Systems Design: Activity Based Costing
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Chapter 4
Systems Design: Activity Based Costing
McGraw-Hill /Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
3-2
Learning Objective 1
Understand the basic approach in activity-based costing and how it differs from conventional costing.
3-3
Assigning Overhead Costs to Products When When cost cost systems systems were were developed developed in in the the 1800s, 1800s, the the emphasis emphasis was was on on simplicity simplicity because: because: 1. 1. Cost Cost and and activity activity data data had had to to be be collected collected by by hand hand and and all all calculations calculations were were done done with with paper paper and and pencil. pencil. 2. 2. Most Most companies companies produced produced aa limited limited variety variety of of similar similar products, products, so so there there was was little little difference difference in in the the overhead overhead costs costs consumed consumed by by each each product. product.
3-4
Plantwide Overhead Rate
Plantwide Overhead Rate A single overhead rate used throughout an entire factory. Direct Direct labor labor has has often often been been used used as as the the allocation allocation base base for for overhead overhead because: because: 1. 1. Direct Direct labor labor information information was was already already being being recorded. recorded. 2. 2. Direct Direct labor labor was was aa large large component component of of product product costs. costs. 3. 3. Managers Managers believed believed direct direct labor labor and and overhead overhead costs costs were were highly highly correlated. correlated.
3-5
Plantwide Overhead Rate Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1. 1. Most Most companies companies sell sell aa large large variety variety of of products products that that consume consume differing differing amounts amounts of of overhead. overhead. 2. 2. As As aa percentage percentage of of total total costs, costs, direct direct labor labor has has been been shrinking shrinking and and overhead overhead has has been been increasing. increasing. Many Many of of the the new new overhead overhead costs costs may may not not be be correlated correlated with with direct direct labor. labor. 3. 3. Technology Technology advancements advancements have have reduced reduced the the cost cost and and complexity complexity of of gathering gathering diverse diverse sources sources of of data. data. AA plantwide plantwide overhead overhead allocation allocation system system may may not not be be optimal optimal for for many many companies companies in in today’s today’s business business environment. environment.
3-6
Departmental Overhead Rates Many Many companies companies have have aa system system in in which which each each department department has has its its own own overhead overhead rate. rate.
Finishing Department Painting Department Shipping Department
The The allocation allocation base base depends depends on on the the nature nature of of the the work work performed performed in in each each department. department. In In the the machining machining department, department, overhead overhead may may be be based based on on machine-hours, machine-hours, but but in in the the assembly assembly department, department, overhead overhead may may be be based based on on labor-hours. labor-hours.
3-7
Departmental Overhead Rates Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs.
The The departmental departmental approach approach relies relies exclusively exclusively on on volume-related volume-related allocation allocation bases bases while while some some overhead overhead costs costs may may be be caused caused by by factors factors that that are are not not related related to to the the volume volume of of production. production.
Activity-base Activity-base costing costing is is required required to to account account for for these these other other factors. factors.
3-8
Activity-Based Costing (ABC)
A number of allocation bases are used for assigning costs to products.
3-9
Activity-Based Costing (ABC) Cost Cost Objects Objects (e.g., (e.g., products products and and customers) customers) Activities Activities Consumption Consumption of of Resources Resources Cost Cost
3-10
Activity-Based Costing (ABC) An event that causes the consumption of overhead resources
Activity
Examples of Activities
Setting up machines
Admitting hospital patients
Billing customers
Opening a bank account
3-11
Activity-Based Costing (ABC) Activity Cost Pool
A “cost bucket” in which costs related to a particular activity are accumulated
Activity Measure
Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs
Activity Rate
A predetermined overhead rate for each activity cost pool.
3-12
Designing an Activity-Based Costing System
The The challenge challenge is is to to select select aa reasonably reasonably small small number number of of activities activities that that explain explain the the bulk bulk of of the the variation variation in in overhead overhead costs. costs. Activities Activities are are usually usually chosen chosen by by interviewing interviewing aa broad broad range range of of managers managers to to find find out out what what activities activities they they think think consume consume most most of of the the organization’s organization’s resources. resources.
3-13
Designing an Activity-Based Costing System Related activities are frequently combined to reduce the amount of detail and record-keeping costs. For example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling.
