Systems Design: Activity-Based Costing Chapter 3: Systems Design: Activity Based Costing. Overhead costs cannot be easily traced to products. Using a plantwide predetermined overhead rate as described in chapter 2 is simple, but using such a rate may inaccurately assign costs to products. Activity-based costing is an alternative that attempts to accurately assign overhead costs to products for financial reporting and other purposes.

Learning Objective LO1 To understand the basic approach in activity-based costing and how it differs from conventional costing. Learning objective number 1 is to understand the basic approach in activity-based costing and how it differs from conventional costing.

Assigning Overhead Costs to Products When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2.    Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2.    Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

Assigning Overhead Costs to Products Plantwide Overhead Rate A single overhead rate used throughout an entire factory. Direct labor has often been used as the allocation base for overhead because: 1.    Direct labor information was already being recorded. 2.    Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated. In the interest of simplicity, companies often established a single overhead pool for an entire factory that used direct labor as the allocation base. Direct labor was the obvious choice because: 1.    Direct labor information was already being recorded. 2.    Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were strongly correlated.

Plantwide Overhead Rate Today, direct labor may no longer be a satisfactory base for allocation of overhead. Most companies sell a large variety of products that consume differing amounts of overhead. As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor. Technology advancements have reduced the cost and complexity of gathering diverse sources of data. Conditions have changed in three ways. 1.    Most companies sell a large variety of products that consume differing amounts of overhead. 2.    As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of these growing overhead costs may not be correlated with direct labor. 3.    Technology advancements have reduced the cost and complexity of gathering diverse sources of data.   These changes suggest that a plantwide overhead allocation system may not be optimal for many companies in today’s business environment. A plantwide overhead allocation system may not be optimal for many companies in today’s business environment.

Departmental Overhead Rates Many companies have a system in which each department has its own overhead rate. The allocation bases depend on the nature of the work performed in each department. In the machining department, overhead may be based on machine-hours, but in the assembly department, overhead may be based on labor-hours. Finishing Department Painting Department Many companies use departmental overhead rates, instead of a plantwide overhead rate. The nature of the work performed in a department will determine the department’s allocation base. For example:  1. Overhead costs in a machining department may be allocated using machine hours. 2.  Overhead costs in an assembly department may be allocated using direct labor hours. Shipping Department

Departmental Overhead Rates Unfortunately, even departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs. The departmental approach relies exclusively on volume-related allocation bases. Some overhead costs may be caused by factors that are not related to the volume of production. Part I. Departmental overhead rates will not correctly assign overhead costs in situations where a company has a range of products and complex overhead costs. Part II. This is because the departmental approach relies exclusively on volume-related allocation bases. Some overhead costs may be caused by factors that are not related to the volume of production. Part III. A more sophisticated approach, such as activity-based costing, is required to account for these other factors. A more sophisticated approach, such as activity-based costing, is required to account for these other factors.

Activity-Based Costing (ABC) A number of allocation bases are used for assigning costs to products. Activity based costing is a technique that uses a number of allocation bases to assign overhead costs more accurately to products than would be achieved by using a plantwide or departmental approach.

Activity-Based Costing (ABC) Cost Objects (e.g., products and customers) A number of allocation bases are used for assigning costs to products. Activities Consumption of Resources Cost objects, such as products, generate activities. For example, a customer order generates the need to complete the activity of preparing a production order. Performing activities consumes resources. For example, preparing a production order uses a sheet of paper and it takes time to fill out. The consumption of resources causes costs. For example, the greater the number of sheets of paper used to prepare a production order and the greater the amount of time devoted to preparing the production order, the greater the cost. Cost

Activity-Based Costing (ABC) An event that causes the consumption of overhead resources Examples of Activities Part I. An activity in activity-based costing is an event that causes the consumption of overhead resources. Part II. Examples of activities include: a.     Setting up machines b.     Admitting patients to a hospital c.     Billing customers d.     Opening an account at a bank Setting up machines Admitting hospital patients Billing customers Opening a bank account

Activity-Based Costing (ABC) An event that causes the consumption of overhead resources Activity Cost Pool A “cost bucket” in which costs related to a particular activity measure are accumulated Activity Measure Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs Part I. An activity cost pool can be thought of as a “cost bucket” in which costs related to a particular activity measure are accumulated. Part II. An activity measure expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs to products and services. Activity measures may or may not be related to volume.

