Ch04

CHAPTER 4 Study Objectives

Activity-Based Costing

Managerial Accounting, Fourth Edition

ACTIVITY-BASED COSTING VERSUS Study Objectives TRADITIONAL COSTING Traditional Costing Systems Allocates overhead using a single predetermined rate. Job order costing: direct labor cost is assumed to be the relevant activity base. Process costing: machine hours is the relevant activity base.

Assumption was satisfactory when direct labor was a major portion of total manufacturing costs. Wide acceptance of a high correlation between direct labor and overhead costs.

Traditional Costing Systems

Study Objectives

Direct labor is still often the appropriate basis for assigning overhead costs when: Direct labor constitutes a significant part of total product cost and High correlation exists between direct labor and changes in overhead costs

Overhead Costs

Direct Labor Hours/Dollars

Products

Need for a New Approach

Study Objectives

Tremendous change in manufacturing and service industries. Decrease in amount of direct labor usage. Significant increase in total overhead costs. May be inappropriate to use plant-wide predetermined overhead rates based on direct labor or machine hours when a lack of correlation exists. Complex manufacturing processes may require multiple allocation bases; this approach is called Activity-Based Costing (ABC).

Activity-Based Costing (ABC)

Study Objectives



An overhead cost allocation system that allocates overhead to multiple activity cost pools and Assigns the activity cost pools to products or services by means of cost drivers that represent the activities used.

Activity-Based Costing (ABC) Study Objectives Terms Activity: any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service. Activity Cost Pool: a distinct type of activity. For example: ordering materials or setting up machines. Cost Drivers: any factors or activities that have a direct cause-effect relationship with the resources consumed.

The Logic Behind ABC

Study Objectives

Products consume activities, and activities consume resources.

Activity-Based Costing (ABC)

Study Objectives



ABC allocates overhead costs in two stages: Stage 1: Overhead costs are allocated to activity cost pools. Stage 2: The overhead costs allocated to the cost pools is assigned to products using cost drivers. The more complex a product’s manufacturing operation, the more activities and cost drivers likely to be present.

Activities and Related Cost Drivers

Study Objectives

ABC System Design – Lift Jack Company

Study Objectives

Traditional Costing vs. ABC Study Objectives ABC does not replace an existing job order/process cost system. ABC does segregate overhead into various cost pools to provide more accurate cost information. ABC, thus, supplements – it does not replace – the traditional cost system.

Traditional Costing vs. ABC Study Objectives An Illustration 

Atlas Company produces two automotive antitheft devices:  The Boot: a high volume item with sales totaling 25,000 per year  The Club: a low volume item with sales totaling 5,000 per year



Each product requires 1 hour of direct labor  Total annual direct labor hours (DLH) 30,000 (25,000 + 5000)  Direct labor cost $12 per unit for each product



Expected annual manufacturing overhead costs $900,000



Direct materials cost:  The Boot - $40 per unit  The Club - $30 per unit

Unit Costs Under Traditional Costing

Study Objectives

Products Manufacturing Costs Direct Materials Direct Labor Overhead Total unit cost

The Boot $40 12 30* $82

The Club $30 12 30* $72

* Predetermined overhead rate: $900,000/30,000 DLH = $30 per DLH Overhead = predetermined overhead rate times direct labor hours ($30 X 1 hr. = $30)

STEPS IN ACTIVITY-BASED COSTING SYSTEM •

•

•

•

Identify and classify the major activities and allocate manufacturing overhead costs to the appropriate cost pools. Identify the cost driver that has a strong correlation to the costs in the cost pool. Compute the overhead rate for each pool. Assign overhead costs for each costs to products using the overhead rates.

Unit Costs Under ABC: Study and Objectives Step 1: Identify Classify Activities and Allocate Overhead to Cost Pools

Activity Cost Pools Setting up machines Machining Inspecting Total

Estimated Overhead $300,000 500,000 100,000 $900,000

Unit Costs Under ABC: Study Objectives Step 2: Identify Cost Drivers

Activity Cost Pools Setting up machines Machining Inspecting

Cost Drivers Number of setups Machine hours Number of Inspections

Expected Use of Cost Drivers Per Activity 1,500 50,000 2,000

Unit Costs Under ABC: Study Objectives Step 3: Compute Overhead Rates Formula for Computing Activity-Based Overhead Rate: Estimated Overhead Per Activity

Activity-Based

Expected Use of Cost Drivers Per Activity

Overhead Rate

Activity Cost Pools Setting up machines Machining Inspecting Total

Estimated Overhead $300,000 500,000 100,000 $900,000

Expected Use of Cost Drivers Per Activity 1,500 setups 50,000 machine hrs. 2,000 inspections

Activity-Based Overhead Rates $200 per setup $ 10 per mach. hour $ 50 per inspection

Unit Costs Under ABC: Study Objectives Step 4: Assign Overhead Costs to Products Part 1: Expected Use of Cost Driver Per Product

Expected Use of Cost Drivers per Product Activity Cost Pools Setting up machines Machining Inspecting

