Activity Based Costing: A Tool to Aid Decision Making 3/24/04 Chapter 8 Activity Based Costing: A Tool to Aid Decision Making 3/24/04

Activity Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” costs. ABC is a good supplement to our traditional cost system I agree!

How Costs are Treated Under Activity-Based Costing Departmental Overhead Rates Level of Complexity Plantwide Overhead Rate Overhead Allocation

Plantwide Overhead Rate Companies tended to use direct labor as the overhead allocation base. There was a belief that direct labor and overhead costs were highly correlated. Automation changed all that.

Plant-wide Overhead Rate POHR = Total Manufacturing Overhead Allocation Base Allocation Base usually Direct Labor Is used for all products manufactured Is applied only to those products that incur or use the allocation base, such as direct labor

Departmental Overhead Rates Finishing Department Many companies have a system in which each department has its own overhead rate. Painting Department Shipping Department

Departmental Overhead Rates Indirect Labor Indirect Materials Other Overhead Stage One: Costs assigned to pools Department 1 Department 2 Department 3 Cost pools

Departmental Overhead Rates Indirect Labor Indirect Materials Other Overhead Stage One: Costs assigned to pools Department 1 Department 2 Department 3 Cost pools Stage Two: Costs applied to products Products

Departmental Overhead Rates Indirect Labor Indirect Materials Other Overhead Stage One: Costs assigned to pools Department 1 Department 2 Department 3 Cost pools Direct Labor Hours Machine Hours Raw Materials Cost Stage Two: Costs applied to products Products Departmental Allocation Bases

Cost of Idle Capacity Activity Based Costing Traditional Cost Accounting The predetermined overhead rate is based on budgeted activity. This results in applying overhead costs of unused, or idle, capacity. Activity Based Costing Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Idle capacity Is charged as a period Cost.

Designing of an ABC System Steps for Implementing ABC Identify and define activities and activity cost pools. Trace costs to those activities and cost objects. Assign all other traceable costs to activity cost pools. Non-traceable costs lumped. Calculate activity rates. Assign costs to cost objects(products, customers). Prepare management reports.

Identify and Define Activities and Activity Cost Pools A part of the production process for which management wants a separate reporting of the costs of the activity involved. Unit-Level Activity (machining) Batch-Level (customer order) Product-Level (product design) Customer-Level (customer relations) Organization- sustaining Activity (lumped)

Identify and Define Activities and Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

Identify and Define Activities and Activity Cost Pools $ Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system.

Identify and Define Activities and Activity Cost Pools Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product Designs - assigned all costs of resources consumed by designing products. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. I.e., machine shop costs Customer Relations – assigned all costs associated with maintaining relations with customers. Other – assigned all overhead costs that are not associated with the other cost pools.

Whenever Possible, Directly Trace all Overhead Costs to Activities and Cost Objects

Assign Costs to Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity cost pools is determined. **Not included because they are directly traced to customer orders.

Assign Costs to Activity Cost Pools Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

Assign Costs to Activity Cost Pools Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

Assign Costs to Activity Cost Pools

Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . . 1,000 customer orders 200 new designs 20,000 machine-hours 100 customer relations activities Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

Calculate Activity Rates ÷

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Traced Cost Objects: Products, Customers

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Cost Objects: Products, Customers

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Second-Stage Allocations $/MH $/Order $/Design $/Customer Cost Objects: Products, Customers Unallocated

Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer – Windward Yachts. Standard Stanchions (no design required) 1. 400 units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours . 3. Selling price is $34 each. 4. Direct materials total $2,110. 5. Direct labor totals $1,850. 6. Shipping costs total $180. Custom Compass Housing (requires new design) 1. One order during the year. 2. Each housing required 4 machine-hours . 3. Selling price is $650 each. 4. Direct materials total $13. 5. Direct labor totals $50. 6. Shipping costs total $25.

Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.

Prepare Management Reports

Prepare Management Reports Customer Profitability Analysis

Predetermined manufacturing Product Margins Traditional Cost Accounting System 400 units x 0.5 MH/unit x $50/MH = $10,000 Predetermined manufacturing overhead rate $1,000,000 20,000 MH = $50/MH =

Comparison of ABC and Traditional Overhead Product Costs Product Standard Custom ABC Trad ABC Trad Overhead 10000 200 Shipping 180 25 Cust Order 630 315 Design 1285 Order size 3800 76 OH assigned 4610 1701

Contrasting ABC and Traditional Costing See TM 8-16 Calculate cost per unit for both Stanchions and Custom Compass Housing Note the shift in overhead costs from the high volume Stanchions to the low volume Custom Compass Housings

Difference Between ABC and Traditional Product Costs Batch-level or product-level costs will ordinarily shift overhead costs from high-volume products produced in large batches to low-volume products produced in small batches. Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organization-sustaining costs and the costs of idle capacity are not assigned to products.

Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because . . . External reports are less detailed than internal reports. It may be difficult to make changes to the company’s accounting system. ABC does not conform to GAAP. Auditors may be suspect of the subjective allocation process based on interviews with employees.

Benefits of ABC More cost pools = more accurate costs on a per unit basis Cost are assigned using relevant versus arbitrary drivers Makes overhead costs more manageable (traceable) Shifts costs from high volume to low volume products as appropriate

Limitations of ABC Too many organization sustaining costs can limit the benefits of ABC There are high costs associated with ABC implementation High time commitments and discipline required in making necessary cost changes

ABC Review Problem See pages 340 – 342 Step 1: Allocate overhead costs to activity pools Step 2: Calculate activity rates by dividing each pool cost by activity Step 3: Use activity rates to assign overhead costs to products based on activities per product

End of Chapter 8