activity-based costing and other cost management tools

Copyright © 2007 Prentice-Hall. All rights reserved1

Activity-Based Costingand Other Cost

Management ToolsChapter 5


Objective 1

Develop departmental overhead rates and activity-based costs

(ABC)


Activity-Based Costing

• A way to allocate indirect cost to production

• Focus – on activities and cost of activities• Each activity has its own cost driver• Uses a separate allocation rate for each

activity



Steps:• Identify the activities• Estimate the total indirect costs of each

activity• Identify the allocation base for each

activity’s indirect costs (the primary cost driver)

• Estimate the total quantity of each allocation base



Steps:5. Compute cost allocation rate for each

activity(Estimated total indirect costs of activity ÷Estimated total quantity of cost allocation base)

6. Obtain actual quantity of each allocation base used by the cost object

7. Allocate indirect costs to cost object


Cost Drivers - examples

Activities: Cost Drivers:Material purchasing # of purchase ordersMaterial handling # of partsProduction scheduling # of batchesQuality inspections # of inspectionsPhotocopying # of pages copiedWarranty service # of service calls


E5-16

Steps:1. Identify each activity

– Material handling– Machine setup– Insertion of parts– Finishing

2. Estimate the total indirect costs of each activity

$12,0003,400

48,00080,000


E5-16Steps:3. Identify the allocation base for each activity’s

indirect costs (the primary cost driver)

Activity Budgeted cost Allocation base

Material handling $12,000 # of partsMachine setup 3,400 # of setupsInsertion of parts 48,000 # of partsFinishing 80,000 # finished direct labor

hoursTotal $143,400


E5-16

Steps:4. Estimate the total quantity of each allocation

base

Activity

Total Est.

Cost

Est. Quant. of Cost

Allocation Base

Mat. handling $12,000 ÷ 3,000 partsMachine setups $ 3,400 ÷ 10 setupsInsertion of parts $48,000 ÷ 3,000 partsFinishing $80,000 ÷ 2,000 hrs


E5-16

Steps:5. Compute cost allocation rate for each activity

Activity

Total Est.

Cost

Est. Quant. of Cost

Allocation Base

Cost Allocation Rate

Mat. handling $12,000 ÷ 3,000 parts = $ 4 per partMachine setups $ 3,400 ÷ 10 setups = $340 per setupInsertion of parts $48,000 ÷ 3,000 parts = $ 16 per partFinishing $80,000 ÷ 2,000 hrs = $ 40 per hour


E5-166. Obtain actual quantity of each allocation

base used by the cost object – 1,000 wheels

7. Allocate indirect costs to cost object Average quantities of cost allocation

bases used per fender:Parts: 3,000 ÷ 1,000 = 3Setups: 10 ÷ 1,000 = 0.01Finishing direct labor hrs: 2,000 ÷ 1,000 = 2


E5-16

Indirect Manufacturing Cost Per Fender

Activity

Actual Quant of Cost

Allocation Base Used per Fender

Cost Alloca-

tion Rate

Cost perFender

Mat. handling 3.00 $ 4.00 = $ 12.00Machine setups 0.01 $340.00 = 3.40Insertion of parts 3.00 $ 16.00 = 48.00Finishing 2.00 $ 40.00 = 80.00Total indirect

cost$143.40


E5-17Total Budgeted Indirect Manufacturing Cost

Activity

Actual Quant of Cost

Allocation Base Used per Fender

Cost Alloca-

tion Rate Total

Mat. handling 10,000 $ 3.75 = $37,500 Machine setups 30 $300.00 = 9,000 Insertion of parts

10,000 $ 24.00 = 240,000

Finishing 3,500 $ 50.00 = 175,000

Total budgeted indirect cost

$461,500


E5-17Indirect Manufacturing Cost Per Rim - Standard

ActivityCost Allocation

Rate

Quant of Cost Alloc. Base Used

Cost perRim

Mat. handling $3.75 4 = $ 15.00Machine setups $300 .015 = 4.50Insertion of parts $24 4 = 96.00Finishing $50 x 1 = 50.00Total indirect cost $165.50


E5-17Indirect Manufacturing Cost Per Rim - Deluxe

ActivityCost Allocation

Rate

Quant of Cost Alloc. Base Used

Cost perRim

Mat. handling $3.75 6 = $ 22.50Machine setups $300 .015 = 4.50Insertion of parts $24 6 = 144.00Finishing $50 x 2.5 = 125.00Total indirect cost $296.00


E5-17

Budgeted total indirect overhead cost $461,500

Budgeted direct labor hrs 5,000

Single allocation rate per $461,500direct labor hr 5,000

= $92.30


E5-17

Indirect manufacturing cost per wheel:Standard model:

2 $92.30 = $184.60Deluxe model:

3 $92.30 = $276.90


E5-17

EnkeIndirect Manufacturing Costs Per Unit

ModelStandard Deluxe

ABC costs $165.50 $296.00Single-rate costs $184.60 $276.90


Objective 2

Use activity-based management (ABM) to make business

decisions


Decisions

• Pricing and product mix• Cutting costs

– Value engineering – reevaluating activities to reduce costs while satisfying customer needs

