acct 1b week 8, chap 7 - cabrillo collegembooth/acct1b/garrison 15e/week 7 7 acct1b... · acct 1b...

Acct 1B

Week 8, Chap 7

Activity Based Costing (ABC)

Instructor: Michael Booth

Cabrillo College

Activity Based Costing:A Tool to Aid Decision Making

Increasingly

competitive global

business

environment

Eliminating

nonvalue added

activities

More

emphasis on

quality

More

emphasis on cost

measurement and

control

Using

technology and

productivity

Global Business Situation

Traditional cost systems were created when

manufacturing processes were labor intensive.

A single company-wide overhead rate,

based on direct labor hours, is used

to allocate overhead to products in

these labor intensive processes.

The Development of a Single

Companywide Cost Driver

The Development of a Single

Companywide Cost Driver

Labor Intensive Process

Overhead costs are relatively small.

Overhead allocations may be inaccurate,but the amounts are relatively insignificant.

Automated Process

Overhead costs are relatively large.

Inaccurate overhead allocation can lead to questionable product cost information.

Activity Based Costing

(ABC)

ABC is designed to provide managers with

cost information for strategic and other

decisions that potentially affect

capacity and therefore “fixed” costs. I agree!

ABC is a

good supplement

to our traditional

cost system

How Costs are Treated UnderActivity–Based Costing

ABC does not assign all manufacturing costs to products.

Manufacturing

costs

Nonmanufacturing

costs

Traditional

product costing

ABC

product costing

All

Som

e

ABC differs from traditional cost accounting in three ways.

Overhead rates may

be based on activity

at capacity.

Activity Based Costing

(ABC)

Both manufacturing

and nonmanufacturing

costs may be

assigned to

products.

Some manufacturing

costs may be excluded

from product

costs.

A number

of cost pools each

allocated to a product

or cost object.

Allocation bases often

differ from

traditional costing

systems.

Overhead Allocation

Companywide

Overhead

Rate

Activity Based

Costing

Many companies

are using activity-

based cost drivers

to improve product

costing.

Activity-Based Cost Drivers

Plantwide Overhead Rate

Companies tended to use direct labor as

the overhead allocation base. There was a

belief that direct labor and overhead

costs were highly correlated.

In class activity Martinez Furniture Company(MFC) makes desk

and chairs. Desks require 5 hours of direct labor per unit and chairs require 2 hours per unit.

Each month MFC normally uses 500,000 hrs of direct labor making 100,000 desks. Sub-assembly and parts used as a material cost per desk is 3 times greater than chairs

Each month MFC normally uses 300,000 hrs of direct labor making 150, 000 chairs

MFC incurs $1,088,000 of material handling cost each month

First Allocation Methodology Use direct hours to allocated the material handling cost

$1,088,000

Desks, 100,000 units, 5 hr/unit, 500,000 hrs total

Chairs, 150,000 units, 2 hr/unit, 300,000 hrs total

. Total direct labor hours (DLH) of 800,000 (500,000 + 300,000) is the more appropriate allocation base. The allocation rate is:

Materials Handling Cost ÷ Cost Driver = Allocation Rate

$1,088,000 ÷ 800,000 DLH = $1.36/DLH

Allocated Materials Handling Cost

Product Allocation Rate

x No. of DL Hours = Allocated Cost

Desks $1.36/DLH x 500,000 = $ 680,000

Chairs $1.36/DLH x 300,000 = 408,000

Total $1,088,000

Second Allocation Method Use direct hours to allocated the material handling cost

$1,088,000

MFC install industrial robots for making desks, and this

changes direct labor hour from 5hr/unit to .4 hr/unit

Desks, 100,000 units, .4 hr/unit, 40,000 hrs total

Chairs, 150,000 units, 2 hr/unit, 300,000 hrs total

Second Allocation MethodWith automation, total direct labor hours (DLH) drops to 340,000 (40,000 + 300,000). The allocation rate is:


$1,088,000 ÷ 340,000 DLH = $3.20/DLH



x No. of DL Hours = Allocated Cost

Desks $3.20/DLH x 40,000 = $ 128,000

Chairs $3.20/DLH x 300,000 = 960,000

Total $1,088,000

ca

Note: the shift in cost, would this change the pricing if the company

uses cost plus Pricing methods?

