The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4 Activity-Based Costing Systems

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-2 Traditional Costing Systems Traditional cost systems were created when manufacturing processes were labor intensive. A single company-wide overhead rate, based on direct labor hours, may be used to allocate overhead to products in these labor intensive processes.

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-3 Overhead is allocated to jobs using direct labor hours. If overhead is $120, how much overhead is allocated to each job? Traditional Costing Systems

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-4 Overhead Rate = $120 ÷ 8 direct labor hours Overhead Rate = $15 per direct labor hour Job 1 = 2 hours × $15 per hour = $30 Job 2 = 6 hours × $15 per hour = $90 Traditional Costing Systems

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-5 Automation increases overhead from $120 to $420 and reduces the Job 2 labor hours from 6 to 1. Allocate the $420 overhead to the two jobs using direct labor. Traditional Costing Systems

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-6 Overhead Rate = $420 ÷ 3 direct labor hours Overhead Rate = $140 per direct labor hour Job 1 = 2 hours × $140 per hour = $280 Job 2 = 1 hour × $140 per hour = $140 Traditional Costing Systems

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-7 Is this reasonable? Automation benefited Job 2, but Job 1 is allocated more overhead. Clearly, we need another cost driver to allocate overhead. Traditional Costing Systems

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-8 Direct labor hours Machine hours Process setups Design time Lot size Customer contact Activity-Based Costing (ABC) A costing method that first assigns costs to activities, then assigns costs to products based on their use of the activities.

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-9 Products Require Activities Consume Resources People Manage Activities Activity-Based Costing (ABC) A costing method that first assigns costs to activities, then assigns costs to products based on their use of the activities.

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-10 ABC is used primarily for decision making, not for inventory valuation for external reporting. Activity-Based Costing (ABC) Both manufacturing and nonmanufacturing costs may be assigned to products. Both manufacturing and nonmanufacturing costs may be assigned to products. Allocation bases often differ from traditional costing systems. Allocation bases often differ from traditional costing systems. A B C ABC is a good supplement to our traditional cost system.

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-11 Level of Complexity Cost of Implementation Level of Benefits Level of Complexity Cost of Implementation Level of Benefits Traditional Costing Activity-Based Costing Activity-Based Costing Activity-Based Costing (ABC)

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-12 Resource Costs Cost Pools: Plants or Departments Cost Objects Traditional Costing Resource Costs Cost Pools: Activities or Activity Centers Cost Objects Activity-Based Costing Directly traced or allocated Predetermined overhead rate Cost driver rates for each activity Activity-Based Costing (ABC)

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-13 Activity Cost Pool An Activity Cost Pool is a “container” in which costs are accumulated that relate to a single activity in the ABC system. $ $ $ $ $ $ Costs Activity-Based Costing (ABC)

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-14  Identify and classify the activities related to the company’s products or services.  Estimate the cost of each activity identified in .  Calculate a cost-driver rate for each activity.  Assign activity costs to products using the cost-driver rate.  Identify and classify the activities related to the company’s products or services.  Estimate the cost of each activity identified in .  Calculate a cost-driver rate for each activity.  Assign activity costs to products using the cost-driver rate. Four Steps in the ABC Process

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-15  Identify and Classify Activities UNIT-LEVEL ACTIVITES Resources acquired and activities performed for individual units. CUSTOMER- LEVEL ACTIVITES Resources acquired and activities p erformed to serve specific customers. BATCH-LEVEL ACTIVITES Resources acquired and activities performed for a group or batch of similar products or services. PRODUCT - LEVEL ACTIVITES Resources acquired and activities performed to produce and sell a specific product or service. FACILITY-LEVEL ACTIVITIES Resources acquired and activities p erformed to provide general capacity to produce goods or services.

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-16 INTERVIEW OR PARTICIPATIVE APPROACH ABC teams include or interview operating employees. INTERVIEW OR PARTICIPATIVE APPROACH ABC teams include or interview operating employees. RECYCLING APPROACH Reuses documentation of processes used for other purposes. RECYCLING APPROACH Reuses documentation of processes used for other purposes. TOP DOWN APPROACH ABC teams of middle- management or above develop the activity dictionary. TOP DOWN APPROACH ABC teams of middle- management or above develop the activity dictionary.  Identify and Classify Activities

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-17 The ABC teams should gather data on the costs of all the activities identified in Step 1.  Estimate the Cost of Activities Examine accounting records for recorded cost information. Ask employees to indicate how much time they work on various activities.

