4-1 Activity- Based Costing and Management Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University 4

4-2  Explain and illustrate the traditional method of calculating average costs of products.  Explain why the traditional method does not adequately serve modern organizations.  Explain how complexity and diversity are important cost drivers.  Explain and illustrate the activity-based costing method of calculating average costs of products. ObjectivesObjectives After reading this chapter, you should be able to: ContinuedContinued

4-3  Explain and illustrate activity-based management.  Prepare ABC-formatted income statements. ObjectivesObjectives

4-4 The Traditional Approach A company makes two products, A and B, and uses machine hours as its cost driver. Machine hours per unit24 Total units100,00025,000 Total hours200,000100,000300,000 Total overhead cost$900,000 A B Total

4-5 The overhead rate is $3 ($900,000 ÷ 300,000), and the allocations of overhead to products are: Total hours200,000100,000300,000 Rate x $3 x $3 x $3 Total overhead$600,000$300,000$900,000 A B Total The Traditional Approach

4-6 Activity-Based Costing Approach Volume is one major driver, measured either in output (units produced) or input (labor hours, machine hours, etc.) Accountants today recognize two other major influences on cost, complexity and diversity of operations. ABC is concerned with resource consumption.

4-7 MultiBrick makes 10,000,000 total bricks, but in a dozen colors, four textures, and eight sizes/shapes, a total of 384 possibilities. The firm mixes and bakes 10 to 18 batches of bricks per day. MultiBrick sells to over 1,000 customers whose orders typically include 15 to 20 different kinds of bricks. MultiBrick Cost Determination Data

4-8 Total manufacturing overhead $800,000 Total output 10,000,000 bricks Model A-42 Model A-88 Model C-11 Total production6,0004,000100,000 Material cost per brick$0.05$0.04$0.03 Direct labor cost per brick$0.06$0.07$0.04 Overhead rate = $800,000 ÷ 10,000,000 = $0.08 per brick MultiBrick Cost Determination Data

4-9 Cost calculations: Model A-42 Model A-88 Model C-11 Material cost per brick$0.05$0.04$0.03 Direct labor cost per brick Overhead cost at $ Total unit cost$0.19$0.19$0.15 MultiBrick Cost Determination Data

4-10 Activity-Based Costing Terms A cost object refers to whatever segment for which you are estimating the cost. Examples:Products, customers, geographical areas, and channels of distribution Cost drivers are activities that cause costs. Examples:Sales, production, number of products, and number of customers.

4-11 Resource Driver refers to activities that drive resource requirements, and therefore drive costs. Examples:People, machinery, space, and utilities An activity driver relates resource-driving activities to products, customers, geographical areas, or other segments of interest. Activity-Based Costing Terms

4-12 MultiBrick Data for Illustration Total Amount Resource Driver Costs in Pool of Driver Rate Setups$120,00010,000 setups$12 Baking time600,000300,000 hours$2 Customer orders 80,0005,000 orders$16 Total cost$800,000 ÷ ÷ ÷ ======

4-13 Activity Data per Year Model A-42 Model A-88 Model C-11 Number of setups baking time, hours Number of customer orders Costs, excluding overhead Material cost per brick$0.05$0.04$0.03 Direct labor cost per brick MultiBrick Data for Illustration

4-14 ABC Analysis of Bricks Material cost$ 300$ 160$ 3000 Direct labor cost Overhead: Setup-based1,8002, Baking time Customer order based Total Cost$3,060$3,340$ 8,280 Divided by annual volume 6,000 4,000100,000 Average cost per brick$ 0.51$0.835$ MultiBrick Data for Illustration Model A-42 Model A-88 Model C-11

4-15 Comparison of Traditional Costs and Activity-Based Costs Traditional Cost Approach: Material cost$ 300$160$ 3000 Direct labor cost Overhead ,000 Total cost$1,140$760$15,000 Model A-42 Model A-88 Model C-11

4-16 Comparison of Traditional Costs and Activity-Based Costs Activity-Based Cost Approach: Material cost$ 300$ 160$ 3000 Direct labor cost Overhead 2,400 2,900 1,280 Total cost$3,060$3,340$8,280 Model A-42 Model A-88 Model C-11

