Chapter 3 Systems Design Activity Based Costing Mc

Learning Objective 1 Understand the basic approach in activity-based costing and how it differs from conventional costing. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Assigning Overhead Costs to Products When cost systems were developed in the 1800 s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand all calculations were done with paper and pencil. 2. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Plantwide Overhead Rate Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1. Most companies sell a large variety of products that consume differing amounts of overhead. 2. As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor. 3. Technology advancements have reduced the cost and complexity of gathering diverse sources of data. A plantwide overhead allocation system may not be optimal for many companies in today’s business environment. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Departmental Overhead Rates Many companies have a system in which each department has its own overhead rate. Finishing Department Painting Department Shipping Department Mc. Graw-Hill /Irwin 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. Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 departmental approach relies exclusively on volume-related allocation bases while some overhead costs may be caused by factors that are not related to the volume of production. Activity-base costing is required to account for these other factors. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Activity-Based Costing (ABC) A number of allocation bases are used for assigning costs to

Activity-Based Costing (ABC) Cost Objects (e. g. , products and customers) Activities Consumption of Resources Cost Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Activity-Based Costing (ABC) An event that causes the consumption of overhead resources Activity Examples of Activities Setting up machines Mc. Graw-Hill /Irwin Admitting hospital patients Billing customers Opening a bank account Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Designing an Activity-Based Costing System The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Hierarchy of Activities Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies,

Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment Labor Related Pool Mc. Graw-Hill /Irwin Machine Related Pool Setup Pool Production Order Pool Parts Admin. Pool General Factory Pool Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment Labor Related Pool Machine Related Pool Setup Pool Production Order Pool Parts Admin. Pool General Factory Pool Second-Stage Allocations $/DLH $/MH $/Setup $/Order $/Part Type $/MH Products Unit-Level Activity Mc. Graw-Hill /Irwin Batch-Level Activity Product-Level Facility-Level Activity Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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

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. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Using Activity-Based Costing Comtek Sound, Inc. Unit costs for materials and labor are: Mc.

Direct Labor-Hours as a Base Total manufacturing overhead costs for the current year are estimated to be $10, 000. The company develops the following overhead rate based upon labor-hours: Predetermined $10, 000 = overhead rate 500, 000 DLHs Mc. Graw-Hill /Irwin = $20 per DLH Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Direct Labor-Hours as a Base Since each product requires two hours of direct labor, $40 of overhead is assigned to each product. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objective 2 Compute activity rates for an activity-based costing system. Mc. Graw-Hill /Irwin

Computing Activity Rates The ABC project team at Comtek has developed the following basic

Computing Activity Rates We can calculate the following activity rates: Using the new activity rates, let’s assign overhead to the two products based upon expected activity. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objective 3 Compute product costs using activity-based costing. Mc. Graw-Hill /Irwin Copyright ©

Computing Overhead Cost per Unit DVD Units Mc. Graw-Hill /Irwin Copyright © 2008 by

Computing Overhead Cost per Unit CD Units Mc. Graw-Hill /Irwin Copyright © 2008 by

Comparing the Two Approaches 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. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objective 4 Contrast the product costs computed under activitybased costing and conventional costing methods. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Comparing the Two Approaches The ABC system assigns $14. 45 less overhead than the traditional system to each CD player. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Comparing the Two Approaches The ABC system assigns $57. 80 more overhead than the traditional system to each DVD player. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Shifting of Overhead Cost Low-volume product When a company implements activity-based costing, overhead cost often shifts from high-volume to lowvolume products with a higher unit product cost resulting for the low-volume products. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Shifting of Overhead Cost High-volume product The traditional system assigns the same amount of all overhead costs to each CD or DVD player ($40 per unit). Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Shifting of Overhead Cost Production Orders Activity Cost Pool (a batch-level cost pool) The ABC system assigns different amounts of Production Order-related overhead costs to each product. This fact can be illustrated in a two-step process. 1. Compute the number of units processed per production order for each product. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Shifting of Overhead Cost 2. Compute production order cost per unit for each product. Notice, the costs are being shifted from the high volume CD players to the low volume DVD players. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Targeting Process Improvements An ABC system can help identify areas where the company can benefit from improving its current processes. Activity-Based Management Focuses on managing activities to eliminate waste and reduce delays and defects. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Targeting Process Improvements The first step in any improvement program is deciding what to improve. 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. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Benefits of Activity-Based Costing ABC improves the accuracy of product costing by: n Increasing the number of cost pools used to accumulate overhead costs. n Using activity cost pools that are more homogeneous than departmental cost pools. n 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. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Activity-Based Costing Critical Assumption The cost in each activity pool is strictly proportional to its activity measure. When this assumption is violated, the accuracy of ABC data can be called into question. For example, managers should be particularly alert to product costs that contain allocated facility-level costs. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Modifying the ABC Model The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: 1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objective 5 Record the flow of costs in an activity-based costing system. Mc.

Cost Flows in an ABC System Sarvik Company uses activity-based costing. The company has five cost pools shown below. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cost Flows in an ABC System Activity rates are determined as follows: Mc. Graw-Hill

Cost Flows in an ABC System Overhead is applied on the basis of actual

Cost Flows in an ABC System Selected transactions recorded by the company: a. Raw materials purchased on account, $915, 000. b. Raw materials used in production, $900, 000 ($810, 000 direct and $90, 000 indirect). c. Factory labor costs, $370, 000 ($95, 000 direct and $275, 000 indirect). d. Depreciation of factory assets, $180, 000. e. Miscellaneous manufacturing overhead costs incurred on account, $230, 000. f. Manufacturing overhead applied, $761, 000. g. Goods costing $1, 650, 000 were manufactured. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cost Flows in an ABC System The following journal entries would be used to record transactions (a) and (b). Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cost Flows in an ABC System The following journal entries would be used to record transactions (c) and (d). Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cost Flows in an ABC System The following journal entry would be used to

Cost Flows in an ABC System Manufacturing Overhead (b) (c) (d) (e) Bal. 90, 000 (g) 761, 000 275, 000 180, 000 230, 000 14, 000 Underapplied Overhead Costs Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.