A&MIS 5251 Introduction to Accounting Activity Based Costing: A Tool to Aid Decision Making Session 10 February 7,2002

A&MIS 5252 Activity Based Costing (ABC) The objective of activity-based costing is to understand overhead and the profitability of products and customers. ABC is a good supplement to our traditional cost system I agree!

A&MIS 5253 Overhead rates may be based on activity at capacity. Overhead rates may be based on activity at capacity. Activity Based Costing (ABC) Activity-Based Costing Both manufacturing and nonmanufacturing costs may be assigned to products. Both manufacturing and nonmanufacturing costs may be assigned to products. Some manufacturing costs may be excluded from product costs. Some manufacturing costs may be excluded from product costs. There are a number of cost pools each of which is allocated using a unique measure of activity. There are a number of cost pools each of which is allocated using a unique measure of activity. Allocation bases often differ from traditional costing systems. Allocation bases often differ from traditional costing systems.

A&MIS 5254 How Costs are Treated Under Activity-Based Costing Level of Complexity Overhead Allocation Plantwide Overhead Rate Plantwide Overhead Rate Departmental Overhead Rates Departmental Overhead Rates Activity Based Costing Activity Based Costing

A&MIS 5255 Plantwide Overhead Rate direct labor Companies tend to use direct labor as the overhead allocation base.

A&MIS 5256 A two stage process is necessary because costs are allocated to departments and then to products. A two stage process is necessary because costs are allocated to departments and then to products. Finishing Department Shipping Department Painting Department Departmental Overhead Rates

A&MIS 5257 Department 1 Department 2 Department 3 Cost pools Indirect Labor Indirect Labor Indirect Materials Indirect Materials Other Overhead Other Overhead Stage One: Costs assigned to pools Departmental Overhead Rates

A&MIS 5258 Department 1 Department 2 Department 3 Cost pools Stage One: Costs assigned to pools Products Stage Two: Costs applied to products Departmental Overhead Rates Indirect Labor Indirect Labor Indirect Materials Indirect Materials Other Overhead Other Overhead

A&MIS 5259 Department 1 Department 2 Department 3 Cost pools Stage One: Costs assigned to pools Products Stage Two: Costs applied to products Direct Labor Hours Machine Hours Raw Materials Cost Departmental Allocation Bases Departmental Overhead Rates Indirect Labor Indirect Labor Indirect Materials Indirect Materials Other Overhead Other Overhead

A&MIS Designing an ABC System Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers) Activities Consumption of Resources Consumption of Resources Cost

A&MIS Designing an ABC System Steps for Implementing ABC  Identify and define activities and activity pools.  Where possible, trace costs to activities and cost objects.  Assign costs to activity cost pools.  Calculate activity rates.  Assign costs to cost objects.  Prepare management reports.

A&MIS Identifying Activity to Include A part of the production process for which management wants a separate reporting of the costs of the activity involved. Unit-Level Activity Batch-Level Activity Product-Level Activity Customer-Level Activity Organization- sustaining Activity

A&MIS Identifying Activity to Include Activity Cost Pool Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity in the ABC system. $ $ $ $ $ $

A&MIS The Mechanics of ABC At Classic Brass, the ultimate cost objects are:  Products,  Customer orders, and  Customers. One overhead cost - shipping - can be traced directly to customer orders. The company’s overhead costs are shown on the next slide.

A&MIS 52515

A&MIS Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Overhead Costs Traced $/DLH Traced Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers

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

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

A&MIS Assigning Costs to Activity Cost Pools Management at Classic Brass believes overhead should be distributed as follows:

A&MIS Assigning Costs to Activity Cost Pools Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

A&MIS Assigning Costs to Activity Cost Pools Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000 Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

A&MIS Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

A&MIS Computation of Activity Rates The ABC team has determined that Classic Brass has the following total activities for each activity cost pool... –1,000 customer orders, –200 new designs, –20,000 machine-hours –100 customers. Now the team can compute the individual activity rates.

A&MIS Computation of Activity Rates

A&MIS Computation of Activity Rates

A&MIS Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer - Windward Yachts. –Windward ordered two products - Stanchions and customer compass housings. Here are the details: Standard Stanchions (no design required) 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, Direct labor totals $1, Shipping costs total $180. Standard Stanchions (no design required) 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, Direct labor totals $1, Shipping costs total $180.

A&MIS Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer - Windward Yachts. –Windward ordered two products - Stanchions and customer compass housings. Here are the details: 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 $ Direct labor totals $ Shipping costs total $25. 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 $ Direct labor totals $ Shipping costs total $25.

A&MIS Assigning Costs to Cost Objects $125 per order × 2 orders = $250 Overhead cost of two orders for standard stanchions.

A&MIS Assigning Costs to Cost Objects Overhead cost of two orders for standard stanchions.

A&MIS Assigning Costs to Cost Objects Overhead cost of one order for custom compass housing. $125 per order × 1 order = $125

A&MIS Assigning Costs to Cost Objects Overhead cost of one order for custom compass housing.

A&MIS Product Margins

A&MIS Product Margins

A&MIS Product Margins Traditional Cost Accounting System Predetermined manufacturing overhead rate $1,000,000 20,000 MH = $50/MH=

A&MIS Product Margins Traditional Cost Accounting System 400 units x 0.5 MH/unit x $50/MH = $10,000

A&MIS Difference Between ABC and Traditional Product Costs ABC will ordinarily shift batch-level and product-level overhead costs from high-volume products produced in large batches to low-volume products produced in small batches.

A&MIS Difference Between ABC and Traditional Product Costs 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.