Activity-Based Costing (ABC) An event that causes the consumption of overhead resources Activity Cost Pool A “cost bucket” in which costs related to a particular activity measure are accumulated Activity Measure Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs An activity rate is a predetermined overhead rate in an activity-based costing system. Each activity cost pool has its own activity rate that is used to apply overhead costs to cost objects. Activity Rate A predetermined overhead rate for each activity cost pool.

Activity-Based Costing (ABC) For each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2. A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product. Part I. Taking each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2. Part II. A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product.

Designing an Activity-Based Costing System In most companies, hundreds or even thousands of different activities cause overhead costs. The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources. Part I. In most companies, hundreds or even thousands of different activities cause overhead costs. The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Part II. Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources.

Designing an Activity-Based Costing System Related activities are frequently combined to reduce the amount of detail and record-keeping costs. For example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling. Part I. Related activities are frequently combined to reduce the amount of detail and record-keeping costs. For example:   Part II. Several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling. Part III. An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured. An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured.

Hierarchy of Activities A common framework for combining activities in manufacturing companies is as follows: Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment is a unit-level activity.  Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities. Product-level activities relate to specific products and must be carried out, regardless of how many batches are run or units produced and sold. For example, designing or advertising a product are product- level activities. Facility-level activities are carried out regardless of which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are facility level activities.

Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment Using activity based costing, the manufacturing overhead costs are allocated to products with a two-stage process. In the first stage, overhead costs are assigned to the six activity cost pools shown on the slide. For example, the production order cost pool may include the salaries of engineers who modify products for individual orders and the costs of scheduling and monitoring orders. In the examples and assignments in this book, the first-stage cost assignments have already been completed.

Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment Unit-Level Activity Batch-Level Activity Facility-Level Activity Product-Level Activity Products $/DLH $/MH $/Setup $/Order $/Part Type Second-Stage Allocations In the second stage, the costs in the activity cost pools are allocated to products, using activity rates and activity measures. For example, if the total cost in the production order cost pool was $450,000 and the company expected to process 1,200 orders, the activity rate would be $375 per order. Each order would be charged $375 for production order costs. Notice, the example shown on the slide includes two unit-level activities, two batch-level activities, one product-level activity, and one facility-level activity.

Using Activity-Based Costing Comtek Sound, Inc.  Comtek Sound, Inc. makes two products that are sold to automobile manufacturers, a radio with a built-in CD player and a radio with a built-in DVD player.  The company has been losing bids to supply CD players, its main product, to lower price competitors.  The company has been winning all bids to supply DVD players, its secondary product. Comtek Sound, Inc. makes two products that are sold to automobile manufacturers, a radio with a built-in CD player and a radio with a built-in DVD player. The company has been losing bids to supply CD players, its main product, to lower price competitors. The company has been winning all bids to supply DVD players, its secondary product.

Using Activity-Based Costing Comtek Sound, Inc.  For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units.  Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor hours.  Both products require two direct labor-hours to complete, for a total of 500,000 direct labor hours. For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units. Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor hours. Both products require two direct labor-hours to complete. The DVD players and CD players consume 100,000 and 400,000 direct labor hours, respectively, for a total of 500,000 direct labor hours.

Using Activity-Based Costing Comtek Sound, Inc.  Unit costs for materials and labor are: Material costs $90 per unit for the DVD player and $50 per unit for the CD player. Labor costs $20 per unit for both the DVD player and the CD player. First, let’s look at how Comtek currently applies overhead using its existing costing system based on direct labor hours.

Direct Labor-Hours as a Base Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon labor-hours: Predetermined overhead rate = $20 per DLH = $10,000,000 500,000 DLHs Total manufacturing overhead costs for the current year are estimated to be $10,000,000. Using a traditional predetermined overhead rate based on direct labor hours, we divide $10,000,000 of estimated overhead by 500,000 direct labor hours to get an overhead rate of $20 per direct labor hour.

Direct Labor-Hours as a Base Since each product requires two hours of direct labor, $40 of overhead is assigned to each product.   Since each product requires two hours of direct labor, $40 of overhead is assigned to each product.     Using the information provided thus far, the unit product cost of each product ($150 for DVD players and $110 for CD players) would be computed as shown. Now let’s see how we assign overhead with an ABC system.

