WHAT’S UP WITH C&C SPORTS? Costs skyrocketed Variance analysis – 4th quarter Lining: $6,250 F price; $8,000 U quantity DL: $1,650 U rate; $14,400 U efficiency VOH: $26,195 U spending; $3,955 U efficiency Additional jackets appear to have added complexity to production processes Need to better understand product costs

TRADITIONAL COSTING AND PORS

ACTIVITY-BASED COSTING CONCEPT

Do both products consume the same amount of forklift resource? WHAT’S THE COST DRIVER? DLHS? batches moved? Suppose one batch of jackets takes 15 hours and three batches of jerseys take 15 hours. Do both products consume the same amount of forklift resource?

TYPES OF ACTIVITIES Unit-level Batch-level Product-level Customer-level Organization-level

TYPES OF ACTIVITIES Unit-level Batch-level Product-level Incurred by production or acquisition of a single unit of product or the delivery of a single unit of service Batch-level Incurred when a group of similar things are made, handled or processed at the same time Product-level Incurred in support of different products or processes Customer-level Incurred to support and sustain a specific customer Organization-level Incurred to support and sustain a business unit

UNIT LEVEL ACTIVITIES Volume or level of activity is proportional to the number of units produced Costs incurred to perform these activities can be allocated using traditional methods such as DLH or MH C&C – operating sewing machines

BATCH-LEVEL ACTIVITIES Volume or level of activity is proportional to the number of batches produced Costs are incurred when a group of similar things are made or handled at the same time C&C – Moving batches of products

PRODUCT-LEVEL ACTIVITIES Activities that support the production and sale of individual products Related to all units and batches produced, regardless of volume C&C – creating patterns for new products

CUSTOMER LEVEL-ACTIVITIES Activities performed to support specific customers Not dependent on the number of units or products sold to that customer Costs for these resources do not affect product cost C&C – making sales calls

ORGANIZATION-SUSTAINING ACTIVITIES Activities performed to maintain the plant facility and provide managerial infrastructure Not dependent on the volume of production, just the number of facilities maintained The cost of these resources is not allocated to products C&C – renting factory space

COMPARISON OF GAAP AND ABC COSTS Cost Category GAAP-Based Product Cost Activity-Based Product Cost Direct Materials ✔ Direct Labor Manufacturing Overhead Unit-Level ✔ Batch-Level Product-Level Organization-Level NOTICE: Under ABC, organization-level costs are not allocated to products S&A Expense Unit-Level ✔ Batch-Level Product-Level NOTICE: Under traditional costing, S&A expenses are not allocated to products

DO YOU KNOW YOUR ABCS? Exercise 7-1 © scibak/iStockphoto

E 7-1 SOLUTION Unit Batch Product Customer Organizational a. Setting up a machine for a production run of 500 units X b. Conducting a seminar for local doctors on the benefits of a new drug c. Embossing a company logo on every product made d. Seating a party of 11 at a restaurant e. Providing technical support for two years following a sale f. Managing a corporation’s accounting department g. Attaching a price tag to each product h. Issuing an invoice i. Developing a corporate advertising campaign j. Recalling a defective product

FIVE STEPS TO IMPLEMENT ABC Identify activities Develop activity cost pools Calculate activity cost pool rates Allocate costs to products or services Calculate unit product costs

ACTIVITY-BASED COSTING (STEPS 1 & 2) See Exhibit 7-5 for details of costs to activity pools

ACTIVITY-BASED COSTING (STEP 3) See Exhibit 7-6 for details of activity cost pool rates

ACTIVITY-BASED COSTING (STEP 4) See Exhibit 7-7 for details of cost allocations to each product

ACTIVITY-BASED COSTING (STEP 5) ÷ ÷ ÷

COMPARISON OF TRADITIONAL & ABC COSTING

UNDER TRADITIONAL COSTING SYSTEMS… Small volume jobs are typically under-costed Large volume jobs are typically over-costed In ABC, this is corected as batch-related and product-level costs are allocated using appropriate batch and product cost drivers

WHEN YOU CHOOSE THE COST POOLS AND COST DRIVERS… BE CAREFUL… WHEN YOU CHOOSE THE COST POOLS AND COST DRIVERS… Once you select a cost driver, you have to monitor and collect data about the consumption of that activity. Can your system do that? There is a cost/benefit tradeoff to consider

IT’S PRACTICE TIME Exercise 7-9

E 7-9 SOLUTION a. Overhead rate = = $19.50/MH Simple Complex Machine hours 50,000 32,000 × Overhead rate $19.50 = Total overhead to product $975,000 $624,000 Total assigned overhead = $975,000 + $624,000 = $1,599,000 Simple Complex Total overhead to product $975,000 $624,000 ÷ Number of units produced 125,000 40,000 = Overhead per unit $7.80 $15.60