An An activity activity dictionary dictionary defines defines each each of of the the activities activities that that will will be be included included in in the the activity-based activity-based costing costing system system and and how how the the activities activities will will be be measured. measured.
3-14
Hierarchy of Activities Level
Activities
Activity Measure
Unit-level
Processing units on machines Processing units by hand Consuming factory supplies
Machine-hours Direct labor-hours Units produced
Batch-level
Processing purchase orders Processing production orders Setting up equipment Handling materials
Purchase orders processed Production orders processed Number of setups Pounds of material handled
Product-level
Testing new products Administering parts inventories Designing products
Hours of testing time Number of part types Hours of design time
Facility-level
General factory administration Plant building and grounds
Direct labor-hours Direct labor-hours
3-15
Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment
Labor Related Related Pool Pool
Machine Machine Related Related Pool
Setup Setup Pool Pool
Production Order Pool
Parts Parts Admin. Admin. Pool Pool
General Factory Pool
3-16
Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment
Labor Related Related Pool Pool
Machine Machine Related Related Pool
Setup Setup Pool Pool
Production Order Pool
Parts Parts Admin. Admin. Pool Pool
General Factory Pool
Second-Stage Allocations $/DLH
$/MH
$/Setup
$/Order
$/Part Type
$/MH
Products Unit-Level Activity
Batch-Level Activity
Product-Level Facility-Level Activity Activity
3-17
Using Activity-Based Costing Comtek Sound, Inc.
Comtek Sound, Inc. makes two products: CD players and DVD players. The company has been losing bids to supply CD players, its main product, to lower priced competitors. The company has been winning all bids to supply DVD players, its secondary product.
3-18
Using Activity-Based Costing Comtek Sound, Inc.
For the current year, Comtek has budgeted sales
of 50,000 DVD units and 200,000 CD units. Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor hours. Both products require two direct labor-hours to complete, for a total of 500,000 direct labor Hours hours. DVDs: 50,000 units @ 2 hours per unit = 100,000 CDs: 200,00 units @ 2 hours per unit = 400,000 Total direct labor-hours 500,000
3-19
Using Activity-Based Costing Comtek Sound, Inc.
Unit costs for materials and labor are: Direct materials Direct Labor
DVD Units $ 90 $ 20
CD Units $ 50 $ 20
3-20
Direct Labor-Hours as a Base Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon labor-hours: Predetermined = overhead rate
$10,000,000 500,000 DLHs
= $20 per DLH
3-21
Direct Labor-Hours as a Base Since Since each each product product requires requires two two hours hours of of direct direct labor, labor, $40 $40 of of overhead overhead is is assigned assigned to to each each product. product. Direct materials Direct labor Manufacturing overhead
DVD Unit $ 90 20 40
CD Unit $ 50 20 40
$
$
(2 DLHs x $20 per DLH)
Unit product cost
150
110
3-22
Comparing the Two Approaches Activity-B ased C osting D irect-Labor C osting D V D U nit C D U nit D V D U nit C D U nit D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00 D irect labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . . . . . . while the unit cost of a DVD unit increased from $150 to $207.80.
3-23
Learning Objective 4
Contrast the product costs computed under activitybased costing and conventional costing methods.
3-24
Comparing the Two Approaches Activity-B ased C osting D irect-Labor C osting D V D U nit C D U nit D V D U nit C D U nit D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00 D irect labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
The The ABC ABC system system assigns assigns $14.45 $14.45 less less overhead overhead than than the the traditional traditional system system to to each each CD CD player. player.
3-25
Comparing the Two Approaches Activity-B ased C osting D irect-Labor C osting D V D U nit C D U nit D V D U nit C D U nit D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00 D irect labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
The The ABC ABC system system assigns assigns $57.80 $57.80 more more overhead overhead than than the the traditional traditional system system to to each each DVD DVD player. player.
3-26
Shifting of Overhead Cost Activity-B ased C osting D irect-Labor C osting D V D U nit C D U nit D V D U nit C D U nit D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00 D irect labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
Low-volume product
When When aa company company implements activity-based costing, overhead overhead cost cost often often shifts shifts from from high-volume high-volume to to lowlowvolume volume products products with with aa higher higher unit unit product product cost cost resulting resulting for for the the low-volume low-volume products. products.
