ActivityBased Costing Chapter 9 Mc GrawHillIrwin Copyright 2008

Activity-Based Costing Chapter 9 Mc. Graw-Hill/Irwin Copyright © 2008 The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objectives: 1. Understand the potential effects of using reported product costs for decision making. 2. Explain how a two stage product costing system works. 3. Compare and contrast plantwide and department allocation methods. 4. Explain how activity-based costing and a two-stage product system are related. 5. Compute product costs using activity-based costing. 6. Compare activity-based product costing to traditional department product costing methods. 7. Demonstrate the flow of costs through accounts using activity-based costing. 8. Apply activity-based costing to marketing and administrative services. 9 -2

Product Costs and Decision Making LO 1 Understand the potential effects of using reported product costs for decision making. Units C-27 s Units produced Direct Labor hrs Costs Direct Material Direct Labor OH @ 120% DL$ Total Costs Cost per unit C-20 s Total 10 2, 000 30 3, 000 40 5, 000 $40, 000 72, 000 $36, 000 78, 000 $76, 000 150, 000 86, 400 93, 600 180, 000 $198, 400 $207, 600 $406, 000 $19, 840 $6, 920 Grange is considering dropping C-27 s. 9 -3

Example: Grange Boats (Cost Estimates) Cost Estimates Original C-20 s Only Direct Materials $76, 000 $36, 000 Direct Labor 150, 000 78, 000 Utilities 2, 400 1, 800 Supplies 2, 500 1, 300 Training 30, 000 15, 600 Supervision 54, 900 Machine Depreciation 29, 550 Plant Depreciation 40, 050 Miscellaneous 20, 600 180, 000 163, 800 $406, 000 $277, 800 Manufacturing Overhead Total Overhead Total Costs Grange’s cost with both C-20 s and C-27 s versus cost wihout C-27 s 9 -4

Example: Grange Boats (Overhead) Original C-20 s Only Utilities 2, 400 1, 800 Supplies 2, 500 1, 300 Training 30, 000 15, 600 Supervision 54, 900 Machine Depreciation 29, 550 Plant Depreciation 40, 050 Miscellaneous 20, 600 180, 000 163, 800 Look at Overhead Manufacturing Overhead Total Overhead Grange allocates $86, 400 overhead to the C-27 s. Only $16, 200 of the overhead is avoided if C 27 s are not produced. Change in Overhead: $16, 200 9 -5

-How overhead costs has been treated so far? ? -It is true for all cases? ? • Some of the overhead might be fixed • Some of the overhead might vary but with other drivers other than direct labor 9 -6

Death Spiral 9 -7

Two-Stage Allocation Systems LO 2 Explain how a two-stage product costing system works. Stage One Allocate overhead costs to departments. Stage Two Allocate department overhead costs to the products or services. 9 -8

Two-Stage Cost Allocation, Continued. . . Cost Pool Intermediate Cost Pools Cost Allocation Rule Overhead Department A Department B Direct Labor Hours Machine Hours 9 -9

Plant-wide versus Department Allocation Method LO 3 Compare and contrast plantwide and department allocation methods. Plantwide Allocation Method One cost pool for the factory One allocation rate Products All overhead costs are recorded in one cost pool and applied to products using one overhead allocation rate. Factory Overhead Costs 9 -10

Department Allocation Overhead costs traced to separate departments and applied to products using a department allocation rate. One cost pool for each department Assembly Department Overhead Costs Each department has an allocation rate Products Packaging Department Overhead Costs 9 -11

Cost Allocation: An Example (Port Arthur) Production and Cost Data Port Arthur Manufacturing Facility Third Quarter 9 -12

Example: Port Arthur (Information) Production and Cost Data Port Arthur Manufacturing Facility Third Quarter 9 -13

Example: Port Arthur (Plant-wide Allocation) Plantwide Cost Allocation Port Arthur Manufacturing Facility Third Quarter 9 -14

Two-Stage Cost Allocation, Continued. . . Cost Pool Overhead Intermediate Cost Pools Assembly Packaging Cost Allocation Rule Machine Hours Direct Labor Cost 9 -15

Example: Cost Allocation, Continued. . . Department Cost Allocation Port Arthur Manufacturing Facility Third Quarter 9 -16

Choice of Cost Allocation Method Which cost allocation method is appropriate? Similar products using same resources Plantwide Allocation Multiple products using resources differently Department Allocation 9 -17

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Using departments 9 -20

Activity-Based Costing (ABC) LO 4 Explain how activity-based costing and a two-stage product system are related. Activity-Based Costing method that first assigns costs to activities and then allocate them to products based on the products’ consumption of activities. Stage One Assign costs to activities Stage Two Allocate costs to products based on the use of each activity An activity is any discrete task that an organization undertakes to make or deliver a product or service. 9 -21

ABC, Continued. . . Activities consume resources Products consume activities 9 -22

