1. Activity based costing

2. There is no true cost of a good or service unless a company manufactures a single product or provides a single service. Otherwise, accountants must allocate costs for all products and services There is no true cost of a good or service unless a company manufactures a single product or provides a single service. Otherwise, accountants must allocate costs for all products and services Allocating service department cost Companies normally allocate service department costs to production department. Accordingly goods and services reflect the total full cost of production. Companies normally allocate service department costs to production department. Accordingly goods and services reflect the total full cost of production.

3. Direct and indirect costs Direct and indirect costs Direct costs arise within the department and are easily traced. Direct costs arise within the department and are easily traced. Indirect costs (common costs) serve two or more departments or cost centers. Therefore they are difficult to trace. Indirect costs (common costs) serve two or more departments or cost centers. Therefore they are difficult to trace. Cost allocation basis: Cost allocation basis: Estimate the overhead costs for the entire plant. Estimate the overhead costs for the entire plant. We allocate to production only the portion of service department cost that relate to the production. We allocate to production only the portion of service department cost that relate to the production.

4. Traditional Costing & Activity based Costing Traditional Costing & Activity based Costing In the traditional method accountants use volume based models or unit based drivers are allocations based on labor hours, machine hours and material costs. Cost drivers are factors that cause an activity to occur. In the traditional method accountants use volume based models or unit based drivers are allocations based on labor hours, machine hours and material costs. Cost drivers are factors that cause an activity to occur. Cost can be tied to volume only if we are dealing with units- related activities. Cost can be tied to volume only if we are dealing with units- related activities. However many costs in a plant do not vary with the volume of production but with the transaction. E.g. Movement of material from inventory requires inspection, scheduling and transportation. However many costs in a plant do not vary with the volume of production but with the transaction. E.g. Movement of material from inventory requires inspection, scheduling and transportation.

5. In activity based costing ABC the performance of activities triggers the consumption of resources that are recorded as costs. In activity based costing ABC the performance of activities triggers the consumption of resources that are recorded as costs. Benefits of ABC Benefits of ABC 1.Yields more information about activities and the resources required to perform the activities. 2. Helps in highlighting high cost activities by identifying the resources. 3. Assist mangers in to eliminate no value activities and direct resources into more productive areas.

6. 4. ABC can be used to study and improve marketing and administrative activities costs. 5. The purpose of ABC is to assign costs to the and activities performed in an organization and then allocate them appropriately to products Limitations Limitations ABC is costly and requires a lot of operating data. ABC is costly and requires a lot of operating data.

7. Example: Example: Comparison of allocations using traditional and ABC method. Comparison of allocations using traditional and ABC method. Boni company provides the following information concerning its two products Boni company provides the following information concerning its two products Product A Product B Unit produced 1020 Unit produced 1020 Machine-hrs per unit 34 Machine-hrs per unit 34 Inspection/PL51 Inspection/PL51 Total budgeted inspection cost $3300 Total budgeted inspection cost $3300

8. Assume Boni Company used ABC; calculate how much inspection cost is allocated to each line. What is the cost per unit for product A and B? Assume Boni Company used ABC; calculate how much inspection cost is allocated to each line. What is the cost per unit for product A and B? Determine how much inspection cost is allocated if Boni uses a traditional cost allocation system based on machine hours. What is the cost per unit for product A and B? Determine how much inspection cost is allocated if Boni uses a traditional cost allocation system based on machine hours. What is the cost per unit for product A and B?

9. ABC Method ABC Method The cost driver is the inspections number The cost driver is the inspections number 3300 budgeted inspection cost = $550 application rate 3300 budgeted inspection cost = $550 application rate 6 budgeted inspections 6 budgeted inspections Product A Product B Product A Product B Total cost/PL $2750$550 Total cost/PL $2750$550 Cost per unit$2750/10$550/20 Cost per unit$2750/10$550/20 $275 $27.50 The results have shown that units of B require less attention probably indicating it is a seasonal product. The results have shown that units of B require less attention probably indicating it is a seasonal product.

10. For the traditional volume based cost allocation, inspection costs are allocated on machine hours. Total machine hours are budgeted as follows 3 × 10 product A units + 4 × 20 product B units = 110 machine hours. This will yield the following rate 3 × 10 product A units + 4 × 20 product B units = 110 machine hours. This will yield the following rate $ 3300 (cost) = $ 30 rate per machine hour $ 3300 (cost) = $ 30 rate per machine hour 110( hours) 110( hours)

11. Product A Product B Product A Product B Total cost/ PL $900$2400 Total cost/ PL $900$2400 cost/ unit $900/10 $2400/20 cost/ unit $900/10 $2400/20 $90$ 120 $90$ 120 The traditional method hinders cost reduction and gives a wrong signal to management. It over costs B the higher volume and under costs A the lower volume product. The traditional method hinders cost reduction and gives a wrong signal to management. It over costs B the higher volume and under costs A the lower volume product.

