ACCT 2302 Fundamentals of Accounting II Spring 2011 Lecture 9 Professor Jeff Yu

Chapter 8: Activity–Based Costing Purposes: ABC is for internal decision making ( e.g. drop or retain a segment ), while absorption costing is for external reporting ( e.g. value inventory, CGS ). Product Cost: ABC assigns some manufacturing (excluding e.g. factory manager’s office supplies) & some nonmanufacturing costs (e.g. shipping costs, sales commissions) to products on a cause-and-effect basis, while absorption costing assigns all manufacturing costs and none of the nonmanufacturing costs to products. Overhead cost pool : ABC uses many overhead cost pools, each with unique cost driver, while absorption costing typically has only one plant- wide cost pool and uses either DLH or MH as the single cost driver. Activity-based Costing (ABC) vs. Traditional Absorption Costing

Activity An event that causes the consumption of overhead cost. Activity Cost Pool A “cost bucket” in which overhead costs caused by a particular activity measure are accumulated. $ $ Basic Concepts of Activity-based Costing Activity Measure An allocation base (cost driver).

5 levels of Activity in ABC system 1.Unit-level activities: performed each time a unit is produced, so costs are proportional to # of units produced. e.g., providing power. 2.Batch-level activities: performed each time a batch is handled, so costs depend on the number of batches. e.g., setting up machine for batch processing, or processing an online order. 3.Product-level activities: e.g., designing / advertising a product. 4.Customer-level activities: e.g., sales calls, general tech support. 5.Organization-sustaining activities: e.g., providing a company- wide computer network.

Classic Brass – An ABC Example Manufacturing overhead is allocated to products using a single plantwide overhead rate based on machine hours.

 Order Size - assigned all costs incurred as a consequence of the number of units produced.  Customer Orders - assigned all costs that are incurred by taking and processing customer orders.  Product Designs - assigned all costs that are incurred by designing products.  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.  Order Size - assigned all costs incurred as a consequence of the number of units produced.  Customer Orders - assigned all costs that are incurred by taking and processing customer orders.  Product Designs - assigned all costs that are incurred by designing products.  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. Step 1: define activity cost pools & activity measures Classic Brass combined correlated activities within a level and identified the following activity cost pools:

At Classic Brass, the ABC team, selected the following activity measures for the identified activity cost pools: Activity Cost PoolActivity Measure Order SizeMachine hours Customer OrdersNumber of customer orders Product DesignNumber of product designs Customer RelationsNumber of active customers OtherNot applicable Step 1: define activity cost pools & activity measures

At the beginning of the period, the ABC team obtains from each department the estimated overhead costs (both manufacturing and nonmanufacturing costs that are not directly traceable to each product) and their distribution of resource consumption across activity cost pools. Step 2: Assign Overhead Costs to Activity Cost Pools

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 Step 2: Assign Overhead Costs to Activity Cost Pools

Step 3: Calculate Activity Rates The estimated total activities for each activity cost pool are: 1,000 customer orders, 400 new designs, 20,000 machine hours and 250 customer relations activities.

Practice Problem Leap Co. uses Activity-based costing system with the following data: Q: If the total activity level for Order Processing is 200 orders, what is the activity rate for the Order processing activity cost pool? Overhead Costs Distribution of resource consumption across Activity Cost Pools FabricationOrder ProcessingOther Wages$360,00035%40%25% Depreciation$140,0005%55%40% Occupancy$160,00030%45%25%

Graphic Illustration of ABC 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 Customer Orders Order Size CustomerRelationsCustomerRelationsOtherOther Overhead Costs First-Stage Allocation Second-Stage Allocations $/Order $/Design $/MH $/Customer Unallocated ProductDesignProductDesign Traced

Standard Stanchions 1.Requires no new design resources. 2.Received 600 customer orders. 3.Produced 30,000 units for these orders, consuming a total of 17,500 machine-hours Standard Stanchions 1.Requires no new design resources. 2.Received 600 customer orders. 3.Produced 30,000 units for these orders, consuming a total of 17,500 machine-hours Step 4: Assigning Overhead to Products

