Activity-Based Costing CHAPTER 3 Activity-Based Costing

Unit-Based Product Costing Model OBJECTIVE 1 Unit-Level Product Costing Unit-Based Product Costing Model

Budgeted annual overhead Budgeted annual driver level OBJECTIVE 1 Unit-Level Product Costing Overhead costs are assigned to products using predetermined overhead rates. Predetermined overhead rate Budgeted annual overhead Budgeted annual driver level = Applied overhead = Overhead rate  Actual driver usage

1 Unit-Level Product Costing Overhead Variances OBJECTIVE 1 Unit-Level Product Costing Overhead Variances The difference between actual overhead and applied overhead is an overhead variance. If actual overhead > applied overhead: underapplied overhead If actual overhead < applied overhead: overapplied overhead Disposal of variance: If immaterial, assign to cost of goods sold. If material, allocate between work-in-process inventory, finished goods inventory, and cost of goods sold.

Overhead Application: Departmental Rates OBJECTIVE 1 Unit-Level Product Costing Overhead Application: Departmental Rates Departmental Rates Costs assigned to individual production department overhead cost pools. Unit level drivers for each department are identified. Pre-determined rates are calculated for each department. Overhead is applied to each product for each department that product passes through.

Limitations of Plantwide and Departmental Rates OBJECTIVE 2 Limitations of Plantwide and Departmental Rates Non-Unit-Related Overhead Costs Plantwide and department rates assume that a product’s consumption of overhead is directly related to units produced. Some costs, however, such as setups cost a certain amount no matter how many products are produced. Other costs, such as engineering hours, may depend on something entirely different, such as work orders, not units.

Limitations of Plantwide and Departmental Rates OBJECTIVE 2 Limitations of Plantwide and Departmental Rates Product Diversity Even if there are significant non-unit driven overhead costs, it will not cause distorted costing if the products all consume overhead in the same proportion as unit-level driven overhead costs. Product diversity simply means that products consume overhead activities in different proportions. This can be caused by differences in product size, complexity, setup time, batch size, etc. The proportion of each activity consumed by a product is called the consumption ratio.

Information: The Boise plant of J, Inc., produces two types of battery-operated toys: robots and race cars. The Boise plant uses a plantwide rate based on direct hours to assign its overhead costs. The company has the following estimated and actual data for the coming year: Estimated overhead: $350,000 Expected activity: $50,000 Actual activity(direct labor hours): Units Robots $10,000 50,000 Race cars $40,000 250,000

Requied: Calculate the predetermined plantwide overhead rate and the applied overhead for each product,using direct labor hour. 2. Calculate the overhead cost per unit for each product. 3. What if robots used 5000 hours instead of 10,000 hours? Calculate the effect on the profitability of this product line if all 50,000 units are sold, and then discuss the implication of this outcome.

Solution: Plantwide rate=350,000/ 50,000=$7.00 per h Applied OH: robots=7.00*10,000=$70,000 race cars=7.00*40,000=$280,000 2. OH per unit(robots)=70,000/50,000=$1.4 OH per unit(race cars)=280,000/250,000=$1.12 3. A reduction of $35,000 of OH assigned to the robots and so profitability for this product line would increase by this amount. Overhead assignments affects product cost and profitability and thus can affect decisions.

Machine hours are used to assign the overhead of the Molding Department, and direct labor hours are used to assign the overhead of the Assembly Department. There are 50,000 robots produced sold and 250,000 race cars. Required: Calculate the overhead rates for each department. Assign overhead to the two products and calculate the overhead cost per unit. How does this compare with the plant wide rate unit cost?

Solution: 1. Molding: $250,000/20,000=$12 Solution: 1.Molding: $250,000/20,000=$12.5per machine hour Assembly:$100,000/40,000=$2.5per machine hour

Limitations of Plantwide and Departmental Rates OBJECTIVE 2 Limitations of Plantwide and Departmental Rates Problems with Costing Accuracy As the toy manufacturer discussed in the text race cars use 40,000 hours of labor and robots use 10,000. If a plantwide rate is used, race cars will receive four times the amount of overhead assigned to robots! But look at the activities: Race cars use three times as many setups as robots. Race cars use about 2 ⅓ times as many inspection hours as robots. Race cars use about 1 ½ times as many moves as robots. Is it fair to assign four times as much overhead to race cars as to robots?

Required: Calculate the four activity rates. Calculate the unit costs using activity rates. Also, calculate the overhead cost per unit. Solution: Machining rate: $150,000/30,000=$5 per machine hour setup rate:$80,000/100=$800 per setup Moving materials rate:$70,000/350=$200 per move inspecting rate:$50,000/4,000=$12.5per hour

Comparison of Unit Costs: Robots Race Cars Activity-based cost 7. 26 3 Comparison of Unit Costs: Robots Race Cars Activity-based cost 7.26 3.75 Unit-based cost 5.40 4.12 In the presence of significant non-unit overhead costs and product diversity, using only unit-based activity drivers can lead to one product subsidizing another(the race cars subsidize the robots),which create the appearance that one group of products is highly profitable and can adversely impact the pricing and competitiveness of another group of products. In a highly competitive environment, accruate cost information is vital.

Limitations of Plantwide and Departmental Rates OBJECTIVE 2 Limitations of Plantwide and Departmental Rates Activity Rates: A Better Approach Instead of using a single pool or department pools based on units, expand the number of pools and rates and base them on activities. The rates are based on causal factors that measure consumption – both unit and non-unit based. Thus in our toy manufacturer we can use four pools related to our four activities: machining, setups, moving materials, and inspections.

Activity-Based Costing System The definition of ABC ACTIVITY BASED COSTING(ABC) is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.(CIMA Official Terminology)

Design Steps for an ABC System OBJECTIVE 3 Activity-Based Costing System Design Steps for an ABC System Identify, define, and classify activities and key attributes. A simple list of activities identified is called an activity inventory. Activity attributes are nonfinancial and financial information items that describe individual activities. An activity dictionary lists the activities in an organization along with desired attributes. A primary activity is one that is consumed by the final cost object.

Design Steps for an ABC System OBJECTIVE 3 Activity-Based Costing System Design Steps for an ABC System Identify the factors that determine the size of the costs of an activity/cause the costs of an activity.—cost drivers Cost driver: a factor influencing the level of cost. Often used in the context of ABC to denote the factor which links activity resource consumption to produce outputs, for example the number of purchase orders would be a cost driver for procurement cost.(CIMA Official Terminology)

Design Steps for an ABC System OBJECTIVE 3 Activity-Based Costing System Design Steps for an ABC System Assign costs consumed by more than one activity in proportion to their usage of the activity as measured by the activity driver. Transaction drivers measure the number of times an activity is performed. Duration drivers measure the demands in terms of the amount of time it takes to perform an activity. Intensity drivers measure the charge each time an activity is performed.

Design Steps for an ABC System OBJECTIVE 3 Activity-Based Costing System Design Steps for an ABC System Collect the costs associated with each cost driver into what are known as cost pools. Cost pool is grouping of costs relating to a particular activity in an activity-based costing system. Charge the costs of each cost pool to products on the basis of their usage of the activity using a cost driver rate.

3 Activity-Based Costing System Transaction analysis OBJECTIVE 3 Activity-Based Costing System Transaction analysis ABC recognises that factors other than volume can explain the level of overhead.The four types of transactions are: Logistical transactions Balancing transactions Quality transactions Charge transactions

Activity-Based Costing Model OBJECTIVE 4 Activity-Based Costing System Activity-Based Costing Model

End of Chapter 4