Activity-Based Costing: A Tool to Aid Decision Making

1. Activity-Based Costing:A Tool to Aid Decision Making Chapter 7 October 7, 2013

2. ABC is designed to provide managers with cost information by product and other non-product cost objectives to better evaluate product and customer profitability ABC is a good supplement to our traditional cost system Activity–Based Costing (ABC) I agree!

3. Absorption Costing vs ABC • Absorption costing – Job Order & Process cost • Used for external reporting • Activity Based Costing (ABC) • Used for internal decision making • Identifies cost by activity, aids in more efficient cost control (General Mills, Seagate examples) • Examines fixed as well as variable cost • Assigns cost to product based on usage of resources, both manufacturing & non-manufacturing

4. Firms using Activity Based Costing • Charles Schwab • Citigroup • Lowe’s • Coca-Cola • Fairchild Semiconductor • Sysco Foods • J & B Wholesale Note: not all are manufacturers

5. Learning Objective 1 Understand activity-based costing and how it differs from a traditional costing system.

6. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Manufacturingcosts Nonmanufacturingcosts (ie, shipping) Traditionalproduct costing ABCproduct costing  ABC assigns both types of costs to products.

7. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Manufacturingcosts Nonmanufacturingcosts Most, butnot all Some All Traditionalproduct costing ABCproduct costing • ABC does not assign all manufacturing costs to products, • ie, lease on manufacturing facility.

8. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Activity–Based Costing Departmental Overhead Rates Level of complexity Plantwide Overhead Rate Number of cost pools • ABC uses more cost pools.

9. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Each ABC cost pool has its own unique measure of activity, ie, invoices processed. Traditional cost systems usually relyon volume measures such as direct laborhours and/or machine hours to allocateall overhead costs to products. • ABC uses more cost pools.

10. How Costs are Treated UnderActivity–Based Costing An event that causes the consumption of overhead resources.ie, purchasing Activity A “cost bucket” in which costs related to a single activity measure (purchasing) are accumulated. Activity Cost Pool $ $ $ $ $ $

11. Transactiondriver Durationdriver Simple countof the number oftimes an activityoccurs. A measureof the amountof time neededfor an activity. How Costs are Treated UnderActivity–Based Costing Two common types of activity measures:

12. How Costs are Treated UnderActivity–Based Costing ABC definesfive levels of activitythat largely do not relateto the volume of unitsproduced. Traditional cost systems usually rely on volumemeasures such as direct labor hours and/or machinehours to allocate all overhead costs to products.

13. Unit-Level Activity Batch-Level Activity Manufacturingcompanies typically combinetheir activities into fiveclassifications. Product-Level Activity Customer-Level Activity Organization-sustaining Activity How Costs are Treated UnderActivity–Based Costing

14. Unit Level Activity • Performed each time a unit of product is produced • Cost should be proportional to the number of units produced • Example • power in a machine shop – consumption is proportional to the number of units machined • Labor to assemble a unit

15. Batch-Level activities • Performed each time a batch of activities occurs, regardless of the number of units in the batch • Cost is based on number of batches processed • Example • placing purchase orders, same cost, regardless of how many units you order • setting up a machine to produce a batch of units, same cost regardless of number of units in the batch

16. Product-level activities • Costs assigned to product lines, not related to the number of products produced • Examples • product design • advertising a product • product management

17. Customer-level activities • Activities related to a specific customer • Examples: • Sales calls • Catalog mailings • Technical support

18. Organization-sustaining activities • Costs which apply to the entire organization, incurred regardless of units, batches, products or customers • Examples: • Rent or depreciation on buildings • Heating or air-conditioning • Janitorial services • Computer network • Preparing external financial reports Note: These costs are usually not allocated

19. Strong topmanagement support Link to evaluationsand rewards Cross-functionalinvolvement Characteristics of Successful ABC Implementations

20. Baxter Battery – An ABC Example Manufacturing overhead is allocated to products usinga single plantwide overhead rate based on machine hours.

