PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 4 Activity-Based Costing and Cost Management

4- 3 Assignment of Indirect Costs to Products and Services  Two systems are used to track the total cost of products and services Job Order Costing Process Costing Indirect Costs

4- 4 Learning Objective 4-1 Assign indirect costs to products or services using a single volume-based cost driver.

4- 5 Review of Volume-Based Cost Systems Recall from earlier chapters that there are three steps to assigning indirect costs in a volume-based cost system: 1.Determine the cost driver (allocation base). 2.Calculate the predetermined overhead rate. 3.Assign indirect costs to individual products or services using the predetermined overhead rate. STEP 1: DETERMINE THE COST DRIVER

4- 6 Review of Volume-Based Cost Systems The next step is to compute the predetermined overhead rate by dividing the estimated total manufacturing overhead cost by the estimated total value of the cost driver, as follows: STEP 2: CALCULATE THE PREDETERMINED OVERHEAD RATE In our Toyota example, total manufacturing overhead cost of $3,000,000 will be divided by the total number of direct labor hours (12,500), as follows:

4- 7 Review of Volume-Based Cost Systems STEP 3: ASSIGN INDIRECT COSTS TO INDIVIDUAL PRODUCTS OR SERVICES To determine how much manufacturing overhead cost to assign to the individual products, we multiply the $240 predetermined overhead rate by the number of direct labor hours required for each product, as shown below:

4- 8 Review of Volume-Based Cost Systems STEP 3: ASSIGN INDIRECT COSTS TO INDIVIDUAL PRODUCTS OR SERVICES To compute the unit manufacturing cost, we need to add the manufacturing overhead cost per unit to the direct materials and direct labor costs provided on a per-unit basis, shown below:

4- 9 Calculate Total Manufacturing Cost and Profitability If we subtract the total manufacturing cost per unit from the unit sales price, we get the gross margin for each product. Remember that gross margin only takes into account the manufacturing cost of the product, before selling and administrative costs such as distribution fees, advertising, dealer costs and profit, and corporate administration charges have been deducted.

4- 10 Activity-Based Costing (ABC) Activity Based Costing (ABC) is a method of assigning indirect costs to products and services based on the activities they require. Two-Stage Allocation Process Using ABC

4- 11 Learning Objective 4-2 Classify activities as unit-, batch-, product-, or facility-level activities.

4- 12 Identify and Classify Activities

4- 13 Learning Objective 4-3 Assign indirect costs to activity cost pools and select a cost driver for each pool.

4- 14 Form Activity Pools and Assign Indirect Costs to Each Pool Machining and Installation (unit level) Machine Setup (batch level) Engineeringand Quality Control (product level) Assume that Toyota has grouped its production activities into three categories.

4- 15 Form Activity Pools and Assign Indirect Costs to Each Pool Recall that the total manufacturing overhead cost for the Tsutsumi plant is estimated at $3,000,000 (in thousands) per year. 1n an ABC system, this indirect cost must be assigned to the three activity cost pools.

4- 16 Form Activity Pools and Assign Indirect Costs to Each Pool Assume that the production engineer makes $120,000 per year and has kept track of the time spent supervising the three major activities. The number of hours spent on each activity is used to allocate the $120,000 salary. Since the supervisor spends 40% of his time overseeing machining and installation activities, $48,000 (40% x $120,000) should be assigned to that activity cost pool.

4- 17 Select a Cost Driver for Each Activity Cost Pool A cost driver is a measure of the underlying activity that occurs in each activity cost pool. The goal is to identify a driver that has a cause and effect relationship with the underlying activity. Traditional cost systems use volume-based cost drivers. ABC systems also include measures that capture something other than the sheer volume of units produced or customers sold. These measures are called non-volume-based cost drivers.

4- 18 Select a Cost Driver for Each Activity Cost Pool Machine hours will be used as the driver for the machining and installation activity. Number of set-ups will be used as the activity driver for the set-up activity. Engineering and inspection hours will be used as the driver to assign engineering and quality control costs.

4- 19 Learning Objective 4-4 Assign indirect costs to products or services using activity rates.

4- 20 Assign Indirect Costs to Products or Services Based on Activity Demands There are two methods that can be used to assign indirect costs to individual products or services based on their activity requirements: activity rates or activity proportions. The method used will depend on the type of information provided and whether you have complete information on all product or service lines. Activity Rates Activity Proportions

4- 21 Activity-Rate Method The activity-rate method is very similar to the predetermined overhead rate computed earlier. Total indirect costs assigned to the machining pool was $720,000. Total machine hours required by each Toyota model is as follows: Activity Rate = $720,000 10,000 = $72 per machine hour

4- 22 Activity-Rate Method To assign the cost to the products, we multiply the activity rate by the activity requirements of each individual product.