3-27
Shifting of Overhead Cost Activity-B ased C osting D irect-Labor C osting D V D U nit C D U nit D V D U nit C D U nit D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00 D irect labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
High-volume product
The The traditional traditional system system assigns assigns the the same same amount amount of of all all overhead overhead costs costs to to each each CD CD or or DVD DVD player player ($40 ($40 per per unit). unit).
3-28
Shifting of Overhead Cost Production Production Orders Orders Activity Activity Cost Cost Pool Pool (a (a batch-level batch-level cost cost pool) pool) The The ABC ABC system system assigns assigns different different amounts amounts of of Production Production Order-related Order-related overhead overhead costs costs to to each each product. product. This This fact fact can can be be illustrated illustrated in in aa two-step two-step process. process. 1. 1. Compute Compute the the number number of of units units processed processed per per production production order order for for each each product. product. Number of units produced per year Number of production orders issued per year Number of units processed per production order
DVD Units 50,000 800 62.5
CD Units 200,000 400 500
3-29
Shifting of Overhead Cost 2. 2. Compute Compute production production order order cost cost per per unit unit for for each each product. product.
Cost to issue a production order Average number of units processed per production order Production order cost per unit
DVD Units CD Units $ 2,625 $ 2,625
$
62.5 42.00 $
500 5.25
Notice, Notice, the the costs costs are are being being shifted shifted from from the the high high volume volume CD CD players players to to the the low low volume volume DVD DVD players. players.
3-30
Targeting Process Improvements
An ABC system can help identify areas where the company can benefit from improving its current processes. Activity-Based Activity-Based Management Management Focuses Focuses on on managing managing activities activities to to eliminate eliminate waste waste and and reduce reduce delays delays and and defects. defects.
3-31
Targeting Process Improvements The The first first step step in in any any improvement improvement program program is is deciding deciding what what to to improve. improve. The The Theory Theory of of Constraints Constraints approach approach targets targets the the highest highest impact impact improvement improvement opportunities. opportunities.
Activity Activity rates rates can can be be used used to to target target areas areas where where costs costs seem seem excessively excessively high. high.
Benchmarking Benchmarking can can be be used used to to compare compare activity activity cost cost information information with with world-class world-class standards standards of of performance performance achieved achieved by by other other organizations. organizations.
3-32
Benefits of Activity-Based Costing ABC ABC improves improves the the accuracy accuracy of of product product costing costing by: by: Increasing Increasing the the number number of of cost cost pools pools used used to to accumulate accumulate
overhead overhead costs. costs. Using Using activity activity cost cost pools pools that that are are more more homogeneous homogeneous than than departmental departmental cost cost pools. pools. Assigning Assigning overhead overhead costs costs using using activity activity measures measures that that cause cause those those costs, costs, rather rather than than relying relying solely solely on on direct direct labor labor hours. hours.
Activity-based Activity-based costing costing also also highlights highlights activities activities that that could could benefit benefit most most from from process process improvement improvement efforts, efforts, such such as as Six Six Sigma. Sigma.
3-33
Limitations Activity-Based Costing 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.
3-34
Activity-Based Costing Critical Assumption
The The cost cost in in each each activity activity pool pool is is strictly strictly proportional proportional to to its its activity activity measure measure.. When When this this assumption assumption is is violated, violated, the the accuracy accuracy of of ABC ABC data data can can be be called called into into question. question. For For example, example, managers managers should should be be particularly particularly alert alert to to product product costs costs that that contain allocated contain allocated facility-level facility-level costs costs..
3-35
Modifying the ABC Model The The illustrations illustrations in in the the chapter chapter assume assume that that ABC ABC is is being being used used for for external external reporting reporting purposes. purposes. IfIf the the system system is is used used for for internal internal decision-making decision-making purposes, purposes, two two important important modifications modifications should should be be made: made: 1. 1. Selling Selling and and administrative administrative costs costs should should be be assigned assigned to to products, products, where where appropriate. appropriate. 2. 2. Facility-level Facility-level costs costs should should be be removed removed from from product product costs. costs.
3-36
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.
