4 activity based costing systems compatibility mode

8/13/2019 4 Activity Based Costing Systems Compatibility Mode

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Copyri ght © 2008 The M cGraw -H il l Companies, Inc. All ri ghts reserved .McGraw-Hill/Irwin

4Activity-Based

Costing Systems




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Learning Objective 1




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Traditional Costing Systems

Traditional cost systems were created whenmanufactur ing processes were labor intensive.

A single company-wide overhead ratebased on direct labor hours may be

used to allocate overhead to productsin these labor intensive processes.



Copyri ght © 2008 The M cGraw -H il l Companies, Inc. All rights reserved .McGraw-Hill/Irwin

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In this example, overhead will be allocated to jobsusing direct labor hours. If total overhead is $120,

how much will be allocated to each job?





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Overhead Rate = $120 ÷ 8 direct labor hours

Overhead Rate = $15 per direct labor hour

Job 1 = 2 hours × $15 per hour = $30Job 2 = 6 hours × $15 per hour = $90





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The company introducesautomated machinery. Totaloverhead rises from $120 to

$420, while the labor timeneeded for Job 2 falls from

6 hours to 1 hour. Nowallocate the $420 overhead

to the two jobs.





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Overhead Rate = $420 ÷ 3 direct labor hours

Overhead Rate = $140 per direct labor hour

Job 1 = 2 hours × $140 per hour = $280Job 2 = 1 hour × $140 per hour = $140





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Is this a reasonable costing method?

Automation benefited only Job 2, but most of the

additional overhead cost was allocated to Job 1.

Clearly, we need to look for another cost driver.





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ProductsRequire

Activi ties

Activi tiesConsume

Resources

PeopleManage

Activi ties

Activity-Based Costing (ABC)

A costing method that identifies the activitiesperformed within the organization as it delivers

its goods and services.




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Directlaborhours

Machinehours

Processsetups

Designtime

Lot size

Customer contact


A costing method that assigns costs toproducts, based on the number of activities the

organization used in producing them.




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Used in internaldecision making as wellas in inventory valuation

for external reporting.


Both manufacturingand nonmanufacturing

costs may beassigned toproducts.

Allocation basesoften differ from

traditional cost ingsystems.

AB C

ABC is a goodsupplement

to our traditionalcost system.




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TraditionalCosting

Activity-BasedCosting

ABC Compared with Traditional Costing




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Resource CostsResource Costs

Cost Pools:Cost Pools:Plants orPlants or

DepartmentsDepartments

Cost ObjectsCost Objects

Traditional CostingResource CostsResource Costs

Cost Pools:Cost Pools: Activi ties or Activi ties or

Activi ty Centers Activi ty Centers

Cost ObjectsCost Objects

Activity-Based Costing

Directly tracedor allocated

Directly tracedor allocated

Predeterminedoverheadrate

Cost driver rates for each activity

ABC Compared with Traditional Costing




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An Activity Cost Activity CostPoolPool is a

common way to

collect coststhat are relatedto a specific

activity in the ABC system.

$

$

$ $

$$

ActivityCosts





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Identify and classify the activitiesrelated to the company’s

products or services.Estimate the cost of each activityidentified in .Calculate a cost-driver rate foreach activity.

Assign activity costs to productsusing the cost-driver rate.

Four Steps in the ABC Process




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Identify and Classify Activities

UNIT-LEVEL ACTIVITIESResources acquired and activities performed for individual units of product.

CUSTOMER-LEVEL ACTIVITIES

Resources acquired and activities p erformed to serve specific customers.

BATCH-LEVEL ACTIVITIESResources acquired and activities performed for a group or batch of

similar products or services.

PRODUCT-LEVEL ACTIVITIESResources acquired and activities performed to produce and sell a specific

product or service.

FACILITY-LEVEL ACTIVITIESResources acquired and activities p erformed to provide general capacity to

produce goods or services.




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INTERVIEW ORINTERVIEW ORPARTICIPATIVEPARTICIPATIVE

APPROACH APPROACH ABC teams include or

interview operatingemployees.

RECYCLINGRECYCLING APPROACH APPROACH

Reuses documentationof processes used for

other purposes.

TOP DOWN APPROACHTOP DOWN APPROACH ABC teams of people fromtop levels of management

generate the activity

dictionary.

Identify and Classify Activities




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The ABC teams should gather data on the costs of allthe activi ties identified in Step 1.

