1. 1 Activity-Based Costing and Activity-Based Management 2005.09

2. 2 Outline 1Introduction 2Explain under-costing and over-costing of products 3Present three guidelines for refining a costing system 4Distinguish between the traditional and the ABC approaches to designing a costing system 5Describe a four-part cost hierarchy

3. 3 6Cost products or services using activity-based costing (ABC) 7Use ABC systems for activity-based management 8Evaluate the costs and benefits of implementing ABC costing systems

4. 4 Introduction Activities generate costs. ABC traces costs to activities.

5. 5 Explain under-costing and over-costing of products

6. 6 Under-costing and Over-costing Product under-costing: A product consumes a relatively high level of total resources but is reported to have a relatively low total cost. Product over-costing: A product consumes a relatively low level of total resources but is reported to have a relatively high total cost.

7. 7 Under-costing and Over-costing Lisa, Rola, and Nancy meet occasionally for lunch. Each one orders separate items. Lisa order amounts to$140 Rola consumes 300 Nancy’s order is 160 Total$600

8. 8 Under-costing and Over-costing Assuming they divide the bill equally, what is the average cost per lunch? $600 ÷ 3 = $200 Lisa and Nancy are over-costed. Rola is under-costed.

9. 9 Existing Single Indirect-Cost Pool System Cole Corporation manufactures two types of lenses : a normal lens (NL) a complex lens (CL). To cost products, Cole currently uses a single indirect-cost rate costing system.

10. 10 Existing Single Indirect-Cost Pool System The cost objects are the total costs of manufacturing and distributing 80,000 normal lenses (NL) and 20,000 complex lenses (CL).

11. 11 Existing Single Indirect- Cost Pool System Normal Lenses (NL) Direct materials$1,520,000 Direct labor 800,000 Total direct costs$2,320,000 Direct cost per unit: $2,320,000 ÷ 80,000 = $29

12. 12 Existing Single Indirect- Cost Pool System Complex Lenses (CL) Direct materials$ 920,000 Direct labor 260,000 Total direct costs$1,180,000 Direct cost per unit: $1,180,000 ÷ 20,000 = $59

13. 13 Existing Single Indirect- Cost Pool System Indirect costs of $2,900,000 are grouped into a single overhead cost pool. 50,000 of direct labor hours are used as the cost-allocation base. What is the indirect cost allocation rate? $2,900,000 ÷ 50,000 = $58 per direct labor hour

14. 14 Existing Single Indirect- Cost Pool System Cole uses 36,000 direct labor-hours to make NL and 14,000 direct labor-hours to make CL. How much indirect costs are allocated to each product? NL: 36,000 × $58 = $2,088,000 CL: 14,000 × $58 = $ 812,000

15. 15 Existing Single Indirect- Cost Pool System What is the total cost of normal lenses (NL)? TC = Direct costs $2,320,000 + Allocated costs $2,088,000 = $4,408,000 What is the cost per unit? $4,408,000 ÷ 80,000 = $55.10

16. 16 Existing Single Indirect- Cost Pool System What is the total cost of complex lenses (CL)? TC = Direct costs $1,180,000 + Allocated costs $812,000 = $1,992,000 What is the cost per unit? UC = 1,992,000 ÷ 20,000 = $99.60

17. 17 Existing Single Indirect- Cost Pool System Normal lenses sell for $60 each and complex lenses for $142 each. Normal Complex Revenue $60.00$142.00 Cost 55.10 99.60 Income $ 4.90$ 42.40 Margin (Profits) 8.2% 29.9%

18. 18 Guidelines for Refining a Costing System Three Guidelines for refining a costing system: Direct-cost tracing ： Classify as many of the total costs as direct costs as is economically feasible. Indirect-cost pools ： Expand the number of cost pools until each of these pools is homogeneous. Cost driver: Identify the preferred cost-allocation base (cost driver) for each indirect-cost pool.

19. 19 Refining a Costing System The sequence of steps to design, produce, and distribute lenses is as follows: 1Design of products and process ： The Design Department designs the molds and defines production processes needed (details of the manufacturing operations).

20. 20 Refining a Costing System 2Manufacturing operations ： Lenses are molded, finished, cleaned, and inspected. 3Shipping and distribution ： Finished lenses are packed and sent to the various customers.

21. 21 Distinguish between the traditional and the ABC approaches to designing a costing system

22. 22 Activity-Based Costing System ABC systems refine costing systems by focusing on individual activities as the fundamental cost object.