To compute activity rates for an activity-based costing system. Learning Objective LO2 To compute activity rates for an activity-based costing system. Learning objective number 2 is to compute activity rates for an activity-based costing system.

Computing Activity Rates The ABC project team at Comtek has developed the following basic information. The ABC project team at Comtek has identified six activity cost pools and activity measures: A labor related cost pool based on the activity measure of direct labor hours. A machine related cost pool based on the activity measure of machine hours. A machine setups cost pool based on the activity measure of number of setups. A production orders cost pool based on the activity measure of number of orders. A parts administration cost pool based on the activity measure of part types. And, a general factory cost pool based on the activity measure of machine hours The ABC team has also estimated the amount of overhead for each activity cost pool, the total number activities for each cost pool, and number of activities for each product as shown. Notice that the total overhead is still $10,000,000.

Computing Activity Rates We can calculate the following activity rates: We calculate an activity rate for each of the six activities by dividing the estimated overhead for an activity by the total expected activity. For example, the activity rate for production orders is $3,150,000 of overhead divided by 1,200 orders, resulting in an activity rate of $2,625 per order. Using the new activity rates, let’s assign overhead to the two products based upon expected activity.

To compute product costs using activity-based costing. Learning Objective LO3 To compute product costs using activity-based costing. Learning objective number 3 is to compute product costs using activity based costing.

Computing Overhead Cost per Unit DVD Units We assign overhead to each product by multiplying individual activity rates times the expected activities. For example, we multiply the activity rate of $400 per machine setup times 3,000 machine setups, resulting in $1,200,000 of overhead assigned to DVD units based on the machine setup activity. We complete the same overhead assignment for the other five activities. We then add the overhead for the six activities to determine the total overhead of $4,890,000, which will be assigned to DVD units. Next, we calculate the overhead cost per DVD unit by dividing $4,890,000 of overhead by 50,000 DVD units. The result is $97.80 of overhead cost per DVD unit.

Computing Overhead Cost per Unit CD Units We follow the same procedure for CD units. For example, we multiply the activity rate of $400 per machine setup times 1,000 machine setups, resulting in $400,000 of overhead assigned to CD units based on the machine setup activity. We do the same overhead assignment for the other five activities and then add the amounts to find that we have assigned a total of $5,110,000 of overhead to CD units. Next, we calculate the overhead cost per CD unit by dividing $5,110,000 of overhead by 200,000 CD units. The result is $25.55 of overhead cost per CD unit.

Comparing the Two Approaches Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . . . Note that assigning overhead using activity-based costing results in a decrease in the unit product cost of a CD unit from $110.00 to $95.55 and an increase in the unit cost of a DVD unit from $150.00 to $207.80. Note that direct material and direct labor costs under the two approaches are the same. The differences in the total unit product cost are a result of the two different approaches to assigning overhead costs. . . . . . while the unit cost of a DVD unit increased from $150 to $207.80.

Learning Objective LO4 To contrast the product costs computed under activity-based costing and conventional costing methods. Learning objective number 4 is to contrast the product costs computed under activity-based costing and conventional costing methods.

Comparing the Two Approaches The ABC system assigns $14.45 less overhead than the traditional system to each CD player ($40.00 - $25.55 = $14.45). The ABC system assigns $14.45 less overhead than the traditional system to each CD player.

Comparing the Two Approaches The ABC system assigns $57.80 more overhead than the traditional system to each DVD player ($97.80 - $40.00 = $57.80). The ABC system assigns $57.80 more overhead than the traditional system to each DVD player.

Shifting of Overhead Cost Low-volume product Activity-based costing shifts costs from high-volume products produced in large batches to low-volume products produced in small batches. This results from the existence of batch-level and product-level costs. When a company implements activity-based costing, overhead cost often shifts from high-volume to low-volume products with a higher unit product cost resulting for the low-volume products.

Shifting of Overhead Cost The traditional system assigns the same amount of all overhead costs (including the costs related to Production Orders) to each CD or DVD player ($40 per unit). High-volume product The traditional system assigns the same amount of all overhead costs to each CD or DVD player ($40 per unit).