12. Assume a production department has 84000 budgeted machine hours and budgeted overhead costs as follows: Assume a production department has 84000 budgeted machine hours and budgeted overhead costs as follows: Machine dep & maintenance $ 840000 Machine dep & maintenance $ 840000 Receiving costs $418000 Receiving costs $418000 Production costs $360000 Production costs $360000 Machine setup costs $37000 Machine setup costs $37000 Inspection costs $192000 Inspection costs $192000 Total $1848000 Total $1848000

13. Assume that the company manufactures and sells three products with the following attributes Assume that the company manufactures and sells three products with the following attributes Product x product Y product z Product x product Y product z Units produced and sold 28000 180006000 Units produced and sold 28000 180006000 Unit direct material cost 201513 Unit direct material cost 201513 Unit direct labor 12 1410 Unit direct labor 12 1410 Machine hrs /unit 1.521 Machine hrs /unit 1.521

14. Receiving orders 1640200 Receiving orders 1640200 Production orders 141219 Production orders 141219 Production runs 4822 Production runs 4822 Inspections 8420 Allocate the costs using the traditional methods and the ABC methods Inspections 8420 Allocate the costs using the traditional methods and the ABC methods

15. Using traditional method Using traditional method $1848000(costs) = $22 / machine hr $1848000(costs) = $22 / machine hr 84000 budgeted machine hours 84000 budgeted machine hours Material + Labor + overhead Material + Labor + overhead Product X costs $20 + 12 + (1.5 x 22= 33) =$65 Product X costs $20 + 12 + (1.5 x 22= 33) =$65 Product Y costs $15 + 14 + (2 x 22= 44) =$73 Product Y costs $15 + 14 + (2 x 22= 44) =$73 Product Z costs$13 + 10 + (1 x 22= 22) =$45 Product Z costs$13 + 10 + (1 x 22= 22) =$45 If we use activity based costing $840000 equipment deprecation and maintenance is allocated on machine hours. Costs of other activities are assigned to the relevant cost driver. If we use activity based costing $840000 equipment deprecation and maintenance is allocated on machine hours. Costs of other activities are assigned to the relevant cost driver.

16. Depreciation Depreciation 840000 deprecation and maintenance = $10.M. hour 84000 840000 deprecation and maintenance = $10.M. hour 84000 Receiving order Receiving order $418000 receiving costs = $1635 per receiving order $418000 receiving costs = $1635 per receiving order 256 receiving order 256 receiving order Product X (1635 x 16)/ 28000= $0.93 Product X (1635 x 16)/ 28000= $0.93 Product Y (1635 x 40)/ 18000= $3.63 Product Y (1635 x 40)/ 18000= $3.63 Product Z (1635 x 200)/ 6000= $54.50 Product Z (1635 x 200)/ 6000= $54.50

17. Production cost Production cost 360000 Production cost = $8000 360000 Production cost = $8000 45 production orders 45 production orders Product X ($8000 x 14)/ 28000= $4 Product X ($8000 x 14)/ 28000= $4 Product Y ($8000 x 12)/ 18000= $5.33 Product Y ($8000 x 12)/ 18000= $5.33 Product Z ($8000 x 19) / 6000= $25.33 Product Z ($8000 x 19) / 6000= $25.33

18. Setup costs Setup costs $37400 setup costs = $ 1100 $37400 setup costs = $ 1100 34 production runs 34 production runs Product X ($1100 x 4)/ 28000= $0.16 Product X ($1100 x 4)/ 28000= $0.16 Product Y ($1100 x 8)/ 18000= $0.49 Product Y ($1100 x 8)/ 18000= $0.49 Product Z ($1100 x 22) / 6000= $4.03 Product Z ($1100 x 22) / 6000= $4.03

19. Inspection costs Inspection costs $19200 inspection costs = $ 6000 $19200 inspection costs = $ 6000 32 inspections 32 inspections Product X ($6000 x 8)/ 28000= $1.71 Product X ($6000 x 8)/ 28000= $1.71 Product Y ($6000 x 4)/ 18000= $1.33 Product Y ($6000 x 4)/ 18000= $1.33 Product Z ($6000 x 20) / 6000= $20.0 Product Z ($6000 x 20) / 6000= $20.0 Therefore the unit cost for the three products using ABC Therefore the unit cost for the three products using ABC

20. X Y Z X Y Z Unit direct material cost $20 1513 Unit direct material cost $20 1513 Unit direct labor 12 1410 Unit direct labor 12 1410 Machine related overhead15 2010 Machine related overhead15 2010 Receiving cost 0.933.6354.50 Receiving cost 0.933.6354.50 Production cost 45.3325.33 Production cost 45.3325.33 Machine setup cost0.160.494.03 Machine setup cost0.160.494.03 Inspections 1.711.3320 Inspections 1.711.3320 Total 53.80 59.78136.86 Total 53.80 59.78136.86

21. Faisal Company has the following marketing costs in the company records. Faisal Company has the following marketing costs in the company records. Transportation 7920 Transportation 7920 Sales promotion 8000 Sales promotion 8000 Credit and collection 5000 Credit and collection 5000 Marketing salaries 36000 36000 Marketing salaries 36000 36000

22. An analysis of the their records produced the following statistics An analysis of the their records produced the following statistics Order size Order size Smallmedium large Smallmedium large Units shipped50018002100 Units shipped50018002100 Circulation pieced distributed 5000075000125000 Circulation pieced distributed 5000075000125000 No. of orders1507030 No. of orders1507030 Marketing salaries$24001690016700 Marketing salaries$24001690016700 Allocate the costs using the traditional methods and the ABC method. Allocate the costs using the traditional methods and the ABC method.

23. Solution Solution Marketing cost Marketing cost Transportation = $ 7920/ 4400= $1.8 Transportation = $ 7920/ 4400= $1.8 Sales promotion = $8000/ 250000= $0.032 Sales promotion = $8000/ 250000= $0.032 Credit and collection = $5000/ 250= $20 Credit and collection = $5000/ 250= $20

24. Cost SmallMedium Large Cost SmallMedium Large Trans 900 = (1.8x500) 3240= (1.8x1800) 3780=(1.8x2100) S. pro 1600= (0.032x 50000) 2400= (0.032x 75000) 4000= (0.032x125000) Cre& coll 3000= (150x20) 1400= (70x20) 600= (30x20) Salary 2400 1690016700 Total 7900 23940 25080 Total 7900 23940 25080 Cost/ unit 15.80 13.3011.94 (7900/500) (23940/1800) ( 25080/ 2100) (7900/500) (23940/1800) ( 25080/ 2100)