Presentation on theme: "Activity Based Costing: A Tool to Aid Decision Making 3/24/04"— Presentation transcript:
1 Activity Based Costing: A Tool to Aid Decision Making 3/24/04 Chapter 8Activity Based Costing: A Tool to Aid Decision Making 3/24/04
2 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!
3 How Costs are Treated Under Activity-Based Costing DepartmentalOverheadRatesLevel of ComplexityPlantwideOverheadRateOverhead Allocation
4 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. Automationchanged all that.
5 Plant-wide Overhead Rate POHR = Total Manufacturing OverheadAllocation BaseAllocation Base usually Direct LaborIs used for all products manufacturedIs applied only to those products that incur or use the allocation base, such as direct labor
6 Departmental Overhead Rates Finishing DepartmentMany companies have a system in which each department has its own overhead rate.Painting DepartmentShipping Department
10 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. Idle capacityIs charged as a periodCost.
11 Designing of an ABC System Steps for Implementing ABCIdentify and define activities and activity cost pools.Trace costs to those activities and cost objects.Assign all other traceable costs to activity cost pools. Non-traceable costs lumped.Calculate activity rates.Assign costs to cost objects(products, customers).Prepare management reports.
12 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-LevelActivity(machining)Batch-Level(customer order)Product-Level(product design)Customer-Level(customer relations)Organization- sustainingActivity (lumped)
13 Identify and Define Activities and Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:
14 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.
15 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. I.e., machine shop costsCustomer Relations – assigned all costs associated with maintaining relations with customers.Other – assigned all overhead costs that are not associated with the other cost pools.
16 Whenever Possible, Directly Trace all Overhead Costs to Activities and Cost Objects
17 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.
18 Assign Costs to Activity Cost Pools Indirect factory wages $500,000Percent consumed by customer orders %$125,000
19 Assign Costs to Activity Cost Pools Factory equipment depreciation $300,000Percent consumed by customer orders %$ 60,000
21 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.
26 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.
27 Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.
30 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=
31 Comparison of ABC and Traditional Overhead Product Costs Product Standard CustomABC Trad ABC TradOverheadShippingCust OrderDesignOrder sizeOH assigned
32 Contrasting ABC and Traditional Costing See TM 8-16Calculate cost per unit for both Stanchions and Custom Compass HousingNote the shift in overhead costs from the high volume Stanchions to the low volume Custom Compass Housings
33 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.
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 Benefits of ABCMore cost pools = more accurate costs on a per unit basisCost are assigned using relevant versus arbitrary driversMakes overhead costs more manageable (traceable)Shifts costs from high volume to low volume products as appropriate
36 Limitations of ABCToo many organization sustaining costs can limit the benefits of ABCThere are high costs associated with ABC implementationHigh time commitments and discipline required in making necessary cost changes
37 ABC Review Problem See pages 340 – 342 Step 1: Allocate overhead costs to activity poolsStep 2: Calculate activity rates by dividing each pool cost by activityStep 3: Use activity rates to assign overhead costs to products based on activities per product