1. Copyright © 2012 McGraw-Hill Ryerson Limited 5-1 PowerPoint Author: Robert G. Ducharme, MAcc, CA University of Waterloo, School of Accounting and Finance MANAGERIAL ACCOUNTING Ninth Canadian Edition GARRISON, CHESLEY, CARROLL, WEBB, LIBBY Activity-Based Costing: A Tool to Aid Decision Making Chapter 5

2. 5-2 Copyright © 2012 McGraw-Hill Ryerson Limited 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! LO 1

3. 5-3 Copyright © 2012 McGraw-Hill Ryerson Limited How Costs are Treated Under Activity–Based Costing ABC differs from traditional cost accounting in four ways. Manufacturing costs Non-manufacturing costs  ABC assigns both types of costs to products. Traditional product costing ABC product costing LO 1

4. 5-4 Copyright © 2012 McGraw-Hill Ryerson Limited How Costs are Treated Under Activity–Based Costing  ABC does not assign all manufacturing costs to products. Manufacturing costs Non-manufacturing costs Traditional product costing ABC product costing All Most, but not all Some ABC differs from traditional cost accounting in four ways. LO 1

5. 5-5 Copyright © 2012 McGraw-Hill Ryerson Limited 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 four ways. LO 1

6. 5-6 Copyright © 2012 McGraw-Hill Ryerson Limited 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 labour hours and/or machine hours to allocate all overhead costs to products. ABC differs from traditional cost accounting in four ways.  ABC uses more cost pools. LO 1

7. 5-7 Copyright © 2012 McGraw-Hill Ryerson Limited How Costs are Treated Under Activity–Based Costing Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses.  ABC bases level of activity on capacity. ABC differs from traditional cost accounting in four ways. LO 1

8. 5-8 Copyright © 2012 McGraw-Hill Ryerson Limited Activity An event that causes the consumption of overhead resources. Activity Cost Pool A “cost bucket” in which costs related to a particular activity measure are accumulated. $ $ $ $ $ $ How Costs are Treated Under Activity–Based Costing

9. 5-9 Copyright © 2012 McGraw-Hill Ryerson Limited 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. LO 1

10. 5-10 Copyright © 2012 McGraw-Hill Ryerson Limited 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 LO 1

11. 5-11 Copyright © 2012 McGraw-Hill Ryerson Limited How Costs are Treated Under Activity–Based Costing Traditional cost systems usually rely on volume measures such as direct labour 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. LO 1

12. 5-12 Copyright © 2012 McGraw-Hill Ryerson Limited 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 LO 1

13. 5-13 Copyright © 2012 McGraw-Hill Ryerson Limited Characteristics of Successful ABC Implementations Strong top management support Cross-functional involvement Link to evaluations and rewards LO 1

14. 5-14 Copyright © 2012 McGraw-Hill Ryerson Limited Designing an ABC System Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers) Activities Consumption of Resources Consumption of Resources Cost LO 1

15. 5-15 Copyright © 2012 McGraw-Hill Ryerson Limited Designing an ABC System Steps for Implementing ABC  Identify and define activities, activity cost pools and activity measures.  Assign overhead costs to activity cost pools.  Calculate activity rates.  Assign overhead costs to cost objects using the activity rates and activity measures.  Prepare management reports. LO 1

16. 5-16 Copyright © 2012 McGraw-Hill Ryerson Limited Classic Brass – An ABC Example Manufacturing overhead is allocated to products using a single plantwide overhead rate based on machine hours. LO 1

17. 5-17 Copyright © 2012 McGraw-Hill Ryerson Limited  Define Activities, Activity Cost Pools, and Activity Measures At Classic Brass, the ABC team, selected the following activity cost pools and activity measures: LO 1

18. 5-18 Copyright © 2012 McGraw-Hill Ryerson Limited  Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.  Product Designs - assigned all costs of resources consumed by designing products.  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 overhead costs that are not associated with the other cost pools.  Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.  Product Designs - assigned all costs of resources consumed by designing products.  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 overhead costs that are not associated with the other cost pools.  Define Activities, Activity Cost Pools, and Activity Measures LO 1

19. 5-19 Copyright © 2012 McGraw-Hill Ryerson Limited LO 2  Assign Overhead Costs to Activity Cost Pools

20. 5-20 Copyright © 2012 McGraw-Hill Ryerson Limited Direct materials, direct labour, and shipping are excluded because Classic Brass’ existing cost system can directly trace these costs to products or customer orders. LO 2  Assign Overhead Costs to Activity Cost Pools

