Management Accounting

Management Accounting
Masters of Business Administration Accounting for Managers Management Accounting Process Costing and ABC Costing By: Associate Professor Dr. GholamReza Zandi

Similarities Between Job-Order and Process Costing
Both systems assign material, labor and overhead costs to products and they provide a mechanism for computing unit product cost. Both systems use the same manufacturing accounts, including Manufacturing Overhead, Raw Materials, Work in Process, and Finished Goods. The flow of costs through the manufacturing accounts is basically the same in both systems. Both systems assign material, labor and overhead costs to products and they provide a mechanism for computing unit product costs. Both systems use the same manufacturing accounts, including Manufacturing Overhead, Raw Materials, Work in Process, and Finished Goods. The flow of costs through the manufacturing accounts is basically the same in both systems.

Differences Between Job-Order and Process Costing
Process costing is used when a single product is produced on a continuing basis or for a long period of time. Job-order costing is used when many different jobs are worked on each period. Process costing systems accumulate costs by department. Job-order costing systems accumulated costs by individual jobs. Process costing systems compute unit costs by department. Job-order costing systems compute unit costs by job on the job cost sheet. Process costing is used when a single product is produced on a continuing basis or for a long period of time. Job-order costing is used when many different jobs, having different production requirements, are worked on each period. Process costing systems accumulate costs by department and assign them uniformly to all units processed during the period. Job-order costing systems accumulate costs by individual jobs. Process costing systems compute unit costs by department. Job-order costing systems compute unit costs by job on the job cost sheet.

Quick Check  Process costing is used for products that are:
a. Different and produced continuously. b. Similar and produced continuously. c. Individual units produced to customer specifications. d. Purchased from vendors. Can you identify the most likely circumstances where a process costing system may be used?

Quick Check  Process costing is used for products that are:
a. Different and produced continuously. b. Similar and produced continuously. c. Individual units produced to customer specifications. d. Purchased from vendors. Process costing is used to assign costs to units of product that are similar and are produced continuously.

Processing Departments
Any location in an organization where materials, labor or overhead are added to the product. The activities performed in a processing department are performed uniformly on all units of production. Furthermore, the output of a processing department must be homogeneous. A processing department is an organizational unit where materials, labor or overhead costs are added to the product. The activities performed in a processing department are performed uniformly on all units passing through it. Furthermore, the output of a processing department must be homogeneous. Products in a process costing environment typically flow in a sequence from one department to another.

Flow of Materials, Labor and Overhead Costs
Direct Materials Work in Process Finished Goods Direct Labor The flow of costs through the manufacturing accounts is basically the same for process and job-order costing. Direct material, direct labor and manufacturing overhead are added to Work in Process. When work in process is completed, the costs are transferred to Finished Goods. When finished goods are sold, the costs are transferred to Cost of Goods Sold. Cost of Goods Sold ManufacturingOverhead

Costs are traced and applied to individual jobs in a job-order cost system. Direct Materials Jobs Finished Goods Direct Labor Nonetheless, there is a key fundamental difference between process and job-order costing systems. Job-order costing systems trace and apply manufacturing costs to jobs. One Work in Process account is often used to accumulate costs for all jobs. The individual job cost sheets serve as a subsidiary ledger. ManufacturingOverhead Cost of Goods Sold

Costs are traced and applied to departments in a process cost system. Direct Materials Processing Department Finished Goods Direct Labor Process costing systems trace and apply manufacturing costs to departments. A separate Work in Process account is maintained for each processing department. Material, labor and overhead costs transferred from one department’s Work in Process account to another department’s Work in Process account are called transferred-in costs. ManufacturingOverhead Cost of Goods Sold

T-Account and Journal Entry Views of Process Cost Flows
For purposes of this example, assume there are two processing departments – Departments A and B. We will use T-accounts and journal entries. Let’s look at the flow of costs through the T-accounts and journal entries for a manufacturing process. For purposes of this example, assume there are two processing departments, A and B.

Process Cost Flows (in T-Account form)
Work in Process Department A Raw Materials Direct Materials Direct Materials Work in Process Department B Direct material costs are debited to the appropriate departmental Work in Process account, depending on where the materials were added to the production process. The Raw Materials account is credited for the corresponding amounts.

