Activity Based Costing: A Tool to Aid Decision Making 11/16/04 Chapter 8

© The McGraw-Hill Companies, Inc., 2003 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 “fixed” costs. ABC is a good supplement to our traditional cost system I agree!

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin How Costs are Treated Under Activity-Based Costing Level of Complexity Overhead Allocation Plantwide PlantwideOverheadRate OverheadRate DepartmentalOverheadRatesDepartmentalOverheadRates Activity Based Costing Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Plantwide Overhead Rate direct labor as Companies tended to use direct labor as the overhead allocation base. There was a belief that direct labor and overhead costs were highly correlated. Automation changed all that.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Departmental Overhead Rates Finishing Department Shipping Department Painting Department Many companies have a system in which each department has its own overhead rate.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Department1Department1Department2Department2Department3Department3 Cost pools IndirectLaborIndirectLaborIndirectMaterialsIndirectMaterialsOtherOverheadOtherOverhead Stage One: Costs assigned to pools Departmental Overhead Rates

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Department1Department1Department2Department2Department3Department3 Cost pools IndirectLaborIndirectLaborIndirectMaterialsIndirectMaterialsOtherOverheadOtherOverhead Stage One: Costs assigned to pools Departmental Overhead Rates Products Products Stage Two: Costs applied to products

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Department1Department1Department2Department2Department3Department3 Cost pools IndirectLaborIndirectLaborIndirectMaterialsIndirectMaterialsOtherOverheadOtherOverhead Stage One: Costs assigned to pools Departmental Overhead Rates Products Products Stage Two: Costs applied to products Departmental Allocation Bases Direct Labor Hours Machine Hours Raw Materials Cost

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cost of Idle Capacity Traditional Cost Accounting The predetermined overhead rate is based on budgeted activity. This results in applying overhead costs of unused, or idle, capacity. 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 Activity Based Costing Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Activity Based Costing Activity Based Costing Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Designing of an ABC System Steps for Implementing ABC  Identify and define major activities and activity cost pools.  Where possible, trace costs directly to activities and cost objects (products).  Assign all other traceable costs to activity cost pools. Non-traceable costs lumped.  Calculate activity rates.  Assign costs to cost objects.  Prepare management reports.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   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-LevelActivity(machining)Batch-LevelActivity (customer order) Product-LevelActivity (product design) Customer-LevelActivity (customer relations) Organization- sustaining Activity (lumped)

© The McGraw-Hill Companies, Inc., 2003 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:

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Activity Cost Pool Activity Cost Pool is a “bucket” in which OH costs are accumulated that relate to a single activity measure in the ABC system. $ $ $ $ $ $

© The McGraw-Hill Companies, Inc., 2003 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. (in this case, machined) 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. (in this case, machined) 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.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Assign Costs to Activity Cost Pools Exhibit 8-3 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.

© The McGraw-Hill Companies, Inc., 2003 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

© The McGraw-Hill Companies, Inc., 2003 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

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Assign Costs to Activity Cost Pools Exhibit 8-4

© The McGraw-Hill Companies, Inc., 2003 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 1,000 customer orders 200 new designs 200 new designs 20,000 machine-hours 20,000 machine-hours 100 customer relations activities 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.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Calculate Activity Rates Exhibit 8-5 ÷

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin TracedTracedTracedTracedTracedTraced Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Overhead Costs Cost Objects: Products, Customers Cost Objects: Products, Customers

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Cost Objects: Products, Customers Cost Objects: Products, Customers OrderSizeOrderSizeCustomerOrdersCustomerOrdersProductDesignProductDesignCustomerRelationsCustomerRelationsOtherOther Overhead Costs First-Stage Allocation

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Cost Objects: Products, Customers Cost Objects: Products, Customers OrderSizeOrderSizeCustomerOrdersCustomerOrdersProductDesignProductDesignCustomerRelationsCustomerRelationsOtherOther Overhead Costs First-Stage Allocation Second-Stage Allocations $/MH$/MH$/Order$/Order$/Design$/Design$/Customer$/Customer UnallocatedUnallocated

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Assigning Costs to Cost Objects VG 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.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Prepare Management Reports

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Prepare Management Reports Customer Profitability Analysis

© The McGraw-Hill Companies, Inc., 2003 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

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Comparison of ABC and Traditional Overhead Product Costs ProductStandardCustom ABCTradABCTrad Overhead$10,000$200 Shipping $ 180 $ 25 Cust Order Design 1,285 Order size3, OH assigned $4,610 $1,701

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin 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.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Benefits of ABC More cost pools = more accurate per unit costs Costs are assigned using relevant versus arbitrary drivers Makes overhead costs more manageable (traceable) Shifts costs from high to low volume products as appropriate Makes for better cost/pricing decisions

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Activity-Based Costing and Reporting Limitations Most companies do not use ABC because... 1.ABC does not conform to GAAP. 2.High costs associated with ABC implementation 3.High time commitment and discipline required 4.Limited benefit if organization sustaining costs too high

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin End of Chapter 8