activity-based costing. over- and undercosting overcosting – a product consumes a low level of...

Activity-Based Costing

Undercosting and Overcosting

• Consider the costing of a bill for four friends who go for dinner. • Each diner orders separate entrees, desserts, and drinks. • Bill details are as follows:

Entrée Dessert Drinks Total Emma $11 $0 $4 $15 J ames 20 8 14 42 J essica 15 4 8 27 Matthew 14 4 6 24 Total $60 $16 $32 $108

Average $15 $4 $8 $27

Over- and Undercosting

• Overcosting – a product consumes a low level of resources (costs) but is allocated high costs per unit

• Undercosting – a product consumes a high level of resources (costs) but is allocated low costs per unit

Direct versus Indirect Costs

Traditional Costing

All production costs All production costs except direct materials except direct materials

and direct labor are and direct labor are lumped together in one lumped together in one

overhead cost pool.overhead cost pool.

Traditional Costing

All production costs All production costs except direct materials except direct materials

and direct labor are and direct labor are lumped together in one lumped together in one

overhead cost pool.overhead cost pool.


An effort is made to An effort is made to account for as many account for as many costs as possible as costs as possible as

direct costs of direct costs of production.production.


An effort is made to An effort is made to account for as many account for as many costs as possible as costs as possible as

direct costs of direct costs of production.production.

IndirectIndirectCostsCosts

ActivityAn event that causes the consumption of overhead

resources.

Activity Cost Pool

A “cost bucket” in which costs related to a particular activity

measure are accumulated.

$

$

$ $

$$

How Costs are Treated UnderActivity–Based Costing

Activity MeasureActivity Measure

An allocation basein an activity-based

costing system.

An allocation basein an activity-based

costing system.


The term cost driver is also used to refer to an

activity measure.

The term cost driver is also used to refer to an

activity measure.

Homogeneous Activity Cost Pools

A homogeneous cost pool is a grouping of overhead costs in which each cost component is consumed in roughly the same proportion by each product line.

A homogeneous cost poolA homogeneous cost pooluses a single cost driver.uses a single cost driver.

Simple countof the number oftimes an activity

occurs.

Transactiondriver

A measureof the amountof time neededfor an activity.

Durationdriver

Two common types of activity measures:


Traditional Product-Costing System

• Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.

• The following information is obtained from company records:

• Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.

• The following information is obtained from company records:

Mode I Mode II Mode IIIProduction: Units 10,000 20,000 4,000 Runs 1 of 10,000 4 of 5,000 10 of 400


Additional information includes:

Mode I Mode II Mode IIIDirect materials 50.00$ 90.00$ 20.00$ Direct labor (hr/board) 3 4 2 Setup time (hr/run) 10 10 10 Machine time (hr/board) 1 1.25 2

Manufacturing overhead is determined as follows


Budgeted manufacturing overhead Budgeted manufacturing overhead $3,894,000 $3,894,000 Budgeted direct-labor hours 118,000Budgeted direct-labor hours 118,000 = $33 per hour= $33 per hour


With these product costs, Aerotech established target selling prices (Cost × 125%).

209.00 x 1.25


Aerotech wishes to see what target selling prices would be suggested when using activity-based

costing.

Aerotech wishes to see what target selling prices would be suggested when using activity-based

costing.

Let’s see how ABC works.Let’s see how ABC works.

Activity Based Costing System (ABC)

ABC systems follow a two-stage

procedure to assign overhead costs to

products.

Assigningoverhead to products is

a

difficult process. I agree!




products.

Let’s beginby identifying

our major activities.

Stage OneIdentify significant

activities and assign overheadcosts to each activity in

proportion to resources used.

Stage OneIdentify significant

activities and assign overheadcosts to each activity in

proportion to resources used.




products.

Overhead assigned to activities are called

“activity cost pools.”

Stage TwoIdentify cost drivers

appropriate to each activityand allocate overhead to

the products.

Stage TwoIdentify cost drivers

appropriate to each activityand allocate overhead to

the products.

Overhead CostsOverhead Costs

Total budgeted cost = $3,894,000Total budgeted cost = $3,894,000

ActivityActivityCostCostPoolsPools

MachineryMachinerycost poolcost pool

$1,212,600$1,212,600

SetupSetupcost poolcost pool$3,000$3,000

EngineeringEngineeringcost poolcost pool$700,000$700,000

FacilityFacilitycost poolcost pool$507,400$507,400

UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel

Identificationof ActivityCost Pools


ActivityActivitymust bemust bedone ondone oneach uniteach unit

producedproduced..

