Activity Based Costing

1. Activity Based Costing

2. Class Announcements • Assignment #3 due October 3rd (today) • Assignment #4 due October 10th • Midterm in-class Thursday October 24th • Trudy Eagan Women in Business Speakers’ Series and Awards Presentation • Location SCHW Auditorium (SCHW 110) • 2:15pm Thursday October 10, 2012 • Guest Speaker: Mary Lou O’Reilly, IBC • Sign in at door • Looking for volunteers at 2:00pm for sign-in

3. Class Objectives • Activity Based Costing as an approach to refined manufacturing overhead allocation • The mechanics of allocating overhead using and ABC approach • The context for understanding successful ABC allocation

4. Costing: Overhead Allocation • Accounting for overhead costs is an imprecise science. Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable. • Allocation of overhead is not a process for costing inventory for reporting purposes but has strategic consequences.

5. Traced Traced Traced Costing: Overhead Allocation Direct Materials Direct Labor Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers

6. Costing: Cost Drivers • Cost driver is a characteristic of an activity or event that results in the incurrence of costs by that activity or event • Often multiple cost drivers will affect the overall cost; an organization may have many cost drivers across its value chain • Cost drivers: • Cause and effect between activity and costs • Be measureable • Predict/explain activity's use of resources reasonably • Based on resources' practical capacity

7. Costing: Overhead Allocation using a Single Company-Wide Cost Driver Labour Intensive Process • Traditional cost systemswere created whenmanufacturing processes were labour intensive. • Overhead costs are relatively small. • A single company-wide overhead rate, based on direct labour hours, is used to allocate overhead to products in these labour intensive processes.. Automated Process • Overhead costs are relatively large. • Inaccurate overhead allocation can lead to questionable product cost information. • Need for multiple cost drivers to allocate overhead costs

8. Allocation of Overhead: Simple • Historically, firms produced a limited variety of goods while their indirect costs were relatively small. • Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of how they are actually incurred. • Peanut-butter costing • The end-result: overcosting and undercosting • Overcosting—a product consumes a low level of resources but is allocated high costs per unit. • Undercosting—a product consumes a high level of resources but is allocated low costs per unit.

9. Allocation of Overhead: Cross-subsidization • The results of overcosting one product and undercosting another. • The overcosted product absorbs too much cost, making it seem less profitable than it really is. • The undercosted product is left with too little cost, making it seem more profitable than it really is.

10. Activity Based Costing Process • “ A system that first accumulates overhead costs for each of the activities of an organization and then assigns the costs of activities to the products, services or other cost objects that caused that activity.” p. 147 • Rationale for Selection: • Increase in product diversity • Increase in indirect costs • Advances in information technology • Competition in foreign markets

11. Allocation of Overhead: Activity-Based Costing The first step is toidentify essentialactivities and costsrequired to performthe activities. Stage 1Assign costs to pools according to activities that cause costs to be incurred. Stage 2Allocate costs in the activity pools to products. Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.

12. Allocation of Overhead: Activity-Based Costing Overhead Costs ActivityCenter 1 ActivityCenter 2 ActivityCenter 3 Product 1 Product 2

13. ABC: Conclusions • Each method is mathematically correct. • Each method is acceptable. • Each method yields a different cost figure, which will lead to different gross margin calculations. • Only overhead is involved. Total costs for the entire firm remain the same—they are just allocated to different cost objects within the firm. • Selection of the appropriate method and drivers should be based on experience, industry practices, as well as a cost-benefit analysis of each option under consideration.

14. ABC: Contexts for its Use • Significant overhead costs allocated using one or two cost pools • Most or all overhead is considered unit-level • Products that consume different amounts of resources • Products that a firm should successfully make and sell consistently show small profits • Operations staff disagreeing with accounting over manufacturing and marketing costs

15. ABC: Advantages • More accurate and informative product costs lead to better pricing decisions. • The activities driving costs are more accurately measured. • Managers gain easier access to the relevant costs.

16. ABC: Limitations Expensive: Substantial Resources required to implement and maintain. Resistance tounfamiliar numbersand reports. Desire to fullyallocate all coststo products. Potentialmisinterpretation ofunfamiliar numbers. Does not conform toGAAP. Two costingsystems may be needed.