E 7-9 SOLUTION (CONT.) b. Simple Assembly 250,000 DLH × $1.25/DLH $312,500 Fabrication 50,000 MH × $9.75/MH 487,500 Setups 2,500 batches × $18.00/batch 45,000 Bonding Total overhead $845,000 Complex Assembly 160,000 DLH × $1.25/DLH $200,000 Fabrication 32,000 MH × $9.75/MH 312,000 Set ups 4,000 batches × $18.00/batch 72,000 Bonding 170,000 Total overhead $754,000 Total assigned overhead = $845,000 + $754,000 = $1,599,000

E 7-9 SOLUTION (CONT.) Simple Complex Total overhead to product $845,000 $754,000 ÷ Number of units produced 125,000 40,000 = Overhead per unit $6.76 $18.85

Labor costs are too high. What’s your first reaction? MANAGEMENT SAYS… Labor costs are too high. What’s your first reaction? Reduce headcount

THE KEY IS ACTIVITY MANAGEMENT LOOK AT THE ACTIVITIES THAT USE LABOR RESOURCES Inefficient production processes Poor facilities layout Non-value added activities Untrained workforce

WHAT ADDS VALUE TO THE PRODUCT? Look at your activities If customers are willing to pay for an activity, it is value-added If customers aren’t willing to pay for it, the activity is non-value-added Eliminate the non-value-added activities and the related resources to reduce costs

HOW IS ABC INFORMATION USED? An ABC analysis may reveal interesting information about product profitability. Source: Activity Based Costing: How ABC is Used in the Organization, Copyright 2005, SAS Institute Inc., Cary, NC. All Rights Reserved. Reproduced with permission of SAS Institute Inc., Cary, NC

TRADITIONAL VS ABC PROFITABILITY Traditional Costing Pants Jerseys Award Jackets Sales $12.00 $14.80 $125.00 Production Costs 9.87 11.17 77.12 Product Margin/Unit $ 2.13 $ 3.63 $ 47.88 Product Margin % 17.75% 24.53% 38.30% Activity-Based Costing Pants Jerseys Award Jackets Sales $12.00 $14.80 $125.00 Production Costs 8.20 10.57 80.04 Selling and Administrative 1.65 2.02 20.82 Product Margin/Unit $ 2.15 $ 2.21 $ 24.14 Product Margin % 17.92% 14.93% 19.31%

DOES ABC CHANGE PRODUCTION COSTS? NO ABC re-allocates costs based on the activities consumed by the products

ACTIVITY-BASED COSTING RECAP Recognizes that various activities and cost levels exist Gathers costs into related cost pools Uses multiple cost drivers to assign costs to products and services based on the consumption of resources by activities ABC focuses on attaching costs to products and services based on the activities used to produce, perform, distribute or support those products and services

LET’S PUT IT ALL TOGETHER Problem 7-19 © Denis Pepin/iStockphoto

P 7-19 SOLUTION a. POR = = 500% DL$ Cashews Chestnuts Direct material $4.20 $3.20 Direct labor 0.30 Overhead 1.50 Cost/lb. 6.00 5.00 40% markup 2.40 2.00 Selling price $8.40 $7.00

P 7-19 SOLUTION (CONT.) b. Cost Pool Calculation Activity Rate Purchasing = $1,000/purchase order Material handling = $800/setup Quality control = $500/batch Roasting = $20/roasting hour Seasoning = $20/seasoning hour Packaging = $20/packaging hour

P 7-19 SOLUTION (CONT.) Cashews Purchasing × $1,000 $4,000   Purchasing × $1,000 $4,000 Material handling × 3 setups × $800 24,000 Quality control × $500 5,000 Roasting × 1 hour × $20 20,000 Seasoning × .5 hour × $20 10,000 Packaging × .1 hour × $20 2,000 Total overhead 65,000 Pounds produced ÷ 100,000 Overhead per pound $0.65

P 7-19 SOLUTION (CONT.) Chestnuts Purchasing × $1,000 $4,000   Purchasing × $1,000 $4,000 Material handling × 3 setups × $800 9,600 Quality control × $500 2,000 Roasting × 1 hour × $20 400 Seasoning × .5 hour × $20 200 Packaging × .1 hour × $20 40 Total overhead 16,240 Pounds produced ÷ 2,000 Overhead per pound $8.12

P 7-19 SOLUTION (CONT.) Cashews Chestnuts Direct material $4.20 $3.20 Direct labor .30 Overhead .65 8.12 Cost/lb. 5.15 11.62 40% markup 2.06 4.65 Selling price $7.21 $16.27