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 Activity-Based Costing Chapter 9 Edited by Dr. Charles Bailey for ACCT3310

9-2 Learning Objectives LO 9-1 Understand the potential effects of using externally reported product costs for decision making. LO 9-2 Explain how a two-stage product costing system works. LO 9-3 Compare and contrast plantwide and department allocation methods. LO 9-4 Explain how activity-based costing and a two-stage product system are related. LO 9-5 Compute product costs using activity-based costing. LO 9-6 Compare activity-based product costing to traditional department product costing methods. LO 9-7 Demonstrate the flow of costs through accounts using activity-based costing. LO 9-8 Apply activity-based costing to marketing and administrative services.

9-3 Product Costs and Decision Making LO 9-1 Understand the potential effects of using externally reported product costs for decision making. Units produced Direct labor-hours Costs: Direct materials Direct labor Manufacturing overhead 120% of DL) Total Cost per unit 10 2,000 $ 40,000 72,000 86,400 $198,400 $ 19, ,000 $ 36,000 78,000 93,600 $207,600 $ 6, ,000 $ 76, , ,000 $406,000 C-27sC-20sTotal Grange is considering dropping C-27s. LO 9-1

9-4 The accountant estimated that overhead will be $163,800. Manufacturing overhead: Utilities Supplies Training Supervision Machine depreciation Plant depreciation Miscellaneous Total overhead $ 2,400 2,500 30,000 54,900 29,550 40,050 20,600 $180,000 $ 1,800 1,300 15,600 54,900 29,550 40,050 20,600 $163,800 OriginalC-20s only LO 9-1 Product Costs and Decision Making

9-5 Direct materials Direct labor Manufacturing overhead Total costs $ 76, , ,000 $406,000 $ 36,000 78, ,800 $277,800 OriginalC-20s only The cost per unit for the C-20s will increase from $6,920 to $9,260. LO 9-1 Product Costs and Decision Making

9-6 The Death Spiral This is a process that begins by attempting to increase price to meet reported product cost. This may result in demand for even fewer units. LO 9-1

9-7 Two-Stage Cost Allocation LO 9-2 Explain how a two-stage product costing system works. Allocate overhead costs to departments. Allocate department overhead costs to the products or services. LO 9-2

9-8 Two-Stage Cost Allocation Overhead Direct labor hours Machine hours Cost pool Cost allocation rule Intermediate cost pools Department ADepartment B LO 9-2

9-9 Two-Stage Cost Allocation Number of units Machine hours – Assembly Direct materials Direct labor – Assembly Direct labor – Packaging Total direct labor Total direct cost Overhead costs: Assembly Packaging Total overhead Total costs 100,000 6,000 $1,500,000 $ 750, ,000 $1,740,000 $3,240,000 40,000 30,000 $2,400,000 $ 600, ,000 $ 960,000 $3,360, ,000 36,000 $3,900,000 $1,350,000 1,350,000 $2,700,000 $6,600,000 $1,620, ,000 $2,430,000 $9,030,000 J25PJ40XTotal Third Quarter – Production and Cost Data The cost system allocates manufacturing overhead to products based on direct labor costs. LO 9-2

9-10 Two-Stage Cost Allocation Units produced Direct material Direct labor: Assembly Packaging Total direct labor Direct cost Applied overhead 90% of direct labor costs) 100,000 $ $ $ $ $ ,000 $ $ $ $ $ J25PJ40X Third Quarter – Unit Cost Report – One allocation rate LO 9-2

9-11 Two-Stage Cost Allocation Units produced Direct material Direct labor: Assembly Packaging Total direct labor Direct cost Applied overhead: $45/machine hour 60% of direct labor cost Total overhead Unit costs 100,000 $ $ $ $ $ $ 8.64 $ ,000 $ $ $ $ $ $ $ J25PJ40X Third Quarter – Unit Cost Report –Two Stage Allocation LO 9-2 Vs. $48.06 $105.60

9-12 Plantwide versus Department-Specific Rates LO 9-3 Compare and contrast plantwide and department allocation methods. All overhead costs are recorded in one cost pool and applied to products using one overhead allocation rate. LO 9-3

9-13 Overhead costs are traced to separate departments and applied to products using a department allocation rate. LO 9-3 Plantwide versus Department-Specific Rates

9-14 Choice of Allocation Methods Similar products using same resources Plantwide allocation Multiple products using resources differently Department allocation LO 9-3