3-37
End of Chapter 4
Systems Design: Activity Based Costing
McGraw-Hill /Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
3-2
Learning Objective 1
Understand the basic approach in activity-based costing and how it differs from conventional costing.
3-3
Assigning Overhead Costs to Products When When cost cost systems systems were were developed developed in in the the 1800s, 1800s, the the emphasis emphasis was was on on simplicity simplicity because: because: 1. 1. Cost Cost and and activity activity data data had had to to be be collected collected by by hand hand and and all all calculations calculations were were done done with with paper paper and and pencil. pencil. 2. 2. Most Most companies companies produced produced aa limited limited variety variety of of similar similar products, products, so so there there was was little little difference difference in in the the overhead overhead costs costs consumed consumed by by each each product. product.
3-4
Plantwide Overhead Rate
Plantwide Overhead Rate A single overhead rate used throughout an entire factory. Direct Direct labor labor has has often often been been used used as as the the allocation allocation base base for for overhead overhead because: because: 1. 1. Direct Direct labor labor information information was was already already being being recorded. recorded. 2. 2. Direct Direct labor labor was was aa large large component component of of product product costs. costs. 3. 3. Managers Managers believed believed direct direct labor labor and and overhead overhead costs costs were were highly highly correlated. correlated.
3-5
Plantwide Overhead Rate Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1. 1. Most Most companies companies sell sell aa large large variety variety of of products products that that consume consume differing differing amounts amounts of of overhead. overhead. 2. 2. As As aa percentage percentage of of total total costs, costs, direct direct labor labor has has been been shrinking shrinking and and overhead overhead has has been been increasing. increasing. Many Many of of the the new new overhead overhead costs costs may may not not be be correlated correlated with with direct direct labor. labor. 3. 3. Technology Technology advancements advancements have have reduced reduced the the cost cost and and complexity complexity of of gathering gathering diverse diverse sources sources of of data. data. AA plantwide plantwide overhead overhead allocation allocation system system may may not not be be optimal optimal for for many many companies companies in in today’s today’s business business environment. environment.
3-6
Departmental Overhead Rates Many Many companies companies have have aa system system in in which which each each department department has has its its own own overhead overhead rate. rate.
Finishing Department Painting Department Shipping Department
The The allocation allocation base base depends depends on on the the nature nature of of the the work work performed performed in in each each department. department. In In the the machining machining department, department, overhead overhead may may be be based based on on machine-hours, machine-hours, but but in in the the assembly assembly department, department, overhead overhead may may be be based based on on labor-hours. labor-hours.
3-7
Departmental Overhead Rates Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs.
The The departmental departmental approach approach relies relies exclusively exclusively on on volume-related volume-related allocation allocation bases bases while while some some overhead overhead costs costs may may be be caused caused by by factors factors that that are are not not related related to to the the volume volume of of production. production.
Activity-base Activity-base costing costing is is required required to to account account for for these these other other factors. factors.
3-8
Activity-Based Costing (ABC)
A number of allocation bases are used for assigning costs to products.
3-9
Activity-Based Costing (ABC) Cost Cost Objects Objects (e.g., (e.g., products products and and customers) customers) Activities Activities Consumption Consumption of of Resources Resources Cost Cost
3-10
Activity-Based Costing (ABC) An event that causes the consumption of overhead resources
Activity
Examples of Activities
Setting up machines
Admitting hospital patients
Billing customers
Opening a bank account
3-11
Activity-Based Costing (ABC) Activity Cost Pool
A “cost bucket” in which costs related to a particular activity are accumulated
Activity Measure
Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs
Activity Rate
A predetermined overhead rate for each activity cost pool.
3-12
Designing an Activity-Based Costing System
The The challenge challenge is is to to select select aa reasonably reasonably small small number number of of activities activities that that explain explain the the bulk bulk of of the the variation variation in in overhead overhead costs. costs. Activities Activities are are usually usually chosen chosen by by interviewing interviewing aa broad broad range range of of managers managers to to find find out out what what activities activities they they think think consume consume most most of of the the organization’s organization’s resources. resources.
3-13
Designing an Activity-Based Costing System Related activities are frequently combined to reduce the amount of detail and record-keeping costs. For example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling.