Developing Activity-Based Costing 1. Identify the activities that consume resources and assign costs to them. 2. Identify the cost driver(s) associated with each activity. 3. Compute a cost rate per cost driver unit or transaction. 4. Allocate costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product. 9 -23

Cost Drivers Factors that cause or “drive” an activity’s costs. Identified activity Identified cost driver Setting up machines Number of hours Handling material Number of production runs Machining Number of machine hours Packaging and shipping Number of shipments 9 -24

Cost Allocation Pools Plantwide One pool Department As many pools as departments ABC As many pools as activities and cost drivers identified 9 -25

Cost Allocation Pools: ABC Cost Flow Diagram: Activity-Based Costing System Overhead Assign costs to activities Set-up Allocate costs to products based on the use of each activity Handle Material Set-up hours Machine Production runs Machine hours Pack & Shipments Products 9 -26

Choosing cost drivers 1. Causal relation. Ideally, choose a cost driver that causes the cost. 2. Benefits received. Choose a cost driver to assign costs in proportion to benefits received. 3. Reasonableness or fairness. When the first two criteria fail, assign costs on the basis of fairness or reasonableness. 9 -27

Cost Hierarchy Classification of cost drivers into general levels of activity; volume, batch, product and so on. 9 -28

Cost Hierarchy, Continued. . . Classification of cost drivers into general levels of activity; volume, batch, product and so on. 9 -29

Cost Hierarchy, Continued. . . Classification of cost drivers into general levels of activity; volume, batch, product and so on. 9 -30

Cost Hierarchy, Continued. . . Classification of cost drivers into general levels of activity; volume, batch, product and so on. 9 -31

Cost Hierarchy, Continued. . . Classification of cost drivers into general levels of activity; volume, batch, product and so on. 9 -32

Assigning costs to products • Step 1: Identify the activities • Step 2: Identify the cost drivers. • Step 3: Compute the cost driver rates. . • Step 4: Assign costs using activity-based costing. 9 -33

Example: ABC, Continued. . . LO 5 Compute product costs using activity-based costing. Production and Cost Data Port Arthur Manufacturing Facility Third Quarter 9 -34

Example: ABC (Step 1) Step 1 Identify the activities 9 -35

Example: ABC (Step 2) Identify the cost drivers and the expected Step 2 volume of each cost driver. 9 -36

Example: ABC (Step 3) Step 3 Compute the Cost Driver Rates Overhead Cost Data Port Arthur Manufacturing Facility Third Quarter 9 -37

Example: ABC (Step 4) Step 4 Allocate costs to products 9 -38

Example: ABC, Continued. . . 9 -39

Cost Flow Diagram Activity-Based Costing System Port Arthur Manufacturing Facility Direct costs Overhead costs Assembly Assemble Set-up J 25 P Packaging Handle Material Inspect & Pack Ship J 40 X 9 -40

Product Cost Methods: A Comparison LO 6 Compare activity-based product costing to traditional department product costing methods. Comparison of Reported Unit Product Costs 9 -41

Overhead Costs using ABC LO 7 Demonstrate the flow of costs through accounts using activity-based costing. Let’s see ABC cost flow for the Assembly Department It’s T Account time 9 -42

Direct Materials Costs (T Accounts) Assembly WIP J 25 P DM Material Inventory 1, 500, 000 2, 400, 000 Assembly WIP J 40 X DM 2, 400, 000 9 -43

Direct Labor Costs (T Accounts) Assembly WIP J 25 P 1, 500, 000 DL 750, 000 DM Wages Payable 750, 000 600, 000 Assembly WIP J 40 X DM 2, 400, 000 DL 600, 000 9 -44

Overhead Costs (T Accounts) Assembling 1, 080, 000 180, 000 900, 000 Setting up Machines 396, 000 Assembly WIP J 25 P 1, 500, 000 DL 750, 000 OH 240, 000 DM 36, 000 Assembly WIP J 40 X 360, 000 DM Handling Material 144, 000 DL 24, 000 120, 000 2, 400, 000 OH 600, 000 1, 380, 000 9 -45

Transfer from Assembly to Packaging (T Accounts) Assembly WIP J 25 P DM 1, 500, 000 2, 490, 000 Packaging WIP J 25 P 2, 490, 000 750, 000 OH 240, 000 DL Assembly WIP J 40 X DM 2, 400, 000 DL OH 4, 380, 000 Packaging WIP J 40 X 4, 380, 000 600, 000 1, 380, 000 9 -46

ABC in Administration LO 8 Apply activity-based costing to marketing and administrative services. The same four-step process 1. Identify the activities that consume resources. 2. Identify the cost driver associated with each activity. 3. Compute a cost rate per cost driver for each unit or transaction. 4. Allocate costs to the marketing or administration activity by multiplying the cost driver rate by the volume of cost driver units consumed by that activity. 9 -47

Problem 1 9 -48

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Problem 2 -Continue from problem 1 9 -50

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Problem 3 -contniue from problem 2 & 3 9 -52

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