Activity Based Costing: A Tool to Aid Decision Making

1. Chapter8 Activity Based Costing:A Tool to Aid Decision Making

2. LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Understand activity-based costing and how it differs from a traditional costing system. 2. Assign costs to cost pools using a first-stage allocation. 3. Compute activity rates for cost pools. 4. Assign costs to a cost object using a second-stage allocation. 5.Preparea report showing activity-based costing product margins from an activity view. 6. (Appendix 8A) Prepare an action analysis report using activity-based costing data and interpret the report.

3. ABC is a good supplement to our traditional cost system Activity Based Costing (ABC) The objective of activity-based costing is to understand overhead and the profitability of products and customers. I agree!

4. Activity Based Costing (ABC) Activity-Based Costing Both manufacturing and nonmanufacturing costs may be assigned to products. There are a number of cost pools each ofwhich is allocated using a unique measure of activity. Some manufacturing costs may be excluded from product costs. Some manufacturing costs may be excluded from product costs. Allocation bases often differ from traditional costing systems.

5. How Costs are Treated Under Activity-Based Costing Activity-Based Costing Departmental Overhead Rates Level of Complexity Plantwide Overhead Rate Overhead Allocation

6. Plantwide Overhead Rate Companies tend to use direct labour as the overhead allocation base.

7. Example of Plantwide Overhead Rate Bell Co. produces two telephones: a cordless phone and a regular model. The company has the following estimated and actual data. Budgeted overhead $360,000 Expected activity (in direct labour hours) 100,000 Actual overhead $380,000 Actual activity (in direct labour hours) 100,000

8. Stage One: Pool Formation Overhead costs are first accumulated in one large plantwide pool, then a plantwide rate is computed using a single cost driver (in this case, direct labour hours). $360,000 / 100,000 DLH = $3.60 per DLH Stage Two: Costs Assigned Overhead costs are then assigned to the products. The plantwide rate is multiplied by the actual amount of the cost driver used by each product. $3.60 x 100,000 DLH = $360,000 applied overhead

9. Let’s examine the manufacturing overhead cost applied to both models CordlessRegular Units produced 10,000 100,000 Direct labour hours 10,000 90,000 Applied overhead costs: $3.60 x 10,000 ………. 36,000 $3.60 x 90,000 ……... 324,000

10. $324,000 $36,000

11. Finishing Department Painting Department Shipping Department Departmental Overhead Rates A two stage process is necessary because costsare allocated to departmentsand then to products.

12. Departmental Overhead Rates Indirect Labour Indirect Materials Other Overhead Stage One: Costs assigned to pools Department 1 Department 2 Department 3 Cost pools

13. Departmental Overhead Rates Indirect Labour Indirect Materials Other Overhead Stage One: Costs assigned to pools Department 1 Department 2 Department 3 Cost pools Stage Two: Costs applied to products Products

14. Departmental Overhead Rates Indirect Labour Indirect Materials Other Overhead Stage One: Costs assigned to pools Department 1 Department 2 Department 3 Cost pools Direct Labour Hours Machine Hours Raw Materials Cost Stage Two: Costs applied to products Products Departmental Allocation Bases

15. Example of Departmental Overhead Rates Stage One: Pool Formation Overhead costs are first divided up and assigned to individual production department, creating departmental overhead costs pool. Fabrication Assembly TOTAL Budgeted OH $252,000 $108,000 $360,000 • Cost drivers: • Assembly department – Direct labour hours (DLH) • Fabrication department – Machine hours (MH)

16. Stage One: Pool Formation $252,000 $108,000

17. Fabrication Assembly TOTAL Budgeted OH $252,000 $108,000 $360,000 Expected/actual DLHCordless 7,000 3,000 10,000 Regular 13,00077,00090,000 Total 20,000 80,000 100,000MHCordless 4,000 1,000 5,000 Regular 36,0009,00045,000 Total 40,000 10,000 50,000 Fabrication rate: $252,000 ÷ 40,000 MH = $6.30 per MH

18. Fabrication Assembly TOTAL Budgeted OH $252,000 $108,000 $360,000 Expected/actual DLHCordless 7,000 3,000 10,000 Regular 13,00077,00090,000 Total 20,000 80,000 100,000MHCordless 4,000 1,000 5,000 Regular 36,0009,00045,000 Total 40,000 10,000 50,000 Assembly rate: $108,000 ÷ 80,000 DLH = $1.35 per DLH

19. Stage Two: Costs Assigned Overhead costs are then assigned to products. The departmental rates are multiplied by the actual amount of the cost drivers used in each department by each product.