Process Cost Flows (in journal entry form)
In journal entry form, debit the respective departmental Work in Process accounts and credit Raw Materials.

Work in Process Department A Salaries and Wages Payable Direct Materials Direct Labor Direct Labor Work in Process Department B Direct labor costs are debited to the appropriate departmental Work in Process account, depending on where the labor was added to the production process. Salaries and Wages Payable is credited for the corresponding amounts. Direct Materials

In journal entry form, debit the respective departmental Work in Process accounts and credit Salaries and Wages Payable.

Work in Process Department A Direct Materials Manufacturing Overhead Direct Labor Actual Overhead Overhead Applied to Work in Process Applied Overhead Work in Process Department B Manufacturing overhead costs are debited to the respective departmental Work in Process accounts. Manufacturing Overhead is credited for the corresponding amounts. Predetermined overhead rates are normally used to apply overhead to the departments. Direct Materials Direct Labor Applied Overhead

In journal entry form, debit the appropriate departmental Work in Process accounts and credit Manufacturing Overhead.

Work in Process Department A Work in Process Department B Direct Materials Transferred to Dept. B Transferred from Dept. A Direct Materials Direct Labor Direct Labor Applied Overhead Applied Overhead The cost of direct materials, direct labor and manufacturing overhead assigned to partially completed units from Department A is debited to Department B and credited to Department A. The transferred-in costs from Department A are added to the manufacturing costs incurred in Department B.

In journal entry form, debit Work in Process  Department B and credit Work in Process  Department A.

Work in Process Department B Finished Goods Direct Materials Cost of Goods Manufactured Cost of Goods Manufactured Direct Labor Applied Overhead Here we see the transfer of completed goods out of Work in Process – Department B and into Finished Goods. Debit Finished Goods and credit Work in Process  Department B for the amount of the cost of goods manufactured. Transferred from Dept. A

In journal entry form, debit Finished Goods and credit Work in Process  Department B.

Work in Process Department B Finished Goods Direct Materials Cost of Goods Manufactured Cost of Goods Manufactured Cost of Goods Sold Direct Labor Applied Overhead Here we see the the flow of manufacturing costs from Finished Goods to Cost of Goods Sold. In T-account form, debit Cost of Goods Sold and credit Finished Goods. Transferred from Dept. A Cost of Goods Sold Cost of Goods Sold

In journal entry form, debit Cost of Goods Sold and credit Finished Goods.

Equivalent Units of Production
Equivalent units are the product of the number of partially completed units and the percentage of completion of those units. Equivalent units are defined as the product of the number of partially completed units and the percentage of completion of those units. Equivalent units need to be calculated because a department usually has some partially completed units in its beginning and ending inventory. These partially completed units complicate the determination of a department’s output for a given period and the unit cost that should be assigned to that output. We need to calculate equivalent units because a department usually has some partially completed units in its beginning and ending inventory.

Equivalent Units – The Basic Idea
Two half completed products are equivalent to one completed product. + = 1 Two half-completed products are equivalent to one completed product. Using this logic, we can say that 10,000 units 70 percent complete are equivalent to 7,000 complete units. So, 10,000 units 70% complete are equivalent to 7,000 complete units.

Quick Check  For the current period, Jones started 15,000 units and completed 10,000 units, leaving 5,000 units in process that are 30 percent complete. How many equivalent units of production did Jones have for the period? a. 10,000 b. 11,500 c. 13,500 d. 15,000 Read the information carefully and determine how many equivalent units of production were manufactured during the period.

Quick Check  For the current period, Jones started 15,000 units and completed 10,000 units, leaving 5,000 units in process that are 30 percent complete. How many equivalent units of production did Jones have for the period? a. 10,000 b. 11,500 c. 13,500 d. 15,000 The correct answer is 11,500 equivalent units. How did you do? 10,000 units + (5,000 units × 0.30) = 11,500 equivalent units

Calculating Equivalent Units
Equivalent units can be calculated two ways: The First-In, First-Out Method (FIFO). The Weighted-Average Method. Equivalent units can be calculated two ways: The FIFO method is covered in the appendix to this chapter. The weighted-average method is included within the main portion of the chapter and it is covered next.

