1. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Supplementary Slides - Activity Based Costing Systems Design: Activity Based Costing

2. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objective 1 Understand the basic approach in activity-based costing and how it differs from conventional costing.

3. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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

4. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Plantwide Overhead Rate 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. 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.

5. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Today, direct labor may no longer be a satisfactory base for allocation of overhead. 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 the new overhead costs may not be correlated with direct labor. 3.Technology advancements have reduced the cost and complexity of gathering diverse sources of data. Today, direct labor may no longer be a satisfactory base for allocation of overhead. 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 the new overhead costs may not be correlated with direct labor. 3.Technology advancements have reduced the cost and complexity of gathering diverse sources of data. Plantwide Overhead Rate A plantwide overhead allocation system may not be optimal for many companies in today’s business environment.

6. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. A number of allocation bases are used for assigning costs to products. Activity-Based Costing (ABC)

7. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CostCost Activity-Based Costing (ABC) Consumption of Resources ActivitiesActivities Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers)

8. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity An event that causes the consumption of overhead resources Setting up machines Examples of Activities Admitting hospital patients Opening a bank account Billing customers Activity-Based Costing (ABC)

9. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity Cost Pool A “cost bucket” in which costs related to a particular activity are accumulated Activity Measure Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs Activity-Based Costing (ABC) Activity Rate A predetermined overhead rate for each activity cost pool.

10. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity-Based Costing (ABC) For each activity in isolation, this system works exactly like the job-order costing system. 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.

11. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Designing an Activity-Based Costing System 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.

12. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Related activities are frequently combined to reduce the amount of detail and record-keeping costs. 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. 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. Designing an Activity-Based Costing System

13. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Graphic Example of Activity-Based Costing Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment Various Manufacturing Overhead Costs

14. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Unit-Level Activity Batch-Level Activity Facility-Level Activity Product-Level Activity Graphic Example of Activity-Based Costing Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment Various Manufacturing Overhead Costs Products $/DLH$/MH$/Setup$/Order$/MH $/Part Type Second-Stage Allocations

15. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Using Activity-Based Costing Comtek Sound, Inc.  Comtek Sound, Inc. makes two products: CD players and DVD players.  The company has been losing bids to supply CD players, its main product, to lower priced competitors.  The company has been winning all bids to supply DVD players, its secondary product.  Comtek Sound, Inc. makes two products: CD players and DVD players.  The company has been losing bids to supply CD players, its main product, to lower priced competitors.  The company has been winning all bids to supply DVD players, its secondary product.

16. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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, for a total of 500,000 direct labor hours.

17. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Using Activity-Based Costing Comtek Sound, Inc.  Unit costs for materials and labor are:

18. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Direct Labor-Hours as a Base

19. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Direct Labor-Hours as a Base Since each product requires two hours of direct labor, $40 of overhead is assigned to each product.

20. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objective 2 Compute activity rates for an activity-based costing system.

21. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. The ABC project team at Comtek has developed the following basic information. Computing Activity Rates

22. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. We can calculate the following activity rates: Using the new activity rates, let’s assign overhead to the two products based upon expected activity. Computing Activity Rates

23. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objective 3 Compute product costs using activity-based costing.

24. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Computing Overhead Cost per Unit DVD Units

25. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Computing Overhead Cost per Unit CD Units

26. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Note that the unit product cost of a CD unit decreased from $110 to $95.55........ while the unit cost of a DVD unit increased from $150 to $207.80. Comparing the Two Approaches

27. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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. Low-volume product Shifting of Overhead Cost

28. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. High-volume product Shifting of Overhead Cost The traditional system assigns the same amount of all overhead costs to each CD or DVD player ($40 per unit).

29. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity-Based Management Focuses on managing activities to eliminate waste and reduce delays and defects. Targeting Process Improvements An ABC system can help identify areas where the company can benefit from improving its current processes.

30. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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. 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 also highlights activities that could benefit most from process improvement efforts, such as Six Sigma.

31. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Costs 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 activities required. 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. Costs 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 activities required. 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. Limitations Activity-Based Costing