21. 5-21 Copyright © 2012 McGraw-Hill Ryerson Limited At Classic Brass the following distribution of resource consumption across activity cost pools is determined. LO 2  Assign Overhead Costs to Activity Cost Pools

22. 5-22 Copyright © 2012 McGraw-Hill Ryerson Limited Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 LO 2  Assign Overhead Costs to Activity Cost Pools

23. 5-23 Copyright © 2012 McGraw-Hill Ryerson Limited Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000  Assign Overhead Costs to Activity Cost Pools LO 2

24. 5-24 Copyright © 2012 McGraw-Hill Ryerson Limited  Assign Overhead Costs to Activity Cost Pools LO 2

25. 5-25 Copyright © 2012 McGraw-Hill Ryerson Limited  Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool...  1,000 customer orders,  400 new designs,  20,000 machine-hours,  250 customer relations activities. Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels. LO 2

26. 5-26 Copyright © 2012 McGraw-Hill Ryerson Limited  Calculate Activity Rates LO 2

27. 5-27 Copyright © 2012 McGraw-Hill Ryerson Limited Traced Direct Materials Direct Materials Direct Labour Direct Labour Shipping Costs Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers Activity-Based Costing at Classic Brass LO 2

28. 5-28 Copyright © 2012 McGraw-Hill Ryerson Limited Direct Materials Direct Materials Direct Labour Direct Labour Shipping Costs Shipping Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers Order Size Order Size Customer Orders Customer Orders Product Design Product Design Customer Relations Customer Relations Other Overhead Costs First-Stage Allocation Activity-Based Costing at Classic Brass LO 2

29. 5-29 Copyright © 2012 McGraw-Hill Ryerson Limited Direct Materials Direct Materials Direct Labour Direct Labour Shipping Costs Shipping Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers Customer Orders Order Size Customer Relations Customer Relations Other Overhead Costs First-Stage Allocation Second-Stage Allocations $/Order $/Design $/MH $/Customer Unallocated Product Design Product Design Activity-Based Costing at Classic Brass LO 2

30. 5-30 Copyright © 2012 McGraw-Hill Ryerson Limited Classic Brass Information Standard Stanchions 1.Requires no new design resources. 2.30,000 units ordered with 600 separate orders. 3.Each stanchion requires 35 minutes of machine time for a total of 17,500 machine-hours. Standard Stanchions 1.Requires no new design resources. 2.30,000 units ordered with 600 separate orders. 3.Each stanchion requires 35 minutes of machine time for a total of 17,500 machine-hours. Custom Compass Housing 1.Requires new design resources. 2.400 separate orders. 3.400 custom designs prepared. 4.1,250 compass housings produced, requiring 2 machine-hours each for a total of 2,500 machine-hours. Custom Compass Housing 1.Requires new design resources. 2.400 separate orders. 3.400 custom designs prepared. 4.1,250 compass housings produced, requiring 2 machine-hours each for a total of 2,500 machine-hours.  Assigning Overhead to Products LO 3

31. 5-31 Copyright © 2012 McGraw-Hill Ryerson Limited  Assigning Overhead to Products The customer-level cost is assigned to customers directly; it is not assigned to products. LO 3

32. 5-32 Copyright © 2012 McGraw-Hill Ryerson Limited Let’s take a look at how Classic Brass system works for just one of the 250 customers – Windward Yachts who placed a total of three orders. Orders 1.Two orders for 150 standard stanchions per order. 2.One order for a custom compass housing. Orders 1.Two orders for 150 standard stanchions per order. 2.One order for a custom compass housing. Machine-hours 1.The 300 standard stanchions required 175 machine-hours. 2.The custom compass housing required 2 machine hours. Machine-hours 1.The 300 standard stanchions required 175 machine-hours. 2.The custom compass housing required 2 machine hours. Assigning Overhead to Customers LO 3

33. 5-33 Copyright © 2012 McGraw-Hill Ryerson Limited Assigning Overhead to Customers LO 3

34. 5-34 Copyright © 2012 McGraw-Hill Ryerson Limited  Prepare Management Reports Product Margin Calculations The first step in computing product margins is to gather each product’s sales and direct cost data. LO 4

35. 5-35 Copyright © 2012 McGraw-Hill Ryerson Limited  Prepare Management Reports Product Margin Calculations The second step in computing product margins is to incorporate the previously computed activity-based cost assignments pertaining to each product. LO 4

