Chapter 4 1 CHAPTER 17 ActivityBased Costing Accounting

Chapter 4 -1

CHAPTER 17 Activity-Based Costing Accounting, Fourth Edition Chapter 4 -2

Study Objectives 1. Recognize the difference between traditional costing and activity based costing. 2. Identify the steps in the development of an activity-based costing system. 3. Know how companies identify the activity cost pools used in activity-based costing. 4. Know how companies identify and use cost drivers in activity-based costing. Chapter 4 -3

Study Objectives 5. Understand the benefits and limitations of activity-based costing. 6. Differentiate between value-added and non-value-added activities. 7. Understand the value of using activity levels in activity-based costing. 8. Apply activity-based costing to service industries. Chapter 4 -4

Traditional Costing To allocate as fairly as possible the true costs of the products. When management has more accurate costs, better decisions can be made. Direct Materials and Direct Labor costs are easiest to trace through: Material requisitions. Payroll time sheets. Chapter 4 -5 SO 1: Recognize the differences between traditional costing and activity-based costing.

Hard Part of Determining Product Costs is? Determining the proper amount of overhead to assign to each product, service or job. Chapter 4 -6

Traditional Costing and ABC Chapter 4 -7

Traditional Costing Allocates overhead using a single predetermined rate. Job order costing: Direct labor cost is assumed to be the relevant activity base. Assumption was satisfactory when direct labor was a major portion of total manufacturing costs. There should be of a high correlation between direct labor costs and overhead costs. Chapter 4 -8 SO 1: Recognize the differences between traditional costing and activity-based costing.

Traditional Costing Allocates overhead using a single predetermined rate. Process Costing: Machine hours is assumed to be the relevant activity base. Assumption was satisfactory when machine hours was a major portion of total manufacturing costs. There should be of a high correlation between machine hours and overhead costs. Chapter 4 -9 SO 1: Recognize the differences between traditional costing and activity-based costing.

Why Do Companies Need a New Approach? 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). Chapter 4 -10 SO 1: Recognize the differences between traditional costing and activity-based costing.

Activity-Based Costing l l l Chapter 4 -11 Is another approach (other than traditional costing) to allocate manufacturing overhead. 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. SO 1: Recognize the differences between traditional costing and activity-based costing.

ABC Definitions 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: The overhead cost attributed to a distinct type of activity. Examples: Purchasing materials. Setting up machines. Cost Drivers: Any factors or activities that have a direct cause-effect relationship with the resources consumed. Chapter 4 -12 SO 1: Identify the steps in management’s decision-making process.

Activity-Based Costing Products consume activities, and Activities consume resources. Chapter 4 -13 SO 1: Recognize the differences between traditional costing and activity-based costing.

Activity-Based Costing 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. Chapter 4 -14 SO 1: Recognize the differences between traditional costing and activity-based costing.

OVERHEAD COSTS Illustration 17 -2 Chapter 4 -15 SO 1: Recognize the differences between traditional costing and activity-based costing.

Overhead Costs Illustration 17 -3 Chapter 4 -16 SO 1: Recognize the differences between traditional costing and activity-based costing.

Activity-Based Costing 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. Chapter 4 -17 SO 2 Identify the steps in the development of an activity-based system.

Activity-Based Costing 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. Chapter 4 -18 SO 1: Recognize the differences between traditional costing and activity-based costing.

Costing Under Traditional Costing Products Manufacturing Costs. The Boot Direct Materials $40 Direct Labor 12 Overhead 30 Total unit cost $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 × 1 hr. = $30) Chapter 4 -19 Illustration 17 -10 SO 2 Identify the steps in the development of an activity-based system.

Four Steps of Activity-Based Costing 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 cost pool to products using the overhead rates. Chapter 4 -20 SO 2 Identify the steps in the development of an activity-based system.

Activity Cost Pools and Estimated Overhead Activity Cost Pools Setting up machines Machining Inspecting Total Estimated Overhead $300, 000 500, 000 100, 000 $900, 000 Illustration 17 -4 Chapter 4 -21 SO 3 Know how companies identify the activity cost pools and use activity-based costing.

