Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 5 Activity-Based Costing

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:

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%) x 1.25

Activity Based Costing System (ABC) two- stage ABC systems follow a two- stage procedure to assign overhead costs to products. Assigning overhead to products is a difficult process. I agree!

Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Let’s begin by identifying our major activities. Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.

Activity Based Costing System (ABC) Overhead assigned to activities are called “activity cost pools.” Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products. ABC systems follow a two-stage procedure to assign overhead costs to products.

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.

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

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

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

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

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

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

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

Exh. 5-9 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

Exh. 5-9 Budgeted Facilities Cost $507,400 Budgeted Direct-Labor Hours 118,000 $4.30/hour $4.30/hour CostAssignment STAGE TWO = = Calculate the pool rate

Other Overhead Costs $14.82

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%). [$ × 1.25][$ × 1.25] The selling price of Mode I and II are reduced and the selling price for Mode III is increased.

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

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.

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

Methods of Data Collection Interview & 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.

Direct versus Indirect Costs Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. IndirectCosts

Indicators of Need for ABC Line managers do not believe the product costs reports Line managers do not believe the product costs reports Marketing does not use costs reports for pricing decisions Marketing does not use costs reports for pricing decisions Product-line profit margins are hard to explain Product-line profit margins are hard to explain Sales are increasing, but profits are declining. Sales are increasing, but profits are declining. Some products that have reported high profit margins are not sold by competitors Some products that have reported high profit margins are not sold by competitors Direct labor is a small percentage of total costs Direct labor is a small percentage of total costs

Optimal Product-Costing System High High Low Low Cost InformationSystemAccuracy Optimalsystem Total Cost Design, implementation and maintenance costs Cost of inferiordecisionsresultingfrominaccurateinformation. Exh. 5-13

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 6 Activity-Based Management and Cost Management Tools

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. The use Of ABC information to help management make decisions

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

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

Using ABM to Eliminate Non- Value-Added Activities and Costs Ê Identify Activities. Ë Identify Non-Value-Added Activities. Ì Understand Activity Linkages, Root Causes, and Triggers. Í Establish Performance Measures. Î Report Non-Value-Added Costs. SpecifypartsSpecifypartsSelectvendorSelectvendorReceivepartsReceivepartsProducegoodsProducegoodsInspectfinishedgoodsInspectfinishedgoodsReworkdefectiveproductsReworkdefectiveproducts

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

Achieving Cost Reduction ActivityReduction ActivityElimination Activity Selection Activity Sharing ReduceNon-Value-AddedCosts

Customer Profitability Analysis Orders small quantities. Orders frequently. Often changes orders. Required special packaging. Demand fast service. A costly customer Customer profitability analysis uses ABC to determine the activities, costs, and profit associated with serving particular customers.

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

Value engineering is used to achieve a product design that meets the target cost. Target Costing Quality of materials Number of parts Change component s Change methods Design a product, and the manufacturing process, so that the product can be manufactured at a cost that will enable the firm to make a profit when the product is sold at an estimated market-driven price.

Kaizen Costing The process of cost reduction during the manufacturing phase of an existing product Kaizen cost goal is established to help achieve continuous cost reduction. 3/31/x13/31/x2.. Product cost } Kaizen goal cost-reductionamount.

Benchmarking The continual search for the most effective method of accomplishing a task, by comparing existing methods and performance levels with those of other organizations. Here are the best practices in our industry...

Re-engineering The complete redesign of a process, with an emphasis on finding creative new ways to accomplish an objective.

Theory of Constraints A management approach seeking to maximize long-run profit through proper management of organizational bottlenecks or constrained resources.

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.

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.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.