McGraw-Hill/IrwinCopyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved. Activity-Based Costing Chapter 9

9-2 Learning Objectives: 1. Understand the potential effects of using reported product costs for decision making. 2. Explain how a two stage product costing system works. 3.Compare and contrast plantwide and department allocation methods. 4. Explain how activity-based costing and a two-stage product system are related. 5.Compute product costs using activity-based costing. 6.Compare activity-based product costing to traditional department product costing methods. 7. Demonstrate the flow of costs through accounts using activity-based costing. 8.Apply activity-based costing to marketing and administrative services.

9-3 Product Costs and Decision Making LO1Understand the potential effects of using reported product costs for decision making. Units produced Direct Labor hrs2,0003,0005,000 C-27sC-20sTotalUnits Cost per unit $19,840$6,920 Direct Material$40,000$36,000$76,000 Direct Labor72,00078,000150, % DL$86,40093,600180,000 Costs Total Costs $198,400$207,600$406,000 Grange is considering dropping C-27s.

9-4 Example: Grange Boats (Cost Estimates) Cost Estimates OriginalC-20s Only Direct Materials$76,000$36,000 Direct Labor150,00078,000 Manufacturing Overhead Utilities2,4001,800 Supplies2,5001,300 Training30,00015,600 Supervision54,900 Machine Depreciation29,550 Plant Depreciation40,050 Miscellaneous20,600 Total Overhead180,000163,800 Total Costs$406,000$277,800 Grange’s cost with both C-20s and C-27s versus cost wihout C-27s

9-5 Example: Grange Boats (Overhead) OriginalC-20s Only Manufacturing Overhead Utilities2,4001,800 Supplies2,5001,300 Training30,00015,600 Supervision54,900 Machine Depreciation29,550 Plant Depreciation40,050 Miscellaneous20,600 Total Overhead180,000163,800 Change in Overhead: $16,200 Look at Overhead Grange allocates $86,400 overhead to the C-27s. Only $16,200 of the overhead is avoided if C- 27s are not produced.

9-6 -How overhead costs has been treated so far?? -It is true for all cases?? Some of the overhead might be fixed Some of the overhead might vary but with other drivers other than direct labor

9-7 Death Spiral

9-8 Two-Stage Allocation Systems LO2 Explain how a two-stage product costing system works. Allocate overhead costs to departments. Allocate department overhead costs to the products or services. Stage One Stage Two

9-9 Two-Stage Cost Allocation, Continued... Cost PoolOverhead Intermediate Cost Pools Cost Allocation Rule Department ADepartment B Direct Labor Hours Machine Hours

9-10 Plant-wide versus Department Allocation Method LO3Compare and contrast plantwide and department allocation methods. Plantwide Allocation MethodAll overhead costs are recorded in one cost pool and applied to products using one overhead allocation rate. One cost pool for the factory Factory Overhead Costs One allocation rate Products

9-11 Department Allocation One cost pool for each department Overhead costs traced to separate departments and applied to products using a department allocation rate. Packaging Department Overhead Costs Products Assembly Department Overhead Costs Each department has an allocation rate

9-12 Cost Allocation: An Example (Port Arthur) Production and Cost Data Port Arthur Manufacturing Facility Third Quarter

9-13 Example: Port Arthur (Information) Production and Cost Data Port Arthur Manufacturing Facility Third Quarter

9-14 Example: Port Arthur (Plant-wide Allocation) Plantwide Cost Allocation Port Arthur Manufacturing Facility Third Quarter

9-15 Two-Stage Cost Allocation, Continued... Cost Pool Overhead Intermediate Cost Pools Cost Allocation Rule AssemblyPackaging Machine Hours Direct Labor Cost

9-16 Example: Cost Allocation, Continued... Department Cost Allocation Port Arthur Manufacturing Facility Third Quarter

9-17 Choice of Cost Allocation Method Similar products using same resources Multiple products using resources differently Which cost allocation method is appropriate? Plantwide Allocation Department Allocation

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9-20 Using departments

9-21 Activity-Based Costing (ABC) LO4Explain how activity-based costing and a two-stage product system are related. Costing method that first assigns costs to activities and then allocate them to products based on the products’ consumption of activities. Stage OneAssign costs to activities Stage TwoAllocate costs to products based on the use of each activity Activity-Based Costing An activity is any discrete task that an organization undertakes to make or deliver a product or service.

9-22 ABC, Continued... Activities consume resources Products consume activities

9-23 Developing Activity-Based Costing 1.Identify the activities that consume resources and assign costs to them. 2.Identify the cost driver(s) associated with each activity. 3.Compute a cost rate per cost driver unit or transaction. 4.Allocate costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product.