Characteristics of the Weighted Average Method
Makes no distinction between work done in prior or current periods. Blends together units and costs from prior and current periods. The equivalent units of production for a department are the number of units transferred to the next department (or finished goods) plus the equivalent units in the department’s ending work in process inventory. Part I The weighted-average method makes no distinction between work done in the prior period and work done in the current period. It blends together units and costs from the prior and current periods. Part II The equivalent units of production for a department are the number of units transferred to the next department (or finished goods) plus the equivalent units in the department’s ending work in process inventory.

Treatment of Direct Labor
Direct Materials Direct labor costs may be small in comparison to other product costs in process costing systems. Conversion Dollar Amount Direct Labor Direct labor costs are often small in comparison to the other product costs in process costing systems. Type of Product Cost

Treatment of Direct Labor
Direct Materials Direct labor costs may be small in comparison to other product costs in process costing systems. Conversion Dollar Amount Therefore, direct labor and manufacturing overhead are often combined into one classification of product cost called conversion costs. The forthcoming example combines these costs. Type of Product Cost Direct labor and manufacturing overhead may be combined into one product cost called conversion.

Weighted-Average Example
Double Diamond Skis reported the following activity in Shaping and Milling Department for the month of May: Assume that Double Diamond Skis’ Shaping and Milling Department reported activity for May as shown on this slide. Notice that Shaping and Milling Department started the month of May with 200 units that are 55% complete as to materials and 30% complete as to conversion (direct labor and overhead). During the month, the Department started 5,000 units into production. During the month of May, 4,800 units were transferred out to the next department. At the end of May, the department had 400 units, 40% complete as to materials and 25% complete as to conversion.

The first step in calculating the equivalent units is to identify the units completed and transferred out of the Department in May (4,800 units). The first step in calculating the equivalent units is to identify the units completed and transferred out of the department in May (4,800 units for materials and conversion). These units are 100 percent complete for both material and conversion.

The second step is to identify the equivalent units of production in ending work in process with respect to materials for the month (160 units) and add this to the 4,800 units from step one. The second step is to calculate the equivalent units as to materials in ending inventory. We know there are 400 units in ending inventory that are 40% complete as to materials. So we know that there are 160 equivalent units as to materials in ending work in process inventory. We add the units completed and transferred out to the equivalent units, yielding 4,960 equivalent units, with respect to materials.

The third step is to identify the equivalent units of production in ending work in process with respect to conversion for the month (100 units) and add this to the 4,800 units from step one. The third step is to calculate the equivalent units in ending inventory as to conversion. We know there are 400 units in ending work in process inventory that are 25% complete as to conversion. So there are 100 equivalent units as to conversion in ending inventory. We add the units completed and transferred out to the equivalent units to arrive at a total equivalent units as to conversion of 4,900 units.

Equivalent units of production always equals: Units completed and transferred + Equivalent units remaining in work in process The equivalent units of production always equals the units completed and transferred out (4,800 units) plus the equivalent units remaining in work in process (160 units for materials and 100 units for conversion).

Materials 5,000 Units Started Beginning Work in Process 200 Units 55% Complete Ending Work in Process 400 Units 40% Complete 4,800 Units Started and Completed A different visual depiction of the equivalent units calculation for materials is shown on this slide. The equivalent units of production equals the units completed and transferred out (4,800 units) plus the equivalent units remaining in work in process (160 units for materials). 4,800 Units Completed 400 × 40% 160 Equivalent Units 4,960 Equivalent units of production

Conversion 5,000 Units Started Ending Work in Process 400 Units 25% Complete Beginning Work in Process 200 Units 30% Complete 4,800 Units Started and Completed A different visual depiction of the equivalent units calculation for conversion is shown on this slide. The equivalent units of production equals the units completed and transferred out (4,800 units) plus the equivalent units remaining in work in process (100 units for conversion). 4,800 Units Completed 400 × 25% 100 Equivalent Units 4,900 Equivalent units of production

Computing Cost Per Equivalent Unit
The following table includes some additional facts for Double Diamond Skis’ Shaping and Milling Department for May. Beginning work in process: units Materials: % complete $ 9,600 Conversion: 30% complete 5,575 Production started during May 5,000 units Production completed during May 4,800 units Costs added to production in May Materials cost $ 368,600 Conversion cost ,900 Ending work in process units Materials: 40% complete Conversion: 25% complete Here we see additional facts with respect to Double Diamond Skis’ Shaping and Milling Department. We will use this information to compute unit costs.