Adoption of ABC costing

Methods Activities associated with Material handling:

Locating a supplier Placing an order Transporting materials from supplier to MFC Inspecting the materials for defects Storing the materials in warehouse Preparing production requisitions Issuing production requisitions to manufacturing for materials

required

Issuing production requisitions is the primary activity that drive the costs of material handling Desks, 2,500 requisitions Chairs, 1,500 requisitions

Assume the same material handling cost of $1,088,000, and allocate based on requistions

Adoption of ABC costing

Methods

Using the number of materials requisitions prepared as the allocation base, the allocation rate is:


$1,088,000 ÷ 4,000 req. = $272/req.



x No. of Req. = Allocated Cost

Desks $272/req. x 2,500 = $ 680,000

Chairs $272/req. x 1,500 = 408,000

Total $1,088,000

Question: Does this method align closer to the materials usage?

Using JIT and ABC

Methodology Activities associated with Material handling:

Locating a supplier

Placing an order

Transporting materials from supplier to MFC

Inspecting the materials for defects

Storing the materials in warehouse

Preparing production requisitions

Issuing production requisitions to manufacturing for materials required

MFC has determined that warehousing, transporting, and storage costs can be reduced if materials are demanded as required. Implementation of JIT will reduced Material Handling from $1,088,000 to

$816,000

Use of digital notification for placement of order based on demand indicates

Desks, 3000 orders placed

Chairs, 2000 orders placed

Allocate the new overhead rate using the revised material handling costs

JIT and ABC MethodologyUsing the number of e-mail purchase orders filed as the allocation base, the allocation rate is:


$816,000 ÷ 5,000 Pos = $163.20/PO



x No. of Pos = Allocated Cost

Desks $163.20/PO x 3,000 = $489,600

Chairs $163.20/PO x 2,000 = 326,400

Total $816,000 Note: the overall change in costs is significantly different than the direct labor

hours.

•In addition, shifting to JIT has reduced the overall costs; this is referred to as

“continuous improvement”• Non-value add steps to be reduced or eliminated (ordering, transporting,

inspections

Kanban Materials requirement planning technique developed by

Toyota Corporation (as a part of just-in-time inventory

system) in which work-centers signal with a card when

they wish to withdraw parts from feeding operations or

the supply bins. Kanban means a visible record (such

as a billboard, card, label, or sign) in Japanese.

Kanban/JIT

JIT (Just In Time Mfg) JIT Auto Seat Production

http://www.youtube.com/watch?v=JTJLhWGVQQs

Departmental Overhead

Rates

Finishing Department

Shipping Department

Painting Department

Many companies have a system

in which each department has

its own overhead rate.

Department

1

Department

2

Department

3Cost pools

Indirect

Labor

Indirect

Materials

Other

OverheadStage One:

Costs assigned

to pools


Rates

Department

1

Department

2

Department

3Cost pools

Indirect

Labor

Indirect

Materials

Other

OverheadStage One:

Costs assigned

to pools


Rates

Products

Stage Two:

Costs applied

to products

Department

1

Department

2

Department

3Cost pools

Indirect

Labor

Indirect

Materials

Other

OverheadStage One:

Costs assigned

to pools


Rates

Products

Stage Two:

Costs applied

to products

Departmental Allocation Bases

Direct

Labor

Hours

Machine

Hours

Raw

Materials

Cost

Cost of Idle Capacity

Traditional Cost

Accounting

The predetermined overhead

rate is based on budgeted

activity. This results in

applying overhead costs of

unused, or idle, capacity.

Activity Based

Costing

Products are charged for the

costs of capacity they use

– not for the costs of

capacity they don’t use.

Designing an ABC System

Cost Objects

(e.g., products

and customers)Activities

Consumption

of Resources

Cost

Designing of an ABC

SystemSteps for Implementing ABC

Identify and define activities and activity cost pools.

Trace costs to activities and cost objects.

Assign costs to activity cost pools.

Calculate activity rates.

Assign costs to cost objects.

Prepare management reports.

Activity-Based Costing

A

B C

Activity-based costing (ABC) is a two-stage allocation

process that employs a variety of cost drivers.

Activity-Based Costing

Activity-based costing (ABC) is a two-stage allocation

process that employs a variety of cost drivers.

Stage 1

Assign costs to pools

according to activities that

cause costs to be incurred.

Stage 2

Allocate costs in the

activity pools to products.

The first step is to

identify essential

activities and costs

required to perform

the activities.

Identify and Define Activities and

Activity Cost Pools

A part of the production

process for which management

wants a separate reporting of the

costs of the activity involved.

