21b - 1 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Appendix 21B: Activity-based Costing Objectives l Describe and develop activity-based costs (ABC) l Decide when ABC is most likely to pass the cost-benefit test

21b - 2 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia David, Matt, and Marc: Total expenses = $900 Cost allocated = $300 per person Rent and Electricity$570 Cable TV 50 High speed Internet access 40 Groceries 240 Total$900 Refining Cost Systems

21b - 3 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Refining Cost Systems More Refined Allocation David Matt Marc Total Rent and Electricity$190$190$190$570 Cable TV 25 – Internet access – 40 – 40 Groceries – Total costs allocated$215$310$375$900 Original cost allocation Difference$(85)$ 10$ 75$ 0

21b - 4 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Sharpening the Focus: From Business Functions to Activities PANEL A—Companywide Business Functions in the Value Chain R&D Design Production Marketing Distribution Customer Service PANEL B—Production Departments/Product Lines Servers Notebook Computers Desktop Computers Inventoriable costs for financial reporting

21b - 5 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Sharpening the Focus: From Business Functions to Activities PANEL C—Activities for Desktop Product Line 1.Kitting—preparing all items for assembly 2.Motherboard preparation—snapping in CPU and memory modules 3.Assembly into chassis 4.Software downloading 5.Testing 6.Boxing Inventoriable costs for financial reporting

21b - 6 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Describe and develop activity-based costs (ABC). Objective 1

21b - 7 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Example of Activities and Cost Drivers: Activities: Material purchasing Material handling Production scheduling Quality inspections Photocopying Warranty service Cost Drivers: No. of purchase orders No. of parts No. of batches No. of inspections No. of pages copied No. of service calls Activity-Based Costing

21b - 8 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Traditional versus Activity-Based Costing Systems l Chemtech produces large quantities of “commodity” chemicals. l It also manufactures small quantities of specialty chemicals. l In the past, Chemtech’s manufacturing department has used direct labour hours as its single allocation base at a 200% rate.

21b - 9 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Traditional versus Activity-Based Costing Systems l Among its many products, the department produces Aldehyde (a commodity chemical used by producing plastics) and... l Phenylephrine Hydrochloride (PH), which is a specialty chemical. l A single customer uses PH in manufacturing blood-pressure medications.

21b - 10 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Traditional versus Activity-Based Costing Systems Chemical Manufacturing Department Overhead Direct Labour Cost Chemical A Chemical B Chemical C Departmental Indirect Cost Pool Cost Allocation Base Product Cost Objects

21b - 11 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Traditional versus Activity-Based Costing Systems Chemical Manufacturing Department Overhead No. of Machine Hours Chemical A Chemical B Chemical C Departmental Indirect Cost Pool Cost Allocation Base Product Cost Objects No. of Samples Taken No. of Batches ProcessingMixingTesting Activity Indirect Cost Pool

21b - 12 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Chemtech Traditional Cost System Aldehyde PH Sale price per Kg $10$70 Less: manufacturing cost per Kg Direct materials 5 20 Direct labour 1 10 Manufacturing overhead 2 20 Gross profit per Kg$ 2$20 Traditional versus Activity-Based Costing Systems

21b - 13 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Traditional versus Activity-Based Costing Systems l Assume that the company produced 7,000 Kg of Aldehyde and 5 Kg of PH. l What is the total labour cost per product? l 7,000 Kg × $1 = $7,000 (Aldehyde) l 5 Kg × $10 = $50 (PH) l What is the total manufacturing overhead allocated to each product?

21b - 14 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Chemtech assigns 140 times as much overhead to Aldehyde as to PH. Chemtech assigns 140 times as much overhead to Aldehyde as to PH. Traditional versus Activity-Based Costing Systems l $7,000 × 200% = $14,000 to Aldehyde l $50 × 200% = $100 to PH

21b - 15 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Activity-Based Costing System Identify activities. Mixing Processing Testing Estimate the total indirect costs of each activity. Labour$150,000 Depreciation 200,000 Other 250,000 Total$600,000 Step 1Step 2

21b - 16 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Activity-Based Costing System Identify the primary cost driver for each activity’s indirect costs. (1)(2) (3) ActivityEstimated CostsCost Driver Mixing$600,000# of batches Processing$300,000# of hours (MH) Testing$600,000# samples Step 3

21b - 17 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Activity-Based Costing System Estimate the total quantity of each allocation base. (1) (4) ActivityEstimated Quantity of Cost Driver Mixing4,000 batches Processing5,000 machine hours (MH) Testing3,000 samples Step 4

21b - 18 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Activity-Based Costing System Calculate the allocation rate for each activity. (1) (5) Activity Cost Allocation Rate Mixing$600,000 ÷ 4,000 = $150/batch Processing$300,000 ÷ 5,000 = $60/MH Testing$600,000 ÷ 3,000 = $200/sample Step 5

21b - 19 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Activity-Based Costing System Obtain the actual quantity of each allocation base used by each product. During the year, Chemtech produced 60 batches of Aldehyde and 1 batch of PH. The remaining batches consist of Chemtech’s other chemicals. Step 6

21b - 20 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Activity-Based Costing System Allocate the costs to each product. Mixing Cost Allocation: Aldehyde: 60 batches × $150 per batch = $9,000 PH: 1 batch × $150 per batch = $150 Step 7

21b - 21 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Activity-Based Costing System The ABC system allocates 29 times as much overhead to Aldehyde as to PH. Activity Cost Driver Units Cost Allocated to: Used By: Aldehyde PH Aldehyde PH Mixing60 batches1 batch$ 9,000$150 Processing30.5 MH2 MH 1,830* 120 Testing14 samples1 sample 2, Total$13,630$470 *30.5 MH × $60 per MH = $1,830

21b - 22 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Cost/kg Traditional ABC (Overhead)SystemSystem Aldehyde$ 2.00$ 1.95 PH$20.00$94.00 Activity-Based Costing System l What is the overhead cost per kg? l Aldehyde: $13,630 ÷ 7,000 = $1.95 l PH: $470 ÷ 5 = $94

21b - 23 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Aldehyde PH Sale price per kg $10.00$ Less:manufacturing cost per kg Direct materials Direct labour Manufacturing overhead Gross profit per kg $ 2.05$(54.00) Activity-Based Costing System Chemtech Gross Profit per Kg.

21b - 24 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Decide when ABC is most likely to pass the cost-benefit test. Objective 2

21b - 25 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia The Cost-Benefit Test l ABC’s benefits are higher when... – the company produces many different products that use different amounts of resources. – the company has high overhead costs. – the company produces high volumes of some products, and low volumes of other products.

21b - 26 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia The Cost-Benefit Test l The costs of adopting ABC are lower when the company has... – accounting and information system expertise to develop the system. – information technology (bar coding, optical scanning) to record cost driver data.

21b - 27 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Managers don’t understand costs and profits. The cost system is outdated. Signs That the Cost System May Be Broken

21b - 28 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia End of Chapter 21B