Compute and Apply Costs
The formula for computing the cost per equivalent unit is : Cost per equivalent unit = Cost of beginning work in process inventory Cost added during the period Equivalent units of production + We calculate the cost per equivalent unit by adding together the cost of beginning work in process inventory and the cost added during the period. We divide the total dollar amount by the number of equivalent units we previously calculated.

Here is a schedule with the cost and equivalent unit information. We begin by adding the costs in beginning inventory to the costs incurred during the current period. The sum of the cost of materials and conversion equals the total cost to be accounted for during the period. Notice that we have 4,960 equivalent units as to materials, and 4,900 equivalent units as to conversion. Let’s look at the calculation of cost per equivalent unit.

Here is a schedule with the cost and equivalent unit information. $356,475 ÷ 4,900 units = $72.75 We have a total materials cost of $378,200 and 4,960 equivalent units, so the cost per equivalent unit is $76.25 for materials. With total conversion costs of $356,475 and total equivalent units of 4,900, we have an average cost per equivalent unit of $72.75 for conversion. The total cost of materials and conversion is $ per equivalent unit. $378,200 ÷ 4,960 units = $76.25

Computing the Cost of Ending Work in Process Inventory
Let’s compute the cost of ending work in process inventory. The first step is to record the equivalent units of production in ending work in process inventory (160 units for materials and 100 units for conversion). Step 1: Record the equivalent units of production in ending work in process inventory.

The second step is to record the cost per equivalent unit ($76.25 for materials and $72.75 for conversion). Step 2: Record the cost per equivalent unit.

The third step is to compute the cost of ending work in process inventory ($12,200 for materials, $7,275 for conversion, and $19,475 in total). Step 3: Compute the cost of ending work in process inventory.

Computing the Cost of Units Transferred Out
Now, let’s compute the cost of units transferred out. The first step is to record the units transferred out to the next department (4,800 units for materials and conversion). Step 1: Record the units transferred out to the next department.

The second step is to record the cost per equivalent unit ($76.25 for materials and $72.75 for conversion). Step 2: Record the cost per equivalent unit.

The third step is to compute the cost of units transferred out ($366,000 for materials, $349,200 for conversion and $715,200 in total). Step 3: Compute the cost of units transferred out.

Reconciling Costs Now let’s compute the costs to be accounted for in the Shaping and Milling Department for the month of May. There are three steps in this computation: The first step is to record the $15,175 cost of beginning work in process. The second step is to record the $719,500 of costs added to production during May. The third step is to sum these two costs to get the total of $734,675. Step 1: Compute the costs to be accounted for by adding the cost of beginning work in process and the production costs added in May.

Reconciling Costs Now we can compute the costs accounted for. There are also three steps in this computation: The first step is to record the previously computed $19,475 cost of ending work in process inventory. The second step is to record the previously computed $715,200 cost of units transferred out. The third step is to sum these two costs to get a total of $734,675. Notice the two totals agree indicating that all costs have been accounted for. Step 2: Compute the costs to accounted for by adding the cost of ending work in process and the cost of units transferred out in May.

FIFO vs. Weighted-Average Method
The FIFO method (generally considered more accurate that the weighted-average method) differs from the weighted-average method in two ways: The computation of equivalent units. The way in which the costs of beginning inventory are treated. The FIFO method (generally considered more accurate than the weighted-average method) differs from the weighted-average method in two ways: The computation of equivalent units. 2. The way in which the costs of beginning inventory are treated.

Equivalent Units – FIFO Method
Let’s revisit the Double Diamond Skis example. Assume the following activity is reported in the Shaping and Milling Department for May: Recall this basic information from the Double Diamond Skis. We completed the calculation of equivalent units for the company using the weighted-average method. Now, we will use the same information to determine equivalent units under FIFO.

Step 1: Determine equivalent units needed to complete beginning inventory. The first step in the accounting process is to determine the equivalent units needed to complete beginning inventory (90 units for materials and 140 units for conversion).

Step 2: Determine units started and completed during the period. The second step is to add the units started and completed during the period (4,600 units for materials and conversion).