Cost Driver Number of setups Machine hours Number of inspections

Expected Use of Cost Drivers Per Activity

The Boot

The Club

1,500 setups 50,000 hours

500 30,000

1,000 20,000

500

1,500

2,000 inspections

Unit Costs Under ABC: Study Objectives Step 4: Assign Overhead Costs to Products Part 2: Assign Cost Pools to Products The Boot Expected Use of Activity Cost Drivers X Cost Pools per Product Setting up machines 500 Machining 30,000 Inspecting 500 Total costs assigned Units produced Overhead cost per unit

Activity-Based Overhead = Cost Rates Assigned $200 $100,000 10 300,000 50 25,000 $425,000 25,000 $17

Unit Costs Under ABC: Study Objectives Step 2: Assign Overhead Costs to Products Part 2: Assign Cost Pools to Products The Club Expected Use of Activity Cost Drivers X Cost Pools per Product Setting up machines 1,000 Machining 20,000 Inspecting 1,500 Total costs assigned Units produced Overhead cost per unit

Activity-Based Overhead = Cost Rates Assigned $200 $200,000 10 200,000 50 75,000 $475,000 5,000 $95

Comparison Study Objectives of Unit Costs Traditional vs. ABC

Manufacturing Costs Direct Materials Direct Labor Overhead Total Cost per Unit

The Boot Traditional Costing ABC $40 $40 12 12 30 17 $82 $69

Overstated $13

The Club Traditional Costing ABC $30 $30 12 12 30 95 $72 $137

Understated $65

Comparison of Unit Costs Study Objectives Traditional vs. ABC

•

•

Note that under ABC, overhead costs are shifted from the high volume product (The Boot) to the low volume product (The Club) because: Low volume products often require more special handling. Assigning overhead using ABC will usually increase the cost per unit of low volume products.

Activity-Based Study Objectives Costing: A Closer Look

More accurate product costing through:  Use of more cost pools to assign overhead costs  Enhanced control over overhead costs  Better management decisions

StudyCosting: Objectives Activity-Based A Closer Look Limitations of ABC

• Can be expensive to use • Some arbitrary allocations continue

Activity-Based Costing: Study Objectives A Closer Look Use ABC When One or More of the Following Exist: Products differ greatly in volume/manufacturing complexity 

Products lines are  Numerous  Diverse  Require different degrees of support services



Overhead costs are a significant portion of total costs



Significant change in manufacturing process or number of products



Managers ignore data from existing system and instead use “bootleg” costing data

Let’sObjectives Review Study Activity-based costing (ABC): c. d. e.

f.

Can be used only in a process cost system Focuses on units of production Focuses on activities performed to produce a product Uses only a single basis of allocation

Let’sObjectives Review Study Activity-based costing (ABC): Can be used only in a process cost system Focuses on units of production Focuses on activities performed to produce a product Uses only a single basis of allocation

Value-Added vs. Study Objectives Non-Value-Added Activities

Activity Based Management (ABM): An extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision making A refinement of ABC used in ABM classifies activities as either value-added or non-valueadded.

Value-Added vs. Study Objectives Non-Value-Added Activities

Value-Added Activity An activity that increases the worth of a product or service such as: Manufacturing Company engineering design machining assembly painting packaging

Service Company performing surgery legal research services delivering packages

Value-Added vs. Study Objectives Non-Value-Added Activities

Non-Value-Added Activities An activity that adds cost to, or increases the time spent on, a product/service without increasing its market value such as: Manufacturing Company Repair of machines Storage of inventory Moving of raw materials, assemblies, and finished goods Building maintenance Inspections Inventory Control

Service Company Taking appointments Reception Bookkeeping/billing Traveling Ordering supplies

CLASSIFICATION OF Study Objectives ACTIVITY LEVELS Unit-level activities: Performed for each unit of production

Batch-level activities: Performed for each batch of product

Product-level activities: Performed in support of an entire product line, but not always performed every time a new unit or batch is produced

Facility-level activities: Required to support or sustain an entire production process

Hierarchy of Activity Levels

Study Objectives

Four Levels

Types of Activities

Cost Drivers

Unit-Level Activities

Machine-related Drilling, cutting, milling Labor-related Assembling, painting Equipment setups Purchase ordering Inspection

Machine Hours

Batch-Level Activities

Product-Level Activities Facility-Level Activities

Direct labor hours/cost

Number of setups/setup time Number of purchase orders Number of inspections or inspection time Material handling Number of material moves Product design Number of product designs Engineering changes Number of changes Plant management Number of employees salaries managed Plant Building depreciation Square footage Property taxes Square footage Utilities Square footage

Activity-Based Costing Study Objectives in Service Industries

Similarities with Manufacturing Firms Overall objective: Identify

key cost-generation activities and keep track of quantity of activities performed for each service provided

General approach is to identify activities, cost pools, and cost drivers Labeling of activities as value-added or non-valueadded Reduction of non-value-added activities

HEARTLAND MANUFACTURING COMPANY Study Objectives Activity Flowchart

Activities

NVA

NVA

NVA

NVA

VA

VA

NVA

NVA

VA

NVA

NVA

NVA

VA

Remov e

Move and

Move Materials

 