9-24 Cost Drivers Factors that cause or “drive” an activity’s costs. Setting up machinesNumber of hours Handling materialNumber of production runs MachiningNumber of machine hours Packaging and shippingNumber of shipments Identified activityIdentified cost driver

9-25 Cost Allocation Pools PlantwideOne pool Department As many pools as departments ABC As many pools as activities and cost drivers identified

9-26 Cost Allocation Pools: ABC Cost Flow Diagram: Activity-Based Costing System Set-up hours Production runs Machine hours Shipments OverheadSet-upHandle Material Pack & Ship ProductsMachine Assign costs to activities Allocate costs to products based on the use of each activity

9-27 Choosing cost drivers 1.Causal relation. Ideally, choose a cost driver that causes the cost. 2.Benefits received. Choose a cost driver to assign costs in proportion to benefits received. 3.Reasonableness or fairness. When the first two criteria fail, assign costs on the basis of fairness or reasonableness.

9-28 Cost Hierarchy Classification of cost drivers into general levels of activity; volume, batch, product and so on.

9-29 Cost Hierarchy, Continued... Classification of cost drivers into general levels of activity; volume, batch, product and so on.

9-30 Cost Hierarchy, Continued... Classification of cost drivers into general levels of activity; volume, batch, product and so on.

9-31 Cost Hierarchy, Continued... Classification of cost drivers into general levels of activity; volume, batch, product and so on.

9-32 Cost Hierarchy, Continued... Classification of cost drivers into general levels of activity; volume, batch, product and so on.

9-33 Assigning costs to products Step 1: Identify the activities Step 2: Identify the cost drivers. Step 3: Compute the cost driver rates.. Step 4: Assign costs using activity-based costing.

9-34 Example: ABC, Continued... LO5Compute product costs using activity-based costing. Production and Cost Data Port Arthur Manufacturing Facility Third Quarter

9-35 Example: ABC (Step 1) Identify the activitiesStep 1

9-36 Example: ABC (Step 2) Identify the cost drivers and the expected volume of each cost driver. Step 2

9-37 Example: ABC (Step 3) Compute the Cost Driver RatesStep 3 Overhead Cost Data Port Arthur Manufacturing Facility Third Quarter

9-38 Example: ABC (Step 4) Step 4Allocate costs to products

9-39 Example: ABC, Continued...

9-40 Cost Flow Diagram Activity-Based Costing System Port Arthur Manufacturing Facility Direct costsOverhead costs AssemblyPackaging Assemble Set-up Handle Material Inspect & Pack Ship J25PJ40X

9-41 Product Cost Methods: A Comparison Comparison of Reported Unit Product Costs LO6Compare activity-based product costing to traditional department product costing methods.

9-42 Overhead Costs using ABC LO7Demonstrate the flow of costs through accounts using activity-based costing. Let’s see ABC cost flow for the Assembly Department It’s T Account time

9-43 Direct Materials Costs (T Accounts) Assembly WIP J40X Material Inventory Assembly WIP J25P 1,500,000 DM 1,500,000 2,400,000 DM 2,400,000

9-44 Direct Labor Costs (T Accounts) Wages Payable 750, ,000 Assembly WIP J25P Assembly WIP J40X DM 1,500,000 DM 2,400,000 DL 750,000 DL 600,000

9-45 Overhead Costs (T Accounts) Handling Material Setting up Machines Assembly WIP J25P Assembly WIP J40X DM 1,500,000 DM 2,400,000 DL 750,000 DL 600,000 Assembling 180,000 36,000 24,000 OH 240, , , ,000 OH 1,380,000 1,080, , ,000

9-46 Transfer from Assembly to Packaging (T Accounts) Assembly WIP J25P Assembly WIP J40X DM 1,500,000 DM 2,400,000 DL 750,000 DL 600,000 OH 240,000 OH 1,380,000 Packaging WIP J25P Packaging WIP J40X 2,490,000 4,380,000 2,490,000 4,380,000

9-47 ABC in Administration LO8Apply activity-based costing to marketing and administrative services. 1.Identify the activities that consume resources. 2.Identify the cost driver associated with each activity. 3.Compute a cost rate per cost driver for each unit or transaction. 4.Allocate costs to the marketing or administration activity by multiplying the cost driver rate by the volume of cost driver units consumed by that activity. The same four-step process

9-48 Problem 1

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9-50 Problem 2-Continue from problem 1

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9-52 Problem 3-contniue from problem 2 & 3

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