Activity Based Costing: A Tool to Aid Decision Making Chapter4 Activity Based Costing: A Tool to Aid Decision Making

Allocates Costs Company-wide at One Rate TRADITIONAL COSTING Allocates Costs Company-wide at One Rate Allocates overhead using a single predetermined overhead rate. Historically based on gross profit or relative sales. Now often on direct labor or machine hours. Process costing: Usuallybased on machine hours. Allocation accurately shows profitability of the company as a whole. Problem: Profitability of individual products may not accurately reflect the effort and costs incurred.

ACTIVITY BASED COSTING (ABC) Both manufacturing and nonmanufacturing overhead costs are assigned to products. There are a number of cost pools each of which is allocated using a unique measure of activity. Some manufacturing costs may be excluded from product costs. Allocation bases often differ from traditional costing systems. Overhead rates may be based on activity at capacity.

Overhead rates based on Activities Activity 1 Activity 3 Activity 2 A two stage process is necessary because costs are allocated to activities and then to products.

Activities and Related Cost Drivers Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity in the ABC system. $ $ $ $ $ $

Designing an ABC System Steps for Implementing ABC Identify and define activities, activity cost pools, and cost drivers. Trace identifiable costs to activities. Allocate overhead costs to activity cost pools. Calculate activity rates based on expected total use of cost drivers. Assign costs to products.

Designing an ABC System Identifiable (Indirect) Costs Activities (Cost Pools) Amount of Activity Used Overhead Costs Costs Applied

ABC Overhead Rates Stage One: Costs assigned to activity pools Indirect Labor Indirect Materials Other Overhead Activity 1 Activity 2 Activity 3 Cost pools

ABC Overhead Rates Machine Hours Inspections Setups Stage One: Costs assigned to activity pools Indirect Labor Indirect Materials Other Overhead Activity 1 Activity 2 Activity 3 Cost pools Based on cost drivers Setups Machine Hours Inspections

ABC Overhead Rates Machine Hours Inspections Setups Stage One: Costs assigned to activity pools Indirect Labor Indirect Materials Other Overhead Activity 1 Activity 2 Activity 3 Cost pools Based on cost drivers Setups Machine Hours Inspections Stage Two: Costs applied to products Products

Traditional Costing vs ABC ABC does segregate overhead into various cost pools to provide more accurate cost information. ABC supplements – it does not replace – the existing traditional job order/process cost system. Why? Variances (over/under applied) would become very complex and not very meaningful.

Activities and Related Cost Drivers

The Mechanics of ABC One overhead cost - shipping - can be traced directly to customer orders.

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Traced $/DLH Traced Products or Customers

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Customer Orders (# of Orders) Product Design Order Size (Mach Hrs) Customer Relations (# of Customers) Other Products or Customers

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Customer Orders Product Design Order Size Customer Relations Other Second-Stage Allocations $/Order $/Design $/MH $/Customer Products or Customers Unallocated

Assigning Costs to Activity Cost Pools Management at Classic Brass believes overhead should be distributed as follows:

Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools. Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools. Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

Computation of Activity Rates The ABC team has determined that Classic Brass has the following total activities for each activity cost pool . . . 1,000 customer orders, 200 new designs, 20,000 machine-hours 100 customers. Now the team can compute the individual activity rates.

Simplified Approach to ABC After the first-stage allocation is complete, computation of activity rates for each activity cost pool can be simplified as follows: ÷ ÷ ÷ ÷

Computation of Activity Rates

Computation of Activity Rates

Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer - Windward Yachts. Windward ordered two products - Stanchions and custom compass housings. Here are the details: Standard Stanchions (no design required) 1. 400 units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours . 3. Selling price is $34 each. 4. Direct materials total $2,110. 5. Direct labor totals $1,850. 6. Shipping costs total $180.

Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer - Windward Yachts. Windward ordered two products - Stanchions and customer compass housings. Here are the details: 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 $13. 5. Direct labor totals $50. 6. Shipping costs total $25.

Assigning Costs to Cost Objects Overhead cost of two orders for standard stanchions. $125 per order × 2 orders = $250

Assigning Costs to Cost Objects Overhead cost of two orders for standard stanchions.

Assigning Costs to Cost Objects Overhead cost of one order for custom compass housing. $125 per order × 1 order = $125

Assigning Costs to Cost Objects Overhead cost of one order for custom compass housing.

Product Margins

Product Margins

Example Traditional Using Machine Hours Total Production Dept O/H $1,000,000 Total Machine Hours 20,000 Overhead Allocation/Machine Hour $50/hr.

Predetermined manufacturing 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

Comparison of Unit Costs Traditional vs ABC Standard Compass Stanchion Housing Traditional Traditional Costing ABC Costing ABC Sales $ 13,600 $ 13,600 $ 650 $ 650 Manufacturing Costs Direct Materials 2,110 2,110 13 13 Direct Labor 1,850 1,850 50 50 Overhead 10,000 4,610 200 1,701 Total Cost per Product 13,960 8,570 263 1,764 Overstated Understated $5,390 $1,438

Comparison of Unit Costs Traditional vs ABC Standard Compass Stanchion Housing Traditional Traditional Costing ABC Costing ABC Sales $ 13,600 $ 13,600 $ 650 $ 650 Manufacturing Costs Direct Materials 2,110 2,110 13 13 Direct Labor 1,850 1,850 50 50 Overhead 10,000 4,610 200 1,701 Total Cost per Product 13,960 8,570 263 1,764 Product Margin (360) 5,030 387 (1,114)

Difference Between ABC and Traditional Product Costs ABC will ordinarily shift batch-level and product-level overhead costs from high-volume products produced in large batches to low-volume products produced in small batches.

Difference Between ABC and Traditional Product Costs 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.

Ease of Adjustment Costs that adjust automatically to changes in activity: Direct materials. Shipping. Costs that could be adjusted to changes in activity: Direct labor. Factory utilities. Administrative wages and salaries. Office equipment depreciation. Marketing wages and salaries. Selling expenses. Costs that are difficult to adjust to changes in activity: Factory equipment depreciation. Factory building lease. Administrative building lease.

Simplified Approach to ABC 2 orders @ $315 per order

Simplified Approach to ABC 1 design @ $1,285 per design

Simplified Approach to ABC Customer margin for Windward Yachts is shown below:

Activity-Based Costing Use ABC When One or More of the Following Exist: Products differ greatly in volume/manufacturing complexity Products lines are Numerous Diverse Require different degrees of support services Overhead costs are a significant portion of total costs Significant change in manufacturing process or number of products Managers ignore data from existing system and instead use “bootleg” costing data

Value-Added vs. Non-Value-Added Activities Value-Added Activity An activity that increases the worth of a product or service such as: Manufacturing Company Service Company engineering design performing surgery machining legal research services assembly delivering packages painting packaging

Value-Added vs. Non-Value-Added Activities An activity that adds cost to, or increases the time spent on, a product/service without increasing its market value such as: Manufacturing Company Service Company Repair of machines Taking appointments Storage of inventory Reception Moving of raw materials, Bookkeeping/billing assemblies, and finished goods Traveling Building maintenance Ordering supplies Inspections Inventory Control

End of Chapter 4 I call this quality time!