ACTG 6310 Chapter 11 – Criticisms of Absorption Cost Systems: Inaccurate Product Costs

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 results Trends - more costs are directly assigned, multiple indirect cost pools occur which also assign marketing and administrative costs to products

Plantwide Overhead Rate Companies tended to use direct labor as the overhead allocation base. There was a belief that direct labor and overhead costs were highly correlated.

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 a good supplement to our traditional cost system I agree!

How Costs are Treated Under Activity-Based Costing Departmental Overhead Rates Level of Complexity Plantwide Overhead Rate Overhead Allocation

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

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

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. Prepare management reports.

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-Level Activity Batch-Level Product-Level Customer-Level Organization- sustaining

Identify and Define Activities and Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

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.

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.

Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects

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.

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

Assign Costs to Activity Cost Pools Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

Assign Costs to Activity Cost Pools

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

Calculate Activity Rates ÷

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

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Cost Objects: Products, Customer Orders, Customers

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Second-Stage Allocations $/MH $/Order $/Design $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated

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) 1. 400 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.

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

Prepare Management Reports

Prepare Management Reports Customer Profitability Analysis

Predetermined manufacturing Product Margins Traditional Cost Accounting System 400 units x 0.5 MH/unit x $50/MH = $10,000 Predetermined manufacturing overhead rate $1,000,000 20,000 MH = $50/MH =

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.

When to use ABC More than one product Different complexities in products Costs of products don’t make sense Increased competition

Benefits of ABC Benefits More accurate product costing More costs can be assigned directly to products Focus switches to control over activities Better information for strategic planning and decision making Product profitability statements can be prepared Provides a means to “value engineer” the cost structure Operations managers often benefit the most

Criticisms of ABC More complex to use Time consuming to set up More detailed accounting Cost driver is often difficult to determine

Cost Driver Analysis Examples of new measures Storage – number of cartons stored Requisition handling – number of requisitions Materials handling – # of parts processed, weight of parts Warehouse stock selection – carton lines Data entry - number of lines, number of invoices Desk top delivery - # of deliveries Freight out – distance traveled

Activity-Based Management Aids for strategy Satisfy customers Improve profits by improving processes Product pricing/ product mix decisions can be made easily Cost reduction hopefully will occur because activities are easier to control than costs

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.

ABC at Service Firms Banks CPA firms Advertising firms U.S. Coast Guard

Homework P11-4 – Milan Pasta P11-9 – Friendly Grocer P11-14 – Wedig Diagnostics DUE WEDNESDAY, FEBRUARY 18