Activity-Based Costing Chapter 9 Activity-Based Costing Chapters 7 and 8 described product costing systems. In the last 15 years or so, many companies have experimented with and implemented costing systems based on production processes rather than accounting systems. One such system is activity-based costing, or ABC, which aids managers in the decision making process. Chapter 9 describes activity-based costing. McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Product Costs and Decision Making L.O. 1 Understand the potential effects of using externally reported product costs for decision making. Units produced Direct labor-hours Costs: Direct materials Direct labor Manufacturing overhead (@ 120%) Total Cost per unit 10 2,000 $ 40,000 72,000 86,400 $198,400 $ 19,840 30 3,000 $ 36,000 78,000 93,600 $207,600 $ 6,920 40 5,000 $ 76,000 150,000 180,000 $406,000 C-27s C-20s The cost per unit of C-27 is $19,840 and Grange is considering dropping it. Grange is considering dropping C-27s. 9 - 2

Product Costs and Decision Making LO1 Product Costs and Decision Making Direct materials Direct labor Manufacturing overhead Total costs $ 76,000 150,000 180,000 $406,000 $ 36,000 78,000 163,800 $277,800 Original C-20s only The cost per unit for the C-20s will increase from $6,920 to $9,260. Grange’s total cost estimate when producing both C-20s and C-27s was $406,000, $198,400 for C-27s, and $207,600 for C-20s. However, if Grange produces only C-20s, total cost estimate is $277,800. If Grange continues the current production of 30 C-20s the per unit cost will go from $6,920 to $9,260 per unit. How can this be? 9 - 3

Two-Stage Cost Allocation L.O. 2 Explain how a two-stage product costing system works. Allocate overhead costs to departments. First stage: Allocate department overhead costs to the products or services. Second stage: Let’s look at a two-stage cost allocation system. First, allocate overhead costs to departments and then allocate the department overhead costs to the products or services. 9 - 4

Plantwide versus Department-Specific Rates L.O. 3 Compare and contrast plantwide and department allocation methods. Plantwide allocation method All overhead costs are recorded in one cost pool and applied to products using one overhead allocation rate. Using a plantwide allocation method, all overhead costs are recorded in one cost pool and applied to products using one predetermined overhead rate. There is one cost pool for the factory. One cost pool for the factory 9 - 5

Activity-Based Costing (ABC) L.O. 4 Explain how activity-based costing and a two-stage product system are related. ABC is a costing method that first assigns costs to activities and then assigns them to products based on the products’ consumption of activities. Assign costs to activities. Stage 1: Activity-based costing is a two-stage allocation method that first assigns overhead costs to activities rather than departments, and then allocates the cost of those activities to products based on the use of each activity. Assign costs to products based on the use of each activity Stage 2: 9 - 6

Developing Activity-Based Costs Step 1: Identify the activities that consume resources and assign costs to them. Step 2: Identify the cost driver(s) associated with each activity. Step 3: Compute a cost rate per cost driver unit or transaction. Developing an activity-based costing system consists of four steps. First, identify activities that consume resources and assign costs to them. Second, identify the cost drivers associated with each activity. Third, compute a cost rate per cost driver unit or transaction. And finally, fourth, allocate the cost of the activities to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product. Step 4: Assign costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product. 9 - 7

Activity-Based Costing Illustrated L.O. 5 Compute product costs using activity-based costing. Number of units Machine hours – Assembly Direct materials Direct labor – Assembly Direct labor – Packaging Total direct labor Total direct cost Overhead costs: Assembly Packaging Total overhead Total costs 100,000 6,000 $1,500,000 $ 750,000 990,000 $1,740,000 $3,240,000 40,000 30,000 $2,400,000 $ 600,000 360,000 $ 960,000 $3,360,000 140,000 36,000 $3,900,000 $1,350,000 1,350,000 $2,700,000 $6,600,000 $1,620,000 810,000 $2,430,000 $9,030,000 J25P J40X Total Third Quarter – Production and Cost Data Let’s go back to the Port Arthur Manufacturing Facility. Total direct costs, that is direct materials and direct labor, are $6,600,000. Total manufacturing overhead costs are $2,430,000. Let’s cost the two products, the J25P and the J40X, using activity-based costing. 9 - 8

Activity-Based Costing Illustrated Step 1: Identify the Activities LO5 Activity-Based Costing Illustrated Step 1: Identify the Activities Assembly Department Setting up machines Handling material Product Assembly Packaging Department Inspection Packing Shipping The first step in activity-based costing is to identify the activities. Activities in the Assembly Department include machine set up, material handling and product assembly. Activities in the Packaging Department include inspection and packing, and shipping. 9 - 9

Activity-Based Costing Illustrated Step 2: Identify the Cost Drivers LO5 Activity-Based Costing Illustrated Step 2: Identify the Cost Drivers Assembly building: Assembling Setting up machines Handling material Packaging building: Inspecting and packing Shipping Machine-hours Setup hours Production runs Direct labor hours No. of shipments 6,000 40 8 60,000 100 30,000 400 22,800 200 J25P J40X Total Cost Driver Volume 36,000 440 48 82,800 300 Activity Cost Driver After identifying the activities, the second step in activity-based costing is to identify the cost drivers and the expected volume of each cost driver. Product assembly costs are driven by machine hours and the expected volume of machine hours is 36,000. The cost driver for machine setup costs is setup hours. Port Arthur Manufacturing Facility expects 440 setup hours. The cost driver for material handling is production runs and Port Arthur Manufacturing Facility expects 48 production runs. In the Packaging Department, inspection and packing costs are driven by the number of direct labor hours. Total direct labor hours expected are 82,800. And finally, shipping costs are driven by the number of shipments: expected number of shipments, 300. 9 - 10

