1 PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2005 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. Cost Allocation & Activity- Based Management Chapter M5

2 Objective 1 Explain the importance of overhead and how overhead traditionally has been applied to products and services. Once you have completed this chapter, you should be able to:

3 Cost allocation is the process of assigning indirect costs to a product or service.

4 The costs of materials handling, supervisors’ salaries, and depreciation of factory equipment usually cannot be traced to a particular product or product line.

5 Unlike direct costs, indirect cost are allocated to products.

6 Adventure Trails

7 Annual Sleeping Bag Production Volume High-volume consumer bag ($70)12,000 Medium-volume bag ($100)6,000 Low-volume specialty bag ($200) 500 Total18,500 Adventure Trails Exhibit 1

8 Adventure Trails Volume-Based Allocation Based on management’s estimates, the company’s accountants have budgeted total manufacturing overhead costs of $231,250 for the coming year. The estimated machine hours for the year is 9,250.

9 Predetermined overhead rate Estimated overhead costs Estimated machine hours = Predetermined overhead rate $231,250 9,250 machine hours = Predetermined overhead rate = $25 per machine hour Adventure Trails

10 Adventure Trails The machine time required to cut and sew the materials for a sleeping bag is equal across the company’s three products. Each sleeping bag requires 0.50 hours of machine time.

11 Adventure Trails Machine Overhead Unit Product Hours Rate Overhead Cost High-volume0.50$25.00$12.50 Medium-volume Low-volume x = Exhibit 3 Overhead Cost per Unit

12 Adventure Trails Unit Manufacturing Costs UnitUnitUnitTotal MaterialsLaborOverheadUnit ProductCostCostCostCost + + = High-volume$ 30.00$20.00$12.50$ Medium- volume Low-volume Exhibit 4

13 Adventure Trails Profitability by Product Line Using Volume-based Costing = High-volume$ $ 62.50$ 7.50 Medium-volume Low-volume Exhibit 5 SellingManufacturingProfit ProductPriceCostMargin –

14 Adventure Trails Based on profit margins, managers may plan to add more low-volume, specialty products to the product line.

15 Objective 2 Identify problems with traditional methods of allocating overhead costs. Once you have completed this chapter, you should be able to:

16 Critics of the traditional cost- allocation method argue that volume-based cost allocation distorts unit overhead costs.

17 11 Adventure Trails Unit Manufacturing Costs Unit Total MaterialsLaborOverheadUnit ProductCost + + = High-volume$ 30.00$20.00$12.50$ Medium- volume Low-volume Exhibit 4 As shown in Exhibit 4, the volume-based system produces questionable results for the unit overhead cost.

18 Economies of scale are the savings a company realizes in unit costs by spreading fixed overhead costs over a larger number of units.

19 One of the problems with the traditional method of allocating overhead costs is that it doesn’t take economies of scale into account.

20 A second problem with traditional cost allocation is the allocation base.

21 Critics of volume-based allocation argue that traditional cost allocation distorts unit overhead costs.

22 Objective 3 Describe the activity hierarchy for classifying overhead costs. Once you have completed this chapter, you should be able to:

23 The overhead hierarchy is a framework that explains how overhead costs change with various activities.

24 Unit-Level Costs Overhead cost per unit | | | | | | | # of units produced Unit- level costs behave like variable costs. Exhibit 6 A Hierarchy of Overhead Activities

25 Batch-Level Costs Overhead cost per unit | | | | | | | # of units in a batch Batch- level costs behave like fixed costs. A Hierarchy of Overhead Activities Exhibit 6

26 Batch-Level Costs Batch-level cost per unit = total activity cost ÷ units in the batch A machine setup costs $500 and the company produces 10 units in the batch. What is the unit setup cost? Batch-level cost per unit = $500 ÷ 10 units = $50 per setup A Hierarchy of Overhead Activities