Estimate the Cost of Activities

Examineaccountingrecords for

recorded cost

information.

Ask employeesto indicate how

much timethey work on

variousactivities.




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May Company has 4 employees in its Quality Control

Department. Salaries and costs for the department total$360,000 per year. May produces 500,000 units ofproduct a year. What is the cost-driver rate per unit?

$360,000 ÷ 500,000 units = $.72 per unit

Two pieces ofinformation are

required to computethe cost-driver rate:

• Activity Cost

• Activity Volume

Activi tyCost

÷ Activi tyVolume

= Cost-DriverRate

Calculate Cost-Driver Rates forActivities




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MAY has a customer service centerwhere customers can call to ask

questions. Customers pay a fixed fee for

each call they make to the service center.It costs MAY $1,260,000 a year to operatethe center. The center receives 120,000

calls per year. The center handles1,000,000 minutes of calls.

What is the appropriate cost driver: totalminutes for all calls or number of calls?

What is the cost-driver rate?





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Since customers are charged “ per call” , theproper activity in this case is the number of

calls handled by the center.

The cost-driver rate would be:$1,260,000 ÷ 120,000 units = $10.50 per call





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Appropriate

cost-driver base

Based on resource’spractical capacity to

support activities

Cause and effectrelationship between

activity and costsMeasurable

Predict or explainan activity’s use

of resources




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Practical Capacity Note

When estimating thecost of an activi ty,

only the costsassociated with theproduct should be

used (practicalcapacity). The cost

of “ unused capacity”should not be

applied to products.

EXAMPLE

Suppose we rent a 1,000square foot warehouse for

$1,000 per month. Only 800sq. ft. are used to store

Product A. The rest of the

warehouse is “ unused” .How much rent cost should be

allocated to Product A?




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20%, or $200 should20%, or $200 shouldbe assigned tobe assigned to

“unused capacity”“unused capacity”

80%, or $80080%, or $800should be assignedshould be assigned

to Product Ato Product A

Practical Capacity Note




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Assign Activity Costs to Products

1. Identify allthe activi tiesrelated to a

given productor service.

2. Determinehow many

units of eachactivity are

used per unitof product.

3. Assign coststo products

using the cost-driver rates foreach activi ty.




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Example: Yazz, Inc. produces 130,000 units of Product Aand 400,000 units for Product B. Using the following

cost information, how much overhead should beallocated to Product A?

Activi ty Cost-Dri ver BaseCost-Driver

RateFactory Floor Space Square Footage 50.000$ 20,000 Sq. Ft.Electricity Kilowatts 0.050$ 15,000 KWWater Gallons 0.160$ 80,000 Gal.

Quality Control Units Inspected 0.850$ 135,000 UnitsPackaging - Inner Ounces of product 0.025$ 270,000 Oz.Packaging - Outer Boxes 1.250$ 135,000 Boxes

Resources Usedby Product A





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Activi tyCost-Driver

BaseCost-Driver

RateCost

AssignedFactory floorspace

Squarefootage

50.000$ 20,000 sq. ft. 1,000,000$

Electricity Kilowatts 0.050$ 15,000 kw. 750$Water Gallons 0.160$ 80,000 gal. 12,800$

Quality control Unitsinspected

0.850$ 135,000 units 114,750$

Inner packaging Ounces ofproduct

0.025$ 270,000 oz. 6,750$

Outer packaging Boxes 1.250$ 135,000 boxes 168,750$Total Cost Assigned to Product A 1,303,800$

Resources Usedby Product A





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Let’s look at anexample from theBilson Company.

Activity-Based Costing Example




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Bilson, Inc. manufactures and sells 5,000 units ofProduct A (deluxe model), and 25,000 units of Product B(standard model) each year.

Product A requires 3.0 direct labor hours (DLH) andProduct B requires 2.5 DLH to produce.

Employing a traditional costing system, Bilson assignsoverhead cost to products using direct labor hours.

The predetermined overhead rate is:Mfg. overhead costDirect labor hours = $1,550,000

77,500 = $20/DLH





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Bilson’s unit product costs usingtraditional costing are:

Product A Product BDirect material 40.00$ 29.00$

Direct labor 30.00 25.00 Manufacturing overhead 3.0 DLH × $20/DLH 60.00

2.5 DLH × $20/DLH 50.00 Total unit product cost 130.00$ 104.00$

Bilson marks its products up by 50 percent and allocatesits $500,000 customer service costs based on revenue.





