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Costing System Refinement: Undercosting, Overcosting, and Activity-Based Costing

This chapter explains the concepts of undercosting and overcosting of products and services, and provides examples and guidelines for refining a costing system. It also discusses the differences between traditional and activity-based costing approaches.

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Costing System Refinement: Undercosting, Overcosting, and Activity-Based Costing

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  1. Activity-Based Costing andActivity-Based Management Chapter 5

  2. Explain undercosting and overcosting of products and services. Learning Objective 1

  3. Undercosting andOvercosting Example Jose, Roberta, and Nancy order separate items for lunch. Jose’s order amounts to $14 Roberta consumed 30 Nancy’s order is 16 Total $60 What is the average cost per lunch?

  4. Undercosting andOvercosting Example $60 ÷ 3 = $20 Jose and Nancy are overcosted. Roberta is undercosted.

  5. Present three guidelines for refining a costing system. Learning Objective 2

  6. Existing Single Indirect-Cost Pool System Example Kole Corporation manufactures a normal lens (NL) and a complex lens (CL). Kole currently uses a single indirect-cost rate job costing system. Cost objects: 80,000 (NL) and 20,000 (CL).

  7. Existing Single Indirect-Cost Pool System Example Normal Lenses (NL) Direct materials $1,520,000 Direct mfg. labor 800,000 Total direct costs $2,320,000 Direct cost per unit: $2,320,000 ÷ 80,000 = $29

  8. Existing Single Indirect-Cost Pool System Example Complex Lenses (CL) Direct materials $ 920,000 Direct mfg. labor 260,000 Total direct costs $1,180,000 Direct cost per unit: $1,180,000 ÷ 20,000 = $59

  9. Existing Single Indirect-Cost Pool System Example INDIRECT-COST POLL All Indirect Costs $2,900,000 INDIRECT COST-ALLOCATION BASE 50,000 Direct Manufacturing Labor-Hours $58 per Direct Manufacturing Labor-Hour

  10. Existing Single Indirect-Cost Pool System Example COST OBJECT: NL AND CL LENSES Indirect Costs Direct Costs Direct Materials Direct Manufacturing Labor DIRECT COSTS

  11. Existing Single Indirect-Cost Pool System Example Kole uses 36,000 direct manufacturing labor-hours to make NL and 14,000 direct manufacturing labor-hours to make CL. How much indirect costs are allocated to each product?

  12. Existing Single Indirect-Cost Pool System Example NL: 36,000 × $58 = $2,088,000 CL: 14,000 × $58 = $812,000 What is the total cost of normal lenses? Direct costs $2,320,000 + Allocated costs $2,088,000 = $4,408,000 What is the cost per unit? $4,408,000 ÷ 80,000 = $55.10

  13. Existing Single Indirect-Cost Pool System Example What is the total cost of complex lenses? Direct costs $1,180,000 + Allocated costs $812,000 = $1,992,000 What is the cost per unit? $1,992,000 ÷ 20,000 = $99.60

  14. Existing Single Indirect-Cost Pool System Example Normal lenses sell for $60 each and complex lenses for $142 each. NormalComplex Revenue $60.00 $142.00 Cost 55.10 99.60 Income $ 4.90 $ 42.40 Margin 8.2% 29.9%

  15. Refining a Costing System Direct-cost tracing Indirect-cost pools Cost-allocation basis

  16. Refining a Costing System 1. Design of Products and Process The Design Department designs the molds and defines processes needed (details of the manufacturing operations).

  17. Refining a Costing System 2. Manufacturing Operations Lenses are molded, finished, cleaned, and inspected. 3. Shipping and Distribution Finished lenses are packed and sent to the various customers.

  18. Distinguish between the traditional and the activity-based costing approaches to designing a costing system. Learning Objective 3

  19. Activity-Based Costing System Fundamental Cost Objects Assignment to Other Cost Objects Activities Cost of: • Product • Service • Customer Costs of Activities

  20. Activity-Based Costing System A cross-functional team at Kole Corporation identified key activities: Design products and processes. Set up molding machine. Operate machines to manufacture lenses. Maintain and clean the molds.

  21. Activity-Based Costing System Set up batches of finished lenses for shipment. Distribute lenses to customers. Administer and manage all processes.

  22. Activity-Based Costing System Activity Indirect Cost Pool Design Setup Shipping Parts- Square feet No. of Setup Hours No. of Shipments Cost Allocation Base Lenses NL Lenses CL Lenses Other Product Cost Objects

  23. Activity-Based Costing System NLCL Quantity produced 80,000 20,000 No. produced/batch 250 50 Number of batches 320 400 Setup time per batch 2 hours 5 hours Total setup-hours 640 2,000 Total setup costs are $409,200.

