit-Level Activity Batch-Level Activity Facility-Level Activity Product-Level Activity Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs Products $/DLH$/MH$/Setup$/Order$/MH $/Part Type Second-Stage Allocations Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment $450,000 1,200 Orders $375/Order

3-18 Using Activity-Based Costing Comtek, Inc.  Comtek, Inc., makes two products: GPS systems and Phone systems.  The company has been losing bids to supply GPS systems to lower-priced competitors.  The company has been winning all bids to supply Phone systems.  Comtek, Inc., makes two products: GPS systems and Phone systems.  The company has been losing bids to supply GPS systems to lower-priced competitors.  The company has been winning all bids to supply Phone systems.

3-19 Using Activity-Based Costing Comtek, Inc.  For the current year, Comtek has budgeted sales of 50,000 phone units and 200,000 GPS units.  Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor-hours.  Both products require two direct labor- hours to complete.  For the current year, Comtek has budgeted sales of 50,000 phone units and 200,000 GPS units.  Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor-hours.  Both products require two direct labor- hours to complete.

3-20 Using Activity-Based Costing Comtek, Inc.  Unit costs for materials and labor are:

3-21 Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon labor-hours: Predetermined overhead rate = $20 per DLH= $10,000, ,000 DLHs Direct Labor-Hours as a Base

3-22 Direct Labor-Hours as a Base Since each product requires two hours of direct labor, $40 of overhead is assigned to each product.

3-23 Learning Objective 3-2 Compute activity rates for an activity-based costing system.

3-24 The ABC project team at Comtek has developed the following basic information. Computing Activity Rates

3-25 We can calculate an activity rate for each of the six activities by dividing the estimated overheard for an activity by the total expected activity. Computing Activity Rates

3-26 Learning Objective 3-3 Compute product costs using activity-based costing.

3-27 Computing Overhead Cost per Unit Phone Units

3-28 Computing Overhead Cost per Unit GPS Units

3-29 Note that the unit product cost of a GPS unit decreased from $110 to $ while the unit cost of a phone unit increased from $150 to $ Comparing the Two Approaches

3-30 Learning Objective 3-4 Contrast the product costs computed under activity-based costing and conventional costing methods.

3-31 Comparing the Two Approaches The ABC system assigns $14.45 less overhead than the traditional system to each GPS unit.

3-32 Comparing the Two Approaches The ABC system assigns $57.80 more overhead than the traditional system to each phone unit.

3-33 When a company implements activity-based costing, overhead cost shifts from high-volume to low-volume products with a higher unit product cost resulting for the low-volume products. Low-volume product Shifting of Overhead Cost

3-34 High-volume product Shifting of Overhead Cost The traditional system assigns the same amount of all overhead costs to each Phone or GPS unit ($40 per unit).

3-35 Shifting of Overhead Cost 1. Compute the number of units processed per production order for each product. Production-Orders Activity Cost Pool (a batch-level cost pool) The ABC system assigns different amounts of Production-Order-related overhead costs to each product. This fact can be illustrated in a two-step process. Production-Orders Activity Cost Pool (a batch-level cost pool) The ABC system assigns different amounts of Production-Order-related overhead costs to each product. This fact can be illustrated in a two-step process.

3-36 Shifting of Overhead Cost 2. Compute production-order cost per unit for each product. Notice, the costs are being shifted from the high-volume GPS systems to the low-volume Phone systems.

3-37 Activity-Based Management Focuses on managing activities to eliminate waste and reduce delays and defects. Targeting Process Improvements An ABC system can help identify areas where the company can benefit from improving its current processes.

3-38 The first step in any improvement program is deciding what to improve. Targeting Process Improvements Benchmarking can be used to compare activity cost information with world- class standards of performance achieved by other organizations. Activity rates can be used to target areas where costs seem excessively high.

3-39 Benefits of Activity-Based Costing ABC improves the accuracy of product costing by: 1. Increasing the number of cost pools used to accumulate overhead costs. 2. Using activity cost pools that are more homogeneous than departmental cost pools. 3. Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor-hours. 4. Activity-based costing also highlights activities that could benefit most from process improvement efforts, such as Six Sigma.

3-40 Costs of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when: 1.Products differ substantially in volume, batch size, and in activities required. 2.Conditions have changed substantially since the existing cost system was established. 3.Overhead costs are high and increasing and no one seems to understand why. 4.Management does not trust the existing cost system and it ignores data from it when making decisions. Costs of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when: 1.Products differ substantially in volume, batch size, and in activities required. 2.Conditions have changed substantially since the existing cost system was established. 3.Overhead costs are high and increasing and no one seems to understand why. 4.Management does not trust the existing cost system and it ignores data from it when making decisions. Limitations of Activity-Based Costing

3-41 The cost in each activity pool is strictly proportional to its activity measure. When this assumption is violated, the accuracy of ABC data can be called into question. Activity-Based Costing Critical Assumption For example, managers should be particularly alert to product costs that contain allocated facility-level costs.

3-42 Modifying the ABC Model The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: 1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs. The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: 1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs.

3-43 End of Chapter 3