Identify Cost Drivers Activity Cost Pools Per Activity Setting up machines Machining Inspecting Expected Use of Cost Drivers Number of setups 1, 500 Machine hours 50, 000 Number of Inspections 2, 000 Illustration 17 -5 Chapter 4 -22 SO 4 Know how companies identify and use cost drivers in activity-based costing

Formula for Computing Activity-Based Overhead Rate Estimated Overhead Per Activity = Activity-Based Overhead Rate Expected Use of Cost Drivers Per Activity Illustration 17 -6 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 Illustration 17 -7 SO 4 Know how companies identify and use cost drivers in activity-based costing Chapter 4 -23

Expected Use of Costs to Products Illustration 17 -8 Chapter 4 -24 SO 4 Know how companies identify and use cost drivers in activity-based costing

Assignment of Activity Cost Pools to Products Illustration 17 -9 Chapter 4 -25 SO 4 Know how companies identify and use cost drivers in activity-based costing

Unit Product Costs Under Traditional and ABC Costing Methods Manufacturing Costs Direct Materials Direct Labor 12 Overhead Total Cost per Unit The Boot Trad. Costing ABC $40 12 12 30 17 $82 $69 Oversstated $13 The Club Trad. Costing ABC $30 12 30 95 $72 $137 Understated $65 Illustration 7 -11 Chapter 4 -26 SO 4 Know how companies identify and use cost drivers in activity-based costing

Results of Using ABC 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. Chapter 4 -27 SO 4 Know how companies identify and use cost drivers in activity-based costing

Benefits of Activity-Based Costing More accurate product costing through: Use of more cost pools to assign overhead costs. Enhanced control overhead costs. Better management decisions. Chapter 4 -28 SO 5 Understand the benefits and limitations of activity-based costing

Limitations of Activity-Based Costing Can be expensive to use (Cost/Benefit). Some arbitrary allocations continue. Chapter 4 -29 SO 5 Understand the benefits and limitations of activity-based costing

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. Chapter 4 -30 SO 5 Understand the benefits and limitations of activity-based costing

Let’s Review Activity-based costing (ABC): A. B. C. D. Chapter 4 -31 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. SO 5 Understand the benefits and limitations of activity-based costing

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-value-added. Chapter 4 -32 SO 6 Differentiate between value-added and non-value activities

Value- Added Activities An activity that increases the worth of a product or service such as: Manufacturing Company Engineering design Machining Assembly Painting Packaging Chapter 4 -33 Service Company Performing surgery Legal research services Delivering packages SO 5 Understand the benefits and limitations of activity-based costing

Non-Value 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 Chapter 4 -34 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 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. Chapter 4 -35

Hierarchy of Activity Levels Illustration 17 -13 Chapter 4 -36 SO 7 Understand the value of using activity levels in activity-based costing.

Activity-Based Costing 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 nonvalue-added. Reduction of non-value-added activities. Chapter 4 -37 SO 8 Apply activity-based costing to service industries.

Major Difficulty of Implementing ABC A larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services. Chapter 4 -38

Condensed Budget of Service Company under Traditional Costing CHECK AND DOUBLECHECK, CPAs Annual Budget Revenue $2, 000 Direct labor $ 600, 000 Overhead (expected) 1, 200, 000 Total Costs 1, 800, 000 Operating income $ 200, 000 Estimated Overhead Direct Labor Costs $1, 200, 000 $600, 000 Chapter 4 -39 = Predetermined overhead rate = 200% Illustration 17 -14 SO 8 Apply activity-based costing to service industries.

Overhead Applied Under Traditional Costing CHECK AND DOUBLECHECK, CPAs Plano Molding Company Audit Revenue $260, 000 Less: Direct professional labor $ 70, 000 Applied Overhead (200% × $70, 000) 140, 000 210, 000 Operating Income $ 50, 000 Illustration 17 -15 Chapter 4 -40 SO 8 Apply activity-based costing to service industries.