9-15 Activity-Based Costing (ABC) LO 9-4 Explain how activity-based costing and a two-stage product system are related. ABC is a costing method that first assigns costs to activities and then assigns them to products based on the products’ consumption of activities. Assign costs to activities. Assign costs to products based on the use of each activity LO 9-4

9-16 Activity-Based Costing (ABC) Activities consume resources Products (or services) consume activities LO 9-4

9-17 Developing Activity-Based Costs Step 1:Identify the activities that consume resources and assign costs to them. Step 2:Identify the cost driver(s) associated with each activity. Step 3:Compute a cost rate per cost driver unit or transaction. Step 4:Assign costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product. LO 9-4

Activity-Based Costing System Cost of Activity A Other Indirect Costs of product/svc (including other non-ABC items) Cost of Product, Service, Customer Fundamental Cost Objects: Labor, materials, etc. (All indirect to the Product or Service) Cost drivers Activity drivers Other Cost drivers Direct Costs Traced Cost of Activity B, etc.

9-19 Cost Drivers Cost drivers are factors that cause or “drive” an activity’s costs. Identified Activity Setting up machines Handling material Machining Packaging and shipping LO 9-4 Identified Cost Driver ?

9-20 Cost Hierarchies This is the classification of cost drivers into general levels of activity; volume, batch, product, and so on. Cost ExampleHierarchy LevelCost Driver Example LO 9-4

9-21 Cost Hierarchies Cost Example Supplies Lubricating oil Machine repair Hierarchy Level Volume related Cost Driver Example Direct labor costs Machine hours Number of units LO 9-4 This is the classification of cost drivers into general levels of activity; volume, batch, product, and so on.

9-22 Cost Hierarchies Cost Example Supplies Lubricating oil Machine repair Hierarchy Level Volume related Cost Driver Example Direct labor cost Machine-hours Number of units Setup costs Material handling Shipping costs Batch relatedSetup hours Production runs Number of shipments LO 9-4 This is the classification of cost drivers into general levels of activity; volume, batch, product, and so on.

9-23 Cost Hierarchies Cost Example Supplies Lubricating oil Machine repair Hierarchy Level Volume related Cost Driver Example Direct labor cost Machine-hours Number of units Setup costs Material handling Shipping costs Batch relatedSetup hours Production runs Number of shipments Compliance costs Design and specification costs Product relatedNumber of products LO 9-4 This is the classification of cost drivers into general levels of activity; volume, batch, product, and so on.

9-24 Cost Hierarchies The cost hierarchy in any ABC system depends on the cost category and its cost driver. Cost Example Supplies Lubricating oil Machine repair Hierarchy Level Volume related Cost Driver Example Direct labor cost Machine-hours Number of units Setup costs Material handling Shipping costs Batch relatedSetup hours Production runs Number of shipments Compliance costs Design and specification costs Product relatedNumber of products General plant costs Plant admin. costs Facility relatedStaying in business! LO 9-4

9-25 Activity-Based Costing Illustrated LO 9-5 Compute product costs using activity-based costing. Number of units Machine hours – Assembly Direct materials Direct labor – Assembly Direct labor – Packaging Total direct labor Total direct cost Overhead costs: Assembly Packaging Total overhead Total costs 100,000 6,000 $1,500,000 $ 750, ,000 $1,740,000 $3,240,000 40,000 30,000 $2,400,000 $ 600, ,000 $ 960,000 $3,360, ,000 36,000 $3,900,000 $1,350,000 1,350,000 $2,700,000 $6,600,000 $1,620, ,000 $2,430,000 $9,030,000 J25PJ40XTotal Third Quarter – Production and Cost Data LO 9-5

9-26 Activity-Based Costing Illustrated Step 1: Identify the Activities Packaging Department Inspection Packing Shipping Assembly Department Setting up machines Handling material Product assembly LO 9-5

9-27 Activity-Based Costing Illustrated Step 2: Identify the Cost Drivers Assembly building: Assembling Setting up machines Handling material Packaging building: Inspecting and packing Shipping Machine-hours Setup hours Production runs Direct labor hours No. of shipments 6, , , , J25PJ40XTotal Cost Driver Volume 36, , ActivityCost Driver LO 9-5

9-28 Activity-Based Costing Illustrated Step 3: Compute the Cost Driver Rates Assembly building: Assembling Setting up machines Handling material Total assembly overhead Packaging building: Inspecting and packing Shipping Total packaging overhead Total overhead $1,080, , ,000 $1,620,000 $ 414, ,000 $ 810,000 $2,430,000 ÷ 36,000 machine hour = ÷ 440 hours = ÷ 48 runs = ÷ 82,800 direct labor hr = ÷ 300 shipments = $ 30/machine hour $ 900/setup hour $ 3,000/run $ 5/direct labor hour $ 1,320/shipment Building and Activity Overhead Cost Cost Driver Volume Cost Driver Rate LO 9-5