ActivityActivityperformedperformed

on eachon eachbatchbatch

produced.produced.

Activities needed to supportActivities needed to supportan entire product linean entire product line Activities that support theActivities that support the

organization as a whole.organization as a whole.

Overhead CostsOverhead Costs

Total budgeted cost = $3,894,000Total budgeted cost = $3,894,000

ActivityActivityCostCostPoolsPools


$1,212,600$1,212,600




MoreCostPools

UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel



Receiving/InspectionReceiving/Inspectioncost poolcost pool $200,000$200,000

Material-HandlingMaterial-Handlingcost pool cost pool $600,000$600,000

Quality-AssuranceQuality-Assurancecost pool cost pool $421,000$421,000

Packaging/ShippingPackaging/Shippingcost poolcost pool $250,000$250,000


$1,212,600$1,212,600




UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel

Various overheadVarious overheadcosts relatedcosts relatedto to machinerymachinery

Maintenance

Depreciation

Computer Support

Lubrication

Electricity

Calibration

Machinery Cost PoolMachinery Cost PoolTotal budgeted cost = $1,212,600

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

CalculateCalculatethe poolthe pool

raterate

Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hour$28.20/hour

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

=

=

Calculation ofCalculation oftotal total setup costsetup cost

Setup Cost PoolSetup Cost PoolTotal budgeted cost = $3,000


STAGE ONESTAGE ONE


raterate

Budgeted Setup Costs $3,000Planned Production Runs 15 runs $200 per run$200 per run


STAGE TWOSTAGE TWO

=

=

Various overheadVarious overheadcosts relatedcosts related

to to engineeringengineering

Engineering salaries

Engineering supplies

Engineering software

Depreciation

Engineering Cost PoolEngineering Cost PoolTotal budgeted cost = $700,000


STAGE ONESTAGE ONE

Allocate basedAllocate basedon on engineeringengineering

transactionstransactions


STAGE TWOSTAGE TWO

Engineering Cost PoolEngineering Cost PoolTotal budgeted cost = $700,000

Various overheadVarious overheadcosts relatedcosts relatedto to generalgeneraloperationsoperations

Plant depr.

Plant mgmt.

Plant maint.

Property taxes

Insurance

Security

Facility Cost PoolFacility Cost PoolTotal budgeted cost = $507,400


STAGE ONESTAGE ONE


raterate

Budgeted Facilities Cost $507,400Budgeted Direct-Labor Hours 118,000 $4.30/hour$4.30/hour


STAGE TWOSTAGE TWO

=

=

Product Cost from ABCHere are the new product costs so far . . .

Additional ABC Information

Mode I Mode II Mode IIIReceiving Lots 18 72 210 Material Handling Moves 21 90 189 Quality/Inspections 40 80 80 Packaging/Shipments 8 60 132

Percentages for the above information are as follows:

Other Overhead Costs

Board Overhead × % ÷ Units = Cost/UnitMode I 200,000$ × 6% ÷ 10,000 = 1.20$ Mode II 200,000 × 24% ÷ 20,000 = 2.40 Mode III 200,000 × 70% ÷ 4,000 = 35.00

Receiving and Inspection Cost Pool


Material-Handling Cost Pool


Quality-Assurance Cost Pool


Packaging and Shipping Cost Pool


Packaging and Shipping Cost Pool


Quality-Assurance Cost Pool

Other Overhead Costs


Receiving and Inspection Cost Pool


Material-Handling Cost Pool

$14.82$14.82

Product Cost from ABCThese are the new product costs when Aerotech uses

ABC.

Product DiversityBoth original and ABC target selling prices are based on

(Cost × 125%).

[$209.00 × 1.25] [$183.44 × 1.25]

The selling price of Mode I and II are reducedThe selling price of Mode I and II are reducedand the selling price for Mode III is increased.and the selling price for Mode III is increased.

Product DiversityCan you identify any problems Aerotech is likely to face

as a result of this distortion?

Traditional costing understates the costTraditional costing understates the costof complex, low volume products.of complex, low volume products.

Activity-Based Management

• A method of management that used ABC as an integral part in critical decision-making situations, including:– Pricing decisions– Cost reduction and process improvement

decisions– Planning and managing activities