© 2012 Pearson Prentice Hall. All rights reserved. ACTIVITY BASED COSTING

© 2012 Pearson Prentice Hall. All rights reserved. Class Announcements  Assignment #3 due October 3 rd (today)  Assignment #4 due October 10th  Midterm in-class Thursday October 24th  Trudy Eagan Women in Business Speakers’ Series and Awards Presentation  Location SCHW Auditorium (SCHW 110)  2:15pm Thursday October 10, 2012  Guest Speaker: Mary Lou O’Reilly, IBC  Sign in at door  Looking for volunteers at 2:00pm for sign-in

© 2012 Pearson Prentice Hall. All rights reserved. Class Objectives 1. Activity Based Costing as an approach to refined manufacturing overhead allocation 2. The mechanics of allocating overhead using and ABC approach 3. The context for understanding successful ABC allocation

© 2012 Pearson Prentice Hall. All rights reserved. Costing: Overhead Allocation  Accounting for overhead costs is an imprecise science. Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable.  Allocation of overhead is not a process for costing inventory for reporting purposes but has strategic consequences.

© 2012 Pearson Prentice Hall. All rights reserved. Traced Costing: Overhead Allocation Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers

© 2012 Pearson Prentice Hall. All rights reserved. Costing: Cost Drivers  Cost driver is a characteristic of an activity or event that results in the incurrence of costs by that activity or event  Often multiple cost drivers will affect the overall cost; an organization may have many cost drivers across its value chain  Cost drivers:  Cause and effect between activity and costs  Be measureable  Predict/explain activity's use of resources reasonably  Based on resources' practical capacity

© 2012 Pearson Prentice Hall. All rights reserved. Costing: Overhead Allocation using a Single Company-Wide Cost Driver Labour Intensive Process  Traditional cost systems were created when manufacturing processes were labour intensive.  Overhead costs are relatively small.  A single company-wide overhead rate, based on direct labour hours, is used to allocate overhead to products in these labour intensive processes.. Automated Process  Overhead costs are relatively large.  Inaccurate overhead allocation can lead to questionable product cost information.  Need for multiple cost drivers to allocate overhead costs

© 2012 Pearson Prentice Hall. All rights reserved. Allocation of Overhead: Simple  Historically, firms produced a limited variety of goods while their indirect costs were relatively small.  Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of how they are actually incurred.  Peanut-butter costing  The end-result: overcosting and undercosting  Overcosting—a product consumes a low level of resources but is allocated high costs per unit.  Undercosting—a product consumes a high level of resources but is allocated low costs per unit.

© 2012 Pearson Prentice Hall. All rights reserved. Allocation of Overhead: Cross- subsidization  The results of overcosting one product and undercosting another.  The overcosted product absorbs too much cost, making it seem less profitable than it really is.  The undercosted product is left with too little cost, making it seem more profitable than it really is.

© 2012 Pearson Prentice Hall. All rights reserved. Activity Based Costing Process  “ A system that first accumulates overhead costs for each of the activities of an organization and then assigns the costs of activities to the products, services or other cost objects that caused that activity.” p. 147  Rationale for Selection:  Increase in product diversity  Increase in indirect costs  Advances in information technology  Competition in foreign markets

© 2012 Pearson Prentice Hall. All rights reserved. Allocation of Overhead: Activity-Based Costing Activity-based costing (ABC) is a two-stage allocation process that employs a variety of cost drivers. Stage 1 Assign costs to pools according to activities that cause costs to be incurred. Stage 2 Allocate costs in the activity pools to products. The first step is to identify essential activities and costs required to perform the activities.

© 2012 Pearson Prentice Hall. All rights reserved. Allocation of Overhead: Activity-Based Costing Overhead Costs Activity Center 1 Product 1Product 2 Activity Center 3 Activity Center 2

© 2012 Pearson Prentice Hall. All rights reserved. ABC: Conclusions  Each method is mathematically correct.  Each method is acceptable.  Each method yields a different cost figure, which will lead to different gross margin calculations.  Only overhead is involved. Total costs for the entire firm remain the same—they are just allocated to different cost objects within the firm.  Selection of the appropriate method and drivers should be based on experience, industry practices, as well as a cost- benefit analysis of each option under consideration.

© 2012 Pearson Prentice Hall. All rights reserved. ABC: Contexts for its Use  Significant overhead costs allocated using one or two cost pools  Most or all overhead is considered unit-level  Products that consume different amounts of resources  Products that a firm should successfully make and sell consistently show small profits  Operations staff disagreeing with accounting over manufacturing and marketing costs

© 2012 Pearson Prentice Hall. All rights reserved. ABC: Advantages  More accurate and informative product costs lead to better pricing decisions.  The activities driving costs are more accurately measured.  Managers gain easier access to the relevant costs.

© 2012 Pearson Prentice Hall. All rights reserved. ABC: Limitations Expensive: Substantial Resources required to implement and maintain. Resistance to unfamiliar numbers and reports. Desire to fully allocate all costs to products. Potential misinterpretation of unfamiliar numbers. Does not conform to GAAP. Two costing systems may be needed.