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1 PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2005 South-Western, a division of Thomson.

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Presentation on theme: "1 PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2005 South-Western, a division of Thomson."— Presentation transcript:

1 1 PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2005 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. Cost Allocation & Activity- Based Management Chapter M5

2 2 Objective 1 Explain the importance of overhead and how overhead traditionally has been applied to products and services. Once you have completed this chapter, you should be able to:

3 3 Cost allocation is the process of assigning indirect costs to a product or service.

4 4 The costs of materials handling, supervisors’ salaries, and depreciation of factory equipment usually cannot be traced to a particular product or product line.

5 5 Unlike direct costs, indirect cost are allocated to products.

6 6 Adventure Trails

7 7 Annual Sleeping Bag Production Volume High-volume consumer bag ($70)12,000 Medium-volume bag ($100)6,000 Low-volume specialty bag ($200) 500 Total18,500 Adventure Trails Exhibit 1

8 8 Adventure Trails Volume-Based Allocation Based on management’s estimates, the company’s accountants have budgeted total manufacturing overhead costs of $231,250 for the coming year. The estimated machine hours for the year is 9,250.

9 9 Predetermined overhead rate Estimated overhead costs Estimated machine hours = Predetermined overhead rate $231,250 9,250 machine hours = Predetermined overhead rate = $25 per machine hour Adventure Trails

10 10 Adventure Trails The machine time required to cut and sew the materials for a sleeping bag is equal across the company’s three products. Each sleeping bag requires 0.50 hours of machine time.

11 11 Adventure Trails Machine Overhead Unit Product Hours Rate Overhead Cost High-volume0.50$25.00$12.50 Medium-volume0.5025.0012.50 Low-volume0.5025.0012.50 x = Exhibit 3 Overhead Cost per Unit

12 12 Adventure Trails Unit Manufacturing Costs UnitUnitUnitTotal MaterialsLaborOverheadUnit ProductCostCostCostCost + + = High-volume$ 30.00$20.00$12.50$ 62.50 Medium- volume55.0020.0012.5087.50 Low-volume130.0030.0012.50172.50 Exhibit 4

13 13 Adventure Trails Profitability by Product Line Using Volume-based Costing = High-volume$ 70.00 $ 62.50$ 7.50 Medium-volume100.0087.5012.50 Low-volume200.00172.5027.50 Exhibit 5 SellingManufacturingProfit ProductPriceCostMargin –

14 14 Adventure Trails Based on profit margins, managers may plan to add more low-volume, specialty products to the product line.

15 15 Objective 2 Identify problems with traditional methods of allocating overhead costs. Once you have completed this chapter, you should be able to:

16 16 Critics of the traditional cost- allocation method argue that volume-based cost allocation distorts unit overhead costs.

17 17 11 Adventure Trails Unit Manufacturing Costs Unit Total MaterialsLaborOverheadUnit ProductCost + + = High-volume$ 30.00$20.00$12.50$ 62.50 Medium- volume55.0020.0012.5087.50 Low-volume130.0030.0012.50172.50 Exhibit 4 As shown in Exhibit 4, the volume-based system produces questionable results for the unit overhead cost.

18 18 Economies of scale are the savings a company realizes in unit costs by spreading fixed overhead costs over a larger number of units.

19 19 One of the problems with the traditional method of allocating overhead costs is that it doesn’t take economies of scale into account.

20 20 A second problem with traditional cost allocation is the allocation base.

21 21 Critics of volume-based allocation argue that traditional cost allocation distorts unit overhead costs.

22 22 Objective 3 Describe the activity hierarchy for classifying overhead costs. Once you have completed this chapter, you should be able to:

23 23 The overhead hierarchy is a framework that explains how overhead costs change with various activities.