 

 

 

M ove

 

Inspe ct

Move

Store

Packag e

and Inspec t

Store

to Production

Set-Up

Machining

Inspe ct

and

Assem bly

and

to

Finish ed

and

Materi als

Materia ls

and Wait

Machi nes

Dril l

Lath e

 

Wait

 

Test

Stora ge

Goods

Ship

1

12

2.5

1.5

2

1

0.2

6

2

0.3

0.5

14

1

Curre nt Days

<-------------------------------------------------------

Total Current Average Time = 44 days

-------------------------------------------------------

----------->

Propo sed Days

1

4

1.5

<-------------------------------------------------------

1.5

2

1

0.2

Total Proposed Average Time = 27 days

2

2

0.3

0.5

10

-----------------------------------------------------

1 ------------>

Activity-Based Costing Study Objectives in Service Industries

Major difficulty to implementing ABC: A larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services.

Activity-Based Costing in Service Industries: Study Objectives Traditional Costing Example CHECK AND DOUBLECHECK, CPAs Annual Budget Revenue Direct labor Overhead (expected) Total Costs Operating income

$2,000,000 $ 600,000 1,200,000 1,800,000 $ 200,000

Estimated overhead =

Predetermined overhead rate

=

200%

Direct labor cost $1,200,000 $600,000

Activity-Based Costing in Service Industries: Study Objectives Traditional Costing Example

CHECK AND DOUBLECHECK, CPAs Plano Molding Company Audit Revenue Less: Direct professional labor Applied Overhead (200% x $70,000) Operating Income

$260,000 $ 70,000 140,000

210,000 $ 50,000

Activity-Based Costing in Service Industries: Study Objectives ABC Costing Example CHECK AND DOUBLECHECK, CPAs Annual Overhead Budget Activity Cost Pools Secretarial support Direct labor Fringe benefits Printing and photocopying Computer support Telephone and postage Legal support Insurance Recruiting and training

Cost Drivers

Expected Use Estimated ÷ of Cost Drivers = Activity-Based Overhead Per Activity Overhead Rates

Direct Prof. hours $ 210,000 Direct labor cost 240,000 Working paper pages 20,000 CPU minutes 200,000 None (traced directly) 71,000 Hours used 129,000 Revenue billed 120,000 Direct Prof. Hours __210,000 $1,200,000

30,000 $ 600,000 20,000 50,000 N/A 860 $2,000,000 30,000

$7 per hour $0.40 per $1 labor $1 per page $4 per minute Based on usage $150 per hour $0.06 per $1 rev. $7 per hour

Activity-Based Costing in Service Industries: Study Objectives ABC Costing Example CHECK AND DOUBLECHECK, CPAs Plano Molding Company Audit ActivityActivity Cost Pools Secretarial support Direct labor Fringe benefits Printing and photocopying Computer support Telephone and postage Legal support Insurance Recruiting and training

Cost Drivers Direct Professional hours Direct labor cost Working paper pages CPU minutes None (traced directly) Hours used Revenue billed Direct Prof. Hours

Actual Use of Drivers

BasedOverhead Rates

3,800 $ 70,000 1,800 8,600

$ $ $ $

156 $260,000 3,800

$150.00 $ 0.06 $ 7.00

7.00 0.40 1.00 4.00

Cost Assigned $ 26,600 28,000 1,800 34,400 8,700 23,400 15,600 26,600 $165,100

Activity-Based Costing in Service Industries: Study Objectives ABC Costing Example CHECK AND DOUBLECHECK, CPAs Plano Molding Company Audit Traditional Costing Revenues Expenses Direct professional labor Applied overhead Total expenses Operating income Profit Margin

ABC

$260,000 $ 70,000 140,000

$260,000 $ 70,000 165,100

210,000 $ 50,000

235,100 $ 24,900

19.2%

9.6%

Appendix Study Objectives Just-In-Time Processing (JIT) A processing system dedicated to having the right amount of materials, products, or parts arrive as they are needed, thereby reducing the amount of inventory.

JUST Study IN TIME PROCESSING Objectives . 100 pairs of sneakers... got it!

Send rubber and shoe laces directly to the factory.

Sales Order Received

s Susan’r Socce ers Sneak

Goods Manufactured

h Goods S

mer o t s u C o ipped t

JIT Objectives Processing Study Objective of JIT: Eliminate all manufacturing inventories Elements of JIT:  Dependable suppliers  Multi-skilled work force  Total quality control system

Benefits of JIT:  Reduced inventory  Enhanced product quality  Reduced rework and storage costs  Savings from improved flow of goods

Let’s Review Study Objectives An activity that adds costs to the product but does not increase market value is a a. Value-added activity b. Cost driver c. Cost-benefit activity d. Nonvalue-added activity

Let’s Review Study Objectives An activity that adds costs to the product but does not increase market value is a a. Value-added activity b. Cost driver c. Cost-benefit activity d. Nonvalue-added activity

ALL ABOUT YOU Study Objectives

ALL ABOUT YOU Study Objectives

ALL ABOUT YOU Study Objectives