Unit-Level

Activity

Batch-Level

Activity

Product-Level

Activity

Customer-Level

ActivityOrganization-

sustaining

Activity


Traditional cost systems usually rely on volume

measures such as direct labor hours and/or machine

hours to allocate all overhead costs to products.

ABC defines

five levels of activity

that largely do not relate

to the volume of units

produced.

Simple count

of the number of

times an activity

occurs.

Transaction

driver

A measure

of the amount

of time needed

for an activity.

Duration

driver

Two common types of activity measures:


Characteristics of Successful ABC Implementations

Strong top

management support

Cross-functional

involvement

Link to evaluations

and rewards


Activity Cost PoolsAt Zap Manufacturing, the ABC team, selected the following

activity cost pools and activity measures:

Activity Pool Activity Measure

Customer orders Number of customer orders

Product design Number of product designs

Order Size Machine hours

Customer Relations Number of active customers

Other Not applicable


Activity Cost Pools Customer Orders - assigned all costs of resources that are

consumed by taking and processing customer orders.

Product Designs - assigned all costs of resources consumed by designing products.

Order Size - assigned all costs of resources consumed as a consequence of the number of units produced.

Customer Relations – assigned all costs associated with maintaining relations with customers.

Other – assigned all overhead costs that are not associated with the other cost pools.

Production Department

Indirect factory wages 500,000$

Factory equipment depreciation 300,000

Factory utilities 120,000

Factory building lease 80,000 1,000,000$

Shipping costs traced to customer orders 40,000

General Administrative Department

Administrative wages and salaries 400,000

Office equipment depreciation 50,000

Administrative building lease 60,000 510,000

Marketing Department

Marketing wages and salaries 250,000

Selling expenses 50,000 300,000

Total overhead costs 1,850,000$

Overhead Costs at Zap Inc.

(Manufacturing and NonManufacturing)

Whenever Possible, Directly Trace Overhead Costs to

Activities and Cost Objects

Assign Costs to Activity Cost Pools

Customer

Orders

Product

Design

Order

Size

Customer

Relations Other Total


Indirect factory wages 25% 40% 20% 10% 5% 100%

Factory equipment depreciation 20% 0% 60% 0% 20% 100%

Factory utilities 0% 10% 50% 0% 40% 100%

Factory building lease 0% 0% 0% 0% 100% 100%

Shipping costs **


Administrative wages and salaries 15% 5% 10% 30% 40% 100%

Office equipment depreciation 30% 0% 0% 25% 45% 100%

Administrative building lease 0% 0% 0% 0% 100% 100%


Marketing wages and salaries 20% 10% 0% 60% 10% 100%

Selling expenses 10% 0% 0% 70% 20% 100%

Activity Cost Pools

At Zap Inc. the following distribution of resource

consumption across activity cost pools is determined.

**Not included because they are directly traced to customer orders.

Customer

Orders

Product

Design

Order

Size

Customer




Factory equipment depreciation

Factory utilities

Factory building lease


Administrative wages and salaries

Office equipment depreciation

Administrative building lease


Marketing wages and salaries

Selling expenses

Total

Activity Cost Pools

Indirect factory wages $500,000

Percent consumed by customer orders 25%

$125,000


















Customer

Orders

Product

Design

Order

Size

Customer





Factory utilities

Factory building lease


Administrative wages and salaries

Office equipment depreciation

Administrative building lease


Marketing wages and salaries

Selling expenses

Total

Activity Cost Pools

















Factory equipment depreciation $300,000

Percent consumed by customer orders 20%

$ 60,000



Customer

Orders

Product

Design

Order

Size

Customer



Indirect factory wages 25% 40% 20% 10% 5% 100%

Factory equipment depreciation 20% 0% 60% 0% 20% 100%

Factory utilities 0% 10% 50% 0% 40% 100%

Factory building lease 0% 0% 0% 0% 100% 100%

Shipping costs **


Administrative wages and salaries 15% 5% 10% 30% 40% 100%

Office equipment depreciation 30% 0% 0% 25% 45% 100%

Administrative building lease 0% 0% 0% 0% 100% 100%


Marketing wages and salaries 20% 10% 0% 60% 10% 100%

Selling expenses 10% 0% 0% 70% 20% 100%

Activity Cost Pools

At Zap Inc. the following distribution of resource

consumption across activity cost pools is determined.