24 24 Unit-Level Costs Overhead cost per unit -------- | | | | | | | # of units produced Unit- level costs behave like variable costs. Exhibit 6 A Hierarchy of Overhead Activities

25 25 Batch-Level Costs Overhead cost per unit -------- | | | | | | | # of units in a batch Batch- level costs behave like fixed costs. A Hierarchy of Overhead Activities Exhibit 6

26 26 Batch-Level Costs Batch-level cost per unit = total activity cost ÷ units in the batch A machine setup costs $500 and the company produces 10 units in the batch. What is the unit setup cost? Batch-level cost per unit = $500 ÷ 10 units = $50 per setup A Hierarchy of Overhead Activities

27 27 Batch-Level Costs Batch-level cost per unit = total activity cost ÷ units in the batch A machine setup costs $500 and the company produces 1,000 units in the batch. What is the unit setup cost? Batch-level cost per unit = $500 ÷ 1,000 units = $0.50 per setup A Hierarchy of Overhead Activities

28 28 Product-Level Costs Overhead cost per unit -------- A B C D E A Hierarchy of Overhead Activities Product- level costs relate to a specific family of products. Exhibit 6 Product

29 29 Facility-Level Costs Overhead cost per unit -------- Product A B C D E Facility- level costs include all other overhead activities. A Hierarchy of Overhead Activities Exhibit 6

30 30 Objective 4 Explain how activity-based costing works. Once you have completed this chapter, you should be able to:

31 31 Activity-Based Costing Activity-based costing (ABC) allocates overhead costs to a product using activities required to produce the product.

32 32 Activity-Based Costing Costs are allocated to the activity pools according to the type of activity carried out in each pool. First Stage Allocation:

33 33

34 34 First-stage allocation Exhibit 7 Conceptual Design of an ABC System Adventure Trails Overhead Costs Indirect Labor Depreci- ation ElectricitySupplies Employee Benefits Overhead Costs

35 35 Number of Setups Volume- based Pool Setup Pool Handling & Inspection Pool General Overhead Pool Units Produced Percentage of Inspections Percentage of Manufacturing Time Conceptual Design of an ABC System Adventure Trails Overhead Costs Indirect Labor Depreci- ation ElectricitySupplies Employee Benefits Overhead Costs Exhibit 7

36 36 Costs are allocated from activity pools to a cost object, such as goods or services. Activity-Based Costing Second Stage Allocation:

37 37 Conceptual Design of an ABC System Second-stage allocation Total Manufacturing Costs High- volume consumer bag Medium- volume bag Low- volume specialty bag Direct Materials Direct Labor Exhibit 7

38 38 Activity-Based Costing Adventure Trails’ Overhead Classified by Cooper’s Hierarchy OverheadActivity CostsBases Unit level$90,000Units produced Batch-level (setups)8,800Number of setups Product-level (handling60,000Percentage of inspec- and inspection) tions byproduct line Facility-level72,450Percentage of manufacturing time Total overhead costs$231,250 Exhibit 8

39 39 Activity-Based Costing Adventure Trails: Machine Hours, Batches, and Handling and Inspection by Product High4,0003$80060%$36,00050% Medium2,000380025%15,00040% Low100580015%9,00010% NumberCost% ofHandlingPercentage of BatchofperHandling& Insp.Manufacturing ProductSizeSetupsSetup& Insp.CostsTime Exhibit 9

40 40 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Unit Level: $90,000 18,500 From Slide 38 Total units produced = $4.86 per unit High Volume Data for Exhibit 10

41 41 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $8,800 11 From Slide 38 Total setups = $800 per setup High Volume Data for Exhibit 10

42 42 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $800 4,000 Cost per setup Batch size = $0.20 per unit High Volume Data for Exhibit 10

43 43 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Product Level: $36,000 $60,000 x 60% 12,000 units 3 batches of 4,000 = $3.00 per unit High Volume Data for Exhibit 10

44 44 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Facility Level: $72,450 From Slide 38 x 50% Percentage of manufacturing time (from Slide 39) $36,225 High Volume Data for Exhibit 10

45 45 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product High Volume Facility Level: $36,225 $72,450 x 0.50 12,000 units 3 batches of 4,000 = $3.02 per unit Data for Exhibit 10

46 46 Activity-Based Costing UnitBatchProductFacilityTotal Overhead Cost Assigned Adding the unit material cost of $35 and the unit labor cost of $20 provides for a total cost of $61.08 to make a high-volume sleeping bag. Volume-based costing provided a total cost of $62.50 per bag. High-volume$4.86$0.20$3.00$3.02$11.08 Medium-volume4.860.402.504.8312.59 Low-volume4.868.0018.0014.4945.35

47 47 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Unit Level: $90,000 18,500 From Slide 38 Total units produced = $4.86 per unit Medium Volume Data for Exhibit 10

48 48 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $8,800 11 From Slide 38 Total setups = $800 per setup Medium Volume Data for Exhibit 10

