Activity Based Costing: A Tool to Aid Decision Making Chapter8 Activity Based Costing: A Tool to Aid Decision Making

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!

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

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

Plantwide Overhead Rate Companies tend to use direct labor as the overhead allocation base.

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

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

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

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

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

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.

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

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

At Classic Brass, the ultimate cost objects are: 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.

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

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

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

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

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

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

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

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.

Computation of Activity Rates

Computation of Activity Rates

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) 1. 400 units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours . 3. Selling price is $34 each. 4. Direct materials total $2,110. 5. Direct labor totals $1,850. 6. Shipping costs total $180.

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 $13. 5. Direct labor totals $50. 6. Shipping costs total $25.

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

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

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

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

Product Margins

Product Margins

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

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

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.

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.

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.

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: ÷ ÷ ÷ ÷

Simplified Approach to ABC 2 orders @ $315 per order

Simplified Approach to ABC 1 design @ $1,285 per design

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

End of Chapter 8 I call this quality time!