36. 5-36 Copyright © 2012 McGraw-Hill Ryerson Limited  Prepare Management Reports Product Margin Calculations The third step in computing product margins is to deduct each product’s direct and indirect costs from sales. LO 4

37. 5-37 Copyright © 2012 McGraw-Hill Ryerson Limited Product Margin Calculations The product margins can be reconciled with the company’s net operating income as follows:  Prepare Management Reports LO 4

38. 5-38 Copyright © 2012 McGraw-Hill Ryerson Limited  Prepare Management Reports Customer Profitability Analysis The first step in computing Windward Yachts’ customer margin is to gather its sales and direct cost data. LO 4

39. 5-39 Copyright © 2012 McGraw-Hill Ryerson Limited  Prepare Management Reports Customer Profitability Analysis The second step is to incorporate Windward Yachts’ previously computed activity-based cost assignments. LO 4

40. 5-40 Copyright © 2012 McGraw-Hill Ryerson Limited  Prepare Management Reports Customer Profitability Analysis The third step is to compute Windward Yachts’ customer margin ($699) by deducting all its direct and indirect costs from its sales. LO 4

41. 5-41 Copyright © 2012 McGraw-Hill Ryerson Limited Targeting Process Improvement Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements. While the theory of constraints approach discussed in Chapter 12 is a powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on where to focus improvement efforts. Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations. LO 4

42. 5-42 Copyright © 2012 McGraw-Hill Ryerson Limited Product Margins Computed Using the Traditional Cost System The first step in computing product margins is to gather each product’s sales and direct cost data. LO 5

43. 5-43 Copyright © 2012 McGraw-Hill Ryerson Limited Product Margins Computed Using the Traditional Cost System Plantwide manufacturing overhead rate $1,000,000 20,000 MH = $50 per machine-hour= The second step in computing product margins is to compute the plantwide overhead rate. LO 5

44. 5-44 Copyright © 2012 McGraw-Hill Ryerson Limited Product Margins Computed Using the Traditional Cost System The third step in computing product margins is allocate manufacturing overhead to each product. 17,500 hours × $50 per hour = $875,000 LO 5

45. 5-45 Copyright © 2012 McGraw-Hill Ryerson Limited Product Margins Computed Using the Traditional Cost System The fourth step is to actually compute the product margins. LO 5

46. 5-46 Copyright © 2012 McGraw-Hill Ryerson Limited The Differences Between ABC and Traditional Product Costs The traditional cost system overcosts the standard stanchions and reports a lower product margin for this product. The traditional cost system undercosts the custom compass housings and reports a higher product margin for this product. LO 5

47. 5-47 Copyright © 2012 McGraw-Hill Ryerson Limited Differences Between ABC and Traditional Product Costs There are three reasons why the reported product margins for the two costing systems differ from one another.  Traditional costing allocates all manufacturing overhead to products. ABC costing only assigns manufacturing overhead costs consumed by products to those products. LO 5

48. 5-48 Copyright © 2012 McGraw-Hill Ryerson Limited Differences Between ABC and Traditional Product Costs  Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. ABC costing also uses non-volume related allocation bases. There are three reasons why the reported product margins for the two costing systems differ from one another. LO 5

49. 5-49 Copyright © 2012 McGraw-Hill Ryerson Limited Differences Between ABC and Traditional Product Costs  Traditional costing disregards selling and administrative expenses because they are assumed to be period expenses. ABC costing directly traces shipping costs to products and includes non-manufacturing overhead costs caused by products in the activity cost pools that are assigned to products. There are three reasons why the reported product margins for the two costing systems differ from one another. LO 5

50. 5-50 Copyright © 2012 McGraw-Hill Ryerson Limited Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because... 1.External reports are less detailed than internal reports. 2.It may be difficult to make changes to the company’s accounting system. 3.ABC does not conform to GAAP. 4.Auditors may be suspect of the subjective allocation process based on interviews with employees. 1.External reports are less detailed than internal reports. 2.It may be difficult to make changes to the company’s accounting system. 3.ABC does not conform to GAAP. 4.Auditors may be suspect of the subjective allocation process based on interviews with employees. LO 5

51. 5-51 Copyright © 2012 McGraw-Hill Ryerson Limited ABC Limitations Substantial resources required to implement and maintain. Resistance to unfamiliar numbers and reports. Desire to fully allocate all costs to products. Potential misinterpretation of unfamiliar numbers. Does not conform to GAAP. Two costing systems may be needed. LO 5

