1. Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Chapter 3 System Design: Activity-Based Costing PowerPoint Authors: Jon A. Booker, Ph.D., CPA, CIA Charles W. Caldwell, D.B.A., CMA Susan Coomer Galbreath, Ph.D., CPA

2. 3-2 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. 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.

4. 3-4 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)

5. 3-5 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.

6. 3-6 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

7. 3-7 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

8. 3-8 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.

9. 3-9 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.

10. 3-10 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.

11. 3-11 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

12. 3-12 Cost Flows in an ABC System The flow of costs through Raw Materials, Work in Process, and other accounts is the same under activity based costing. The only difference in activity based costing is that more than one predetermined overhead rate is used to apply costs to products.

13. 3-13 End of Chapter 3