1. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Adapted by Cynthia Fortin, CPA, CMA

2. 3-2 Video preparation  http://video.wileyaccountingupdates.com /2011/06/15/activity-based-costing/ http://video.wileyaccountingupdates.com /2011/06/15/activity-based-costing/

3. 3-3 Allocation of Overhead Conventional Method (chap. 2) Factory overhead applied to production using some type of averaging - labor-hours, machine-hours, etc. Copyright © 2007 Pearson Education Canada

4. 3-4 Why Broad Averaging?  Historically limited variety of goods indirect costs were relatively small compared to direct costs  Simplicity To use broad averages to allocate costs uniformly regardless of how they are actually incurred Copyright © 2007 Pearson Education Canada

5. 3-5 Conventional Costing leads to Overcosting Consumed a low level of resources allocated high costs per unit Undercosting Consumed a high level of resources but is allocated low costs per unit Copyright © 2007 Pearson Education Canada

6. 3-6 The overcosted products are subsidizing the undercosted products Copyright © 2007 Pearson Education Canada

7. 3-7 Refining a Costing System 1.Direct-cost tracing Reduce amount of indirect costs by classifying more costs as direct 2. Indirect-cost pools Expand the number of indirect-cost pools until the costs in each pool have a similar cause & effect relationship Copyright © 2007 Pearson Education Canada

8. 3-8 3. Cost-allocation bases Consider using a different cost- allocation base for each indirect-cost pool Choose allocation base based on what causes the cost pool to change Refining a Costing System

9. 3-9 Not One but many allocation bases are used for assigning costs to products.

10. 3-10 CostCost Activity-Based Costing (ABC) What causes the activities (e.g. number of orders, set-ups,) (e.g. number of orders, set-ups,) What causes the activities (e.g. number of orders, set-ups,) (e.g. number of orders, set-ups,) ActivitiesActivities Cost Objects

11. 3-11 Activity An event that causes the consumption of overhead resources Setting up machines Examples of Activities Admitting hospital patients Opening a bank account Billing customers Activity-Based Costing (ABC)

12. 3-12 Activity Cost Pool A “cost bucket” accumulating costs of a particular activity Activity Measure Measures how much of the activity is carried out Used as the allocation base for applying overhead costs. Activity-Based Costing (ABC) Activity Rate A predetermined overhead rate for each activity cost pool. Same process as conventional costing but more than one pool

13. 3-13 Hierarchy of Activities

14. 3-14 Example of Activity-Based Costing Various Manufacturing Overhead Costs Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment

15. 3-15 Unit-Level Activity Batch-Level Activity Facility- Level Activity Product- Level Activity Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs Products $/DLH$/MH$/Setup$/Order$/MH $/Part Type Second-Stage Allocations Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment

16. 3-16 Using Activity-Based Costing Comtek Sound, Inc.  Comtek Sound, Inc., makes two products: CD players and DVD players.  The company has been losing bids to supply CD players to lower-priced competitors.  The company has been winning all bids to supply DVD players.  Comtek Sound, Inc., makes two products: CD players and DVD players.  The company has been losing bids to supply CD players to lower-priced competitors.  The company has been winning all bids to supply DVD players.

17. 3-17 Comtek Sound, Inc.  For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units.  Comtek’s traditional cost system applies manufacturing overhead to products based on direct- labor hours.  Both products require two direct labor-hours to complete, for a total of 500,000 direct labor-hours.  For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units.  Comtek’s traditional cost system applies manufacturing overhead to products based on direct- labor hours.  Both products require two direct labor-hours to complete, for a total of 500,000 direct labor-hours.

18. 3-18 Conventional Costing 1.Cost objectsCDDVD 2.Direct costs Labor2020 Materials5090 3.Cost allocation base: labor-hours 4.Overhead Pool $10,000,000 5. Total hours 250,000*2= 500,000 6. O/H rate 10,000,000/500,000=$204040 7. Total cost $110 $150

19. 3-19 The ABC project team at Comtek has developed the following basic information. Computing Activity Rates AB A DE

20. 3-20 Computing Activity Rates BAC

21. 3-21 Computing Overhead Cost per Unit DVD Units C D

22. 3-22 Computing Overhead Cost per Unit CD Units

23. 3-23 Note that the unit product cost of a CD unit decreased from $110 to $95.55........ while the unit cost of a DVD unit increased from $150 to $207.80. Comparing the Two Approaches

24. 3-24 Comparing the Two Approaches The ABC system assigns $14.45 less overhead than the conventional system to each CD player.

25. 3-25 Comparing the Two Approaches The ABC system assigns $57.80 more overhead than the conventional system to each DVD player.

26. 3-26 When a company implements activity-based costing, overhead cost often shifts from high- volume to low-volume products with a higher unit product cost resulting for the low-volume products. Low-volume product Shifting of Overhead Cost

27. 3-27 Activity-Based Management Focuses on managing activities to eliminate waste and reduce delays and defects. Targeting Process Improvements Note: for real implementation read case study of Xu Ji Electric Co. Ltd http://www.cimaglobal.com/Documents/Thought_leadership_docs/6Activity- based-costing-China.pdfhttp://www.cimaglobal.com/Documents/Thought_leadership_docs/6Activity- based-costing-China.pdf.

28. 3-28 The first step in any improvement program is deciding what to improve. Targeting Process Improvements The Theory of Constraints approach targets the highest impact improvement opportunities. Activity rates can be used to target areas where costs seem excessively high. Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations.

29. 3-29 Benefits of Activity-Based Costing ABC improves the accuracy of product costing by: 1. Increasing the number of cost pools 2. Using activity cost pools that are more uniform than departmental cost pools 3. Using activity measures that cause those costs

30. 3-30 Costs of implementing an ABC system may outweigh the benefits

31. 3-31 Benefits more likely to be worth the costs when: 1.Products differ substantially volume, batch size, and in activities required. 2.Conditions have changed substantially since the existing cost system was established. 3.Overhead costs are high and increasing and no one seems to understand why. 4.Management does not trust the existing cost system and it ignores data from it when making decisions. Costs Benefits