52. 5-52 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5A ABC Action Analysis

53. 5-53 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5A: ABC Action Analysis Conventional ABC analysis does not identify potentially relevant costs. An action analysis report helps because it: Shows what costs have been assigned to a cost object. Indicates how difficult it would be to adjust those costs in response to changes in the level of activity. Conventional ABC analysis does not identify potentially relevant costs. An action analysis report helps because it: Shows what costs have been assigned to a cost object. Indicates how difficult it would be to adjust those costs in response to changes in the level of activity. LO 6

54. 5-54 Copyright © 2012 McGraw-Hill Ryerson Limited Constructing an action analysis report begins with the first-stage allocation process. In addition to computing an overall activity rate for each activity cost pool, an activity rate is computed for each type of overhead cost that is consumed supporting a given activity. Let’s revisit the stage-one allocations from the Classic Brass example that we discussed earlier. Appendix 5A: ABC Action Analysis LO 6

55. 5-55 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5A: ABC Action Analysis $125,000 ÷ 1,000 orders = $125 per order Other entries in the table are computed similarly. LO 6

56. 5-56 Copyright © 2012 McGraw-Hill Ryerson Limited $125 per order × 600 orders = $75,000 Other entries in the table are computed similarly. Appendix 5A: ABC Action Analysis LO 6

57. 5-57 Copyright © 2012 McGraw-Hill Ryerson Limited $125 per order × 400 orders = $50,000 Other entries in the table are computed similarly. Appendix 5A: ABC Action Analysis LO 6

58. 5-58 Copyright © 2012 McGraw-Hill Ryerson Limited Next, label each cost using an ease of adjustment code: Green costs adjust more or less automatically to changes in activity level without any action by managers. Yellow costs can be adjusted to changes in activity level, but it would require management action to realize the change in cost. Red costs can be adjusted to changes in activity level only with a great deal difficulty and with management intervention. Next, label each cost using an ease of adjustment code: Green costs adjust more or less automatically to changes in activity level without any action by managers. Yellow costs can be adjusted to changes in activity level, but it would require management action to realize the change in cost. Red costs can be adjusted to changes in activity level only with a great deal difficulty and with management intervention. Appendix 5A: ABC Action Analysis LO 6

59. 5-59 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5A: ABC Action Analysis LO 6

60. 5-60 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B Using a Modified form of Activity-Based Costing to Determine Product costs for External Reports

61. 5-61 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B ABC product costs: Include organization-sustaining costs and unused capacity costs. Exclude non-manufacturing costs even if they are caused by the products. ABC product costs: Include organization-sustaining costs and unused capacity costs. Exclude non-manufacturing costs even if they are caused by the products. A modified form of activity-based costing can be used to develop product costs for external financial reports. LO 7

62. 5-62 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B Maxtar Industries provides the following information for the company as a whole and for its only two products—premium and standard smoker/barbecue units. LO 7

63. 5-63 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B Assuming that Maxtar’s traditional cost system relies on one predetermined plantwide overhead rate with direct labour-hours (DLHs) as the allocation base, then its plantwide overhead rate is computed as follows: Predetermined overhead rate = $3.80 per DLH= $1,520,000 400,000 DLHs LO 7

64. 5-64 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B Maxtar’s traditional cost system would report unit product costs as follows: 2.0 DLH × $3.80 per DLH 1.5 DLH × $3.80 per DLH LO 7

65. 5-65 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B The ABC project team at Maxtar has developed the following basic information. LO 7

66. 5-66 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B We can calculate the following activity rates: Using the new activity rates, let’s assign overhead to the two products based upon expected activity. LO 7

67. 5-67 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B Premium Product Standard Product LO 7

68. 5-68 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B Activity-based unit product costs for both product lines LO 7

69. 5-69 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B Activity-based unit product costs for both product lines $728,000 ÷ 50,000 units $792,000 ÷ 200,000 units LO 7

70. 5-70 Copyright © 2012 McGraw-Hill Ryerson Limited Appendix 5B Note that the unit product cost of a Standard unit decreased from $53.70 to $51.96.......... while the unit cost of a Premium unit increased from $71.60 to $78.56. Comparing the two approaches LO 7

71. 5-71 Copyright © 2012 McGraw-Hill Ryerson Limited End of Chapter 5