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Volume 5,000 25,000 Sales Price 195.00$ 156.00$

Sales Revenue 975,000$ 3,900,000$Direct Material 40.00$ 200,000 29.00$ 725,000 Direct Labor 30.00 150,000 25.00 625,000 Overhead 60.00 300,000 50.00 1,250,000

Gross Margin 65.00$ 325,000$ 52.00$ 1,300,000$Customer Service Costs 100,000 400,000 Product operating income 225,000$ 900,000$

Product A Product B

$975,000 ÷ ($975,000 +$3,900,000) × $500,000

Traditional Costing$130.00 × 1.50





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Sales of Product A have increased steadily since introduction,but company income has declined. Management at Bilson isunhappy with the traditional costing system and they have

decided to try activity-based costing.

In addition, management hasobserved that the cost of direct

labor is relatively stable.Since labor does not behavelike a unit-level cost, labor will

be combined with overhead andthe total conversion cost

will be assigned using ABC.





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The total conversion cost is:Traditional overhead $1,550,000Labor (77,500 hours @ $10) 775,000

Total $2,325,000

In addition, management hasobserved that the cost of direct

labor is relatively stable.Since labor does not behavelike a unit-level cost, labor will

be combined with overhead andthe total conversion cost

will be assigned using ABC.





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Activi ty Cost Machine setups 800,000$

Quality inspections 450,000 Production orders 225,000 Machine-hours worked 650,000 Material receipts 200,000

Total 2,325,000$

Management has identified the following five activitiesand costs in the production of its two products:

Total conversion cost





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The following transaction data has beencomplied by management of Bilson:

Acti vi ty Total Product A Product B Machine setups 5,000 3,000 2,000

Quali ty inspections 9,000 6,000 3,000 Production orders 600 200 400 Machi ne-hours w orked 50,000 15,000 35,000 Material receipts 800 150 650





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These data can be used to develop predeterminedcost-driver rates for each of the five activities:

Activi ty CostsTotal

TransactionsRate per

Transaction Machine setups 800,000$ 5,000 160.00$ per setup Quali ty inspections 450,000 9,000 50.00 per inspection Production orders 225,000 600 375.00 per order Machi ne-hours w orked 650,000 50,000 13.00 per hour Material receipts 200,000 800 250.00 per receipt Total 2,325,000$

$ 800,000 ÷ 5,000 Machine setups = $160.00 per setup





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Product A Activi ty ABC Rate Transactions Amount

Machine setups 160.00$ 3,000 480,000$Quali ty inspections 50.00 6,000 300,000 Production orders 375.00 200 75,000 Machine-hours worked 13.00 15,000 195,000 Material receipts 250.00 150 37,500 Total overhead assigned 1,087,500$

Number of uni ts produced ÷ 5,000 Conversion per unit $217.50

The activi ty-based overhead rates we just calculatedcan be used to assign conversion costs to Bilson’s

two products.





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two products.Product B

Activi ty ABC Rate Transactions Amount Machine setups $160.00 2,000 320,000$

Quality inspections 50.00 3,000 150,000 Production orders 375.00 400 150,000 Machine-hours w orked 13.00 35,000 455,000 Material receipts 250.00 650 162,500 Total overhead assigned 1,237,500$Number of units produced ÷ 25,000 Conversion per unit 49.50$





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two products.Product B

Activi ty ABC Rate Transactions Amount Machine setups $160.00 2,000 320,000$

Quality inspections 50.00 3,000 150,000 Production orders 375.00 400 150,000 Machine-hours w orked 13.00 35,000 455,000 Material receipts 250.00 650 162,500 Total overhead assigned 1,237,500$Number of units produced ÷ 25,000 Overhead per uni t 49.50$

Total conversion assigned to Product A 1,087,500$Total conversion assigned to Product B 1,237,500

Total overhead 2,325,000$





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Let’s compute the product cost for A and Busing our ABC overhead rates:

Activity Based Costing Product A Product B

Direct materials 40.00$ 29.00$Conversion 217.50 49.50 Total unit product cost 257.50$ 78.50$

These amounts did notchange as a result of using ABC.





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Now compare the unit product costs using thetraditional costing system and our ABC system.

Costing Method Product A Product B Acti vi ty-based costing 257.50$ 78.50$Tradi tional costing 130.00 104.00

Remember, we used one overheadrate based on direct labor hours.





