Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 5 Activity-Based Costing and Management

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 1

5-3 Traditional, Volume-Based Product-Costing System Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records: Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records:

5-4 Traditional, Volume-Based Product-Costing System Additional information includes: Manufacturing overhead is determined as follows

5-5 Traditional, Volume-Based Product-Costing System Budgeted manufacturing overhead $3,894,000 Budgeted direct-labor hours 118,000 = $33 per hour

5-6 Traditional, Volume-Based Product-Costing System With these product costs, Aerotech established target selling prices (Cost × 125%) x 1.25

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 2

5-8 Activity Based Costing System (ABC) two-stage ABC systems follow a two-stage procedure to assign overhead costs to products. Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used. Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 3

5-10 Overhead Costs Total budgeted cost = $3,894,000 ActivityCostPools Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 Unit Level Batch Level Product- Sustaining Level Facility Level Identification of Activity Cost Pools Identification of Activity Cost Pools Activity must be done on each unit produced. Activityperformed on each batchproduced. Activities needed to support an entire product line Activity required in order for the production process to occur.

5-11 Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000 Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 Unit Level Batch Level Product- Sustaining Level Facility Level

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objectives 3 & 4

5-13 Machinery Cost Pool Total budgeted cost = $1,212,600 Maintenance Depreciation Computer Support Lubrication Electricity Calibration Activitycostpool STAGE ONE Various overhead costs related to machinery

5-14 Calculate the pool rate Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hour $28.20/hour CostAssignment STAGE TWO = =

5-15 Calculation of total setup cost Setup Cost Pool Total budgeted cost = $3,000 Activitycostpool STAGE ONE

5-16 Calculate the pool rate Budgeted Setup Costs $3,000 Planned Production Runs 15 runs $200 per run $200 per run CostAssignment STAGE TWO = =

5-17 Various overhead costs related to engineering Engineering salaries Engineering supplies Engineering software Depreciation Engineering Cost Pool Total budgeted cost = $700,000Activitycostpool STAGE ONE

5-18 Allocate based on engineering transactions CostAssignment STAGE TWO Engineering Cost Pool Total budgeted cost = $700,000

5-19 Various overhead costs related to general operations Plant depr. Plant mgmt. Plant maint. Property taxes Insurance Security Facility Cost Pool Total budgeted cost = $507,400Activitycostpool STAGE ONE

5-20 Budgeted Facilities Cost $507,400 Budgeted Direct-Labor Hours 118,000 $4.30/hour $4.30/hour CostAssignment STAGE TWO = = Calculate the pool rate

5-21 Other Overhead Costs

5-22 Other Overhead Costs $14.82

5-23 Product Cost from ABC These are the new product costs when Aerotech uses ABC.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 5

5-25 Distorted Product Costs Both original and ABC target selling prices are based on (Cost × 125%). [$ × 1.25][$ × 1.25] The selling price of Mode I and II are reduced and the selling price for Mode III is increased.

5-26 Can you identify any problems Aerotech is likely to face as a result of this distortion? Traditional costing understates the cost of complex, low volume products. Distorted Product Costs

5-27 Two Key Points A large proportion of non- unit-level activities A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately. A large proportion of non- unit-level activities A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately. Product diversity When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs. Product diversity When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 6

5-29 Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider... Degree of Correlation Cost of Measurement BehavioralEffects

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 7

5-31 COLLECTING ABC DATA INTERVIEWS AND PAPER TRAILS - The information for ABC systems initially comes from interviews with employees in the support departments and a review of each department’s records. STORYBOARDING - A procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities. MULTIDISCIPLINARY ABC PROJECT TEAMS – To gather information from all facets of an organizations operations, it is essential to involve personnel from a variety of functional areas. A typical ABC project team includes ACCOUNTING, FINANCE, PRODUCTION, OPERATIONS, ENGINEERS, MARKETING etc.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 8

5-33 Activity-Based Management The use of ABC costing information to help management make decisions

5-34 Activity-Based Management Activity-based costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs. Activity-based management focuses on managing activities to reduce costs.

5-35 Two-Dimensional ABC and Activity-Based Management Activities

5-36 Two-Dimensional ABC and Activity-Based Management Cost Objects Activities Resource costs Cost Assignment View

5-37 Two-Dimensional ABC and Activity-Based Management ActivityTriggersActivityTriggers Cost Objects Activities RootCausesRootCauses Process View Activity Analysis Resource costs Cost Assignment View PerformanceMeasuresPerformanceMeasures Activity Evaluation

5-38 Elimination of Non-Value-Added Costs Nonvalue- added activities Necessar y Unnecessary Activities Reduce or Eliminate Continually Evaluate and Improve

5-39 Using ABM to Eliminate Non- Value-Added Activities and Costs 1. Identify Activities. 2. Identify Non-Value-Added Activities. 3. Understand Activity Linkages, Root Causes, and Triggers. 4. Establish Performance Measures. 5. Report Non-Value-Added Costs. SpecifypartsSpecifypartsSelectvendorSelectvendorReceivepartsReceivepartsProducegoodsProducegoodsInspectfinishedgoodsInspectfinishedgoodsReworkdefectiveproductsReworkdefectiveproducts

5-40 Using ABM to Eliminate Non- Value-Added Activities and Costs Inspection time Process time Storage time Move time Waiting time

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 9

5-42 Customer Profitability Analysis Customer profitability analysis uses activity-based costing to determine the activities, costs, and profit associated with serving particular customers.

5-43 Customer Profitability Analysis Orders small quantities. Orders frequently. Often changes orders. Required special packaging. Demand fast service. A costly customer

5-44 Customer Profitability Analysis A company may use these customer related costs to help determine the profitability of each customer.

5-45 Customer Profitability Analysis 75% of actual operating income 50% of actual operating income 25% of actual operating income

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 10

5-47 Activity-Based Management in the Service Industry Activity Analysis Customer Profitability Analysis

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 11

5-49 Just-in-Time Inventory and Production Management No materials are purchased and no products are manufactured until they are needed. The primary goal of a JIT production system is to reduce or eliminate inventories at every stage of production. The primary goal of a JIT production system is to reduce or eliminate inventories at every stage of production.

5-50 Key Features of the JIT Approach Smooth, uniform production rate Pull method of production Purchase is small lot sizes Quick, inexpensive setups High quality materials Effective preventive maintenance Teamwork Multiskilled workers

5-51 JIT Purchasing Long-term contracts with suppliers.Long-term suppliers. Only a few suppliers. suppliers. Parts delivered in small lots. Parts delivered in small lots. Minimal inspection of materials.Minimal materials. Grouped payments to vendor.Grouped vendor.

5-52 End of Chapter 5 This is my kind of cost pool!