2. 5 - 1 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Activity-Based Costing and Activity-Based Management Chapter 5

3. 5 - 2 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 1 Explain undercosting and overcosting of products and services.

4. 5 - 3 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Undercosting and Overcosting Example Jose, Roberta, and Nancy order separate items for lunch. Jose’s order amounts to$14 Roberta consumed 30 Nancy’s order is 16 Total$60 What is the average cost per lunch?

5. 5 - 4 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Undercosting and Overcosting Example $60 ÷ 3 = $20 Jose and Nancy are overcosted. Roberta is undercosted.

6. 5 - 5 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 2 Present three guidelines for refining a costing system.

7. 5 - 6 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Existing Single Indirect- Cost Pool System Example Kole Corporation manufactures a normal lens (NL) and a complex lens (CL). Kole currently uses a single indirect-cost rate job costing system. Cost objects: 80,000 (NL) and 20,000 (CL).

8. 5 - 7 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Existing Single Indirect- Cost Pool System Example Normal Lenses (NL) Direct materials$1,520,000 Direct mfg. labor 800,000 Total direct costs$2,320,000 Direct cost per unit: $2,320,000 ÷ 80,000 = $29

9. 5 - 8 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Existing Single Indirect- Cost Pool System Example Complex Lenses (CL) Direct materials$ 920,000 Direct mfg. labor 260,000 Total direct costs$1,180,000 Direct cost per unit: $1,180,000 ÷ 20,000 = $59

10. 5 - 9 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Existing Single Indirect- Cost Pool System Example All Indirect Costs $2,900,000 All Indirect Costs $2,900,000 50,000 Direct Manufacturing Labor-Hours 50,000 Direct Manufacturing Labor-Hours INDIRECT-COST POLL INDIRECT COST-ALLOCATION BASE $58 per Direct Manufacturing Labor-Hour

11. 5 - 10 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Existing Single Indirect- Cost Pool System Example Indirect Costs Direct Costs Indirect Costs Direct Costs COST OBJECT: NL AND CL LENSES DIRECT COSTS Direct Materials Direct Materials Direct Manufacturing Labor Direct Manufacturing Labor

12. 5 - 11 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Existing Single Indirect- Cost Pool System Example Kole uses 36,000 direct manufacturing labor-hours to make NL and 14,000 direct manufacturing labor-hours to make CL. How much indirect costs are allocated to each product?

13. 5 - 12 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Existing Single Indirect- Cost Pool System Example NL: 36,000 × $58 = $2,088,000 CL: 14,000 × $58 = $812,000 What is the total cost of normal lenses? Direct costs $2,320,000 + Allocated costs $2,088,000 = $4,408,000 What is the cost per unit? $4,408,000 ÷ 80,000 = $55.10

14. 5 - 13 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Existing Single Indirect- Cost Pool System Example What is the total cost of complex lenses? Direct costs $1,180,000 + Allocated costs $812,000 = $1,992,000 What is the cost per unit? $1,992,000 ÷ 20,000 = $99.60

15. 5 - 14 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Existing Single Indirect- Cost Pool System Example Normal lenses sell for $60 each and complex lenses for $142 each. Normal Complex Revenue$60.00$142.00 Cost 55.10 99.60 Income$ 4.90$ 42.40 Margin 8.2% 29.9%

16. 5 - 15 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Refining a Costing System Direct-cost tracing Indirect-cost pools Cost-allocation basis

17. 5 - 16 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Refining a Costing System 1. Design of Products and Process The Design Department designs the molds and defines processes needed (details of the manufacturing operations).

18. 5 - 17 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Refining a Costing System 2. Manufacturing Operations Lenses are molded, finished, cleaned, and inspected. 3. Shipping and Distribution Finished lenses are packed and sent to the various customers.

19. 5 - 18 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 3 Distinguish between the traditional and the activity-based costing approaches to designing a costing system.

20. 5 - 19 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Activity-Based Costing System Fundamental Cost Objects Activities Costs of Activities Assignment to Other Cost Objects Cost of: Product Service Customer

21. 5 - 20 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Activity-Based Costing System A cross-functional team at Kole Corporation identified key activities: Design products and processes. Set up molding machine. Operate machines to manufacture lenses. Maintain and clean the molds.

22. 5 - 21 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Activity-Based Costing System Set up batches of finished lenses for shipment. Distribute lenses to customers. Administer and manage all processes.

23. 5 - 22 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Activity-Based Costing System No. of Setup Hours Lenses NL Lenses CL Lenses Other Cost Allocation Base Product Cost Objects No. of Shipments Parts- Square feet SetupDesignShipping Activity Indirect Cost Pool

24. 5 - 23 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Activity-Based Costing System NL CL Quantity produced80,00020,000 No. produced/batch 250 50 Number of batches 320 400 Setup time per batch2 hours5 hours Total setup-hours 640 2,000 Total setup costs are $409,200.