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Adopting activity-based costing usually resultsin a shift of batch-level and product-level

overhead costs from high-volume standardproducts to low-volume, more complex products.





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Can you see how different allocationCan you see how different allocationmethods might lead to makingmethods might lead to making

different management decisions?different management decisions?







4-48

Based on these results Bilson also decides to use ABC to assignits $500,000 customer service costs. The applicable activity is

number of customer consultations. Customers buying Product A,the deluxe model, require more consultations than those buying

Product B, the standard model.

Cost per consultation = $500,000 ÷ 125,000 consultations = $4.00





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Sales Revenue 975,000$ 3,900,000$Direct Material 40.00$ 200,000 29.00$ 725,000 Conversion 217.50 1,087,500 49.50 1,237,500

Gross Margin (62.50)$ (312,500)$ 77.50$ 1,937,500$Customer Service Costs 200,000 300,000 Product operating income (512,500)$ 1,637,500$

Product A Product B

ABC CostingNo change in sales price

Let’s compare product income using traditional and ABC costing.





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ABCCosting

TraditionalCosting


Sales Revenue 975,000$ 3,900,000$Direct Material 40.00$ 200,000 29.00$ 725,000 Conversion 217.50 1,087,500 49.50 1,237,500

Gross Margin (62.50)$ (312,500)$ 77.50$ 1,937,500$Customer Service Costs 200,000 300,000 Product operating income (512,500)$ 1,637,500$

Product A Product B


Sales Revenue 975,000$ 3,900,000$Direct Material 40.00$ 200,000 29.00$ 725,000 Direct Labor 30.00 150,000 25.00 625,000 Overhead 60.00 300,000 50.00 1,250,000

Gross Margin 65.00$ 325,000$ 52.00$ 1,300,000$Customer Service Costs 100,000 400,000 Product operating income 225,000$ 900,000$

Product A Product B




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4-52

Should Bilsonincrease the price

of Product A?

Should Bilson

reduce the priceof Product B?

Should Bilsondrop Product A?

Product Profitability

Now that we havemeasured productcosts accurately,

we see how profitableeach product really is.




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The price of Product A, the deluxe model, shouldprobably be increased. Customers who buydeluxe models may buy based on featuresinstead of price.The price of Product B, the standard model, maybe too high. Customers who buy standardmodels are price sensitive. Decreasingthe price would increase volume,

possibly resulting in more income.

Product Profitability




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Customer Profitability

What are the costs andbenefits of servingspecific customers?

Activity-based analysis canbe used to track the costsof serving customers and

those customers’ contribution

to company profits.

Service calls

Buy/sell orders

Order changes




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Estimating Costs of New Products

Apply ABC analysis of presentproduct lines to proposed newproducts.

This is valid as long as theactivities involved with the newproducts are similar to those forthe present products.




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ABC in Service and MerchandisingCompanies

Identify and classify the activitiesrelated to the company’s products orservices.Estimate the cost of each activityidentified in .Calculate a cost-driver rate for eachactivity.

Assign activity costs to products usingthe relevant cost-driver rates.

The process is exactly the same as for manufacturing!




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More accurate and informativeproduct costs lead to better pricingdecisions.The activities driving costs are moreaccurately measured.

Managers gain easier access to therelevant costs.

An ABC system is very expensiveto develop and implement, andvery time-consuming to maintain.

ABC– Benefits and Limitations




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When Should a Company Use ABC?Indirect costs are significant in proportion to direct costs.

Goods are complex, requiring many inputs and processes.

Complex, low-volume products are profitable whilestandard, high-volume products are not.

Different departments believe costs are assignedinaccurately.The company loses bids it thought were low, and wins bidsit thought were high.

Operations have changed significantly, but the costingsystem has not changed.

Introduction of new models result in higher sales, apparentprofits per unit, but an overall income decline.

Indirect costs are significant in proportion to direct costs.

Goods are complex, requiring many inputs and processes.

Complex, low-volume products are profitable whilestandard, high-volume products are not.

Different departments believe costs are assignedinaccurately.The company loses bids it thought were low, and wins bidsit thought were high.

Operations have changed significantly, but the costingsystem has not changed.

Introduction of new models result in higher sales, apparentprofits per unit, but an overall income decline.



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End of Chapter 4

4 activity based costing systems compatibility mode

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