An An activity activity dictionary dictionary defines defines each each of of the the activities activities that that will will be be included included in in the the activity-based activity-based costing costing system system and and how how the the activities activities will will be be measured. measured.
3-14
Hierarchy of Activities Level
Activities
Activity Measure
Unit-level
Processing units on machines Processing units by hand Consuming factory supplies
Machine-hours Direct labor-hours Units produced
Batch-level
Processing purchase orders Processing production orders Setting up equipment Handling materials
Purchase orders processed Production orders processed Number of setups Pounds of material handled
Product-level
Testing new products Administering parts inventories Designing products
Hours of testing time Number of part types Hours of design time
Facility-level
General factory administration Plant building and grounds
Direct labor-hours Direct labor-hours
3-15
Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment
Labor Related Related Pool Pool
Machine Machine Related Related Pool
Setup Setup Pool Pool
Production Order Pool
Parts Parts Admin. Admin. Pool Pool
General Factory Pool
3-16
Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment
Labor Related Related Pool Pool
Machine Machine Related Related Pool
Setup Setup Pool Pool
Production Order Pool
Parts Parts Admin. Admin. Pool Pool
General Factory Pool
Second-Stage Allocations $/DLH
$/MH
$/Setup
$/Order
$/Part Type
$/MH
Products Unit-Level Activity
Batch-Level Activity
Product-Level Facility-Level Activity Activity
3-17
Using Activity-Based Costing Comtek Sound, Inc.
Comtek Sound, Inc. makes two products: CD players and DVD players. The company has been losing bids to supply CD players, its main product, to lower priced competitors. The company has been winning all bids to supply DVD players, its secondary product.
3-18
Using Activity-Based Costing Comtek Sound, Inc.
For the current year, Comtek has budgeted sales
of 50,000 DVD units and 200,000 CD units. Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor hours. Both products require two direct labor-hours to complete, for a total of 500,000 direct labor Hours hours. DVDs: 50,000 units @ 2 hours per unit = 100,000 CDs: 200,00 units @ 2 hours per unit = 400,000 Total direct labor-hours 500,000
3-19
Using Activity-Based Costing Comtek Sound, Inc.
Unit costs for materials and labor are: Direct materials Direct Labor
DVD Units $ 90 $ 20
CD Units $ 50 $ 20
3-20
Direct Labor-Hours as a Base Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon labor-hours: Predetermined = overhead rate
$10,000,000 500,000 DLHs
= $20 per DLH
3-21
Direct Labor-Hours as a Base Since Since each each product product requires requires two two hours hours of of direct direct labor, labor, $40 $40 of of overhead overhead is is assigned assigned to to each each product. product. Direct materials Direct labor Manufacturing overhead
DVD Unit $ 90 20 40
CD Unit $ 50 20 40
$
$
(2 DLHs x $20 per DLH)
Unit product cost
150
110
3-22
Comparing the Two Approaches Activity-B ased C osting D irect-Labor C osting D V D U nit C D U nit D V D U nit C D U nit D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00 D irect labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . . . . . . while the unit cost of a DVD unit increased from $150 to $207.80.
3-23
Learning Objective 4
Contrast the product costs computed under activitybased costing and conventional costing methods.
3-24
Comparing the Two Approaches Activity-B ased C osting D irect-Labor C osting D V D U nit C D U nit D V D U nit C D U nit D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00 D irect labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
The The ABC ABC system system assigns assigns $14.45 $14.45 less less overhead overhead than than the the traditional traditional system system to to each each CD CD player. player.
3-25
Comparing the Two Approaches Activity-B ased C osting D irect-Labor C osting D V D U nit C D U nit D V D U nit C D U nit D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00 D irect labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
The The ABC ABC system system assigns assigns $57.80 $57.80 more more overhead overhead than than the the traditional traditional system system to to each each DVD DVD player. player.
3-26
Shifting of Overhead Cost Activity-B ased C osting D irect-Labor C osting D V D U nit C D U nit D V D U nit C D U nit D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00 D irect labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
Low-volume product
When When aa company company implements activity-based costing, overhead overhead cost cost often often shifts shifts from from high-volume high-volume to to lowlowvolume volume products products with with aa higher higher unit unit product product cost cost resulting resulting for for the the low-volume low-volume products. products.
