18-1 Chapter 16 … “Job Order Costing”: allocated overhead using Pred. Overhead Rate with Direct Labor as an allocation (activity) base. Chapter 17 … “Process Costing”: allocated overhead using Predetermined Overhead Rate often with Machine Hours as the allocation (activity) base. Chapter 18 … Activity-Based-Costing (ABC): allocates overhead using multiple rates and multiple activity bases. Allocating Overhead

18-2 The Need for a New Approach  Huge change in manufacturing & service industries.  Decrease in amount of direct labor usage.  Significant increase in total overhead costs.  Single plant-wide overhead rates gives poor info when manufacturing is more complex and less human labor is involved.  Complex manufacturing processes may require multiple allocation bases; this approach is called: Activity-Based Costing (ABC). Traditional Costing

18-3  Allocates overhead to multiple activity-based cost pools versus the OLD methods that used single allocation base (labor hours, machine hours etc.  Assigns the activity-based cost pools to products or services by means of “cost drivers” … an activity that is the root cause of why a cost occurs. In the past this was direct labor hours and sometimes machine hours. Activity-Based Costing

18-4  Activity: any event, action, transaction, or work sequence that causes a cost to be incurred.  Activity Cost Pool: a distinct type of activity. Ex: ordering materials; setting up machines; packing to ship.  Cost Drivers: any factors or activities that have a direct cause-effect relationship with the resources consumed. Ex: direct labor; machine setups; engineering change orders; special inspections; handling and storage; machine hours. Activity-Based Costing

18-5 ONE “Activity” = 1) Owning a Car

18-6

18-7 TWO 1) Owning a Car Activities = 2) Driving a Car

18-8

18-9

18-10

18-11  ABC allocates overhead costs in two stages: 1: Overhead costs are allocated to activity cost pools. 2: Assigns overhead allocated to the activity cost pools to products, using cost drivers.  The more complex a product’s manufacturing operation, the more activities and cost drivers are likely to be present. A-B-C … Activity-Based Costing

18-12 (a)Estimated overhead = Predetermined overhead rate Direct labor costs (a) $270,000 = 180% of direct labor cost $50,000 + $100,000

18-13 (c) Traditional costingStandard Custom $50,000 X 180%$90,000 $100,000 X 180% $180,000 $90,000 $180,000

18-14 (b)Activity cost pools Cost drivers Estimated overhead MachiningMachine hours$170,000 Machine setupSet up hours 100,000

18-15 (b)Activity cost pools Cost drivers Estimated overhead MachiningMachine hours$170,000 Machine setupSet up hours 100,000

18-16 Activity-based costing Machining: 1,000 X $85$85,000 1,000 X $85 $85,000 Machine setup: 100 X $20020, X $200 80,000 $105,000 $165,000 Standard Custom

18-17 (c) Traditional costingStandard Custom $50,000 X 180%$90,000 $100,000 X 180% $180,000 $90,000 $180,000 Activity-based costing Machining: 1,000 X $85$85,000 1,000 X $85 $85,000 Machine setup: 100 X $20020, X $200 80,000 $105,000 $165,000

18-18 Traditional & Activity-Based Costing

18-19 (a)Traditional costing system Product 540XProduct 137YProduct 249S Sales$180,000 $160,000 $70,000 Costs 55,000 50,000 15,000 Operating income$125,000 $110,000 $55, , , , , , ,000

18-20 (b)Activity-based costing system Product 540XProduct 137YProduct 249S Sales$180,000 $160,000 $70,000 Costs 50,000 35,000 Operating income$130,000 $125,000 $35, , , , , , ,000

18-21 (a)Traditional costing system Product 540XProduct 137YProduct 249S Sales$180,000 $160,000 $70,000 Costs 55,000 50,000 15,000 Operating income$125,000 $110,000 $55,000 (b)Activity-based costing system Product 540XProduct 137YProduct 249S Sales$180,000 $160,000 $70,000 Costs 50,000 35,000 Operating income$130,000 $125,000 $35,000 (c)Product 540X:($130,000 – $125,000) ÷ $125,000 = 4.00% Product 137Y($125,000 – $110,000) ÷ $110,000 = 13.64% Product 249S($35,000 – $55,000) ÷ $55,000 = (36.36%) 410, , , , , ,000