20. Let’s examine the manufacturing overhead cost applied to both models CordlessRegular Units produced 10,000 100,000 Direct labour hours 10,000 90,000 Machine hours 5,000 45,000 Applied overhead costs: $1.35 x 3,000 DLH + $6.30 x 4,000 MH …… 29,250 $1.35 x 77,000 DLH + $6.30 x 36,000 MH …... 330,750

21. Stage Two: Cost Allocation $330,750 $29,250

22. COST DISTORTIONS Total overhead costs applied to each product Cordless Regular Plantwide rate $36,000$324,000 Departmental rates $29,250$330,750 Cost distortion $6,750 $ (6,750)

23. Cost Distortion

24. Designing an ABC System Cost Objects (e.g., products and customers) Consumption of Resources Activities Cost

25. Designing an ABC System Steps for Implementing ABC • Identify and define activities and activity cost pools. • Whenever possible, directly trace overhead costs to activities and cost objects. • Assign costs to activity cost pools. • Calculate activity rates. • Assign costs to cost objects using the activity rates and activity measures. • Prepare management reports.

26. Identifying Activity to Include Unit-Level Activity Batch-Level Activity A part of the production process for which management wants a separate reporting of the costs of the activity involved. Product-Level Activity Customer-Level Activity Organization-Sustaining Activity

27. Identifying Activity to Include Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity in the ABC system. $ $ $ $ $ $

28. Let’s revisit our example of telephones Bell Co. produces two telephones: a cordless phone and a regular model. The company has the following estimated and actual data. Budgeted overhead $360,000 Expected activity (in direct labour hours) 100,000 Actual overhead $380,000 Actual activity (in direct labour hours) 100,000 The main problem with using either a plantwide rate or departmental rates for assigning overhead costs is the assumption that direct labour hours and/or machine hours drive all overhead costs.

29. In fact, a significant portion of overhead costs is not driven or caused by direct labour hours. Look below. Activity Cost Data (overhead activities) ActivityActivity Costs Setup $120,000 Material handling 60,000 Machining 100,000 Testing 80,000 Total $360,000 Setup and materials handling activities (50% of the overhead costs) are batch-level activities related to the number of production runs and material moves, respectively.

30. The following shows the activity usage measures CordlessRegular Total Units produced per yr 10,000 90,000 100,000 Prime costs $78,000 $738,000 $816,000 Direct labour hours 10,000 90,000 100,000 Machine hours 5,000 45,000 50,000 Production runs 20 10 30 Number of moves 60 30 90 Now, let’s compute a rate for each overhead activity, then use these activity rates to assign overhead costs.

31. Activity Cost Data (overhead activities) ActivityActivity Activity Rate Costs Measures Setup $120,000 30 runs $4,000/run Material handling 60,000 90 moves $666.67/move Machining 100,000 50,000 MH $2.00/MH Testing 80,000 100,000 DLH $0.80/DLH Total $360,000

33. Let’s examine the manufacturing overhead cost applied to both models CordlessRegular Applied overhead costs: Setups: ($4,000 x 20 runs) 80,000 ($4,000 x 10 runs) 40,000 Material handling: ($666.67 x 60 moves) 40,000 ($666.67 x 30 moves) 20,000 Machining: ($2 x 5,000 MH) 10,000 ($2 x 45,000 MH) 90,000 Testing: ($0.80 x 10,000 DLH) 8,000 ($0.80 x 90,000 DLH) 72,000 Manufacturing costs $138,000$222,000

34. Stage Two: Cost Allocation $222,000 $138,000

35. COST DISTORTIONS Total overhead costs applied to each product Cordless Regular ABC $138,000$222,000 Departmental rates $29,250$330,750 Cost distortion $108,750 $(108,750)

36. Cost Distortion

37. 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.

39. Assigning Costs to Activity Cost Pools Management at Classic Brass believes overhead should be distributed as follows:

40. Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools. Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

41. Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools. Factory equipment amortization $300,000 Percent consumed by customer orders 20% $ 60,000

42. Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

43. This number should then equal the total of the individual overhead item to be allocated Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools. These costs should be cross-added to get the total

44. Computation of Activity Rates After the first-stage allocation is complete, computation of activity rates for each activity cost pool is as follows: ÷ ÷ ÷ ÷

45. Activity-Based Costing at Classic Brass Direct Materials Direct Labour Shipping Costs Overhead Costs Traced Traced Traced Cost Objects: Products, Customer Orders, Customers

46. Activity-Based Costing at Classic Brass Direct Materials Direct Labour Shipping Costs Overhead Costs First-Stage Allocation Customer Orders $315,000 Product Design $257,000 Product Units $380,000 Customer Relations $367,500 Other $490,500 Cost Objects: Products, Customer Orders, Customers

47. Activity-Based Costing at Classic Brass Direct Materials Direct Labour Shipping Costs Overhead Costs First-Stage Allocation Customer Orders Product Design Product Units Customer Relations Other Second-Stage Allocations $315/Order $1,285/Design $19/MH $3,675/Customer Cost Objects: Products, Customer Orders, Customers Unallocated

48. 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 Custom Compass Housings. • The details are outlined on the following slide.

49. Assigning Costs to Cost Objects 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 labour totals $1,850. 6. Shipping costs total $180. 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 labour totals $50. 6. Shipping costs total $25.

50. Product Margin – Standard Stanchions 2 orders @ $315 per order