Activity-Based Costing Budget CHECK AND DOUBLECHECK, CPAs Annual Overhead Budget Expected Use of Activity-Based Estimated Cost Drivers Overhead Activity Cost Pools Cost Drivers Overhead Per Activity Rates Secretarial support Direct Prof. hours $ 210, 000 30, 000 $7 per hour Direct labor Fringe benefits Direct labor cost 240, 000 $ 600, 000 $0. 40 per $1 labor Printing and photocopying Working paper pages 20, 000 $1 per page Computer support CPU minutes 200, 000 50, 000 $4 per minute Telephone and postage None (traced directly) 71, 000 N/A Based on usage Legal support Hours used 129, 000 860 $150 per hour Insurance (professional liability, etc. ) Revenue billed 120, 000 $2, 000 $0. 06 per $1 rev. Recruiting and training Direct Prof. Hours __ 210, 000 30, 000 $7 per hour $1, 200, 000 Illustration 17 -16 Chapter 4 -41 SO 8 Apply activity-based costing to service industries.

Assigning Overhead in a Service Company CHECK AND DOUBLECHECK, CPAs Plano Molding Company Audit Activity. Based Overhead Rate $ 7. 00 $ 0. 40 $ 1. 00 $ 4. 00 Actual Use of Activity Cost Pools Cost Drivers Driver Secretarial support Direct Professional hours 3, 800 Direct labor Fringe benefits Direct labor cost $ 70, 000 Printing and photocopying Working paper pages 1, 800 Computer support CPU minutes 8, 600 Telephone and postage None (traced directly) Legal support Hours used 156 $150. 00 Insurance Revenue billed $260, 000 $ 0. 06 Recruiting and training Direct Prof. Hours 3, 800 $ 7. 00 Cost Assigned $ 26, 600 28, 000 1, 800 34, 400 8, 700 23, 400 15, 600 26, 600 $165, 100 Illustration 17 -17 Chapter 4 -42 SO 8 Apply activity-based costing to service industries.

Comparison of Traditional and ABC CHECK AND DOUBLECHECK, CPAs Plano Molding Company Audit Revenues Expenses Direct professional labor Applied overhead Total expenses Operating income Profit Margin Traditional Costing $260, 000 $ 70, 000 140, 000 $ 24, 900 210, 000 19. 2% ABC . $260, 000 $ 70, 000 165, 100 $ 50, 000 235, 100 9. 6% Illustration 17 -18 Chapter 4 -43 SO 8 Apply activity-based costing to service industries.

Review Recognize the difference between traditional and activity-based costing. Traditional system allocates overhead to products using predetermined unit-based output rate. ABC allocates overhead to activity cost pools and assigns cost to products using cost drivers. Identify the steps in the development of an activitybased costing system. Step 1: Identify the major activities and allocate the overhead costs to cost pools. Step 2: Identify the cost driver highly correlated to the cost pool. Step 3: Compute the overhead rate per cost driver. Step 4: Assign cost pools to products or services using the overhead rates. Chapter 4 -44

Review Know how companies identify cost pools used in ABC. Analyze each operation or process, document and time every task, action, or transaction. Know how companies identify and use cost drivers in ABC. Cost drivers identified for assigning activity cost pools must: Accurately measure the consumption of the activity. Have related data easily available. Understand the benefits and limitations of ABC: Benefits: Enhanced control overhead costs. Better management decisions. Limitations: Higher costs accompany multiple activity centers and cost drivers. Some costs must still be allocated arbitrarily. Chapter 4 -45

Review Differentiate between value-added and non-value-added activities. Value-added activities increase the worth of a product or service. Non-value-added activities add cost to, or increase the time spent on, a product or service without increasing its market value. Understand the value of using activity levels in ABC. Activities may be classified as: Unit-level Batch-level Product-level Facility-level Failure to recognize this classification can result in distorted product costing. Chapter 4 -46

Review Apply ABC to service industries. Same objective – improved costing of services provided. The general approach to costing is also the same: Analyze operations. Identify activities. Accumulate overhead costs by activity cost pools. Identify and use cost drivers to assign cost to services. Chapter 4 -47

Just-in-Time 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. Chapter 4 -48

JUST-in-TIME PROCESSING. 100 pairs of sneakers. . . got it! Send rubber and shoe laces directly to the factory. Sales Order Received ’s Susane Socc sr r Sneake Chapter 4 -49 Goods Manufactured stomer Cu o t d e p p i h Goods S Illustration 17 -A 1

Just-in-Time 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. Chapter 4 -50

Let’s Review 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. Non-value-added activity. Chapter 4 -51

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