LO5 Activity-Based Costing Illustrated Step 3: Compute the Cost Driver Rates Assembly building: Assembling Setting up machines Handling material Total assembly overhead Packaging building: Inspecting and packing Shipping Total packaging overhead Total overhead $1,080,000 396,000 144,000 $1,620,000 $ 414,000 $ 810,000 $2,430,000 36,000 machine hour 440 hours 48 runs 82,800 direct labor hour 300 shipments $ 30/machine hour $ 900/setup hour $3,000/run $ 5/direct labor hour $ 1,320/shipment Building and Activity Overhead Cost Cost Driver Volume Rate Third step: compute the cost driver rates. For product assembly we have $30 per machine hour. If costs assigned to machine setup equals $396,000 and the expected volume of setup hours is 440, the overhead rate is $900 per setup hour. Computing the cost driver rate for material handling gives us $3,000 per production run. In the Packaging Department, we have overhead rates of $5 per direct labor hour for inspection and packing and $1,320 per shipment for shipping. 9 - 11

Activity-Based Costing Illustrated Step 4: Assign Costs Using ABC LO5 Activity-Based Costing Illustrated Step 4: Assign Costs Using ABC Assembly building: Assembling @ $30/machine hour Machine setup @ $900/setup hour Handling material @ $3,000/run Packaging building: Inspection and packaging @ $5/direct labor hour Shipping @ $1,320/ shipment Total ABC overhead $180,000 36,000 24,000 300,000 132,000 $672,000 $ 900,000 360,000 120,000 114,000 264,000 $1,758,000 J25P J40X Overhead Finally, allocate costs to the products using the predetermined overhead rate per activity. Product assembly at $30 per machine hour allocated $180,000 and $900,000 to J25P and J40X respectively. Machine setup at $900 per set-up hour allocates $36,000 and $360,000 to J25P and J40X respectively. Material handling at $3,000 per production run allocates $24,000 and $120,000 to J25P and J40X respectively and so on. Inspecting and packing at $5 per direct labor hour allocated $300,000 and $114,000 to J25P and J40X respectively. Finally, shipping is allocated at $1,320 per shipment which attributed $132,000 and $264,000 to J25P and J40X respectively. Allocating costs to the products using the predetermined overhead rate per activity results in total overhead costs allocated to J25P of $672,000 and to J40X of $1,758,000. 9 - 12

Comparison of Reported Unit Product Costs Unit Costs Compared L.O. 6 Compare activity-based product costing to traditional department product costing methods. Plantwide rate Department (building) rate Activity-based costing $48.06 $41.04 $39.12 $105.60 $123.15 $127.95 J25P J40X Comparison of Reported Unit Product Costs Take a moment to compare the per-unit product cost using a plantwide rate, a department rate and activity-based costing for allocating overhead. The J25P has a per-unit product cost of $48.06 using a plantwide allocation rate for overhead costs, $41.04 using a department rate, and $39.12 using activity-based costing. The J40X has a per-unit product cost of $105.60 using a plantwide allocation rate for overhead costs, $123.15 using a department rate, and $127.95 using activity-based costing. Notice using volume to allocate overhead costs results in over costing high-volume products like the J25P and under costing low-volume products like the J40X. 9 - 13

Cost Flows through Accounts L.O. 7 Demonstrate 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! Let’s see how costs flow through the accounts in the Assembly Department using activity-based costing. 9 - 14

Overhead Costs Assembling 180,000 900,000 1,080,000 Assembly WIP J25P LO7 Overhead Costs Assembling 180,000 900,000 1,080,000 Assembly WIP J25P DM 1,500,000 DL 750,000 OH 240,000 Setting Up 36,000 360,000 396,000 Assembly WIP J40X DM 2,400,000 DL 600,000 OH1,380,000 The overhead control account for each activity is credited for the cost allocated to the individual products. The assembling control account is credited and the assembly work-in-process account for the J25P is debited for $180,000. It is credited and the assembly work-in-process account for the J40X is debited for $900,000. The machine setup control account is credited and the assembly work-in-process account for the J25P is debited for $36,000. It is credited and the assembly work-in-process account for the J40X is debited for $360,000. The material handling control account is credited and the assembly work-in-process account for the J25P is debited for $24,000. It is credited and the assembly work-in-process account for the J40X is debited for $120,000. Total overhead allocated to the J25P product is $240,000 ($180,000 assembling costs plus $36,000 set-up costs plus $24,000 material handling costs). Total overhead allocated to the J40X product is $1,380,000 ($900,000 assembling, $360,000 set-up and $120,000 material handling). Remember, the overhead control accounts were originally debited for the cost assigned to that activity. Handling Material 24,000 120,000 144,000 9 - 15

ABC Costing in Administration L.O. 8 Apply activity-based costing to marketing and administrative services. The same four-step process: Step 1: Identify the activities that consume resources. Step 2: Identify the cost driver associated with each activity. Step 3: Compute a cost rate per cost driver for each unit or transaction. Applying activity-based costing to marketing and administrative services involves the same four-step process. First, identify the activities that consume resources and assign costs to them. Second, identify the cost drivers associated with each activity. Third, compute a cost rate per cost driver unit or transaction. And finally, fourth, assign the cost of the activities to marketing or administration by multiplying the cost driver rate by the volume of cost driver units consumed by the activity. Step 4: Assign costs to the marketing or administration activity by multiplying the cost driver rate by the volume of cost driver units consumed by the product. 9 - 16

End of Chapter 9 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.