Activity-Based Costing and Management

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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:

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

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

Traditional, Volume-Based Product-Costing System With these product costs, Aerotech established target selling prices (Cost × 125%). 209.00 x 1.25

Activity Based Costing System (ABC) 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.

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

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

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

STAGE TWO Calculate the pool rate Cost Assignment Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hour = = Cost Assignment

STAGE ONE Setup Cost Pool Calculation of total setup cost Activity Total budgeted cost = $3,000

STAGE TWO Calculate the pool rate Cost Assignment Budgeted Setup Costs $3,000 Planned Production Runs 15 runs $200 per run = = Cost Assignment

STAGE ONE Engineering Cost Pool Various overhead costs related to engineering Engineering salaries Engineering software Engineering supplies Depreciation Activity cost pool Engineering Cost Pool Total budgeted cost = $700,000

STAGE TWO Engineering Cost Pool Allocate based on engineering Total budgeted cost = $700,000 Allocate based on engineering transactions Cost Assignment

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

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

Other Overhead Costs

Other Overhead Costs $14.82

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

Distorted Product Costs Both original and ABC target selling prices are based on (Cost × 125%). The selling price of Mode I and II are reduced and the selling price for Mode III is increased. [$209.00 × 1.25] [$183.44 × 1.25]

Distorted Product Costs 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.

Two Key Points Product diversity 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.

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 Behavioral Effects Cost of Measurement

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

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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.

Two-Dimensional ABC and Activity-Based Management Activities

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

Two-Dimensional ABC and Activity-Based Management Resource costs Cost Assignment View Root Causes Process View Activity Analysis Performance Measures Activity Evaluation Activities Activity Triggers Cost Objects

Elimination of Non-Value-Added Costs Activities Nonvalue-added activities Unnecessary Necessary Reduce or Eliminate Continually Evaluate and Improve

Using ABM to Eliminate Non-Value-Added Activities and Costs Identify Activities. Identify Non-Value-Added Activities. Understand Activity Linkages, Root Causes, and Triggers. Establish Performance Measures. Report Non-Value-Added Costs. Specify parts Select vendor Receive parts Produce goods Inspect finished goods Rework defective products

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

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

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

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

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.

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

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

This is my kind of cost pool!

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