**Not included because they are directly traced to customer orders.

Customer

Orders

Product

Design

Order

Size

Customer



Indirect factory wages 125,000$ 200,000$ 100,000$ 50,000$ 25,000$ 500,000$

Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000

Factory utilities - 12,000 60,000 - 48,000 120,000

Factory building lease - - - - 80,000 80,000


Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000

Office equipment depreciation 15,000 - - 12,500 22,500 50,000

Administrative building lease - - - - 60,000 60,000


Marketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000

Selling expenses 5,000 - - 35,000 10,000 50,000

Total 315,000$ 257,000$ 380,000$ 367,500$ 490,500$ 1,810,000$

Activity Cost Pools


In class Exercise 7-2 Organize into pairs

Complete first stage allocation per exhibit 7-4 & 7-5

Exercise 7-2SecuriCorp operates a fleet of armored cars that make scheduled pickups and deliveries in the

Los Angeles area. The company is implementing an activity-based costing system that has four

activity cost pools: Travel, Pickup and Delivery, Customer Service, and Other. The activity

measures are miles for the Travel cost pool, number of pickups and deliveries for the Pickup and

Delivery cost pool, and number of customers for the Customer Service cost pool. The Other cost

pool has no activity measure because it is an organization-sustaining activity. The following costs

will be assigned using the activity-based costing system:

Calculate Activity Rates

The ABC team determines that Zap Inc. will have these total activities for each activity cost pool . . .

1,000 customer orders

200 new designs

20,000 machine-hours

100 customer relations activities

Now the team can compute the individual

activity rates by dividing the total cost for

each activity by the total activity levels.

Calculate Activity Rates

(a) (b) (a) (b)

Activity Cost Pools Total Cost Total Activity Activity Rate

Customer orders 315,000$ 1,000 orders $315 per order

Product design 257,000 200 designs $1,285 per design

Order size 380,000 20,000 MachHrs $19 per MH

Customer relations 367,500 100 customer $3,675 per customer

Other 490,500 Not applicable Not applicable

Computation of Activity Rates

÷

Traced Traced Traced

Activity-Based Costing at Zap Inc.

Direct

Materials

Direct

Labor

Shipping

CostsOverhead Costs

Cost Objects:Products, Customer Orders, Customers

Activity-Based Costing at Classic Brass

Direct

Materials

Direct

Labor

Shipping

Costs


Order

Size

Customer

Orders

Product

Design

Customer

RelationsOther

Overhead Costs

First-Stage Allocation

Activity-Based Costing at Classic Brass

Direct

Materials

Direct

Labor

Shipping

Costs


Order

Size

Customer

Orders

Product

Design

Customer

RelationsOther

Overhead Costs

First-Stage Allocation

Second-Stage Allocations

$/MH $/Order $/Design $/Customer

Unallocated

In class Exercise 7-3 Work in pairs

Complete the activity rate for each of the activity cost

pools

EXERCISE 7-3

Activity Rate

Green Thumb Gardening is a small gardening service that uses activity-based costing to estimate costs for

pricing and other purposes. The proprietor of the company believes that costs are driven primarily by the size

of customer lawns, the size of customer garden beds, the distance to travel to customers, and the number of

customers. In addition, the costs of maintaining garden beds depends on whether the beds are low

maintenance beds (mainly ordinary trees and shrubs) or high maintenance beds (mainly flowers and exotic

plants). Accordingly, the company uses the five activity cost pools listed below:

Assigning Costs to Cost Objects

Let’s take a look at how our system works for just one

customer – Windward Turbine Systems.

Standard Electric Motor (no design required)

1. 400 units ordered with 2 separate orders.

2. Each electric motor required 0.5 machine-hours .

3. Selling price is $34 each.

4. Direct materials total $2,110.

5. Direct labor totals $1,850.

6. Shipping costs total $180.

Custom Gear Reduction telemetry (requires new design)

1. One order during the year.

2. Each housing required 4 machine-hours .

3. Selling price is $650 each.

4. Direct materials total $13.

5. Direct labor totals $50.

6. Shipping costs total $25.

Assigning Costs to Cost Objects

(a) (b) (a) (b)

Activity Cost Pools Activity Rate Activity ABC Cost

Customer orders (per order) 315$ 2 630$

Product design (per design) 1,285 0 -

Order size (MH) 19 200 3,800

Customer relations 3,675 N/A

Overhead Cost for the Standard Electric Motor

(a) (b) (a) (b)

Activity Cost Pools Activity Rate Activity ABC Cost

Customer orders 315$ 1 315$

Product design 1,285 1 1,285

Order size 19 4 76

Customer relations 3,675 N/A

Overhead Cost for the Custom Gear Reduction Telemetry

The customer-level cost is assigned to

customers directly; it is not assigned to

products.