9-29 Activity-Based Costing Illustrated Step 4: Assign Costs Using ABC Assembly building: $30/machine hour Machine $900/setup hour Handling $3,000/run Packaging building: Inspection and $5/direct labor hour $1,320/ shipment Total ABC overhead $180,000 36,000 24, , ,000 $672,000 $ 900, , , , ,000 $1,758,000 J25PJ40XOverhead LO 9-5

9-30 Cost Flow Diagram – ABC System Manufacturing overhead Direct costs Assembly buildingPackaging building AssemblingSetup Handling material Inspecting/ packaging Shipping J25PJ40X Directly assigned Machine hours Setup hours Runs Direct LH Ship- ments LO 9-5

9-31 Activity Based Costing – Illustrated Direct material Direct labor: Assembly Packaging Total direct labor Direct costs Overhead: Assembly building: $30 per machine hour Machine $900 per setup hour Handling $3,000 per run Package building: Inspecting and $5 per direct labor hour $1,320 per shipment Total ABC overhead Total ABC cost Number of units Unit cost $1,500,000 $ 750, ,000 $1,740,000 $3,240,000 $ 180,000 36,000 24, , ,000 $ 672,000 $3,912, ,000 $ $2,400,000 $ 600, ,000 $ 960,000 $3,360,000 $ 900, , , , ,000 $1,758,000 $5,118,000 40,000 $ J25PJ40X LO 9-5

9-32 Unit Costs Compared LO 9-6 Compare activity-based product costing to traditional department product costing methods. Plantwide rate Department (building) rate Activity-based costing $48.06 $41.04 $39.12 $ $ $ J25PJ40X Comparison of Reported Unit Product Costs LO 9-6

9-33 Cost Flows through Accounts LO 9-7 Demonstrate the flow of costs through accounts using activity-based costing. Let’s see ABC cost flow for the Assembly Department. It's T-account time! LO 9-7

9-34 Direct Materials Costs Materials Inventory 1,500,000 2,400,000 Assembly WIP J25P DM 1,500,000 Assembly WIP J40X DM 2,400,000 LO 9-7

9-35 Direct Labor Costs Wages Payable 750, ,000 Assembly WIP J25P DM 1,500,000 DL 750,000 Assembly WIP J40X DM 2,400,000 DL 600,000 LO 9-7

9-36 Overhead Costs Assembly WIP J25P DM 1,500,000 DL 750,000 OH 240,000 Assembly WIP J40X DM 2,400,000 DL 600,000 OH 1,380,000 Assembling 180, ,000 1,080,000 Setting Up 36, , ,000 Handling Material 24, , ,000 LO 9-7

9-37 Transfer from Assembly to Packaging Packaging WIP J25P 2,490,000 Packaging WIP J40X 4,380,000 Assembly WIP J25P 2,490,000 DM 1,500,000 DL 750,000 OH 240,000 Assembly WIP J40X 4,380,000 DM 2,400,000 DL 600,000 OH 1,380,000 LO 9-7

9-38 ABC Costing in Administration LO 9-8 Apply activity-based costing to marketing and administrative services. Step 1:Identify the activities that consume resources. Step 2:Identify the cost driver associated with each activity. Step 3:Compute a cost rate per cost driver for each unit or transaction. Step 4:Assign costs to the marketing or administration activity by multiplying the cost driver rate by the volume of cost driver units consumed for that activity. LO 9-8

Major Differences, Traditional Costing vs. ABC Typical System ABC One or a few indirect Many pools cost pools Application base may Base more likely a Application base may Base more likely a be a true cost driver true cost driver be a true cost driver true cost driver Application base often Bases likely to be Application base often Bases likely to be financial (direct labor cost, non-financial (# of parts, direct material cost, etc) number of operations, direct material cost, etc) number of operations, hours of testing, etc.) hours of testing, etc.)

Decision Usefulness of Cost Hierarchies  Different levels of cost drivers: Level_______ Useful for Decisions Such As… Output-unitShall we increase production, and at what price? BatchHow often should we produce batches? What base amount must we charge to set up a “run,” regardless of the number of units made? Product/Service-RelatedShould we continue to offer this service/product? Facility-RelatedShall we continue in business or dissolve it?

9-41 End of Chapter 9