Shifting of Overhead Cost Consider the Production Orders activity cost pool (a batch-level cost pool): The ABC system assigns different amounts of Production Order-related overhead costs to each product. This fact can be illustrated in a two-step process. 1. Compute the number of units processed per production order for each product Consider the Production Orders activity cost pool (a batch-level cost pool): The ABC system assigns different amounts of Production Order-related overhead costs to each product. This fact can be illustrated in a two-step process. First, compute the number of units processed per production order for each product (62.5 units for DVDs and 500 units for CDs)

Shifting of Overhead Cost 2. Compute production order cost per unit for each product. Second, compute the production order cost per unit for each product ($42 for DVDs and $5.25 for CDs) Notice, the costs are being shifted from the high volume product (CD players) to the low volume product (DVD players). Notice, the costs are being shifted from the high volume CD players to the low volume DVD players.

Targeting Process Improvements One of the great benefits derived from using an ABC system is that it can help identify areas where the company can benefit from improving its current processes. One of the great benefits derived from an ABC system is that it can help identify areas where the company can benefit from improving its current processes. Activity-based management focuses on managing activities to eliminate waste, decrease processing time, and reduce defects. Activity-based management is used in organizations as diverse as manufacturing companies, hospitals, and the U.S. Marine Corps. Activity-Based Management involves focusing on activities to eliminate waste, decrease processing time, and reduce defects.

Targeting Process Improvements The first step in any improvement program is deciding what to improve. The Theory of Constraints approach targets the highest impact improvement opportunities. Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations. Activity rates can be used to target areas where costs seem excessively high. The first step in any improvement program is to decide what to improve. The Theory of Constraints approach discussed in the Prologue is one tool for targeting the highest impact improvement opportunities. Activity-based management provides another approach. Activity-rates can be used to target areas where costs seem excessively high. Benchmarking can also be used to compare activity cost information with world-class standards of performance achieved by other organizations.

Benefits of Activity-Based Costing ABC Improves the accuracy of product costing by: Increasing the number of cost pools used to accumulate overhead costs. Using activity cost pools that are more homogeneous than departmental cost pools. Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. Activity-based costing improves the accuracy of product costs in three ways:  1.    It increases the number of cost pools used to accumulate overhead costs. 2.    It uses activity cost pools that are more homogeneous than departmental cost pools. 3.    It assigns overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. Some activity measures may be unit-level in nature, while others may be batch-level, product-level or facility-level in nature. In addition, activity-based costing highlights the activities that could benefit most from process improvement efforts, such as Six Sigma. Activity-based costing also highlights activities that could benefit most from process improvement efforts, such as Six Sigma.

Limitations Activity-Based Costing Costs of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when: Products differ substantially in volume, batch size, and in activities required. Conditions have changed substantially since the existing cost system was established. Overhead costs are high and increasing and no one seems to understand why. Management does not trust the existing cost system and it ignores data from it when making decisions. The cost of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when:   1.   Products differ substantially in volume, batch size, and in the activities they require. 2.   Conditions have changed substantially since the existing cost system was established. 3.   Overhead costs are high and increasing and no one seems to understand why. 4.   Management does not trust the existing cost system and it ignores data from it when making decisions.

Activity-Based Costing Critical Assumption The cost in each activity pool is strictly proportional to its activity measure. When this assumption is violated, the accuracy of ABC data can be called into question. Part I. The cost in each activity pool is strictly proportional to its activity measure. When this assumption is violated, the accuracy of ABC data can be called into question. Part II. For example, managers should be particularly alert to product costs that contain allocated facility-level costs. For example, managers should be particularly alert to product costs that contain allocated facility-level costs.

Modifying the ABC Model The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: 1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs. The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: 1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs.

To record the flow of costs in an activity-based costing system. Learning Objective LO5 To record the flow of costs in an activity-based costing system. Learning objective number 5 is to record the flow of costs in an activity-based costing system.

Cost Flows in an ABC System Sarvik Company uses activity-based costing. The company has five cost pools shown below. The ABC project team at Sarvik Company has identified five activity cost pools and activity measures: A machine related cost pool based on the activity measure of machine hours; A purchase orders cost pool based on the activity measure of number of orders; A machine setups cost pool based on the activity measure of number of setups; A product testing cost pool based on the activity measure of number of tests; and A general factory cost pool based on the activity measure of direct labor hours The ABC team has also estimated the amount of overhead for each activity cost pool, the total number activities for each cost pool, and the number of activities for each product.

