4-1 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Activity-Based Accounting 4 PowerPresentation® prepared by David J. McConomy, Queen’s University

4-2 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Learning Objectives l Discuss the importance of unit costs to managers’ decisions. l Describe functional-based costing approaches. l Explain why functional-based costing approaches may produce distorted costs.

4-3 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Learning Objectives (continued) l Explain how an activity-based costing system works. l Provide a detailed description of how activities can be grouped into homogeneous sets to reduce the number of activity rates.

4-4 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. l Describe activity-based customer and supplier costing. Learning Objectives (continued)

4-5 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Unit Costs The unit cost is the total cost associated with the units produced divided by the number of units produced Although the concept is simple, the practical reality ofthe computation can be somewhat more complex because of the following issues: –What is meant by “total cost”? –How do we measure the costs to be assigned? –How do we assign costs to the product?

4-6 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Unit Costs (continued) Unit costs are important for: l inventory valuation l income determination l providing input to a variety of decisions such as pricing, make or buy, and accept or reject special orders

4-7 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Measurement Systems Two possible measurement systems are actual costing and normal costing. Actual costing assigns the actual costs of direct materials, direct labour, and overhead to products. Normal costing assigns the actual costs of direct materials and direct labour to products; however, overhead cots are assigned to products using predetermined rates.

4-8 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Activity Capacity Measures Units (of driver) Theoretical Practical Expected actual Normal Time

4-9 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Functional-Based Costing: Plantwide Rate Overhead Costs Assign Costs Plantwide Pool Cost Assignment Products Direct Tracing Stage One: Pool Formation Unit-Level Driver Stage Two: Costs Assigned

4-10 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc. Belring, Inc. produces two telephones: a cordless and a regular model. The company has the following estimated and actual data: Budgeted overhead $360,000 Expected activity (DLH) 100,000 Actual overhead $380,000 Actual activity (DLH) 100,000

4-11 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc. (continued) Predetermined Overhead Rate= Budgeted overhead  Expected activity =$360,000  100,000 DLH =$3.60 per DLH

4-12 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc. (continued) CordlessRegular Units produced10,000100,000 Prime costs$78,000$738,000 Direct labour hours10,00090,000

4-13 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc. – Unit Cost Computation: Plantwide Rate CordlessRegular Prime costs$ 78,000$ 738,000 Overhead costs: $3.60 x 10,00036, $3.60 x 90, ,000 Total mfg. costs$114,000$1,062,000 Units produced  10,000  100,000 Unit cost$ 11.40$ ===============

4-14 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Functional-Based Costing: Departmental Rates Overhead Costs Assign Costs Department A Pool Assign Costs Products Department B Pool Assign Costs Products Stage One: Pool Formation Unit-Level Drivers Stage Two: Costs Assigned

4-15 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc. – Departmental Data FabricationAssembly Budgeted OH$252,000$108,000======= Expected and actual usage (DLH): Cordless7,0003,000 Regular13,00077,000 20,00080,000===== Expected and actual usage (MH): Cordless9,0001,000 Regular36,000 4,000 45,0005,000=====

4-16 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc. – Departmental Rates Overhead Rates: Fabrication Rate=Budgeted OH / Expected MH =$252,000/45,000 =$5.60 per fabrication MH Assembly Rate=Budgeted OH / Expected DLH =$108,000/80,000 =$1.35 per assembly DLH

4-17 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc. – Unit Cost Computation: Departmental Rate CordlessRegular Prime costs$ 78,000$738,000 Overhead costs: ($5.60 x 9,000) + ($1.35 x 3,000) 54, ($5.60 x 36,000) + ($1.35 x 77,000) ,500 Total mfg. costs$132,450$1,043,550 Units produced  10,000  100,000 Unit cost$ 13.25$ ===============

4-18 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Symptoms of an Outdated Functional Cost System l The outcome of bids is difficult to explain. l Competitors’ prices appear unrealistically low. l Products that are difficult to produce show high profits. l Operational managers want to drop products that appear profitable. l Profit margins are difficult to explain.

4-19 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Symptoms of an Outdated Functional Cost System (continued) l The company has a highly profitable niche all to itself. l Customers do not complain about price increases. l The accounting department spends a lot of time supplying cost data for special projects. l Some departments are using their own accounting system. l Product costs change because of changes in financial reporting regulations.

4-20 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc.– Activity Usage CordlessRegularTotal Units produced per year10,000100,000110,000 Prime costs$78,000$738,000$816,000 Direct labour hours10,00090,000100,000 Machine hours10,00040,00050,000 Production runs Number of moves603090

4-21 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc. – Additional OH Cost Data ActivityActivity Cost Setups$120,000 Material handling60,000 Machining100,000 Testing 80,000 Total$360,000 =======

4-22 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. ABC: Two-Stage Assignment Cost Of Resources Assign Costs Activities Assign Costs Products Direct Tracing Driver tracing Driver Tracing

4-23 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc. – Activity Rates Activity rates are computed below: Setup rate:$120,000/30 = $4,000 per run Material-handling rate:$60,000/90 = $ per move Machining rate:$100,000/50,000 = $2 per MH Testing rate:$80,000/100,000 = $0.80 per DLH

4-24 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Belring, Inc. – Activity-Based Costing Unit Cost Computation CordlessRegular Prime costs$ 78,000$ 738,000 Overhead costs: Setups80,00040,000 Material handling40,00020,000 Machining20,00080,000 Testing 8,000 72,000 Total mfg. costs$226,000$ 950,000 Units produced  10,000  100,000 Unit cost$ 22.60$ 9.50=====

4-25 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Comparison of Unit Costs CordlessRegular Activity based unit cost Functional based unit cost: Plantwide rate$11.40$10.62 Departmental rate

4-26 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Activity Categories Unit-level activities are those performed each time a unit is produced. Examples: Power and machine hours are used each time a unit is produced. Direct materials and direct labour activities are also unit-level activities, even though they are not overhead costs.

4-27 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Activity Categories (continued) Batch-level activities are those performed each time a batch of products is produced. Examples: Setups, inspections, production scheduling, and material handling.

4-28 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Activity Categories (continued) Product-level (sustaining) activities are those performed as needed to support the various products produced by a company. These activities consume inputs that develop products or allow products to be produced and sold. Examples: Engineering changes, development of product testing procedures, marketing a product and process engineering.

4-29 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Activity Categories (continued) Facility-level activities are those that sustain a factory's general manufacturing processes. Examples: Plant management, landscaping, support of community programs, security, property taxes, and plant amortization.

4-30 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. ABC Customer Costing Use Customer as Cost Object Diversity Issues:  Order Frequency  Delivery Frequency  Geographic Distances  Sales and Promotional Support  Engineering Support

4-31 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. ABC Customer Costing Use Customer as Cost Object Used For: Pricing Customer Mix Improving profitability

4-32 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. ABC Supplier Costing Use Supplier as Cost Object Relating To: Purchase Cost Quality Supplier Reliability Delivery Performance