23. 23 Activity-Based Costing System ABC: (1) calculates the costs of individual activities (2) assigns costs to cost objects (such as products and services) on the basis of the activities undertaken (consumed) to produce each product or service.

24. 24 Activity-Based Costing System Activities Cost of Activities Cost of Product, Service, or Customer

25. 25 Activity-Based Costing System A cross-functional team at Cole Corporation identified 7 key activities: –Design products and processes –Set up molding machine –Operate machines to manufacture lenses –Maintain and clean the molds

26. 26 Activity-Based Costing System –Set up batches of finished lenses for shipment. –Distribute lenses to customers. –Administer and manage all processes.

27. 27 Activity-Based Costing System Molding machine setup data for NL and CL: NL CL Total quantity produced80,00020,000 No. produced per batch 250 50 Number of batches 320 400 Setup time per batch 2 hours 5 hours Total setup hours 640 2,000

28. 28 Activity-Based Costing System Total setup costs are $409,200. What is the setup cost per setup hour? A: $409,200 ÷ 2,640 hours = $155 What is the setup cost per direct labor hour? A: $409,200 ÷ 50,000 = $8.184 (p.13)

29. 29 Activity-Based Costing System (ABC) Cost allocation using setup-hours: NL: $155 × 640 = $ 99,200 CL: $155 × 2,000 = $310,000 Total $409,200 (TCS) Cost allocation using direct labor-hours: NL: $8.184 × 36,000 = $294,624 (O. costing) CL: $8.184 × 14,000 = $114,576 (U. costing) Total $409,200

30. 30 Activity-Based Costing System How should Cole Co. allocate setup costs? setup hours A: Setup costs should be allocated on the basis of setup hours. Why? There is a strong cause-and-effect relationship between setup-related overhead costs and setup-hours, a resource-consuming costing model.

31. 31 A four-part cost hierarchy

32. 32 Cost Hierarchies A cost hierarchy is a categorization of costs into different cost pools on the basis of the different types of cost drivers (cost-allocation bases).

33. 33 Cost Hierarchies ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases (cost drivers): 1Unit-level costs 2Batch-level costs 3Product-sustaining costs (or Customer-sustaining costs) 4Facility-sustaining costs

34. 34 Unit-Level Costs –are resources consumed by activities performed on each individual unit of product or service. Direct material Direct labor Energy Machine depreciation

35. 35 Batch-Level Costs –are resources consumed by activities that are related to a batch (group of units) of product rather than to each individual unit of product. Setup costs Procurement costs Material moving costs Inspection costs

36. 36 Product-Sustaining Costs –are resources consumed by activities undertaken related to individual products or services. Design costs Design change costs Engineering costs

37. 37 Facility-Sustaining Costs –are resources consumed by activities that cannot be traced to individual products but related to the organization as a whole. General administration costs –Rent –Building security

38. 38 Cost products or services using activity-based costing (ABC)

39. 39 Implementing Activity-Based Costing Step 1: Identify the chosen cost objects. The objective is to calculate the total costs of designing, manufacturing, and distributing NL and CL.

40. 40 Implementing Activity-Based Costing Step 2: Identify the direct costs of the product. Cole identifies direct materials costs and direct labor costs as direct costs. Mold cleaning and maintenance costs of $360,000 are also identified as direct costs of the lenses.

41. 41 Implementing Activity-Based Costing The existing cost system classifies mold cleaning and maintenance costs ($360,000) as part of the $2,900,000 indirect costs. Recall that indirect costs were allocated to products using direct labor-hours.

42. 42 Implementing Activity-Based Costing Mold cleaning and maintenance costs of $360,000 are batch-level-costs. Why? Because these costs consist of workers’ wages for cleaning molds after each batch of lenses is run.

