“Cost Driver” (the activity) Owning a car More traditional approach: One “Cost Pool” “Cost Driver” (the activity) Owning a car  

2) Owning a Car 1) Driving a Car Two Cost Drivers (Activities with a cause-effect relationship to the cost pools)

Allocating Overhead 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 (activity cost pools) and multiple activity bases (cost drivers).

Traditional Costing 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 complex … less human labor. Complex manufacturing processes may require multiple allocation bases called: Activity-Based Costing (ABC).

This “total” is one single “activity cost-pool” In Ch16 & 17 we used “Mfg OverHead” to develop a single “predetermined overhead rate” of $1,300,000. This “total” is one single “activity cost-pool” Machine lube oil 10,000 Machine maint parts 80,000 Machine maint labor 160,000 Machine set-up 120,000 Machine calibration & Testing 40,000 Machine repair 320,000 Factory security guards 190,000 Factory managers salary 100,000 Factory Utilities Factory Lease 300,000 Total Mfg Overhead Costs … $1,300,000

A-B-C Costing Approach In Ch16 & 17 we used “Mfg OverHead” to develop a single “predetermined overhead rate” of $1,300,000. A-B-C Costing Approach Machine lube oil 10,000 Machine maint parts 80,000 Machine maint labor 160,000 Machine set-up 120,000 Machine calibration & Testing 40,000 Machine repair 320,000 Factory security guards 190,000 Factory managers salary 100,000 Factory Utilities Factory Lease 300,000 Machine Maintenance Cost Pool …… $250,000 Machine Set-Up Cost Pool .… $160,000 Machine Repair Cost Pool … $320,000 Misc Factory Cost Pool … $670,000 Total …….. $1,300,000 Total Mfg Overhead Costs … $1,300,000

Activity‐based costing (A-B-C) assumes that the steps or activities required to manufacture a product are what determine the overhead costs incurred. Each overhead cost, whether variable or fixed, is assigned to a category of costs. These categories are called … activity cost pools. Cost drivers are the actual activities that cause the total cost in an activity cost pool to increase. When using ABC, the total cost of each activity pool is divided by the total number of units of the activity to determine the cost per unit.

Activity-Based Costing Activity: event, action, transaction, or work sequence that causes a cost to be incurred. Ex: ordering materials, setting up a machine, packing a machine for shipping. Activity Cost Pool: a collection of costs incurred when certain operations (activities) are performed within the organization. Ex: ordering materials; setting up machines; packing. Cost Drivers: 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 Cost Pools: Payroll taxes A-B-C assumes that steps or activities needed to make a product determines the overhead costs incurred. What manufacturing overhead “steps” or “activities are involved in making product Payroll taxes Fringe benefits Electricity Factory rent Equipment maintenance Factory maintenance

Cost Driver Factor (activity) that controls the amount of costs incurred for each “step” or “activity”. Payroll taxes Fringe benefits Electricity Factory rent Equip maint Factory maint ... Direct Labor Hours ... Direct Labor Hours ... Machine Hours ... Square Feet ... Machine Hours ... Square Feet

Activity Cost Pool: Expenses influenced by the same cost drivers can now be grouped into activity cost pools. Direct Labor Hours: Payroll taxes Fringe benefits Machine Hours: Electricity Equipment maintenance Number of Square Feet: Factory rent Factory maintenance

Example Using Traditional “Predetermined Overhead Rate”

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

Continued (c) Traditional costing Standard Custom $50,000 X 180%    Custom  $50,000 X 180% $90,000 $100,000 X 180%               $180,000 * Rate = 180% of direct labor cost

Same Example Using “A-B-C Costing”

Machining Cost Machine Hours

Machining Cost Machine Hours Set-Up Cost Set-Up Hours

Calculation to Allocate A-B-C Standard Custom Machining 1,000 x $85 $ 85,000 $ 85,000

Standard Custom Standard Custom Calculation to Allocate A-B-C Standard Custom Machining 1,000 x $85 $ 85,000 $ 85,000 Calculation to Allocate A-B-C Standard Custom Machining 1,000 x $85 $ 85,000 $ 85,000 Set-Up 100 x $200 20,000 400 x $200 80,000 105,000 165,000

Calculation to Allocate A-B-C Traditional costing Standard    Custom  $50,000 X 180% $90,000 $100,000 X 180%               $180,000 270,000 Calculation to Allocate A-B-C Standard Custom Machining 1,000 x $85 $ 85,000 $ 85,000 Set-Up 100 x $200 20,000 400 x $200 80,000 105,000 165,000 270,000

