Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 11 th Edition Chapter 8

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-Based Costing: A Tool to Aid Decision Making Chapter Eight

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect fixed as well as variable costs. ABC is a good supplement to our traditional cost system I agree!

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Manufacturing costs Nonmanufacturing costs  ABC assigns both types of costs to products. Traditional product costing ABC product costing

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing  ABC does not assign all manufacturing costs to products. Manufacturing costs Nonmanufacturing costs “Best practice” ABC differs from traditional costing in five ways. Traditional product costing ABC product costing All Most, but not all Some

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing Plantwide Overhead Rate Plantwide Overhead Rate Departmental Overhead Rates Departmental Overhead Rates Activity–Based Costing Activity–Based Costing Number of cost pools Level of complexity “Best practice” ABC differs from traditional costing in five ways.  ABC uses more cost pools.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways.  ABC uses more allocation bases. Traditional Costing Number of Allocation Bases ABC Bases usually rely solely on volume measures. Volume measures plus other bases.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways.  ABC uses more allocation bases. The most commonly used allocation base in traditional costing is direct labor hours. Direct labor hours work well when overhead increases as direct labor hours increase.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing Problems:  In many processes, overhead is increasing while direct labor is decreasing.  Variety and complexity of products is increasing. The most commonly used allocation base in traditional costing is direct labor hours. “Best practice” ABC differs from traditional costing in five ways.  ABC uses more allocation bases.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways.  ABC uses more allocation bases. All overhead costs are not related to volume measures like direct labor hours. ABC uses volume as well as other allocation bases not related to the volume of production.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses.  ABC bases level of activity on capacity.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Characteristics of Successful ABC Implementations Strong top management support Cross-functional involvement Link to evaluations and rewards

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Designing an ABC System Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers) ActivitiesActivities Consumption of Resources Consumption CostCost

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Designing 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Manufacturing companies typically combine their activities into five classifications. Unit-LevelActivityBatch-LevelActivityProduct-LevelActivityCustomer-LevelActivity Organization- sustaining Activity

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Activities should only be combined within a level if they are highly correlated. When combining activities, they should be grouped together only at the appropriate level.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Activity Cost Pool An Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system. $ $ $ $ $ $

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Simple count of the number of times an activity occurs. Transaction driver A measure of the amount of time needed for an activity. Duration driver Two types of activity measures:

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   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. 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   When Possible, Directly Trace Overhead Costs to Activities and Cost Objects

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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   Assign Costs to Activity Cost Pools

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000   Assign Costs to Activity Cost Pools

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Assign Costs to Activity Cost Pools

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Calculate Activity Rates

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Traced Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-Based Costing 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 OrderSizeOrderSizeCustomerOrdersCustomerOrdersProductDesignProductDesignCustomerRelationsCustomerRelationsOtherOther Overhead Costs First-Stage Allocation

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-Based Costing 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 OrderSizeOrderSizeCustomerOrdersCustomerOrdersProductDesignProductDesignCustomerRelationsCustomerRelationsOtherOther Overhead Costs First-Stage Allocation Second-Stage Allocations $/MH $/Order $/Design $/Customer Unallocated

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   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) 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, Direct labor totals $1, 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 $ Direct labor totals $ Shipping costs total $25.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Prepare Management Reports

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Prepare Management Reports Customer Profitability Analysis

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Product Margins Traditional Cost Accounting System Predetermined manufacturing overhead rate $1,000,000 20,000 MH = $50/MH= 400 units x 0.5 MH/unit x $50/MH = $10,000

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Differences Between ABC and Traditional Product Costs Product margins are different for four reasons:  Traditional costing assigns design costs to both products based on machine hours. ABC assigns product design costs to a product only if product design work is required.  Traditional costing assigns customer order costs, a batch- level cost, using a unit-level allocation base, machine hours. ABC assigns these batch-level costs using a batch-level activity measure.  Traditional costing assigns only manufacturing costs to products. ABC also assigns nonmanufacturing costs to products.  Traditional costing assigns all manufacturing costs to products. The ABC system does not assign organization- sustaining manufacturing costs to the products.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Differences Between ABC and Traditional Product Costs When batch-level and product-level costs are present, ABC will usually shift costs from high volume products, produced in large batches, to low volume products produced in small batches. This cost shifting will usually have its greatest impact on the per unit cost of the low volume products.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Targeting Process Improvement Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements. While the theory of constraints approach discussed in Chapter 1 is a powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on where to focus improvement efforts.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because... 1.External reports are less detailed than internal reports. 2.It may be difficult to make changes to the company’s accounting system. 3.ABC does not conform to GAAP. 4.Auditors may be suspect of the subjective allocation process based on interviews with employees. 1.External reports are less detailed than internal reports. 2.It may be difficult to make changes to the company’s accounting system. 3.ABC does not conform to GAAP. 4.Auditors may be suspect of the subjective allocation process based on interviews with employees.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin ABC Limitations Substantial resources required to implement and maintain. Resistance to unfamiliar numbers and reports. Desire to fully allocate all costs to products. Potential misinterpretation of unfamiliar numbers. Does not conform to GAAP. Two costing systems may be needed.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Appendix 8A: ABC Action Analysis Conventional ABC analysis does not identify potentially relevant costs. An action analysis report helps because it: Shows what costs have been assigned to a cost object. Indicates how difficult it would be to adjust those costs in response to changes in the level of activity. Conventional ABC analysis does not identify potentially relevant costs. An action analysis report helps because it: Shows what costs have been assigned to a cost object. Indicates how difficult it would be to adjust those costs in response to changes in the level of activity.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Appendix 8A: ABC Action Analysis Constructing an action analysis report begins with the first-stage allocation process. In addition to computing an overall activity rate for each activity cost pool, an activity rate is computed for each type of overhead cost that is consumed supporting a given activity. Let’s revisit the stage-one allocations from the Classic Brass example that we discussed earlier.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Appendix 8A: ABC Action Analysis $125,000 ÷ 1,000 orders = $125 per order Other entries in the table are computed similarly.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Appendix 8A: ABC Action Analysis $125 per order × 2 orders = $250 Other entries in the table are computed similarly.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Appendix 8A: ABC Action Analysis $125 per order × 1 orders = $125 Other entries in the table are computed similarly.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Appendix 8A: ABC Action Analysis Next, label each cost using an ease of adjustment code: Green costs adjust more or less automatically to changes in activity level without any action by managers. Yellow costs can be adjusted to changes in activity level, but it would require management action to realize the change in cost. Red costs can be adjusted to changes in activity level only with a great deal difficulty and with management intervention. Next, label each cost using an ease of adjustment code: Green costs adjust more or less automatically to changes in activity level without any action by managers. Yellow costs can be adjusted to changes in activity level, but it would require management action to realize the change in cost. Red costs can be adjusted to changes in activity level only with a great deal difficulty and with management intervention.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Appendix 8A: ABC Action Analysis

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin End of Chapter 8