18-22 Illustration 18-3 ABC system design—Lift Jack Company Traditional & Activity-Based Costing

18-23 Engineering,

18-24 Machinery,

18-25 Machine Set-Up,

18-26 Quality Control,

18-27 Factory utilities,

18-28 Maintenance,

18-29 Budgeted Costs Activity Cost Pool Cost Driver Engineering design Engineering prototypes Engineering Engineering hours Depreciation, machinery Electricity, machinery Machinery Machine hours Machine setup, indirect labor Machine setup, indirect materials Machine setup Number of setups Inspections Tests Quality control Number of tests or inspections Depreciation, plant; Insurance, plant; Property taxes; Oil, heating; Electricity, plant lighting Factory utilities Square feet or Machine hours Machine maintenance wagesMaintenance Number of machines or Machine hours

18-30 Four steps: 1.Identify / classify activities involved in the making specific products, … and allocate overhead to cost pools. 2.Identify the cost driver with a strong correlation to the costs accumulated in the cost pool (above). 3.Compute the activity-based overhead rate for each cost driver. 4.Assign overhead costs to products, using the overhead rates determined for each cost pool (cost per driver). Activity Based Costing

18-31  “Company” produces two products (abdominal trainers): ► Ab Bench: a high volume item with sales totaling 25,000 units annually. ► Ab Coaster: a low volume item with sales totaling 5,000 units annually. Illustration: Example of ABC Versus Traditional Costing

18-32  “Company” produces two products (abdominal trainers): ► Ab Bench: a high volume item with sales totaling 25,000 units annually. ► Ab Coaster: a low volume item with sales totaling 5,000 units annually.  Each product requires 1 hour of direct labor. ► Total annual direct labor hours (DLH) 30,000 (25, ,000) ► Direct labor cost $12 per unit for each product Illustration:

18-33 Illustration:  “Company” produces two products (abdominal trainers): ► Ab Bench: a high volume item with sales totaling 25,000 units annually. ► Ab Coaster: a low volume item with sales totaling 5,000 units annually.  Each product requires 1 hour of direct labor. ► Total annual direct labor hours (DLH) 30,000 (25, ,000) ► Direct labor cost $12 per unit for each product  Direct materials cost: ► Ab Bench - $40 per unit ► Ab Coaster - $30 per unit

18-34  “Company” produces two products (abdominal trainers): ► Ab Bench: a high volume item with sales totaling 25,000 units annually. ► Ab Coaster: a low volume item with sales totaling 5,000 units annually.  Each product requires 1 hour of direct labor. ► Total annual direct labor hours (DLH) 30,000 (25, ,000) ► Direct labor cost $12 per unit for each product  Direct materials cost: ► Ab Bench - $40 per unit ► Ab Coaster - $30 per unit Expected annual manufacturing overhead costs $900,000. Illustration: Required: Calculate unit costs under ABC.

18-35 * Overhead rate = $900,000/30,000 DLH = $30 per DLH Overhead = ($30 X 1 hr. = $30) Illustration: Manufacturing costsAb BenchAb Coaster Direct materials$40$30 Direct labor12 Overhead30 Total unit cost$82$72 Example of ABC Versus Traditional Costing

18-36 Identify and Classify Activities and Allocate Overhead to Cost Pools (Step 1) Overhead costs are assigned directly to the appropriate activity cost pool. Expected annual manufacturing overhead costs $900,000.

