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Activity Based Costing: A Tool to Aid Decision Making.

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Presentation on theme: "Activity Based Costing: A Tool to Aid Decision Making."— Presentation transcript:

1 Activity Based Costing: A Tool to Aid Decision Making

2 Overhead rates may be based on activity at capacity. Overhead rates may be based on activity at capacity. Activity Based Costing (ABC) Both manufacturing and nonmanufacturing costs may be assigned to products. Both manufacturing and nonmanufacturing costs may be assigned to products. Some manufacturing costs may be excluded from product costs. Some manufacturing costs may be excluded from product costs. A number of cost pools each allocated to a product or cost object. A number of cost pools each allocated to a product or cost object. Allocation bases often differ from traditional costing systems. Allocation bases often differ from traditional costing systems.

3 How Costs are Treated Under Activity-Based Costing Level of Complexity Overhead Allocation Plantwide PlantwideOverheadRate OverheadRate DepartmentalOverheadRatesDepartmentalOverheadRates Activity Based Costing Costing

4 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. 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 Activity Based Costing Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Activity Based Costing Activity Based Costing Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use.

5 Difference Between ABC and Traditional Product Costs 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.

6 Designing an ABC System Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers) ActivitiesActivities Consumption of Resources Consumption CostCost

7 Designing of an ABC System Steps 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.

8   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-LevelActivityBatch-LevelActivityProduct-LevelActivityCustomer-LevelActivity Organization- sustaining Activity

9   Identify and Define Activities and Activity Cost Pools Activity Cost Pool Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system. $ $ $ $ $ $

10 Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers Activity 1 Activity 2 Activity 3 Activity 4 OtherOther Overhead Costs First-Stage Allocation

11   Assign Costs to Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity cost pools is determined. ** Not included because they are directly traced to customer orders.

12 Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000   Assign Costs to Activity Cost Pools

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14   Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool... 1,000 customer orders 1,000 customer orders 200 new designs 200 new designs 20,000 machine-hours 20,000 machine-hours 100 customer relations activities 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.

15   Calculate Activity Rates ÷

16 TracedTracedTracedTracedTracedTraced Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers

17 Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers OrderSizeOrderSizeCustomerOrdersCustomerOrdersProductDesignProductDesignCustomerRelationsCustomerRelationsOtherOther Overhead Costs First-Stage Allocation Second-Stage Allocations $/MH$/MH$/Order$/Order$/Design$/Design$/Customer$/Customer UnallocatedUnallocated

18   Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer – Windward Yachts. Standard Stanchions (no design required) units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours. 3. Selling price is $34 each. 4. Direct materials total $2, Direct labor totals $1, Shipping costs total $180. Custom Compass Housing (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 $ Direct labor totals $ Shipping costs total $25.

19   Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.

20 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.


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