When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. Assigning Overhead Costs to Products 3-1

Plantwide Overhead Rate Plantwide Overhead Rate A single overhead rate used throughout an entire factory. Direct labor has often been used as the allocation base for overhead because: 1. Direct labor information was already being recorded. 2. Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated. Direct labor has often been used as the allocation base for overhead because: 1. Direct labor information was already being recorded. 2. Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated. 3-2

Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1.Most companies sell a large variety of products that consume differing amounts of overhead. 2.As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor. 3.Technology advancements have reduced the cost and complexity of gathering diverse sources of data. Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1.Most companies sell a large variety of products that consume differing amounts of overhead. 2.As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor. 3.Technology advancements have reduced the cost and complexity of gathering diverse sources of data. Plantwide Overhead Rate A plantwide overhead allocation system may not be optimal for many companies in today’s business environment. 3-3

Departmental Overhead Rates Machining Department Shipping Department Assembly Department Many companies have a system in which each department has its own overhead rate. The allocation base depends on the nature of the work performed in each department. In the machining department, overhead may be based on machine-hours, but in the assembly department, overhead may be based on labor-hours. 3-4

Activity-base costing is required to account for these other factors. The departmental approach relies exclusively on volume-related allocation bases while some overhead costs may be caused by factors that are not related to the volume of production. Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs. Departmental Overhead Rates 3-5

A number of allocation bases are used for assigning costs to products. Activity-Based Costing (ABC) 3-6

CostCost Activity-Based Costing (ABC) Consumption of Resources ActivitiesActivities Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers) 3-7

Activity An event that causes the consumption of overhead resources Setting up machines Examples of Activities Admitting hospital patients Opening a bank account Billing customers Activity-Based Costing (ABC) 3-8

Activity Cost Pool A “cost bucket” in which costs related to a particular activity are accumulated. Activity Measure Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs. Activity-Based Costing (ABC) Activity Rate A predetermined overhead rate for each activity cost pool. 3-9

Activity-Based Costing (ABC) For each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2. A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product. 3-10

Related activities are frequently combined to reduce the amount of detail and record-keeping costs. An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured. For example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling. Designing an Activity-Based Costing System 3-11

Hierarchy of Activities 3-12

Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment 3-13

Unit-Level Activity Batch-Level Activity Facility-Level Activity Product-Level Activity Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs Products $/DLH$/MH$/Setup$/Order$/MH $/Part Type Second-Stage Allocations Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment 3-14

Using Activity-Based Costing Comtek Sound, Inc.  Comtek Sound, Inc. makes two products: CD players and DVD players.  The company has been losing bids to supply CD players, its main product, to lower priced competitors.  The company has been winning all bids to supply DVD players, its secondary product.  Comtek Sound, Inc. makes two products: CD players and DVD players.  The company has been losing bids to supply CD players, its main product, to lower priced competitors.  The company has been winning all bids to supply DVD players, its secondary product. 3-15

Note that the unit product cost of a CD unit decreased from $110 to $ while the unit cost of a DVD unit increased from $150 to $ Comparing the Two Approaches 3-16

Activity-Based Management Focuses on managing activities to eliminate waste and reduce delays and defects. Targeting Process Improvements An ABC system can help identify areas where the company can benefit from improving its current processes. 3-17

The first step in any improvement program is deciding what to improve. Targeting Process Improvements The Theory of Constraints approach targets the highest impact improvement opportunities. Activity rates can be used to target areas where costs seem excessively high. Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations. 3-18

Benefits of Activity-Based Costing ABC improves the accuracy of product costing by: Increasing the number of cost pools used to accumulate overhead costs. Using activity cost pools that are more homogeneous than departmental cost pools. Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. ABC improves the accuracy of product costing by: Increasing the number of cost pools used to accumulate overhead costs. Using activity cost pools that are more homogeneous than departmental cost pools. Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. Activity-based costing also highlights activities that could benefit most from process improvement efforts, such as Six Sigma. 3-19

Costs of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when: 1.Products differ substantially in volume, batch size, and in activities required. 2.Conditions have changed substantially since the existing cost system was established. 3.Overhead costs are high and increasing and no one seems to understand why. 4.Management does not trust the existing cost system and it ignores data from it when making decisions. Costs of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when: 1.Products differ substantially in volume, batch size, and in activities required. 2.Conditions have changed substantially since the existing cost system was established. 3.Overhead costs are high and increasing and no one seems to understand why. 4.Management does not trust the existing cost system and it ignores data from it when making decisions. Limitations of Activity-Based Costing 3-20

Activity rates are determined as follows: Cost Flows in an ABC System 3-21

Overhead is applied on the basis of actual activities during the year. Cost Flows in an ABC System 3-22