© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-1 Activity-Based Costing and Cost Management Systems Activity-Based Costing and Cost Management Systems 5 Chapter Five

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-2 Traditional, Volume-Based Product-Costing System [Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. [The following information is obtained from company records: [Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. [The following information is obtained from company records:

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-3 Traditional, Volume-Based Product-Costing System Additional information includes: Manufacturing overhead is determined as follows

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-4 Traditional, Volume-Based Product-Costing System Budgeted manufacturing overhead $3,894,000 Budgeted direct-labor hours 118,000 = $33 per hour

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-5 Traditional, Volume-Based Product-Costing System With these product costs, Aerotech established target selling prices (Cost × 125%) x 1.25

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-6 Traditional, Volume-Based Product-Costing System Aerotech wishes to see what target selling prices would be suggested when using activity-based costing. Let’s see how ABC works.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-7 Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Assigning overhead to products is a difficult process. I agree!

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-8 Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Let’s begin by identifying our major activities. Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used. Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-9 Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Overhead assigned to activities are called “activity cost pools.” Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products. Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-10 Overhead Costs Total budgeted cost = $3,894,000 ActivityCostPools Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 Unit Level Batch Level Product- Sustaining Level Facility Level Identification of Activity Cost Pools Identification of Activity Cost Pools Activity must be done on each unit produced. Activityperformed on each batchproduced. Activities needed to support an entire product line Activity required in order for the production process to occur.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-11 Overhead Costs Total budgeted cost = $3,894,000 ActivityCostPools Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 More Cost Pools Unit Level Batch Level Product- Sustaining Level Facility Level Identification of Activity Cost Pools Identification of Activity Cost Pools

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-12 Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000 Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 Unit Level Batch Level Product- Sustaining Level Facility Level

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-13 Various overhead costs related to machinery Maintenance Depreciation Computer Support Lubrication Electricity Calibration Machinery Cost Pool Total budgeted cost = $1,212,600Activitycostpool STAGE ONE

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-14 Calculate the pool rate Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hour $28.20/hour CostAssignment STAGE TWO = =

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-15 Calculation of total setup cost Setup Cost Pool Total budgeted cost = $3,000Activitycostpool STAGE ONE

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-16 Calculate the pool rate Budgeted Setup Costs $3,000 Planned Production Runs 15 runs $200 per run $200 per run CostAssignment STAGE TWO = =

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-17 Various overhead costs related to engineering Engineering salaries Engineering supplies Engineering software Depreciation Engineering Cost Pool Total budgeted cost = $700,000Activitycostpool STAGE ONE

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-18 Allocate based on engineering transactions CostAssignment STAGE TWO Engineering Cost Pool Total budgeted cost = $700,000

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-19 Exh. 5-9 Various overhead costs related to general operations Plant depr. Plant mgmt. Plant maint. Property taxes Insurance Security Facility Cost Pool Total budgeted cost = $507,400Activitycostpool STAGE ONE

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-20 Exh. 5-9 Calculate the pool rate Budgeted Facilities Cost $507,400 Budgeted Direct-Labor Hours 118,000 $4.30/hour $4.30/hour CostAssignment STAGE TWO = =

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-21 Product Cost from ABC Here are the new product costs so far...

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-22 Other Overhead Costs

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-23 Other Overhead Costs $14.82

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-24 Product Cost from ABC These are the new product costs when Aerotech uses ABC.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-25 Product Diversity Both original and ABC target selling prices are based on (Cost × 125%). [$ × 1.25][$ × 1.25] The selling price of Mode I and II are reduced and the selling price for Mode III is increased.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-26 Product Diversity Can you identify any problems Aerotech is likely to face as a result of this distortion? Traditional costing understates the cost of complex, low volume products.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-27 ABC: Some Key Issues The Past l lSmall number of products which did not differ much in required manufacturing support. l lLabor was the dominant element in the cost structure. The Past l lSmall number of products which did not differ much in required manufacturing support. l lLabor was the dominant element in the cost structure. The Present l lNumerous products with more and complicated production requirements. l lLabor is becoming an ever smaller part component of total production costs. The Present l lNumerous products with more and complicated production requirements. l lLabor is becoming an ever smaller part component of total production costs.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-28 Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider... Degree of Correlation Cost of Measurement BehavioralEffects

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-29 Homogeneous Activity Cost Pools A homogeneous cost pool is a grouping of overhead costs in which each cost component is consumed in roughly the same proportion by each product line. A homogeneous cost pool uses a single cost driver.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-30 Transaction Costing Activities Paperwork Usually Result In Transactionprocessing provides a readilymeasurable gauge of departmentalactivity.Transactionprocessing provides a readilymeasurable gauge of departmentalactivity.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-31 Storyboarding A procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities. Step 1 Step 1 Step 2 Step 2 Step 3 Step 3 Step 4 Step 4 These are the steps we follow to build a memory board. These are the steps we follow to build a memory board.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-32 Direct versus Indirect Costs Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. IndirectCosts

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-33 Indicators of Need for ABC Line managers do not believe the product costs reports Line managers do not believe the product costs reports Marketing does not use costs reports for pricing decisions Marketing does not use costs reports for pricing decisions Product-line profit margins are hard to explain Product-line profit margins are hard to explain Sales are increasing, but profits are declining. Sales are increasing, but profits are declining. Some products that have reported high profit margins are not sold by competitors Some products that have reported high profit margins are not sold by competitors Direct labor is a small percentage of total costs Direct labor is a small percentage of total costs

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-34 Optimal Product-Costing System High High Low Low Cost InformationSystemAccuracy Optimalsystem Total Cost Design, implementation and maintenance costs Cost of inferiordecisionsresultingfrominaccurateinformation. Exh. 5-13

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-35 Cost Management Systems l Measure the cost of resources consumed. l Identify and eliminate non-value-added costs. l Determine the efficiency and effectiveness of all major activities. l Identify and evaluate new activities that can improve future performance. Objectives

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-36 Non-Value-Added Costs Suppose our production process looks like this: StorageTimeWaitingTimeProcessTimeMoveTimeInspectionTime VANVANVANVANVA VA = Valued-added activity NVA = Non-value-added activity

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-37 Non-Value-Added Costs VA = Valued-added activity NVA = Non-value-added activity Our goal is to reduce or eliminate the non-value-added activities. StorageTimeWaitingTimeProcessTimeMoveTimeInspectionTime VANVANVANVANVA

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-38 ABC in the Service Industry ImplementationProblemsImplementationProblems High proportion of facility-level costs Activities tend to be nonrepetitive human tasks.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 5-39 End of Chapter 5 This is real value-added time!