18-37 Identify Cost Drivers (Step 2) Cost driver should accurately measure the actual consumption of the activity by the various products. From (Step 1)

18-38 Calcuulate Overhead Rates (Step 3) Calculate an activity-based overhead rate per cost driver. From Step 1 From Step 2Step 3 Results

18-39 In assigning overhead, it is necessary to know the expected use of cost drivers for each product. Ab Coaster requires more set-ups and inspections than Ab Bench due to its low volume. Assign Overhead Cost to Products (Step 4)

18-40 Assign Overhead Cost to Products (Step 4) To assign overhead, multiply the ABC rates per cost driver by the number of cost drivers expected to be used per product.

18-41 Assign Overhead Cost to Products (Step 4) To assign overhead, multiply the ABC rates per cost driver by the number of cost drivers expected to be used per product.

18-42 A likely consequence of the differences in assigning overhead is that Atlas has been overpricing the Ab Bench and possibly losing market share to competitors. It also has been sacrificing profitability by underpricing the Ab Coaster. Illustration Comparing Unit Costs Example of ABC Versus Traditional Costing

18-43 Illustration Comparing Unit Costs Example of ABC Versus Traditional Costing

18-44 More accurate product costing through:  Use of more cost pools to assign overhead costs.  Enhanced control over overhead costs.  Better management decisions. Benefits of ABC  Can be expensive to use.  Some arbitrary allocations continue. Limitations of ABC Activity-Based Costing: A Closer Look

18-45 When to Use ABC Factors to consider: 1.Product lines differ in volume and manufacturing complexity. 2.Product lines are numerous and diverse. 3.Overhead costs constitute a significant portion of total costs. 4.The manufacturing process or the number of products has changed significantly. 5.Production or marketing managers are ignoring data provided by the existing system. Activity-Based Costing: A Closer Look

18-46 Value-Added Versus Non–Value-Added Activities Activity Based Management (ABM): An extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision making. ► Value-added activities ► Non–value-added activities Activity-Based Costing: A Closer Look

18-47 An activity that increases the perceived worth of a product or service such as: Value-Added Activities Manufacturing Company Engineering design Machining services Assembly Painting Service Company Performing surgery Legal research Delivering packages Activity-Based Costing: A Closer Look

18-48 An activity that adds cost to, or increases the time spent on, a product/service without increasing market value such as: Non–Value-Added Activities Manufacturing Company Repair of machines Storage of inventory Building maintenance Inspection Service Company Taking appointments Reception Bookkeeping and billing Advertising Activity-Based Costing: A Closer Look

18-49

18-50 Objective: Identify key cost-generation activities and keep track of quantity of activities performed for each service provided.  General approach is to identify activities, cost pools, and cost drivers.  Labeling of activities as value-added or non-value-added.  A larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services provided by the company. Activity-Based Costing in Service Industries

18-51 Traditional Costing Example The public accounting firm of Check and Doublecheck prepares the following condensed annual budget. Illustration Activity-Based Costing in Service Industries

18-52 Traditional Costing Example Illustration Under traditional costing Check and Doublecheck would compute applied overhead and operating income as: Activity-Based Costing in Service Industries

18-53 Activity-Based Costing Example Check and Doublecheck distributes its estimated annual overhead costs of $1,200,000 to several activity cost pools. Illustration Activity-Based Costing in Service Industries

18-54 Activity-Based Costing Example Assigning overhead in a service industry Illustration Activity-Based Costing in Service Industries

18-55 Activity-Based Costing Example Illustration Comparison of traditional costing with ABC in a service company. Activity-Based Costing in Service Industries

18-56 JIT manufacturing is dedicated to having the right amount of materials, parts, or products just as they are needed.. Illustration 18A-1 APPENDIX 18A JUST-IN-TIME PROCESSING

18-57 Objective of JIT Processing  To eliminate all manufacturing inventories. Elements of JIT Processing  Dependable suppliers.  Multiskilled work force.  Total quality control system. APPENDIX 18A JUST-IN-TIME PROCESSING

18-58 APPENDIX 18A JUST-IN-TIME PROCESSING Benefits of JIT Processing  Significant reduction or elimination of manufacturing inventories.  Enhanced product quality.  Reduction or elimination of rework costs and inventory storage costs.  Production cost savings from the improved flow of goods through the processes.