E18-2 Ayala Inc. has conducted the following analysis related to its product lines, using a traditional costing system (volume-based) and an activity-based costing system. Both the traditional and the activity-based costing systems include direct materials and direct labor costs. For each product line, compute operating income using the traditional costing system. (b) For each product line, compute operating income using the activity-based costing system. Products Sales Revenue Traditional A-B-C Product 540X 180,000 55,000 50,000 Product 137Y 160,000 35,000 Product 249S 70,000 15,000

E18-2 Ayala Inc. has conducted the following analysis related to its product lines, using a traditional costing system (volume-based) and an activity-based costing system. Both the traditional and the activity-based costing systems include direct materials and direct labor costs. Products Sales Revenue Traditional A-B-C Product 540X 180,000 55,000 50,000 Product 137Y 160,000 35,000 Product 249S 70,000 15,000 (a) Traditional costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 55,000 50,000 15,000 Operating income $125,000 $110,000 $55,000

E18-2 Ayala Inc. has conducted the following analysis related to its product lines, using a traditional costing system (volume-based) and an activity-based costing system. Both the traditional and the activity-based costing systems include direct materials and direct labor costs. Products Sales Revenue Traditional A-B-C Product 540X 180,000 55,000 50,000 Product 137Y 160,000 35,000 Product 249S 70,000 15,000 (b) Activity-based costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 50,000 35,000 Operating income $130,000 $125,000 $35,000

410,000 120,000 120,000 (b) Activity-based costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 50,000 35,000 Operating income $130,000 $125,000 $35,000 410,000 120,000 290,000

(a) Traditional costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 55,000 50,000 15,000 Operating income $125,000 $110,000 $55,000 410,000 120,000 290,000 (b) Activity-based costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 50,000 35,000 Operating income $130,000 $125,000 $35,000 410,000 120,000 290,000 (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%)

(a) Traditional costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 55,000 50,000 15,000 Operating income $125,000 $110,000 $55,000 410,000 120,000 290,000 (b) Activity-based costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 50,000 35,000 Operating income $130,000 $125,000 $35,000 410,000 120,000 290,000 (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%)

(a) Traditional costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 55,000 50,000 15,000 Operating income $125,000 $110,000 $55,000 410,000 120,000 290,000 (b) Activity-based costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 50,000 35,000 Operating income $130,000 $125,000 $35,000 410,000 120,000 290,000 (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%)

Difference between the 2 methods (a) Traditional costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 55,000 50,000 15,000 Operating income $125,000 $110,000 $55,000 410,000 120,000 290,000 (b) Activity-based costing system   Product 540X Product 137Y Product 249S Sales $180,000 $160,000 $70,000 Costs 50,000 35,000 Operating income $130,000 $125,000 $35,000 410,000 120,000 290,000 (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%) Difference between the 2 methods

Engineering,

Machinery,

Machine Set-Up,

Quality Control,

Factory utilities,

Maintenance,

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 maintenance wages Maintenance Number of machines or Machine hours

Activity Based Costing Four steps: Identify / classify activities involved in making specific products, … and allocate overhead to cost pools. Identify the cost driver with a strong correlation to the costs accumulated in the cost pool (above).

Expected annual manufacturing overhead costs $900,000. “Company” produces two products (abdominal trainers): Ab Bench: a high volume sales = 25,000 units. Ab Coaster: a low volume sales = 5,000 units. Expected annual manufacturing overhead costs $900,000.

Example of ABC Versus Traditional Costing Illustration: Manufacturing costs Ab Bench Ab Coaster Direct materials $40 $30 Direct labor 1 hr @ 12 Overhead 30 30 Total unit cost $82 $72 * Overhead rate = $900,000/30,000 DLH = $30 per DLH Overhead = ($30 X 1 hr. = $30)

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

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

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

Assign Overhead Cost to Products (Step 4) 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. 500 1,000 30,000 20,000 500 1,500

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.

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.

Example of ABC Versus Traditional Costing Remember - Traditional Costing Was:

Example of ABC Versus Traditional Costing Comparing Unit Costs Using traditional costing may have caused company to over-price the Ab Bench … (losing sales & market share). Also most likely caused company to under-price the Ab Coaster … (probably resulting in decreased profitability).

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

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

Activity-Based Costing: A Closer Look Value-Added vs 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

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

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