1. Activity Based Costing LECTURE SEVEN (7) Issah Hamdu Faculty of Business Management & Globalization Tel: Ext 8978 Email: issah@limkokwing.edu.my (Feb – Jun 2010 Semester) BACCT2101 Cost Accounting

2. Traditional, Volume-Based Product-Costing System Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records: Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records:

3. Traditional, Volume-Based Product- Costing System Additional information includes: Manufacturing overhead is determined as follows

4. Traditional, Volume-Based Product- Costing System Budgeted manufacturing overhead $3,894,000 Budgeted direct-labor hours 118,000 = $33 per hour

5. Traditional, Volume-Based Product- Costing System With these product costs, Aerotech established target selling prices (Cost × 125%). 209.00 x 1.25

6. Traditional, Volume-Based Product- Costing System Aerotech wishes to see what target selling prices would be suggested when using activity-based costing. Let’s see how ABC works.

7. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Assigning overhead to products is a difficult process. I agree!

8. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Let’s begin by identifying our major activities. Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used. Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.

9. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Overhead assigned to activities are called “activity cost pools.” Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products. Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products.

10. Overhead Costs Total budgeted cost = $3,894,000 ActivityCostPools Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 Unit Level Batch Level Product- Sustaining Level Facility Level Identification of Activity Cost Pools Identification of Activity Cost Pools Activity must be done on each unit produced. Activityperformed on each batchproduced. Activities needed to support an entire product line Activity required in order for the production process to occur.

11. Overhead Costs Total budgeted cost = $3,894,000 ActivityCostPools Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 More Cost Pools Unit Level Batch Level Product- Sustaining Level Facility Level Identification of Activity Cost Pools Identification of Activity Cost Pools

12. Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000 Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 Unit Level Batch Level Product- Sustaining Level Facility Level

13. Various overhead costs related to machinery Maintenance Depreciation Computer Support Lubrication Electricity Calibration Machinery Cost Pool Total budgeted cost = $1,212,600Activitycostpool STAGE ONE

14. Calculate the pool rate Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hour $28.20/hour CostAssignment STAGE TWO = =

15. Calculation of total setup cost Setup Cost Pool Total budgeted cost = $3,000Activitycostpool STAGE ONE

16. Calculate the pool rate Budgeted Setup Costs $3,000 Planned Production Runs 15 runs $200 per run $200 per run CostAssignment STAGE TWO = =

17. Various overhead costs related to engineering Engineering salaries Engineering supplies Engineering software Depreciation Engineering Cost Pool Total budgeted cost = $700,000Activitycostpool STAGE ONE

18. Allocate based on engineering transactions CostAssignment STAGE TWO Engineering Cost Pool Total budgeted cost = $700,000

19. Various overhead costs related to general operations Plant depr. Plant mgmt. Plant maint. Property taxes Insurance Security Facility Cost Pool Total budgeted cost = $507,400Activitycostpool STAGE ONE

20. Calculate the pool rate Budgeted Facilities Cost $507,400 Budgeted Direct-Labor Hours 118,000 $4.30/hour $4.30/hour CostAssignment STAGE TWO = =

21. Product Cost from ABC Here are the new product costs so far...

22. Other Overhead Costs

23. $14.82

24. Product Cost from ABC These are the new product costs when Aerotech uses ABC.

25. Product Diversity Both original and ABC target selling prices are based on (Cost × 125%). [$209.00 × 1.25][$183.44 × 1.25] The selling price of Mode I and II are reduced and the selling price for Mode III is increased.

26. Product Diversity Can you identify any problems Aerotech is likely to face as a result of this distortion? Traditional costing understates the cost of complex, low volume products.

27. ABC: Some Key Issues The Past –Small number of products which did not differ much in required manufacturing support. –Labor was the dominant element in the cost structure. The Past –Small number of products which did not differ much in required manufacturing support. –Labor was the dominant element in the cost structure. The Present –Numerous products with more and complicated production requirements. –Labor is becoming an ever smaller part component of total production costs. The Present –Numerous products with more and complicated production requirements. –Labor is becoming an ever smaller part component of total production costs.

28. Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider... Degree of Correlation Cost of Measurement BehavioralEffects

29. Homogeneous Activity Cost Pools A homogeneous cost pool is a grouping of overhead costs in which each cost component is consumed in roughly the same proportion by each product line. A homogeneous cost pool uses a single cost driver.

30. Transaction Costing Activities Paperwork Usually Result In Transactionprocessing provides a readilymeasurable gauge of departmentalactivity.Transactionprocessing provides a readilymeasurable gauge of departmentalactivity.

31. Storyboarding A procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities. Step 1 Step 1 Step 2 Step 2 Step 3 Step 3 Step 4 Step 4 These are the steps we follow to build a memory board. These are the steps we follow to build a memory board.

32. Direct versus Indirect Costs Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. IndirectCosts

33. Indicators of Need for ABC Line managers do not believe the product costs reports Line managers do not believe the product costs reports Marketing does not use costs reports for pricing decisions Marketing does not use costs reports for pricing decisions Product-line profit margins are hard to explain Product-line profit margins are hard to explain Sales are increasing, but profits are declining. Sales are increasing, but profits are declining. Some products that have reported high profit margins are not sold by competitors Some products that have reported high profit margins are not sold by competitors Direct labor is a small percentage of total costs Direct labor is a small percentage of total costs

34. Optimal Product-Costing System High High Low Low Cost InformationSystemAccuracy Optimalsystem Total Cost Design, implementation and maintenance costs Cost of inferiordecisionsresultingfrominaccurateinformation.

35. Cost Management Systems –Measure the cost of resources consumed. –Identify and eliminate non-value-added costs. –Determine the efficiency and effectiveness of all major activities. –Identify and evaluate new activities that can improve future performance. Objectives

36. Non-Value-Added Costs Suppose our production process looks like this: StorageTimeWaitingTimeProcessTimeMoveTimeInspectionTime VANVANVANVANVA VA = Valued-added activity NVA = Non-value-added activity

37. Non-Value-Added Costs VA = Valued-added activity NVA = Non-value-added activity Our goal is to reduce or eliminate the non-value-added activities. StorageTimeWaitingTimeProcessTimeMoveTimeInspectionTime VANVANVANVANVA

38. ABC in the Service Industry ImplementationProblemsImplementationProblems High proportion of facility-level costs Activities tend to be nonrepetitive human tasks.