• Routine Planning and Control Decisions– Create budgets– Evaluate workers


ABC in Merchandising and Service Companies

• Allocate period costs among product or service lines


E5-18Enke Company

ABC Data Gross Profits Standard DeluxeSale price $300.00 $440.00Direct materials 30.00 46.00Direct labor 45.00 50.00Indirect overhead 165.50 296.00Gross profit $59.50 $48


E5-18Enke Company

ABC Data Gross Profits Standard DeluxeSale price $300.00 $440.00Direct materials 30.00 46.00Direct labor 45.00 50.00Indirect overhead 184.60 276.90 Gross profit $40.40 $67.10


E5-18

Finishing activity cost per rim:2.0 hrs per rim x $40 per hour = $80 per rim


E5-18New cost of deluxe rim:Direct materials $46.00Direct labor 50.00Indirect costs:

Materials handling 22.50Machine setups 4.50Insertion parts 144.00Finishing 80.00

Total $347.00


Objective 3

Decide when ABC is most likely to pass the cost-benefit test


Cost-Benefit Test

• When the benefits of adopting ABC/ABM exceed the costs


E5-19

Indications that ABC might pass the cost-benefit test

• Enke produces two different products that use different amounts of the company's resources.

• Indirect manufacturing costs are a large portion of total costs.


E5-19

• Enke hired a new controller who should have the accounting expertise to develop an ABC system.

• Enke recently purchased bar coding information technology, which reduces the cost to keep track of allocation bases such as the number of parts.


E5-19

Warning signs that Enke's old cost system was "broken”:

• Managers cannot explain profits—despite switching to what should have been a more profitable product mix, profits were declining.

• Enke was using a direct-labor-based single allocation rate system developed 20 years ago.


E5-19

• Enke reengineered its production process but it had not changed its accounting system (until Babin developed the new ABC system).


Objective 4

Describe a just-in-time(JIT) production system, and

record its manufacturing costs


Just-in-Time SystemsReceive order from customer

Schedule production

Defect-free materials are delivered by suppliers just in time for production

Finished product is delivered to customer


Just-in-Time Systems

cutting

shapingsmoothing

grinding Finished Goods


Just-in-Time

• Production activities in self-contained cells• Short setup times• Broad employee roles• Small batches produced just in time• Shortened manufacturing cycle times• Emphasis on quality• Supply-chain management


Just-in-Time Costing

• “Backlash costing” – records cost of production when units are completed

• Inventory accounts – only two– Raw and In-Process Inventory– Finished Goods Inventory

• Manufacturing costs – only two– Direct materials– Conversion costs


Exercise 5-22GENERAL JOURNAL

DATE DESCRIPTION REF DEBIT CREDIT

(in millions)Raw & In Process Inventory 6,500

Accounts Payable6,500

Conversion Costs 7,420Various accounts

7,420


Exercise 5-22GENERAL JOURNAL

DATE DESCRIPTION REF DEBIT CREDIT

Finished Goods Inventory 11,200

Raw and In Process Inventory (200x$24)

4,800

Conversion Costs(200x$32)6,400

Cost of Goods Sold ($196x56) 10,976

Finished Goods Inventory10,976


Exercise 5-22

GENERAL JOURNALDATE DESCRIPTION REF DEBIT CREDIT

Cost of Goods Sold 1,020Conversion Costs

1,020

Conversion Costs7,420 6,400

Bal. 1,020


Exercise 5-22

Finished Goods Inventory

Beg bal 100 10,976 Goods sold

Bal. 324

Goods completed 11,200


Objective 5

Contrast the four types of quality costs and use them to make

decisions


Total Quality Management

Goals• To provide customers with superior

products and services• Continuous improvement

– Improve quality– Eliminate defects and waste


Types of Quality Costs

• Prevention costs – avoid poor quality goods or services– Employee training– Improved materials– Preventive maintenance



• Appraisal costs – detect poor quality goods or services– Inspection throughout production– Inspection of final product– Product testing



• Internal failure costs – avoid poor quality goods or services before delivery to customers– Production loss caused by downtime– Rejected product units



• External failure costs – when poor quality products are delivered to customers and company has to make things right with customer– Lost profits from lost customers– Warranty costs– Service costs at customer sites– Sales returns due to quality problems


E5-24

Prevention costs:• Training employees in TQM• Training suppliers in TQM• Identifying preferred suppliers who commit

to on-time delivery of perfect quality materials


E5-24

Appraisal costs:• Strength testing one item from each batch

of panels • Avoid inspection of raw materials

Internal failure costs:• Avoid rework and spoilage


E5-24

External failure costs:• Avoid lost profits from lost sales due to

disappointed customers• Avoid warranty costs


E5-24Costs of Adopting New Quality

Program:Prevention costs:

Training employees in TQM $ 30,000Training suppliers in TQM 40,000Identifying preferred suppliers 60,000

Appraisal costs:Strength testing 65,000

Total costs of adopting new program $195,000


E5-24Costs of Not Adopting New Quality Program:Appraisal costs:

Inspection of raw materials $ 45,000Internal failure costs:Rework and spoilage. 55,000External failure costs:

Lost profits from lost sales 90,000Warranty costs 15,000

Total costs of not adopting $205,000


End of Chapter 5

activity-based costing and other cost management tools

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