27 Batch-Level Costs Batch-level cost per unit = total activity cost ÷ units in the batch A machine setup costs $500 and the company produces 1,000 units in the batch. What is the unit setup cost? Batch-level cost per unit = $500 ÷ 1,000 units = $0.50 per setup A Hierarchy of Overhead Activities

28 Product-Level Costs Overhead cost per unit A B C D E A Hierarchy of Overhead Activities Product- level costs relate to a specific family of products. Exhibit 6 Product

29 Facility-Level Costs Overhead cost per unit Product A B C D E Facility- level costs include all other overhead activities. A Hierarchy of Overhead Activities Exhibit 6

30 Objective 4 Explain how activity-based costing works. Once you have completed this chapter, you should be able to:

31 Activity-Based Costing Activity-based costing (ABC) allocates overhead costs to a product using activities required to produce the product.

32 Activity-Based Costing Costs are allocated to the activity pools according to the type of activity carried out in each pool. First Stage Allocation:

33

34 First-stage allocation Exhibit 7 Conceptual Design of an ABC System Adventure Trails Overhead Costs Indirect Labor Depreci- ation ElectricitySupplies Employee Benefits Overhead Costs

35 Number of Setups Volume- based Pool Setup Pool Handling & Inspection Pool General Overhead Pool Units Produced Percentage of Inspections Percentage of Manufacturing Time Conceptual Design of an ABC System Adventure Trails Overhead Costs Indirect Labor Depreci- ation ElectricitySupplies Employee Benefits Overhead Costs Exhibit 7

36 Costs are allocated from activity pools to a cost object, such as goods or services. Activity-Based Costing Second Stage Allocation:

37 Conceptual Design of an ABC System Second-stage allocation Total Manufacturing Costs High- volume consumer bag Medium- volume bag Low- volume specialty bag Direct Materials Direct Labor Exhibit 7

38 Activity-Based Costing Adventure Trails’ Overhead Classified by Cooper’s Hierarchy OverheadActivity CostsBases Unit level$90,000Units produced Batch-level (setups)8,800Number of setups Product-level (handling60,000Percentage of inspec- and inspection) tions byproduct line Facility-level72,450Percentage of manufacturing time Total overhead costs$231,250 Exhibit 8

39 Activity-Based Costing Adventure Trails: Machine Hours, Batches, and Handling and Inspection by Product High4,0003$80060%$36,00050% Medium2, %15,00040% Low %9,00010% NumberCost% ofHandlingPercentage of BatchofperHandling& Insp.Manufacturing ProductSizeSetupsSetup& Insp.CostsTime Exhibit 9

40 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Unit Level: $90,000 18,500 From Slide 38 Total units produced = $4.86 per unit High Volume Data for Exhibit 10

41 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $8, From Slide 38 Total setups = $800 per setup High Volume Data for Exhibit 10

42 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $800 4,000 Cost per setup Batch size = $0.20 per unit High Volume Data for Exhibit 10

43 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Product Level: $36,000 $60,000 x 60% 12,000 units 3 batches of 4,000 = $3.00 per unit High Volume Data for Exhibit 10

44 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Facility Level: $72,450 From Slide 38 x 50% Percentage of manufacturing time (from Slide 39) $36,225 High Volume Data for Exhibit 10

45 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product High Volume Facility Level: $36,225 $72,450 x ,000 units 3 batches of 4,000 = $3.02 per unit Data for Exhibit 10

46 Activity-Based Costing UnitBatchProductFacilityTotal Overhead Cost Assigned Adding the unit material cost of $35 and the unit labor cost of $20 provides for a total cost of $61.08 to make a high-volume sleeping bag. Volume-based costing provided a total cost of $62.50 per bag. High-volume$4.86$0.20$3.00$3.02$11.08 Medium-volume Low-volume

47 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Unit Level: $90,000 18,500 From Slide 38 Total units produced = $4.86 per unit Medium Volume Data for Exhibit 10