Custom Compass Housing 1.Requires new design resources product designs prepared for 400 customer orders 3.1,250 compass housings produced, requiring 2 machine-hours each for a total of 2,500 machine-hours. Custom Compass Housing 1.Requires new design resources product designs prepared for 400 customer orders 3.1,250 compass housings produced, requiring 2 machine-hours each for a total of 2,500 machine-hours. Step 4: Assigning Overhead to Products

Product Margin for each product = sales – costs directly traceable to the product – overhead costs assigned using ABC Step 5: Prepare Management Reports

Practice Problem Feld Co. uses Activity-based costing system with the following data: The company makes 470 units of product W26B a year, requiring a total of 660 machine hours, 50 orders and 40 inspection hours per year. The product ‘s price is $118 per unit, direct material cost is $40.30 per unit and direct labor cost is $42.22 per unit. Q: What is the product margin for product W26B? Activity Cost PoolTotal OH CostTotal Activity Assembly$1,137,36084,000 machines hours Order Processing$28,4791,100 orders Inspection$97,1551,270 inspection hours

two orders for standard stanchions, 150 units per order; and one order for 1 custom compass housing. These 3 orders consumed a total of 177 machine hours. One customer of Classic Brass, Windward Yachts, placed a total of 3 orders during the year: two orders for standard stanchions, 150 units per order; and one order for 1 custom compass housing. These 3 orders consumed a total of 177 machine hours. Assigning Overhead to Customers

Customer Margin = sales – costs directly traceable to the customer – overhead costs assigned to the customer using ABC Prepare Management Reports

Practice Problem DFW Co. uses Activity-based costing system with the following data: A customer, Mr. Websley, made 6 orders and bought a total of 40 units of product M2B during Each unit of product M2B is sold at $90, costs $50 in direct material and consumes 1.5 direct labor hours. The direct labor rate is $10 per hour. Q: What is the customer margin for Mr. Websley in 2009? Activity Cost PoolTotal Overhead CostTotal Activity Order Size$6,0003,000 direct labor hours Order Processing$10, orders Customer Relations$40, customers

For Next Class  Finish activity based costing  Start Chapter 9: profit planning

Homework Question 1 Holden Co. uses Activity-based costing system with the following data: The company makes 1,000 units of product W26A a year, requiring a total of 25 inspection hours, 100 machine hours and 50 orders per year. Q: How much overhead cost would be assigned to each unit of product W26A? Activity Cost PoolTotal Overhead CostTotal Activity Assembly$80,0004,000 machines hours Order Processing$40,0001,000 orders Inspection$20,0001,000 inspection hours Other$10,000N/A

Homework Question 2 Fogerty Co. makes 2 products (Hubs & Sprockets) with data below: Activity Cost Pool Est. total OH Cost Activity Measure Activity: Hubs Activity: Sprockets Machine Setup$72,000# of setups Special Processing $200,000Machine hours5,0000 General Factory$816,000DL hours8,00016,000 DM/unitDLH/unitDL RateAnnual Production Hubs$320.8 hour$15/hour10,000 units Sprockets$180.4 hour$15/hour40,000 units Q: If the price of Hubs is $120 per unit, what is the product margin for Hubs?

Homework Question 3 Advanced Products Co. uses ABC system with the following data: Est. total OH CostsDistribution of resource consumption across Activity Cost Pools DL SupportOrder Processing Customer Support Other Wages$300,00040%30%20%10% Other OH$100,00030%10%20%40% Est. Total Activities20,000 DLHs400 orders200 customersN/A During the year, it completed one order for a new customer, SZE. SZE ordered 10 units of the product. Each unit is sold at $300, costs $180 in DM, $50 in DL and consumes 2 DLHs. Q: What is the customer margin for SZE?