A&MIS Ease of Adjustment Costs that adjust automatically to changes in activity: –Direct materials. –Shipping. Costs that could be adjusted to changes in activity: –Direct labor. –Factory utilities. –Administrative wages and salaries. –Office equipment depreciation. –Marketing wages and salaries. –Selling expenses. Costs that are difficult to adjust to changes in activity: –Factory equipment depreciation. –Factory building lease. –Administrative building lease.

A&MIS 52539

A&MIS Simplified Approach to ABC After the first-stage allocation is complete, computation of activity rates for each activity cost pool can be simplified as follows: ÷ ÷ ÷÷

A&MIS Simplified Approach to ABC 2 $315 per order

A&MIS Simplified Approach to ABC 1 $1,285 per design

A&MIS Simplified Approach to ABC Customer margin for Windward Yachts is shown below:

A&MIS End of Chapter 8 I call this qualitytime!

A&MIS Puzzle A shipping company had trouble determining how much it should cost to ship materials from Ohio to a point near the Atlantic ocean. In spite of numerous trips within the Great Lakes area, the company still found it difficult to predict costs. What do you suppose was making cost estimation difficult?

A&MIS Agenda Today Clarify our views of the activity paradigm Discuss efficiency & effectiveness Summarize the basics about the relationship of standards to the costs incurred Review some problems

A&MIS Outputs Inputs Basic Activity View

A&MIS Activities Activities are about actions, doing something, effort, work done, not the consequences of the work or effort. Metrics or measures are the ways we are going to quantify the volume of activity during a time period. Different activities require different metrics.

A&MIS Activity Terminology Statistics represent the numeric values assigned to the metrics for a period. Data sources are the primary or secondary sources of the statistics.

A&MIS Thinking About Activities InputsActivitiesOutputs 1. LaborAssemblingProducts 2. MaterialsProcessingIntermediate products 3.PartsAssembling Assembly 4.EquipmentStampingSteel part 5.ServicesInsuranceRisk reduction 6.Warehouse Storing Availability

A&MIS An Observation Defining activities can be difficult, particularly in service and creative work. Even when we can define an activity, it can be difficult to separate measures of activity level from measures of output. It is simpler to focus on outputs, which is what the text tends to do in places. But properly defining activities is crucial

A&MIS Related Terminology What does it mean to be efficient? What does it mean to be effective?

A&MIS Efficiency Measures of efficiency nearly always compare the inputs to an activity or process with its outputs. The greater the output per unit of input, the more efficient. The fewer the units of input required to make one unit of output, the greater the efficiency. Efficiency is a general concept that relates to entities ranging from individuals performing a single task to entire economies.

A&MIS Efficiency Since the productivity of labor has been so key to the wealth of a society, we continue to focus on the productivity of people. Sales per person, gross margin per person, and physical output per person, are measures of efficiency as well as measures of productivity. Cost per sales dollar, or cost per unit of output are the most common measures of efficiency used in managerial accounting.

A&MIS Efficiency in Accounting In accounting we use cost standards, flexible budgets and profitability measures to evaluate efficiency. These standards relate the work done to the cost incurred to achieve that work. Physical measures are useful, but the ultimate measures include profitability. We may measure other operating variables because we believe they relate to profitability in the longer run.

A&MIS Just in time Basic Activity View INPUTS Outputs Input/Output

A&MIS Input/Output Relationships INPUTSOUTPUTS Yield or Productivity Efficiency

A&MIS Basic Activity View Outputs INPUTS Input/Output Utilization Rates Productivity

A&MIS Effectiveness Effectiveness is concerned with the achievement of objectives. Making a sales goal, achieving a target market share, completing a project on schedule, satisfying customers, and retaining employees--which may or may not change productivity. So effectiveness is a separate issue: Did we achieve the goal?

A&MIS Effectiveness Measures Percent of the goal achieved. Percent variance from goal. Improvement from past experience Percent of the goal achieved compared with last period. Percent variance from goal compared with last period. Examples from your experience?

A&MIS Effectiveness Measures Headcount, cycle time, customer satisfaction, and other measures are believed to lead to greater profitability. But they are not measures of efficiency per se.

A&MIS Operational (Technical) Control Provides feedback to employees and their managers about the efficiency of activities being performed. Measures of effectiveness might include cycle times, spoilage rates, lost units, late shipments, etc.

A&MIS Break for it!

A&MIS Standard Costing A management system that makes sense in a technical planning and control context Concerned with economic efficiency, not effectiveness beyond this one isssue.

A&MIS Roots Originated as part of the scientific management movement of the early to mid 20 th century. Represents a move away from arbitrary management methods to those based on observable “scientific” information. This movement followed the successes of medicine and agriculture earlier in the 20 th century.

A&MIS Substance Standards represent the output that should be achieved at a specified level of perfection based on the operating capacities of people, equipment, management, process design, etc.

A&MIS Relationship Overview Standard cost + Unfavorable variances - Favorable variances = (Actual) cost incurred (GAAP)

A&MIS Relationship Overview (dr/cr) Standard cost (dr) + Unfavorable variances (dr) - Favorable variances (cr) = (Actual) cost incurred (dr)

A&MIS Formulae Output achieved x unit standard = total input at standard Materials, labor and driver activity: AQ O (output) x sq (unit standard) = SQ (total material, labor or driver activity “allowed” at standard) Standard cost per unit = Σ(sq x sp)

A&MIS Formulae Standard cost of production = AQ O x Σ(sq x sp) When the price variance is isolated and recorded at usage, aqap = spsq + (ap–sp)aq + (aq-sq)sp aqap = spsq + apaq – spaq + aqsp - sqsp

A&MIS Nothing in the world can take the place of PERSISTENCE. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded it's almost a proverb. Education will not; the world is filled with educated derelicts. PERSISTENCE and DETERMINATION alone are omnipotent. _Calvin Coolidge Today’s Quote