4-17 Consumption Ratios Consumption ratios is the resource utilized by a given product divided by the total amount of the resource available. Since MultiBrick is producing a total of 10,000,000 bricks, the consumption ratio of each model is: Model A-42: 6,000 bricks ÷ 10,000,000 = 0.06% Model A-88: 4,000 bricks ÷ 10,000,000 = 0.04% Model C-11: 100,000 bricks ÷ 10,000,000 = 1.00%

4-18 Consumption Ratios Model A-42: 150 setups ÷ 10,000 total = 1.50% Model A-88: 180 setups ÷ 10,000 total = 1.80% Model C-11: 30 setups ÷ 10,000 total = 0.30% Model A-42: 60 hours ÷ 300,000 total = % Model A-88: 50 hours ÷ 300,000 total = % Model C-11: 300 hours ÷ 300,000 total = % Model A-42: 30 orders ÷ 5,000 total = 0.60% Model A-88: 40 orders ÷ 5,000 total = 0.80% Model C-11: 20 orders ÷ 5,000 total = 0.40%

4-19 Who Uses ABC? Productive/Service Costing58% Process Analysis51% Performance Management49% Profitability Assessment38% Value-Based Management18% Primary Objective

4-20 Who Uses ABC? Public Sector40% Service24% Manufacturing24% Consulting11% Industry

4-21 Kinds of Variability 1.Unit level activities 2.Batch level activities 3.Sustaining activities 4.Facility-sustaining or company-sustaining activities

4-22 Types of Activities (continued) Unit level activities are those performed each time a unit is produced or sold. Examples:Materials, components, drilling and welding

4-23 Batch level activities are those that a company performs when it makes a group of units, regardless of how many units are in the batch. Example:Machine setups Types of Activities (continued)

4-24 Sustaining activities arise because a company does particular types of business, or maintains a particular product or service. Examples:Advertising devoted to the product, engineering and development related to the product. Types of Activities (continued)

4-25 Facility-sustaining or company-sustaining activities and costs relate to an entire plant, office, or company as a whole. Example:Rent of the corporate headquarters building Types of Activities (continued)

4-26 ABC and Ethics Because some costs are on the borderline between being direct or indirect to a product or line, managerial accountants must use some judgment in assigning costs to products. Whenever decisions involve judgment, the potential for an ethical conflict exists.

4-27 Activity-Based Management (ABM) Activity-Based Management (ABM) is using information about activities to manage many aspects of an organization, rather than simply managing costs.

4-28 Re-engineering describes the development of new ways to perform existing activities and ways to stop performing non-value-adding activities. Benchmarking is the practice of comparing your company with some of the industry leaders. Process value analysis (PVA) uses activity analysis to manage costs. PVA focuses on manufacturing processes and seeks to reduce or optimize the activities performed within a process. Activity-Based Management (ABM)

4-29 Process Value Analysis (PVA) PVA focuses on manufacturing processes and seeks to reduce or optimize the activities performed within a process. Value-added:An operation that actually changes the physical aspects of the part. Examples: Turning, milling, and drilling

4-30 Process Value Analysis (PVA) PVA focuses on manufacturing processes and seeks to reduce or optimize the activities performed within a process. Non-Value-added, but necessary: An operation/activity that does not change the physical aspects of the part, but is necessary in order to do so. Examples: Setup time and inspecting

4-31 Process Value Analysis (PVA) PVA focuses on manufacturing processes and seeks to reduce or optimize the activities performed within a process. Non-Value-added, and unnecessary: An activity that does not changes the physical aspects of the part and is not necessary for value added operations to be performed. Examples: Queue time

4-32 ABC/ABM and World-Class Manufacturing ABC is most beneficial for companies with a great deal of complexity and diversity in their products and operations.

4-33 ABC/ABM Analysis and Income Reporting Patterson Homewares, Inc. Income Statement for 20X2, in thousands FlooringTileCarpetTotal Sales$300.4$503.5$623.3$1,427.2 Unit-level variable costs Unit-level C/M$110.3$342.4$374.0$ Batch-level variable costs Batch-level C/M$100.7$316.0$321.2$ Product-sustaining costs Product margin$ 11.5$259.3$247.5$ Facility-sustaining costs Income$ 297.8

4-34 The End Chapter 4

4-35