  24. Activity-Based Costing System What is the setup cost per setup-hour? $409,200 ÷ 2,640 hours = $155 What is the setup cost per direct manufacturing labor-hour? $409,200 ÷ 50,000 = $8.184

  25. Activity-Based Costing System Allocation using direct labor-hours: NL: $8.184 × 36,000 = $294,624 CL: $8.184 × 14,000 = $114,576 Total $409,200 Allocation using setup-hours: NL: $155 × 640 = $ 99,200 CL: $155 × 2,000 = $310,000 Total $409,200

  26. Describe a four-part cost hierarchy. Learning Objective 4

  27. Cost Hierarchies A cost hierarchy is a categorization of costs into different cost pools. Cost drivers bases (cost-allocation bases) Degrees of difficulty in determining cause-and-effect relationships

  28. Cost Hierarchies ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: 1. Output unit-level costs 2. Batch-level costs 3. Product-sustaining costs 4. Facility-sustaining costs

  29. Output Unit-Level Costs These are resources sacrificed on activities performed on each individual unit of product or service. Energy Machine depreciation Repairs

  30. Batch-Level Costs These are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. Setup-hours Procurement costs

  31. Product-Sustaining Costs These are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services. Design costs Engineering costs

  32. Facility-Sustaining Costs These are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. General administration – rent – building security

  33. Cost products or services using activity-based costing. Learning Objective 5

  34. ImplementingActivity-Based Costing Step 1 Step 2 Identify cost objects. Identify the direct costs of the products. NL CL Direct material Direct labor Mold cleaning and maintenance

  35. ImplementingActivity-Based Costing Cleaning and maintenance costs of $360,000 are direct batch-level costs. Why? Because these costs consist of workers’ wages for cleaning molds after each batch of lenses is run.

  36. Normal Lenses (NL) Cost Hierarchy DescriptionCategory Direct materials Unit-level $1,520,000 Direct mfg. labor Unit-level 800,000 Cleaning and maint. Batch-level 160,000 Total direct costs $2,480,000 ImplementingActivity-Based Costing

  37. Complex Lenses (CL) Cost Hierarchy DescriptionCategory Direct materials Unit-level $ 920,000 Direct mfg. labor Unit-level 260,000 Cleaning and maint. Batch-level 200,000 Total direct costs $1,380,000 ImplementingActivity-Based Costing

  38. ImplementingActivity-Based Costing Step 3 Select the cost-allocation bases to use for allocating indirect costs to the products. (1) (2) (3) ActivityCost HierarchyTotal Costs Design Product-sustaining $450,000 Setups Batch-level $409,200 Operations Unit-level $637,500

  39. ImplementingActivity-Based Costing Step 4 Identify the indirect costs associated with each cost-allocation base. Overhead costs incurred are assigned to activities, to the extent possible, on the basis of a cause-and-effect relationship.

  40. ImplementingActivity-Based Costing Step 5 Compute the rate per unit. (1) (5) NLCLTotal Setup-hours: 640 2,000 2,640 $409,200 ÷ 2,640 = $155

  41. ImplementingActivity-Based Costing Step 6 Compute the indirect costs allocated to the products. NL: $155 × 640 = $ 99,200 CL: $155 × 2,000 = 310,000 Total $409,200

  42. ImplementingActivity-Based Costing Step 7 Compute the costs of the products. NL and CL would show three direct cost categories. 1. Direct materials 2. Direct manufacturing labor 3. Cleaning and maintenance

  43. ImplementingActivity-Based Costing NL and CL would show six indirect cost pools. 1. Design 2. Molding machine setups 3. Manufacturing operations 4. Shipment setup 5. Distribution 6. Administration

  44. Use activity-based costing systems for activity-based management. Learning Objective 6

  45. Activity-Based Management ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits. Product pricing and mix decisions Cost reduction and process improvement decisions Design decisions

  46. Product Pricing andMix Decisions ABC gives management insight into the cost structures for making and selling diverse products. It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs.

  47. Cost Reduction and ProcessImprovement Decisions Manufacturing and distribution personnel use ABC systems to focus on cost-reduction efforts. Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base.

  48. Design Decisions Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can work with their customers to evaluate the costs and prices of alternative designs.

  49. Compare activity-based costing systems and department- costing systems. Learning Objective 7

  50. ABC and DepartmentIndirect-Cost Rates Many companies have evolved their costing system from using a single cost pool to using separate indirect-cost rates for each department: Design Manufacturing Distribution

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