Step 3: Add the equivalent units in ending working in process inventory. The third step is to add the equivalent units in ending work in process inventory (160 units for materials and 100 units for conversion). This calculation results in 4,850 and 4,840 equivalent units as to materials and conversion, respectively.

FIFO Example Materials 5,000 Units Started 90 Equivalent Units
Beginning Work in Process 200 Units 55% Complete Ending Work in Process 400 Units 40% Complete 4,600 Units Started and Completed Here is a visual depiction showing the computation of equivalent units for materials. 200 × 45% 90 Equivalent Units 4,600 Units Completed 400 × 40% 160 Equivalent Units 4,850 Equivalent units of production

FIFO Example Conversion 5,000 Units Started 140 Equivalent Units
Beginning Work in Process 200 Units 30% Complete Ending Work in Process 400 Units 25% Complete 4,600 Units Started and Completed Here is a visual depiction showing the computation of equivalent units for conversion. 200 × 70% 140 Equivalent Units 4,600 Units Completed 400 × 25% 100 Equivalent Units 4,840 Equivalent units of production

Equivalent Units: Weighted Average vs. FIFO
As shown below, the equivalent units in beginning inventory are subtracted from the equivalent units of production per the weighted-average method to obtain the equivalent units of production under the FIFO method. The FIFO method removes the equivalent units that were already in beginning inventory from the equivalent units as defined using the weighted-average method. Thus, the FIFO method isolates the equivalent units due to work performed during the current period. This can be illustrated using the Double Diamond Skis example as follows: The equivalent units of material produced per the weighted-average method (4,960 units) minus the equivalent units of material in beginning inventory (110 units) equals the equivalent units of production per the FIFO method (4,850 units). The equivalent units of conversion per the weighted-average method (4,900 units) minus the equivalent units of conversion in beginning inventory (60 units) equals the equivalent units of production per the FIFO method (4,840 units).

Cost per Equivalent Unit - FIFO
The following table includes some additional facts for Double Diamond Skis’ Shaping and Milling Department for May. Beginning work in process: units Materials: % complete $ 9,600 Conversion: 30% complete 5,575 Production started during May 5,000 units Production completed during May 4,800 units Costs added to production in May Materials cost $ 368,600 Conversion cost ,900 Ending work in process units Materials: 40% complete Conversion: 25% complete Let’s return to our Double Diamond Skis information and apply FIFO to our production report. The information on your screen is the same as we used earlier in this chapter.

The formula for computing the cost per equivalent unit under FIFO method is: Cost per equivalent unit = Cost added during the period Equivalent units of production We calculate the cost per equivalent unit by dividing costs added during the period by the equivalent units we previously calculated.

We compute the cost per equivalent unit by taking the costs added in the Shaping and Milling Department and dividing by the appropriate number of equivalent units. For materials, we calculated 4,850 equivalent units, and we calculated 4,840 equivalent units for conversion costs. The cost per equivalent unit for materials is $76.00 and for conversion is $ The total cost per equivalent unit is $

Step 1: Record the equivalent units of production in ending work in process inventory. Let’s compute the cost of ending work in process inventory. The first step is to record the equivalent units of production in ending work in process inventory (160 units for materials and 100 units for conversion).

Step 2: Record the cost per equivalent unit. The second step is to record the cost per equivalent unit ($76.00 for materials and $72.50 for conversion).

Step 3: Compute the cost of ending work in process inventory. The third step is to compute the cost of ending work in process inventory ($12,160 for materials, $7,250 for conversion, and $19,410 in total).

Step 1: Record the cost in beginning work in process inventory. The first component of the computation is to record the cost in beginning work in process inventory ($9,600 for materials, $5,575 for conversion, and $15,175 in total).

Step 2: Determine the cost to complete the units in beginning work in process inventory. The second component of the computation is to determine the cost to complete the units in beginning work in process inventory. Begin by recording the equivalent units of production required to complete the units in beginning inventory (90 units for materials and 140 units for conversion). Next, record the cost per equivalent unit ($76.00 for materials and $72.50 for conversion). Finally, compute the cost to complete the units in beginning work in process inventory ($6,840 for materials, $10,150 for conversion, and a total of $16,990).