3-27
Shifting of Overhead Cost Activity-B ased C osting D irect-Labor C osting D V D U nit C D U nit D V D U nit C D U nit D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00 D irect labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
High-volume product
The The traditional traditional system system assigns assigns the the same same amount amount of of all all overhead overhead costs costs to to each each CD CD or or DVD DVD player player ($40 ($40 per per unit). unit).
3-28
Shifting of Overhead Cost Production Production Orders Orders Activity Activity Cost Cost Pool Pool (a (a batch-level batch-level cost cost pool) pool) The The ABC ABC system system assigns assigns different different amounts amounts of of Production Production Order-related Order-related overhead overhead costs costs to to each each product. product. This This fact fact can can be be illustrated illustrated in in aa two-step two-step process. process. 1. 1. Compute Compute the the number number of of units units processed processed per per production production order order for for each each product. product. Number of units produced per year Number of production orders issued per year Number of units processed per production order
DVD Units 50,000 800 62.5
CD Units 200,000 400 500
3-29
Shifting of Overhead Cost 2. 2. Compute Compute production production order order cost cost per per unit unit for for each each product. product.
Cost to issue a production order Average number of units processed per production order Production order cost per unit
DVD Units CD Units $ 2,625 $ 2,625
$
62.5 42.00 $
500 5.25
Notice, Notice, the the costs costs are are being being shifted shifted from from the the high high volume volume CD CD players players to to the the low low volume volume DVD DVD players. players.
3-30
Targeting Process Improvements
An ABC system can help identify areas where the company can benefit from improving its current processes. Activity-Based Activity-Based Management Management Focuses Focuses on on managing managing activities activities to to eliminate eliminate waste waste and and reduce reduce delays delays and and defects. defects.
3-31
Targeting Process Improvements The The first first step step in in any any improvement improvement program program is is deciding deciding what what to to improve. improve. The The Theory Theory of of Constraints Constraints approach approach targets targets the the highest highest impact impact improvement improvement opportunities. opportunities.
Activity Activity rates rates can can be be used used to to target target areas areas where where costs costs seem seem excessively excessively high. high.
Benchmarking Benchmarking can can be be used used to to compare compare activity activity cost cost information information with with world-class world-class standards standards of of performance performance achieved achieved by by other other organizations. organizations.
3-32
Benefits of Activity-Based Costing ABC ABC improves improves the the accuracy accuracy of of product product costing costing by: by: Increasing Increasing the the number number of of cost cost pools pools used used to to accumulate accumulate
overhead overhead costs. costs. Using Using activity activity cost cost pools pools that that are are more more homogeneous homogeneous than than departmental departmental cost cost pools. pools. Assigning Assigning overhead overhead costs costs using using activity activity measures measures that that cause cause those those costs, costs, rather rather than than relying relying solely solely on on direct direct labor labor hours. hours.
Activity-based Activity-based costing costing also also highlights highlights activities activities that that could could benefit benefit most most from from process process improvement improvement efforts, efforts, such such as as Six Six Sigma. Sigma.
3-33
Limitations Activity-Based Costing 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.
3-34
Activity-Based Costing Critical Assumption
The The cost cost in in each each activity activity pool pool is is strictly strictly proportional proportional to to its its activity activity measure measure.. When When this this assumption assumption is is violated, violated, the the accuracy accuracy of of ABC ABC data data can can be be called called into into question. question. For For example, example, managers managers should should be be particularly particularly alert alert to to product product costs costs that that contain allocated contain allocated facility-level facility-level costs costs..
3-35
Modifying the ABC Model The The illustrations illustrations in in the the chapter chapter assume assume that that ABC ABC is is being being used used for for external external reporting reporting purposes. purposes. IfIf the the system system is is used used for for internal internal decision-making decision-making purposes, purposes, two two important important modifications modifications should should be be made: made: 1. 1. Selling Selling and and administrative administrative costs costs should should be be assigned assigned to to products, products, where where appropriate. appropriate. 2. 2. Facility-level Facility-level costs costs should should be be removed removed from from product product costs. costs.
3-36
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.
3-37
End of Chapter 4
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