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-18 MAY Company has 4 employees in its Quality Control Department. Salaries and costs for the department total $360,000 per year. MAY produces 500,000 units of product a year. What is the cost-driver rate per unit? $360,000 ÷ 500,000 units = $.72 per unit MAY Company has 4 employees in its Quality Control Department. Salaries and costs for the department total $360,000 per year. MAY produces 500,000 units of product a year. What is the cost-driver rate per unit? $360,000 ÷ 500,000 units = $.72 per unit Two pieces of information are required to compute the cost-driver rate: Activity Cost Activity Volume Two pieces of information are required to compute the cost-driver rate: Activity Cost Activity Volume  Calculate Cost-Driver Rates for Activities

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-19 MAY has a customer service center where customers can call to ask questions. Customers pay a fixed fee for each call they make to the service center. It costs MAY $1,260,000 a year to operate the center. The center receives 120,000 calls per year. The center handles 1,000,000 minutes of calls. What is the appropriate cost driver; total minutes for all calls or number of calls? What is the cost-driver rate? MAY has a customer service center where customers can call to ask questions. Customers pay a fixed fee for each call they make to the service center. It costs MAY $1,260,000 a year to operate the center. The center receives 120,000 calls per year. The center handles 1,000,000 minutes of calls. What is the appropriate cost driver; total minutes for all calls or number of calls? What is the cost-driver rate?  Calculate Cost-Driver Rates for Activities

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-20 Since customers are charged “per call”, the proper activity in this case is the number of calls handled by the center. The cost-driver rate would be: $1,260,000 ÷ 120,000 units = $10.50 per call Since customers are charged “per call”, the proper activity in this case is the number of calls handled by the center. The cost-driver rate would be: $1,260,000 ÷ 120,000 units = $10.50 per call  Calculate Cost-Driver Rates for Activities

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-21  Calculate Cost-Driver Rates for Activities Appropriate cost-driver base Based on resource’s practical capacity to support activities Cause and effect relationship between activity and costs Measurable Predict or explain an activity’s use of resources

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-22 Practical Capacity Note When estimating the cost of an activity, only the costs associated with the product should be used (practical capacity). The cost of “unused capacity” should not be applied to products. EXAMPLE Suppose we rent a 1,000 square foot warehouse for $1,000 per month. Only 800 sq. ft. are used to store Product A. The rest of the warehouse is “unused”. How much rent cost should be allocated to Product A? EXAMPLE Suppose we rent a 1,000 square foot warehouse for $1,000 per month. Only 800 sq. ft. are used to store Product A. The rest of the warehouse is “unused”. How much rent cost should be allocated to Product A?

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin %, or $200 should be assigned to “unused capacity” 80%, or $800 should be assigned to Product A Practical Capacity Note

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-24  Assign Activity Costs to Products 1. Identify all the activities related to a given product or service. 2. Determine how many units of each activity are used per unit of product. 3. Assign costs to products using the cost- driver rates for each activity.

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-25 Example: Yazz, Inc. produces 130,000 units of Product A and 400,000 units for Product B. Using the following cost information, how much overhead should be allocated to Product A?  Assign Activity Costs to Products

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-26  Assign Activity Costs to Products