Cost Flows in an ABC System Activity rates are determined as follows: We calculate an activity rate for each of the five activities by dividing the estimated overhead for an activity by the total expected activity. For example, the activity rate for purchase orders is $63,000 of overhead divided by 700 orders, resulting in an activity rate of $90 per order.

Cost Flows in an ABC System Overhead is applied on the basis of actual activities during the year. Assume the company incurred actual activity levels for the year as shown. We assign overhead by multiplying individual activity rates times the actual activities. For example, we multiply the activity rate of $90 per purchase order times 800 actual purchase orders, resulting in $72,000 of applied overhead due to the production order activity. We do the same overhead assignment for the other four activities and then add the amounts to find that we have assigned a total of $761,000 of overhead. Now that we have assigned the overhead, let’s look at the entries necessary to record all of the cost flows in an ABC system.

Cost Flows in an ABC System Selected transactions recorded by the company: Raw materials purchased on account, $915,000. Raw materials used in production, $900,000 ($810,000 direct and $90,000 indirect). Factory labor costs, $370,000 ($95,000 direct and $275,000 indirect). Depreciation of factory assets, $180,000. Miscellaneous manufacturing overhead costs incurred on account, $230,000. Manufacturing overhead applied, $761,000. Goods costing $1,650,000 were manufactured. We will record the transactions that you see on your screen. Why don’t you jot down the entries, and then check your work, as we examine each transaction on the following screens. Remember, on the previous slide, we determined the amount of manufacturing overhead to apply using activity-based costing.

Cost Flows in an ABC System The following journal entries would be used to record transactions (a) and (b). The following journal entries would be used to record transactions (a) and (b): (a) Raw material purchases of $915,000      Debit Raw Materials for $915,000      Credit Accounts Payable for $915,000 (b) Raw material requisitions of $900,000      Debit Work in Process for $810,000      Debit Manufacturing Overhead for $90,000      Credit Raw Materials for $900,000

Cost Flows in an ABC System The following journal entries would be used to record transactions (c) and (d). The following journal entries would be used to record transactions (c) and (d): (c) Labor costs of $370,000 incurred      Debit Work in Process for $95,000      Debit Manufacturing Overhead for $275,000 Credit Salaries and Wages Payable for $370,000 (d)  Depreciation of $180,000 recorded Debit Manufacturing Overhead for $180,000 Credit Accumulated Depreciation for $180,000     

Cost Flows in an ABC System The following journal entry would be used to record transaction (e). The following journal entry would be used to record transaction (e). (e) Miscellaneous manufacturing overhead costs of $230,000 incurred Debit Manufacturing Overhead for $230,000 Credit Accounts Payable for $230,000

Cost Flows in an ABC System The following journal entry would be used to record transaction (f). The following journal entry would be used to record transaction (f). (f) Manufacturing overhead costs of $761,000 applied to production. First, compute $761,000 using ABC data as shown. Then: Debit Work in Process for $761,000 Credit Manufacturing Overhead for $761,000

Cost Flows in an ABC System The following journal entry would be used to record transaction (g). The following journal entry would be used to record transaction (g). (g) Goods costing $1,650,000 completed during the year Debit Finished Goods for $1,650,000 Credit Work in Process for $1,650,000

Cost Flows in an ABC System Bal. 14,000 Manufacturing Overhead (b) 90,000 (c) 275,000 (d) 180,000 (e) 230,000 (g) 761,000 Notice that overhead is underapplied by $14,000. This amount is calculated by computing the total actual manufacturing overhead incurred of $775,000 ($90,000 + $275,000 + $180,000 + $230,000) and deducting the manufacturing overhead applied of $761,000. Underapplied Overhead Costs

Cost Flows in an ABC System The flow of costs through Raw Materials, Work in Process, and other accounts is the same under activity based costing. The only difference in activity based costing is that more than one predetermined overhead rate is used to apply costs to products. Note that the flow of costs through Raw Materials, Work in Process, and other accounts is the same under activity-based costing as it was in Chapter 2 when using a job-order costing. The only difference is that ABC uses more than one predetermined overhead rate to apply costs to products.

End of Chapter 3 End of chapter 3.