21.  Define Activities, Activity Cost Pools, and Activity Measures At Baxter Battery, the ABC team selected the followingactivity cost pools and activity measures:

22.  Define Activities, Activity Cost Pools, and Activity Measures • Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. • Design Changes - assigned all costs of resources consumed by customer requested design changes. • Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. • Customer Relations – assigned all costs associated with maintaining relations with customers. • Other – assigned all organization-sustaining costs and unused capacity costs (typically absorbed by existing products)

23. Learning Objective 2 Assign costs to cost pools using a first-stage allocation.

24. Assigning costs to Products • All costs that can be directly assigned should be. For example: • Direct material • Direct labor • Shipping expense

25.  Assign Overhead Costs to Activity Cost Pools

26.  Assign Overhead Costs to Activity Cost Pools At Baxter Battery the following distribution of resource consumption across activity cost pools is determined.

27.  Assign Overhead Costs to Activity Cost Pools Indirect factory wages $6,000,000 Percent consumed by customer orders 30% $1,800,000

28.  Assign Overhead Costs to Activity Cost Pools Factory equipment depreciation $3,500,000 Percent consumed by customer orders 20% $ 700,000

29.  Assign Overhead Costs to Activity Cost Pools

30. Learning Objective 3 Compute activityrates for cost pools.

31.  Calculate Activity Rates The ABC team determines that Baxter Battery will have these total activities for each activity cost pool: • 10,000 customer orders, • 4,000 design changes, • 800,000 machine-hours, • 2,000 customers served. Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

32.  Calculate Activity Rates

33. Traced Traced Traced Activity–Based Costing at Baxter Battery Direct Materials Direct Labor Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers

34. Activity–Based Costing at Baxter Battery Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation CustomerOrders OrderSize Customer Relations Other Design Changes Cost Objects: Products, Customer Orders, Customers

35. Activity–Based Costing at Baxter Battery Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation CustomerOrders OrderSize Customer Relations Other Design Changes Second-Stage Allocations $/Order $/Change $/MH $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated

36. Learning Objective 4 Assign costs to a cost object using a second-stage allocation.

37.  Assigning Overhead to Products Baxter Battery Information • SureStart • Requires no new design resources. • 800,000 batteries ordered with 4,000 separate orders. • Each SureStart requires 36 minutes of machinetime for a total of 480,000 machine-hours. • LongLife • Requires new design resources. • 400,000 batteries ordered with 6,000 separate orders. • 4,000 custom designs prepared. • Each LongLife requires 48 minutes of machinetime for a total of 320,000 machine-hours.

38.  Assigning Overhead to Products

39. Assigning Overhead to Customers Let’s take a look at how Baxter Battery’s system works for just one of the 2,000 customers – Acme Auto Parts who placed a total of twelve orders. Note that the four orders for LongLifes required a design change. • Orders • Eight orders for 60 SureStarts per order. • Four orders for 50 LongLifes per order. • Machine-hours • The 480 SureStarts required 288 machine-hours. • The 200 LongLifes required 160 machine hours.

40. Assigning Overhead to Customers

41. Learning Objective 5 Use activity-based costing to compute product and customer margins.

42.  Prepare Management Reports Product Margin Calculations The first step in computing product margins is togather each product’s sales and direct cost data.

43.  Prepare Management Reports Product Margin Calculations The second step in computing product margins is toincorporate the previously computed activity-basedcost assignments pertaining to each product.

44.  Prepare Management Reports Product Margin Calculations The third step in computing product marginsis to deduct each product’s direct and indirect costs from sales.

45.  Prepare Management Reports Product Margin Calculations The product margins can be reconciled with the company’s net operating income as follows:

46.  Prepare Management Reports Customer Margin Analysis The first step in computing Acme Auto Parts’ customer margin is to gather its sales and direct cost data.

47.  Prepare Management Reports Customer Margin Analysis The second step is to incorporate Acme Auto Parts’ previously computed activity-based cost assignments.

48.  Prepare Management Reports Customer Margin Analysis The third step is to compute Acme Auto Parts’ customer margin of $384 by deducting all its direct and indirect costs from its sales.

49. Product Margins Computed Using the Traditional Cost System The first step in computing product margins is togather each product’s sales and direct cost data.

50. 480,000 hours × $17.50 per hour = $8,400,000 Product Margins Computed Using the Traditional Cost System The third step in computing product margins isallocate manufacturing overhead to each product.