Step 3: Determine the cost of units started and completed this period. The third component of the computation is to determine the cost of units started and completed this period. The first step is to record the units started and completed this period (4,600 units for materials and conversion). The second step is to record the cost per equivalent unit ($76.00 for materials and $72.50 for conversion). The third step is to compute the cost of units started and completed during this period ($349,600 for materials, $333,500 for conversion, and $683,100 in total).

Step 4: Determine the total cost of units transferred out. The final computation is to determine the total cost of units transferred out ($715,265).

Reconciling Costs There are three steps to compute the costs to be accounted for: The first step is to record the cost of beginning work in process ($15,175). The second step is to record the costs added to production during the period ($719,500 = $368,500 + $350,900). The third step is to sum these two costs ($734,675).

Reconciling Costs There are also three steps to compute the costs accounted for: Begin by recording the cost of ending work in process inventory ($19,410). Next, record the cost of units transferred out ($715,265). Finally, sum these two costs ($734,675). Notice the two totals agree indicating that all costs have been accounted for.

A Comparison of Costing Methods
In a lean production environment, FIFO and weighted-average methods yield similar unit costs. When considering cost control, FIFO is superior to weighted-average because it does not mix costs of the current period with costs of the prior period. In most situations, the weighted-average and FIFO methods will produce very similar unit costs, particularly in a lean production environment. From a cost control standpoint, the FIFO method is superior to the weighted-average method because it does not mix costs of the current period with costs of the prior period.

Activity-Based Costing (ABC)
Cost Objects (e.g., products and customers) Activities Consumption of Resources The basic idea of ABC is as follows. A customer order triggers a number of activities. Performing the activities consumes resources. The consumption of resources incurs costs. Cost

A number of allocation bases are used for assigning costs to products. Activity based costing is a technique that uses numerous allocation bases in an attempt to assign overhead costs more accurately to products than the plantwide or departmental approaches discussed thus far.

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 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 Part I An activity cost pool can be thought of as a “cost bucket” in which costs related to a particular activity 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. Part III 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.

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
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. Part II 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 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 using 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: 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. Recently, 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.

 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.

 Unit costs for materials and labor are: Materials cost $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 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 yield 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.

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 also has estimated the amount of overhead for each activity cost pool, the total number of activities for each cost pool, and the 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.

Computing Overhead Cost per Unit
DVD Units We assign overhead to each product by multiplying individual activity rates by the expected number of activities. For example, we multiply the activity rate of $400 per machine setup by 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 by 1,000 machine setups, resulting in $400,000 of overhead assigned to CD units based on the machine setup activity. We use 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 assigning overhead using activity-based costing results in a decrease in the unit product cost of a CD unit from $ to $95.55 and an increase in the unit cost of a DVD unit from $ to $ 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. Note that the unit product cost of a CD unit decreased from $110 to $ while the unit cost of a DVD unit increased from $150 to $

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

The ABC system assigns $57.80 more overhead than the traditional system to each DVD player ($ $40.00 = $57.80). The ABC system assigns $ 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 occurs because of 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.

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).

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)

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
An ABC system can help identify areas where the company can benefit from improving its current processes. Activity-Based Management Focuses on managing activities to eliminate waste and reduce delays and defects. 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, and reduce delays and defects. Activity-based management is used in organizations as diverse as manufacturing companies, hospitals, and the U.S. Marine Corps.

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: It increases the number of cost pools used to accumulate overhead costs. It uses activity cost pools that are more homogeneous than departmental cost pools. 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: Products differ substantially in volume, batch size, and in the activities they require. 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. For example, managers should be particularly alert to product costs that contain allocated facility-level costs. 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.

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: Selling and administrative costs should be assigned to products, where appropriate. Facility-level costs should be removed from product costs.

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 of activities for each cost pool, and the number of activities for each product.

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.

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 by the actual activities. For example, we multiply the activity rate of $90 per purchase order by 800 actual purchase orders, resulting in $72,000 of applied overhead due to the production order activity. We use 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.

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.

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

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

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 Cash/Accounts Payable for $230,000

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

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

Bal ,000 Manufacturing Overhead (b) ,000 (c) ,000 (d) ,000 (e) ,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

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.

The End End of Chapter 1.

Management Accounting

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