25. 5 - 24 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Activity-Based Costing System What is the setup cost per setup-hour? $409,200 ÷ 2,640 hours = $155 What is the setup cost per direct manufacturing labor-hour? $409,200 ÷ 50,000 = $8.184

26. 5 - 25 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Activity-Based Costing System Allocation using direct labor-hours: NL: $8.184 × 36,000=$294,624 CL: $8.184 × 14,000=$114,576 Total$409,200 Allocation using setup-hours: NL: $155 × 640=$ 99,200 CL: $155 × 2,000=$310,000 Total$409,200

27. 5 - 26 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 4 Describe a four-part cost hierarchy.

28. 5 - 27 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Cost Hierarchies A cost hierarchy is a categorization of costs into different cost pools. Cost drivers bases (cost-allocation bases) Degrees of difficulty in determining cause-and-effect relationships

29. 5 - 28 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Cost Hierarchies ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: 1.Output unit-level costs 2.Batch-level costs 3.Product-sustaining costs 4.Facility-sustaining costs

30. 5 - 29 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Output Unit-Level Costs These are resources sacrificed on activities performed on each individual unit of product or service. Energy Machine depreciation Repairs

31. 5 - 30 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Batch-Level Costs These are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. Setup-hours Procurement costs

32. 5 - 31 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Product-Sustaining Costs These are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services. Design costs Engineering costs

33. 5 - 32 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Facility-Sustaining Costs These are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. General administration – rent– building security

34. 5 - 33 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 5 Cost products or services using activity-based costing.

35. 5 - 34 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Implementing Activity-Based Costing Identify cost objects. NL CL Identify the direct costs of the products. Direct material Direct labor Mold cleaning and maintenance Step 1Step 2

36. 5 - 35 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Implementing Activity-Based Costing Cleaning and maintenance costs of $360,000 are direct batch-level costs. Why? Because these costs consist of workers’ wages for cleaning molds after each batch of lenses is run.

37. 5 - 36 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Implementing Activity-Based Costing Normal Lenses (NL) Cost Hierarchy DescriptionCategory Direct materialsUnit-level$1,520,000 Direct mfg. laborUnit-level 800,000 Cleaning and maint.Batch-level 160,000 Total direct costs$2,480,000

38. 5 - 37 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Implementing Activity-Based Costing Complex Lenses (CL) Cost Hierarchy DescriptionCategory Direct materialsUnit-level$ 920,000 Direct mfg. laborUnit-level 260,000 Cleaning and maint.Batch-level 200,000 Total direct costs$1,380,000

39. 5 - 38 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Implementing Activity-Based Costing Select the cost-allocation bases to use for allocating indirect costs to the products. (1) (2) (3) Activity Cost Hierarchy Total Costs DesignProduct-sustaining$450,000 Setups Batch-level$409,200 OperationsUnit-level$637,500 Step 3

40. 5 - 39 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Implementing Activity-Based Costing Identify the indirect costs associated with each cost-allocation base. Overhead costs incurred are assigned to activities, to the extent possible, on the basis of a cause-and-effect relationship. Step 4

41. 5 - 40 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Implementing Activity-Based Costing Compute the rate per unit. (1) (5) NL CLTotal Setup-hours:6402,0002,640 Step 5 $409,200 ÷ 2,640 = $155

42. 5 - 41 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Implementing Activity-Based Costing Compute the indirect costs allocated to the products. NL:$155 × 640 =$ 99,200 CL:$155 × 2,000 = 310,000 Total$409,200 Step 6

43. 5 - 42 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Implementing Activity-Based Costing Compute the costs of the products. NL and CL would show three direct cost categories. Step 7 1.Direct materials 2.Direct manufacturing labor 3.Cleaning and maintenance

44. 5 - 43 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Implementing Activity-Based Costing NL and CL would show six indirect cost pools. 1.Design 2.Molding machine setups 3.Manufacturing operations 4.Shipment setup 5.Distribution 6.Administration

45. 5 - 44 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 6 Use activity-based costing systems for activity-based management.

46. 5 - 45 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Activity-Based Management ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits. Product pricing and mix decisions Cost reduction and process improvement decisions Design decisions

47. 5 - 46 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Product Pricing and Mix Decisions ABC gives management insight into the cost structures for making and selling diverse products. It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs.

48. 5 - 47 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Cost Reduction and Process Improvement Decisions Manufacturing and distribution personnel use ABC systems to focus on cost-reduction efforts. Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base.

49. 5 - 48 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Design Decisions Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can work with their customers to evaluate the costs and prices of alternative designs.

50. 5 - 49 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 7 Compare activity-based costing systems and department- costing systems.

51. 5 - 50 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 8 Evaluate the costs and benefits of implementing activity-based costing systems.

52. 5 - 51 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster ABC In Service and Merchandising Companies The general approach to ABC in the service and merchandising areas is very similar to the approach in manufacturing. Costs are divided into homogeneous cost pools and classified as output unit-level, batch-level, product- or service-sustaining, and facility-sustaining costs.

53. 5 - 52 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster ABC In Service and Merchandising Companies The cost pools correspond to key activities. Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool.

54. 5 - 53 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster End of Chapter 5