Traditional, Volume-Based Product-Costing System

2. Traditional, Volume-Based Product-Costing System • Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. • The following information is obtained from company records:

3. Traditional, Volume-Based Product-Costing System Additional information includes: Manufacturing overhead is determined as follows

4. Budgeted manufacturing overhead $3,894,000 Budgeted direct-labor hours 118,000 = $33 per hour Traditional, Volume-Based Product-Costing System

5. Traditional, Volume-Based Product-Costing System With these product costs, Aerotech established target selling prices (Cost × 125%). 209.00 x 1.25

6. Traditional, Volume-Based Product-Costing System Aerotech wishes to see what target selling prices would be suggested when using activity-based costing. Let’s see how ABC works.

7. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Assigning overhead to products is a difficult process. I agree!

8. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Let’s begin by identifying our major activities. Stage OneIdentify significant activities and assign overhead costs to each activity in proportion to resources used.

9. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Overhead assigned to activities are called “activity cost pools.” Stage TwoIdentify cost drivers appropriate to each activity and allocate overhead to the products.

10. Activity must be done on each unit produced. Activity performed on each batch produced. Activities needed to support an entire product line Activity required in order for the production process to occur. Overhead Costs Total budgeted cost = $3,894,000 Identification of Activity Cost Pools Activity Cost Pools Product- Sustaining Level Unit Level Batch Level Facility Level Machinery cost pool $1,212,600 Setup cost pool $3,000 Engineering cost pool $700,000 Facility cost pool $507,400

11. Overhead Costs Total budgeted cost = $3,894,000 Identification of Activity Cost Pools Activity Cost Pools Product- Sustaining Level Unit Level Batch Level Facility Level Machinery cost pool $1,212,600 Setup cost pool $3,000 Engineering cost pool $700,000 Facility cost pool $507,400 More Cost Pools

12. Product- Sustaining Level Unit Level Batch Level Facility Level Machinery cost pool $1,212,600 Setup cost pool $3,000 Engineering cost pool $700,000 Facility cost pool $507,400 Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000

13. STAGE ONE Various overhead costs related to machinery Maintenance Lubrication Depreciation Electricity Computer Support Calibration Activity cost pool Machinery Cost Pool Total budgeted cost = $1,212,600

14. STAGE TWO Calculate the pool rate Budgeted Machinery Costs$1,212,600 Budgeted Machine Hours 43,000 $28.20/hour = = Cost Assignment

15. STAGE ONE Calculation of total setup cost Activity cost pool Setup Cost Pool Total budgeted cost = $3,000

16. STAGE TWO Calculate the pool rate Budgeted Setup Costs $3,000 Planned Production Runs 15 runs $200 per run = = Cost Assignment

17. STAGE ONE Various overhead costs related to engineering Engineering salaries Engineering software Engineering supplies Depreciation Activity cost pool Engineering Cost Pool Total budgeted cost = $700,000

18. STAGE TWO Engineering Cost Pool Total budgeted cost = $700,000 Allocate based on engineering transactions Cost Assignment

19. STAGE ONE Various overhead costs related to general operations Plant depr. Property taxes Plant mgmt. Insurance Plant maint. Security Activity cost pool Facility Cost Pool Total budgeted cost = $507,400

20. STAGE TWO Calculate the pool rate Budgeted Facilities Cost $507,400 Budgeted Direct-Labor Hours 118,000 $4.30/hour = = Cost Assignment

21. Product Cost from ABC Here are the new product costs so far . . .

22. Other Overhead Costs

23. Other Overhead Costs $14.82

24. Product Cost from ABC These are the new product costs when Aerotech uses ABC.

25. Product Diversity Both original and ABC target selling prices are based on (Cost × 125%). The selling price of Mode I and II are reduced and the selling price for Mode III is increased. [$209.00 × 1.25] [$183.44 × 1.25]

26. Product Diversity Can you identify any problems Aerotech is likely to face as a result of this distortion? Traditional costing understates the cost of complex, low volume products.

27. The Past Small number of products which did not differ much in required manufacturing support. Labor was the dominant element in the cost structure. The Present Numerous products with more and complicated production requirements. Labor is becoming an ever smaller part component of total production costs. ABC: Some Key Issues

28. Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . . Degree of Correlation Behavioral Effects Cost of Measurement

29. Homogeneous Activity Cost Pools A homogeneous cost pool is a grouping of overhead costs in which each cost component is consumed in roughly the same proportion by each product line. A homogeneous cost pool uses a single cost driver.

30. Usually Result In Activities Paperwork Transaction Costing Transaction processing provides a readily measurable gauge of departmental activity.

31. Storyboarding A procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities. Step 1 These are the steps we follow to build a memory board. Step 2 Step 3 Step 4

32. Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. Direct versus Indirect Costs Indirect Costs

33. Indicators of Need for ABC Direct labor is a small percentage of total costs Product-line profit margins are hard to explain Line managers do not believe the product costs reports Sales are increasing, but profits are declining. Some products that have reported high profit margins are not sold by competitors Marketing does not use costs reports for pricing decisions

34. Optimal Product-Costing System Cost Total Cost High Cost of inferior decisions resulting from inaccurate information. Design, implementation and maintenance costs Information System Accuracy Low Low High Optimal system

35. Cost Management Systems Objectives • Measure the cost of resources consumed. • Identify and eliminate non-value-added costs. • Determine the efficiency and effectiveness of all major activities. • Identify and evaluate new activities that can improve future performance.

36. Storage Time Waiting Time Process Time Move Time Inspection Time NVA NVA VA NVA NVA Non-Value-Added Costs Suppose our production process looks like this: VA = Valued-added activity NVA = Non-value-added activity

37. Storage Time Waiting Time Process Time Move Time Inspection Time NVA NVA VA NVA NVA Non-Value-Added Costs Our goal is to reduce or eliminate the non-value-added activities. VA = Valued-added activity NVA = Non-value-added activity

38. ABC in the Service Industry Activities tend to be nonrepetitive human tasks. Implementation Problems High proportion of facility-level costs