In class Exercise 7-4 Work in pairs

Determine the overhead cost that would be assigned to

each of the products using activity based costing

systems

EXERCISE 7-4

Total ABC CostTotal ABC Cost Total ABC Cost

Klumper Corporation is a diversified manufacturer of industrial goods. The

company’s activity-based costing system contains the following six activity cost

pools and activity rates:

Prepare Management Reports

Standard Electric Motor

Sales 13,600$

Cost:

Direct materials 2,110$

Direct labor 1,850

Shipping costs 180

Customer orders 630

Product design -

Order size 3,800 8,570

Product margin 5,030$

Custom Gear Reduction Telemetry

Sales 650$

Cost:

Direct materials 13$

Direct labor 50

Shipping costs 25

Customer orders 315

Product design 1,285

Order size 76 1,764

Product margin (1,114)$

400 * $34/unit = $13,600

2 orders * $315/order= $630

$19 * 200 machine hours= $3,800

1* $650/unit = $650

1 orders* $315/order= $315

1 new design x $1,285 = $1,285

$19* 4 machine hours = $76

Windward Turbine Inc

Product margins:

Standard Electric Motor 5,030$

Custom Gear Reduction Telemetry (1,114)

Total product margin 3,916

Less: Customer relations 3,675

Customer margin 241$

Prepare Management Reports

Customer Profitability Analysis

1 customer * $3,675

Product Margins

Standard

Electric

Motor

Compass

Gear

Reduction

Telemetry

Sales 13,600$ 650$

Costs

Direct materials (2,110) (13)

Direct labor (1,850) (50)

Manufacturing overhead (10,000) (200)

Product margin (360)$ 387$

Traditional Cost Accounting System

Predetermined manufacturing

overhead rate

$1,000,000

20,000 MachineHr= $50/MachineHr=

400 units x 0.5 MH/unit x $50/MH = $10,000

4 units x $50/MH = $200

Difference Between ABC and

Traditional Product Costs

Traditional: Batch-level or product-level costs will

ordinarily shift overhead costs from high-volume products

produced in large batches to low-volume products produced in

small batches.

Under ABC both

manufacturing and

nonmanufacturing costs

may be assigned to

products. Organization-

sustaining costs and the

costs of idle capacity are

not assigned to products.

Targeting Process ImprovementActivity-based costing can be

used to identify areas that would benefit from process

improvements.

The theory of constraints approach is a powerful tool for

targeting the area in an organization whose improvement will yield the greatest benefits.

Theory of Constraints: any manageable system is limited in achieving more of its goal by a very small number of constraints, and that there is always at least one constraint. The TOC process seeks to identify the constraint and restructure the rest of the organization around it

Measurement using ABCGreen – Costs that adjust automatically to changes in

activity without management action

- Direct materials

Yellow – Costs that could, in principle, be adjusted to

changes in activity, but management action would be

required

- Direct Labor, Indirect labor wages

Red – Costs that would be very difficult to adjust to

changes in activity and management action would be

required

- Other manufacturing overhead,

Selling and Administrative expense

Activity-Based Costing and External

Reporting

Most companies do not use ABC for external reporting

because . . .

1. External reports are less detailed than internal

reports.

2. It may be difficult to make changes to the company’s

accounting system.

3. ABC does not conform to GAAP.

4. Auditors may be suspect of the subjective allocation

process based on interviews with employees.

Limitations of ABC

ABC systems are a

major project requiring

substantial resources.

The benefits of

increased accuracy

must outweigh these

additional costs.

ABC produces

numbers, like product

margins, that are at

odds with numbers

produced by traditional

costing system. Some

managers find it

difficult to adjust to this

change.

ABC data can be misinterpreted and must

be used with care when making decisions.

Employee Attitudes and

the Availability of Data ABC implementation may lead to cost-cutting

measures that result in job losses.

Loss of jobs will impact . . .

Employees’ personal lives

Morale of retained employees

It may be difficult to get employ cooperation

for successful implementation under these

conditions.

In class exercise Organize into pairs

Lambert Fabrication, Inc

Working papers provided

ABC Allocations

Product Margin Analysis

Assignments:

See web: http//cabrillo.blackboard.com

This will be updated weekly

Note: Use McGrawHill CONNECT on BLACKBOARD to submit assignments

http://www.cabrillo.edu/~mbooth/index_files/Related_links.htm

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