43. 43 Implementing Activity-Based Costing Mold cleaning and maintenance costs of $360,000 under ABC system: $360,000 / 720 batches = $500 / batch NL: 320 batches * $500 = $160,000 CL: 400 batches * $500 = $200,000

44. 44 Implementing Activity-Based Costing Allocation of mold cleaning and maintenance costs $360,000 under traditional costing system: $360,000 / 50,000 D.L.hours = $7.2 per D.L.hour NL: 36,000 hours * $7.2 = $259,200 vs. $160,000 CL: 14,000 hours * $7.2 = $100,800 vs. $200,000

45. 45 Implementing Activity-Based Costing Mold cleaning and maintenance costs of $360,000 under two costing systems: TCSABC NL $259,200 $160,000 (O. costing) CL $100,800 $200,000 (U. costing)

46. 46 Implementing Activity-Based Costing Normal Lenses (NL) Description Cost Hierarchy Category Direct materialsUnit-level $1,520,000 Direct laborUnit-level 800,000 Mold cleaning & maintenanceBatch-level 160,000 Total direct costs $2,480,000

47. 47 Implementing Activity-Based Costing Complex Lenses (CL) Description Cost Hierarchy Category Direct materialsUnit-level $ 920,000 Direct labor Unit-level 260,000 Mold cleaning & maintenanceBatch-level 200,000 Total direct costs $1,380,000

48. 48 Implementing Activity-Based Costing Step 3: Select the cost drivers (cost-allocation bases) to use in allocating activity costs to the products.

49. 49 Implementing Activity-Based Costing Six activities were identified. 1Design 2Molding machines setups* 3Manufacturing operations 4Shipment 5Distribution 6Administration

50. 50 Implementing Activity-Based Costing Step 4: Identify the activity costs associated with each cost driver (cost-allocation base). Overhead costs incurred are assigned to activities, to the extent possible, on the basis of a cause-and-effect relationship. Total molding machines setup costs are $409,200.

51. 51 Implementing Activity-Based Costing Step 5: Compute the rate per unit of each cost driver (cost allocation base) used to allocate molding machines setup costs to the products. Setup hours: NL CL Total 640 2,000 2,640 $409,200 ÷ 2,640 = $155 per setup hour.

52. 52 Implementing Activity-Based Costing Step 6: Compute the setup costs allocated to the products. NL: $155 × 640 hours = $ 99,200 CL: $155 × 2,000 hours = 310,000 Total $409,200

53. 53 Implementing Activity-Based Costing Setup cost of $409,200 under traditional costing system: $409,200 / 50,000 D.L.hours = $8.18 D.L.hour NL: 36,000 hours * $8.18 = $294,600 CL: 14,000 hours * $8.18 = $114,600

54. 54 Implementing Activity-Based Costing Setup cost of $409,200 ABC TCS NL $ 99,200 $ 310,000 (O. costing) CL $294,600 $114,600 (U. costing)

55. 55 Implementing Activity-Based Costing Step 7: Compute the costs of the products by adding all direct and indirect costs assigned to them. NL and CL would show three direct cost categories. 1Direct material costs 2Direct labor costs 3Mold cleaning and maintenance costs

56. 56 Implementing Activity-Based Costing NL and CL would show six activity cost pools. 1Design 2Molding machine setups 3Manufacturing operations 4Shipment 5 Distribution 6Administration

57. 57 Use ABC systems for activity-based management

58. 58 Activity-Based Management ABM describes management decisions that use activity-based costing information to improve profits. –Product mix and pricing decisions –Customer mix and pricing decisions –Cost reduction and process improvement decisions –Design decisions

59. 59 Product Pricing and Mix Decisions ABC provides more accurate product cost information and gives management insight into the cost structures for making and selling diverse products.

60. 60 Cost Reduction and Process Improvement Decisions Value-added activities vs. Non value-added activities

61. 61 Design Decisions Management can identify and evaluate new designs to improve operating performance by evaluating how product and process designs affect activities and costs. Companies can work with their customers to evaluate the costs and prices of alternative design choices.

62. 62 Evaluate the costs and benefits of implementing ABC costing systems

63. 63 ABC Systems Are Most Beneficial When... –significant amounts of indirect costs are allocated using only one or two cost pools. –all or most costs are identified as output unit-level costs. –products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.

64. 64 ABC Systems Are Most Beneficial When... –products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits. –complex products appear to be very profitable and simple products appear to be losing money.

65. 65 ABC Systems Are Most Beneficial When... –operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.

66. 66 Limitations of ABC Systems The main limitations of ABC are the measurements necessary to implement the system. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.

67. 67 Limitations of ABC Systems Activity-cost rates also need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand.

68. 68 ABC In Service And Merchandising Companies The general approach to ABC in the service and merchandising areas is very similar to the approach in manufacturing. Costs are divided into homogeneous cost pools and classified as unit-level, batch level, product, or service-sustaining and facility sustaining costs.

69. 69 END Thank You