49 49 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $800 2,000 From Slide 39 Batch size = $0.40 per unit Medium Volume Data for Exhibit 10

50 50 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Product Level: $15,000 $60,000 x 25% 6,000 units 3 batches of 2,000 = $2.50 per unit Medium Volume Data for Exhibit 10

51 51 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Facility Level: $72,450 From Slide 38 x 40% $28,980 Medium Volume Percentage of manufacturing time (from Slide 39) Data for Exhibit 10

52 52 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Medium Volume Facility Level: $28,980 $72,450 x.40 6,000 units 3 batches of 2,000 = $4.83 per unit Data for Exhibit 10

53 53 Activity-Based Costing UnitBatchProductFacilityTotal Overhead Cost Assigned Adding the unit material cost of $55 and the unit labor cost of $20 provides for a total cost of $87.59 to make a high-volume sleeping bag. Volume-based costing provided a total cost of $87.50 per bag. High-volume$4.86$0.20$3.00$3.02$11.08 Medium-volume4.860.402.504.8312.59 Low-volume4.868.0018.0014.4945.35

54 54 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Unit Level: $90,000 18,500 From Slide 38 Total units produced = $4.86 per unit Low Volume Data for Exhibit 10

55 55 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $8,800 11 From Slide 38 Total setups = $800 per setup Low Volume Data for Exhibit 10

56 56 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Batch Level: $800 100 From Slide 39 Batch size = $8.00 per unit Low Volume Data for Exhibit 10

57 57 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Product Level: $9,000 $60,000 x 15% 500 units 5 batches of 100 = $18.00 per unit Low Volume Data for Exhibit 10

58 58 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Facility Level: $72,450 From Slide 38 x 10% $7,245 Low Volume Percentage of manufacturing time (from Slide 39) Data for Exhibit 10

59 59 Activity-Based Costing Adventure Trails: Activity-Based Cost by Product Low Volume Facility Level: $7,245 $72,450 x.10 500 units 5 batches of 100 = $14.49 per unit Data for Exhibit 10

60 60 Activity-Based Costing UnitBatchProductFacilityTotal Overhead Cost Assigned High-volume$4.86$0.20$3.00$3.02$11.08 Medium-volume4.860.402.504.8312.59 Low-volume4.868.0018.0014.4945.35 Adding the unit material cost of $130 and the unit labor cost of $30 provides for a total cost of $205.35 to make a high-volume sleeping bag. Volume-based costing provided a total cost of $172.50 per bag.

61 61 Activity-Based Costing High$ 30.00$20.00$4.86$0.20$ 3.00$ 3.02$ 61.08 Medium55.0020.004.860.402.504.8387.59 Low130.0030.004.868.0018.0014.49205.35 UnitUnitOverhead MaterialsLaborUnitBatchProductFacility ProductCostCostLevelLevelLevelLevel Total Adventure Trails: Activity-Based Cost by Product Exhibit 10

62 62 Volume-Based Costs per Unit versus Activity-Based Costs per Unit Allocation High Medium Low Method Volume Volume Volume Volume-based (Exhibit 5)$62.50$87.50$172.50 ABC (Exhibit 10)61.0887.59205.35 Percentage change– 2.3%0%+ 19% Exhibit 11

63 63 Accountants use the term product cross-subsidy to describe a situation in which one product subsidizes the reported costs of another

64 64 Comparison of Per-Unit Profitability Using Two Approaches ABCABCTraditional SellingManufacturingProfitProfit PriceCostMarginMargin = High-volume$ 70.00$ 61.08$ 8.92$ 7.50 Medium-volume100.0087.5912.4112.50 Low-volume200.00205.35(5.35)27.50 Exhibit 12 Product –

65 65 Comparison of Per-Unit Profitability Using Two Approaches What are the implications for Adventure Trails?

66 66 Comparison of Per-Unit Profitability Using Two Approaches The high-volume consumer bags are subsidizing low- volume specialty bags. A long-run strategy of adding other specialty bags to the company’s product line could be disastrous.

67 67 Objective 5 Explain how service organizations use cost information for decision making. Once you have completed this chapter, you should be able to:

68 68 The primary activities a service organization carries out are its core activities; its supporting activities are called noncore activities. The core activity in a public school is education. A noncore activity is providing bus transportation.

69 69 THE END Chapter M5

70 70


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