4- 23 Learning Objective 4-5 Assign indirect costs to products or services using activity proportions.

4- 24 Activity-Proportion Method The activity-proportion method can also be used to assign the total cost of the machining and installation pool of $720,000. This method will calculate activity proportions or percentages of the cost driver, machine hours.

4- 25 Activity-Proportion Method The allocation of the machining and installation cost of $720,000 to the specific models is shown in the table below.

4- 26 Compute Total Manufacturing Overhead To complete the ABC allocations, we need to add up the cost of all three activities for each product line. Notice that more of the total manufacturing overhead cost is assigned to the Prius than the Scion.

4- 27 Calculate Unit Costs and Gross Margin To calculate the cost per unit, we need to divide the total manufacturing overhead by the number of units of each product.

4- 28 Calculate Unit Costs and Gross Margin To determine the total manufacturing cost per unit, the manufacturing overhead calculated using ABC is added to the direct materials and direct labor costs.

4- 29 Calculate Unit Costs and Gross Margin In this hypothetical example, subtracting the unit manufacturing costs under ABC from the unit sales price provided earlier results in the following gross margin analysis.

4- 30 Learning Objective 4-6 Compare the results of a volume- based cost system to activity-based costing.

4- 31 Comparison of Volume-Based and Activity- Based Cost Systems A comparison of the unit manufacturing overhead per unit and the gross profit margin percentage of each product under a volume- based system to activity-based costing illustrates the different results from the two cost systems. Remember that the only difference between the two methods is in how they assign indirect costs (overhead) to each product.

4- 32 Learning Objective 4-7 Apply activity-based costing to a service industry.

4- 33 Activity-Based Costing in Service Industries ABC can also be useful in service industries, particularly when different types of customers require different levels of service. Although service providers do not have manufacturing overhead, they incur many indirect costs, such as rent, supplies, supervision, advertising, and administrative expenses.

4- 34 Activity-Based Costing in Service Industries The activity-based costing process begins by identifying and classifying activities using the activity hierarchy.

4- 35 Learning Objective 4-8 Describe how managers use the results of activity-based costing for cost management.

4- 36 Activity-Based Management Activity-based management (ABM) includes all the actions that managers take to improve operations or reduce costs based on the ABC data. The first step in any improvement program is to target areas that need improvement. What Activities Are Performed? What Activities Are Performed? How Much Does it Cost to Perform Each Activity? Does the Activity Add Value to the Customer?

4- 37 Just-in-Time (JIT) Inventory In a JIT system, materials are purchased and units are made only as they are needed to satisfy customer demand. JIT is a "demand pull" system, where materials and products are pulled through the manufacturing system based on customer demand. In a traditional manufacturing setting, products are pushed through the system and often end up sitting in inventory.

4- 38 Total Quality Management Total quality management (TQM) is a management approach that aims to improve product quality by reducing and eliminating errors, streamlining activities, and continuously improving production processes: 1.Prevention costs; 2.Appraisal or inspection costs; 3.Internal failure costs; and 4.External failure costs.

4- 39 Target Costing and Life Cycle Cost Management Target costing is a proactive approach to cost management that managers can use to determine what costs should be in order for the company to earn an acceptable profit across a product’s life cycle. The product life cycle represents the life of the product from its infancy (an idea), through design, development, product introduction, growth, maturity, and eventual decline.

4- 40 Target Costing and Life Cycle Cost Management In pursuing cost management, managers need to set their cost reduction goals across all stages of the product life cycle, including: 1.product introduction, 2.growth, 3.maturity, and 4.eventual decline. Costs tend to be higher Most revenue earned In today’s digital and technological age, product life cycles become increasingly short.

4- 41 Target Costing and Life Cycle Cost Management With target costing, the price is set by the market based on what the company believes consumers will be willing to pay for the product or service. The desired profit margin is then subtracted from the market price to determine the target cost. The $24,000 target cost is the most that can be spent on the product and still achieve the 20% return on sales (given a market sales price of $30,000 per unit).

4- 42 Target Costing and Life Cycle Cost Management Given the target unit cost, how much can Toyota spend on the new model across its entire life cycle and still meet the target profit? The next step is to determine whether it is feasible to design, develop, manufacture, and deliver the product at a total life-cycle cost of $1,440,000,000.

4- 43 Summary of ABC and ABM To gain the true benefits of activity based costing, managers must move from simply measuring costs, to find ways to manage or reduce costs. Although ABC and ABM have many potential benefits, these benefits must be weighed against the costs of obtaining the more accurate information. Implementing an ABC can be a difficult task.

4- 44 End of Chapter 4