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-27 Let’s look at an example from the Bilson Company. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-28 Bilson, Inc. manufactures and sells 5,000 units of Product A (deluxe model), and 25,000 units of Product B (standard model) each year. Product A requires 3.0 DLH and Product B requires 2.5 DLH to produce. Employing a traditional costing system, Bilson assigns overhead cost to products using direct labor hours. The predetermined overhead rate is: Bilson, Inc. manufactures and sells 5,000 units of Product A (deluxe model), and 25,000 units of Product B (standard model) each year. Product A requires 3.0 DLH and Product B requires 2.5 DLH to produce. Employing a traditional costing system, Bilson assigns overhead cost to products using direct labor hours. The predetermined overhead rate is: Mfg. overhead cost Direct labor hours = $1,550,000 77,500 =$20/DLH Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-29 Bilson’s unit product costs using traditional costing are: Bilson marks its products up by 50 percent and allocates its $500,000 customer service costs based on revenue. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-30 $975,000 ÷ ($975,000 +$3,900,000) × $500,000 Traditional Costing $ × 1.50 Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-31 Sales of Product A have increased steadily since introduction, but company income has declined. Management at Bilson is unhappy with the traditional costing system and they have decided to try activity-based costing. In addition, management has observed that the cost of direct labor is relatively stable. Since labor does not behave like a unit-level cost, labor will be combined with overhead and the total conversion cost will be assigned using ABC. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-32 The total conversion cost is: Traditional overhead $1,550,000 Labor (77,500 $10) 775,000 Total$2,325,000 The total conversion cost is: Traditional overhead $1,550,000 Labor (77,500 $10) 775,000 Total$2,325,000 In addition, management has observed that the cost of direct labor is relatively stable. Since labor does not behave like a unit-level cost, labor will be combined with overhead and the total conversion cost will be assigned using ABC. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-33 Management has identified the following five activities and costs in the production of its two products: Total conversion cost Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-34 The following transaction data has been complied by management of Bilson: Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-35 These data can be used to develop predetermined cost-driver rates for each of the five activities: $ 800,000 ÷ 5,000 Machine setups = $ per setup Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-36 The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilson’s two products. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-37 The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilson’s two products. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-38 The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilson’s two products. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-39 Let’s compute the product cost for A and B using our ABC overhead rates: These amounts did not change as a result of using ABC. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-40 Now compare the unit product costs using the traditional costing system and our ABC system. Remember, we used one overhead rate based on direct labor hours. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-41 Now compare the unit product costs using the traditional costing system and our ABC system. Adopting activity-based costing usually results in a shift of batch-level and product-level overhead costs from high-volume standard products to low-volume, more complex products. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-42 Can you see how different allocation methods might lead to making different management decisions? Now compare the unit product costs using the traditional costing system and our ABC system. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-43 Based on these results Bilson also decides to use ABC to assign Its $500,000 customer service costs. The applicable activity is number of customer consultations. Customers buying Product A, the deluxe model, require more consultations than those buying Product B, the standard model. Cost per consultation = $500,000 ÷ 125,000 consultations = $4.00 Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-44 ABC Costing No change in sales price Let’s compare product income using traditional and ABC costing. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-45 ABC Costing Traditional Costing

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-46 Should Bilson increase the price of Product A? Should Bilson reduce the price of Product B? Should Bilson drop Product A? Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-47 The price of Product A, the deluxe model, should probably be increased. Customers who buy deluxe models may buy based on features instead of price. The price of Product B, the standard model, may be too high. Customers who buy standard models are price sensitive. Decreasing the price would increase volume, possibly resulting in more income. Activity-Based Costing Example

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-48  More accurate and informative product costs lead to better decisions.  More accurate measurements of the activities driving costs.  Provides managers with easier access to relevant costs.  More accurate and informative product costs lead to better decisions.  More accurate measurements of the activities driving costs.  Provides managers with easier access to relevant costs. An ABC system is very expensive to develop and implement; it is also very time-consuming. ABC– Benefits and Limitations

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-49 When Should a Company Use ABC? Indirect costs are significant in proportion to direct costs. Goods are complex, requiring many inputs and processes. Complex, low-volume products are profitable while standard, high-volume products are not. Different departments believe costs are assigned inaccurately. The company loses bids it thought were low, and wins bids it thought were high. Operations have changed significantly, but the costing system has not changed. Introduction of new models result in higher sales, apparent profits per unit, but an overall income decline. Indirect costs are significant in proportion to direct costs. Goods are complex, requiring many inputs and processes. Complex, low-volume products are profitable while standard, high-volume products are not. Different departments believe costs are assigned inaccurately. The company loses bids it thought were low, and wins bids it thought were high. Operations have changed significantly, but the costing system has not changed. Introduction of new models result in higher sales, apparent profits per unit, but an overall income decline.

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin 4-50 End of Chapter 4