48 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $8, From Slide 38 Total setups = $800 per setup Medium Volume Data for Exhibit 10

49 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $800 2,000 From Slide 39 Batch size = $0.40 per unit Medium Volume Data for Exhibit 10

50 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Product Level: $15,000 $60,000 x 25% 6,000 units 3 batches of 2,000 = $2.50 per unit Medium Volume Data for Exhibit 10

51 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Facility Level: $72,450 From Slide 38 x 40% $28,980 Medium Volume Percentage of manufacturing time (from Slide 39) Data for Exhibit 10

52 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Medium Volume Facility Level: $28,980 $72,450 x.40 6,000 units 3 batches of 2,000 = $4.83 per unit Data for Exhibit 10

53 Activity-Based Costing UnitBatchProductFacilityTotal Overhead Cost Assigned Adding the unit material cost of $55 and the unit labor cost of $20 provides for a total cost of $87.59 to make a high-volume sleeping bag. Volume-based costing provided a total cost of $87.50 per bag. High-volume$4.86$0.20$3.00$3.02$11.08 Medium-volume Low-volume

54 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Unit Level: $90,000 18,500 From Slide 38 Total units produced = $4.86 per unit Low Volume Data for Exhibit 10

55 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $8, From Slide 38 Total setups = $800 per setup Low Volume Data for Exhibit 10

56 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $ From Slide 39 Batch size = $8.00 per unit Low Volume Data for Exhibit 10

57 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Product Level: $9,000 $60,000 x 15% 500 units 5 batches of 100 = $18.00 per unit Low Volume Data for Exhibit 10

58 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Facility Level: $72,450 From Slide 38 x 10% $7,245 Low Volume Percentage of manufacturing time (from Slide 39) Data for Exhibit 10

59 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Low Volume Facility Level: $7,245 $72,450 x units 5 batches of 100 = $14.49 per unit Data for Exhibit 10

60 Activity-Based Costing UnitBatchProductFacilityTotal Overhead Cost Assigned High-volume$4.86$0.20$3.00$3.02$11.08 Medium-volume Low-volume Adding the unit material cost of $130 and the unit labor cost of $30 provides for a total cost of $ to make a high-volume sleeping bag. Volume-based costing provided a total cost of $ per bag.

61 Activity-Based Costing High$ 30.00$20.00$4.86$0.20$ 3.00$ 3.02$ Medium Low UnitUnitOverhead MaterialsLaborUnitBatchProductFacility ProductCostCostLevelLevelLevelLevel Total Adventure Trails: Activity-Based Cost by Product Exhibit 10

62 Volume-Based Costs per Unit versus Activity-Based Costs per Unit Allocation High Medium Low Method Volume Volume Volume Volume-based (Exhibit 5)$62.50$87.50$ ABC (Exhibit 10) Percentage change– 2.3%0%+ 19% Exhibit 11

63 Accountants use the term product cross-subsidy to describe a situation in which one product subsidizes the reported costs of another

64 Comparison of Per-Unit Profitability Using Two Approaches ABCABCTraditional SellingManufacturingProfitProfit PriceCostMarginMargin = High-volume$ 70.00$ 61.08$ 8.92$ 7.50 Medium-volume Low-volume (5.35)27.50 Exhibit 12 Product –

65 Comparison of Per-Unit Profitability Using Two Approaches What are the implications for Adventure Trails?

66 Comparison of Per-Unit Profitability Using Two Approaches The high-volume consumer bags are subsidizing low- volume specialty bags. A long-run strategy of adding other specialty bags to the company’s product line could be disastrous.

67 Objective 5 Explain how service organizations use cost information for decision making. Once you have completed this chapter, you should be able to:

68 The primary activities a service organization carries out are its core activities; its supporting activities are called noncore activities. The core activity in a public school is education. A noncore activity is providing bus transportation.

69 THE END Chapter M5

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