1. Activity Based Costing: A Tool to Aid Decision Making Chapter 8

2. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Activity Based Costing (ABC) The objective of activity-based costing is to understand overhead and the profitability of products and customers. ABC is a good supplement to our traditional cost system I agree!

3. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Overhead rates may be based on activity at capacity. Overhead rates may be based on activity at capacity. Activity Based Costing (ABC) Activity-Based Costing Both manufacturing and nonmanufacturing costs may be assigned to products. Both manufacturing and nonmanufacturing costs may be assigned to products. Some manufacturing costs may be excluded from product costs. Some manufacturing costs may be excluded from product costs. There are a number of cost pools each of which is allocated using a unique measure of activity. There are a number of cost pools each of which is allocated using a unique measure of activity. Allocation bases often differ from traditional costing systems. Allocation bases often differ from traditional costing systems.

4. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill How Costs are Treated Under Activity-Based Costing Level of Complexity Overhead Allocation Plantwide Overhead Rate Plantwide Overhead Rate Departmental Overhead Rates Departmental Overhead Rates Activity Based Costing Activity Based Costing

5. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Plantwide Overhead Rate direct labor Companies tend to use direct labor as the overhead allocation base.

6. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill A two stage process is necessary because costs are allocated to departments and then to products. A two stage process is necessary because costs are allocated to departments and then to products. Finishing Department Shipping Department Painting Department Departmental Overhead Rates

7. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Department 1 Department 2 Department 3 Cost pools Indirect Labor Indirect Labor Indirect Materials Indirect Materials Other Overhead Other Overhead Stage One: Costs assigned to pools Departmental Overhead Rates

8. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Department 1 Department 2 Department 3 Cost pools Stage One: Costs assigned to pools Products Stage Two: Costs applied to products Departmental Overhead Rates Indirect Labor Indirect Labor Indirect Materials Indirect Materials Other Overhead Other Overhead

9. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Department 1 Department 2 Department 3 Cost pools Stage One: Costs assigned to pools Products Stage Two: Costs applied to products Direct Labor Hours Machine Hours Raw Materials Cost Departmental Allocation Bases Departmental Overhead Rates Indirect Labor Indirect Labor Indirect Materials Indirect Materials Other Overhead Other Overhead

10. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Designing an ABC System Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers) Activities Consumption of Resources Consumption of Resources Cost

11. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Designing an ABC System Steps for Implementing ABC  Identify and define activities and activity pools.  Where possible, trace costs to activities and cost objects.  Assign costs to activity cost pools.  Calculate activity rates.  Assign costs to cost objects.  Prepare management reports.

12. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Identifying Activity to Include A part of the production process for which management wants a separate reporting of the costs of the activity involved. Unit-Level Activity Batch-Level Activity Product-Level Activity Customer-Level Activity Organization- sustaining Activity

13. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Identifying Activity to Include Activity Cost Pool Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity in the ABC system. $ $ $ $ $ $

14. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Mechanics of ABC At Classic Brass, the ultimate cost objects are:  Products,  Customer orders, and  Customers. One overhead cost - shipping - can be traced directly to customer orders. The company’s overhead costs are shown on the next slide.

15. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill

16. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Overhead Costs Traced $/DLH Traced Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers

17. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Order Size Order Size Customer Orders Customer Orders Product Design Product Design Customer Relations Customer Relations Other Overhead Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers First-Stage Allocation

18. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers Order Size Order Size Customer Orders Customer Orders Product Design Product Design Customer Relations Customer Relations Other Overhead Costs First-Stage Allocation Second-Stage Allocations $/MH $/Order $/Design $/Customer Unallocated

19. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Assigning Costs to Activity Cost Pools Management at Classic Brass believes overhead should be distributed as follows:

20. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Assigning Costs to Activity Cost Pools Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

21. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Assigning Costs to Activity Cost Pools Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000 Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

22. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

23. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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.

24. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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: ÷ ÷ ÷÷

25. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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: 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. 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.

26. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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. 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.

27. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Simplified Approach to ABC 2 orders @ $315 per order

28. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Simplified Approach to ABC 1 design @ $1,285 per design

29. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Product Margins

30. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Product Margins

31. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Product Margins Traditional Cost Accounting System Predetermined manufacturing overhead rate $1,000,000 20,000 MH = $50/MH=

32. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Product Margins Traditional Cost Accounting System 400 units x 0.5 MH/unit x $50/MH = $10,000

33. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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.

34. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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.

35. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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.

36. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill

37. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill End of Chapter 8 I call this qualitytime!