PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Activity-Based Costing: A Tool to Aid Decision Making Chapter 7

7-2 Activity–Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity, and therefore, affect “fixed” as well as variable costs. ABC is a good supplement to our traditional cost system I agree!

7-3 Learning Objective 1 Understand activity- based costing and how it differs from a traditional costing system.

7-4 How Costs are Treated Under Activity–Based Costing ABC differs from traditional cost accounting in three ways. Manufacturing costs Nonmanufacturing costs  ABC assigns both types of costs to products. Traditional product costing ABC product costing

7-5 How Costs are Treated Under Activity–Based Costing  ABC does not assign all manufacturing costs to products. Manufacturing costs Nonmanufacturing costs Traditional product costing ABC product costing All Most, but not all Some ABC differs from traditional cost accounting in three ways.

7-6 How Costs are Treated Under Activity–Based Costing Plantwide Overhead Rate Plantwide Overhead Rate Departmental Overhead Rates Departmental Overhead Rates Activity–Based Costing Activity–Based Costing Number of cost pools Level of complexity  ABC uses more cost pools. ABC differs from traditional cost accounting in three ways.

7-7 How Costs are Treated Under Activity–Based Costing Each ABC cost pool has its own unique measure of activity. Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products. ABC differs from traditional cost accounting in three ways.  ABC uses more cost pools.

7-8 Activity An event that causes the consumption of overhead resources. Activity Cost Pool A “cost bucket” in which costs related to a single activity measure are accumulated. $ $ $ $ $ $ How Costs are Treated Under Activity–Based Costing

7-9 Activity Measure An allocation base in an activity-based costing system. How Costs are Treated Under Activity–Based Costing The term cost driver is also used to refer to an activity measure.

7-10 Simple count of the number of times an activity occurs. Transaction driver A measure of the amount of time needed for an activity. Duration driver Two common types of activity measures: How Costs are Treated Under Activity–Based Costing

7-11 How Costs are Treated Under Activity–Based Costing Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products. ABC defines five levels of activity that largely do not relate to the volume of units produced.

7-12 Manufacturing companies typically combine their activities into five classifications. Unit-Level Activity Batch-Level Activity Product-Level Activity Customer-Level Activity Organization- sustaining Activity How Costs are Treated Under Activity–Based Costing

7-13 Characteristics of Successful ABC Implementations Strong top management support Cross-functional involvement Link to evaluations and rewards

An ABC Example Classic Brass Classic Brass Income Statement Year Ended December 31, 2011 Sales $3,200,000 Cost of goods sold: Direct materials $ 975,000 Direct labor ,250 Manufacturing overhead* ,000,000 2,326,250 Gross margin ,750 Selling and administrative expenses: Shipping expenses ,000 General administrative expenses ,000 Marketing expenses , ,000 Net operating loss $ (1,250) * The company’s traditional cost system allocates manufacturing overhead to products using a plantwide overhead rate and machine-hours as the allocation base. Inventory levels did not change during the year.

7-15 Steps for Implementing Activity-Based Costing: 1. Define activities, activity cost pools, and activity measures. 2. Assign overhead costs to activity cost pools. 3. Calculate activity rates. 4. Assign overhead costs to cost objects using the activity rates and activity measures. 5. Prepare management reports.

7-16  Define Activities, Activity Cost Pools, and Activity Measures At Classic Brass, the ABC team selected the following activity cost pools and activity measures: Activity Cost Pool Activity Measure Customer orders Number of customer orders Product design Number of product designs Order size Machine-hours Customer relations Number of active customers Other. Not applicable

7-17 Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product design - assigned all costs of resources consumed by customer requested Product design. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations – assigned all costs associated with maintaining relations with customers. Other – assigned all organization-sustaining costs and unused capacity costs Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product design - assigned all costs of resources consumed by customer requested Product design. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations – assigned all costs associated with maintaining relations with customers. Other – assigned all organization-sustaining costs and unused capacity costs  Define Activities, Activity Cost Pools, and Activity Measures