2 Traditional Costing Systems Direct materials and direct labor costs are traced to products and services; indirect costs are allocated by some method to products/services.Products are often undercosted or overcosted under this system.Product-cost cross subsidization resultsTrends - more costs are directly assigned, multiple indirect cost pools occur which also assign marketing and administrative costs to products
3 Plantwide Overhead Rate Companies tended to use direct labor asthe overhead allocation base. There was a belief that direct labor and overhead costs were highly correlated.
4 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.ABC is agood supplement to our traditional cost systemI agree!
5 How Costs are Treated Under Activity-Based Costing DepartmentalOverheadRatesLevel of ComplexityPlantwideOverheadRateOverhead Allocation
6 Activity Based Costing (ABC) Both manufacturingand nonmanufacturingcosts may beassigned toproducts.A numberof cost pools each allocated to a productor cost object.Some manufacturingcosts may be excludedfrom productcosts.Allocation bases oftendiffer fromtraditional costingsystems.Overhead rates arebased on activities
7 Cost of Idle Capacity Activity Based Costing Traditional Cost AccountingThe predetermined overhead rate is based on budgeted activity. This results in applying overhead costs of unused, or idle, capacity.Activity Based CostingProducts are charged for the costs of capacity they use – not for the costs of capacity they don’t use.
8 Designing of an ABC System Steps for Implementing ABCIdentify 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.
9 Identify and Define Activities and Activity Cost Pools A part of the productionprocess for which managementwants a separate reporting of thecosts of the activity involved.Unit-LevelActivityBatch-LevelProduct-LevelCustomer-LevelOrganization- sustaining
10 Identify and Define Activities and Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:
11 Identify and Define Activities and Activity Cost Pools $Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system.
12 Identify and Define Activities and 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.
13 Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects
14 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.
15 Assign Costs to Activity Cost Pools Indirect factory wages $500,000Percent consumed by customer orders %$125,000
16 Assign Costs to Activity Cost Pools Factory equipment depreciation $300,000Percent consumed by customer orders %$ 60,000
18 Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . .1,000 customer orders200 new designs20,000 machine-hours100 customer relations activitiesNow the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.
23 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 $2,110.5. Direct labor totals $1,850.6. 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 $13.5. Direct labor totals $50.6. Shipping costs total $25.
24 Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.
27 Predetermined manufacturing Product MarginsTraditional Cost Accounting System400 units x 0.5 MH/unit x $50/MH = $10,000Predetermined manufacturingoverhead rate$1,000,00020,000 MH= $50/MH=
28 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.
29 When to use ABC More than one product Different complexities in productsCosts of products don’t make senseIncreased competition
30 Benefits of ABC Benefits More accurate product costing More costs can be assigned directly to productsFocus switches to control over activitiesBetter information for strategic planning and decision makingProduct profitability statements can be preparedProvides a means to “value engineer” the cost structureOperations managers often benefit the most
31 Criticisms of ABC More complex to use Time consuming to set up More detailed accountingCost driver is often difficult to determine
32 Cost Driver Analysis Examples of new measures Storage – number of cartons storedRequisition handling – number of requisitionsMaterials handling – # of parts processed, weight of partsWarehouse stock selection – carton linesData entry - number of lines, number of invoicesDesk top delivery - # of deliveriesFreight out – distance traveled
33 Activity-Based Management Aids for strategySatisfy customersImprove profits by improving processesProduct pricing/ product mix decisions can be made easilyCost reduction hopefully will occur because activities are easier to control than costs
34 Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because . . .External reports are less detailed than internal reports.It may be difficult to make changes to the company’s accounting system.ABC does not conform to GAAP.Auditors may be suspect of the subjective allocation process based on interviews with employees.
35 ABC at Service Firms Banks CPA firms Advertising firms U.S. Coast Guard
36 Homework P11-4 – Milan Pasta P11-9 – Friendly Grocer P11-14 – Wedig DiagnosticsDUE WEDNESDAY, FEBRUARY 18