Chapter 17

1. Chapter 17 Activity-Based Costing and Analysis

2. Conceptual Learning Objectives C1: Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and activity-based costing method. C2: Explain cost flows for the plant wide overhead rate method. C3: Explain cost flows for the departmental overhead rate method. C4: Explain cost flows for activity-based costing.

3. Analytical Learning Objectives A1: Identify and assess advantages and disadvantages of the plantwide overhead rate method. A2: Identify and assess advantages and disadvantages of the departmental overhead rate method. A3: Identify and assess advantages and disadvantages of activity-based costing.

4. Procedural Learning Objectives P1: Allocate overhead costs to products using the plantwide overhead rate method. P2: Allocate overhead costs to products using departmental overhead rate method. P3: Allocate overhead costs to products using activity-based costing.

5. Assigning Overhead Costs C1 Direct Materials Indirect FactoryOverhead Goods in Process FinishedGoods Allocate Indirect Cost of GoodsSold Direct Labor

6. Assigning Overhead Costs Overhead costs are not directly related to production volume, and therefore cannot be traced to units of product in the same way as direct materials and direct labor.Consequently, we must assign overhead costs using an allocation system. This chapter identifies three methods of overhead allocation.

7. Single plant-wide overhead rate Departmental overhead rates Activity-based costing Assigning Overhead Costs C1 Overhead can be assigned to production in one of three ways:

8. Plant Wide Overhead Rate Method When overhead costs are closely related to volume-related measures this method is logical. 1. Total budgeted overhead costs are combined into one overhead cost pool. 2. Next, the cost pool is divided by the chosen allocation base, such as total direct labor hours, to arrive at a single plant wide allocation rate. 3. Finally, this rate is applied to assign costs to all products. 4. The target of the cost assignment or CostObject is the unit of product.

9. Indirect Costs Single Plant-Wide Overhead Rate Cost Allocation Base Cost Objects Product 1 Product 2 Product 3 Plant Wide Overhead Rate Method C2 Overhead Cost

10. Plant Wide Overhead Rate Method Illustration P1

11. Total budgeted overhead costs Total budgeted DLH Plant Wide Overhead Rate Method Illustration P1 Plantwide overhead rate =

12. $4,800,000 100,000 DLH = $48/DLH Plant Wide Overhead Rate Method Illustration P1 Plantwide overhead rate =

13. Plant Wide Overhead Rate Method Illustration P1

14. Information is readily available Easy to implement Often sufficient to meet external financial reporting needs Plant Wide Overhead Rate Method -Advantages

15. Overhead costs may not bear any relationship with direct labor hours. Example: Technology Intensive vs. Labor Intensive production stages. Various types of products within the same company may not use overhead costs in the same proportion. Plant Wide Overhead Rate Method -Disadvantages

16. Departmental Overhead Rate Method Many companies have several departments that produce various products and consumes overhead resources in a substantially different way. Example: Machining Dept => Machine HoursAssembly Dept => Labor Hours Departmental OH Rate is a better method to allocate of costs to departments when overhead resources are consumed in substantially different ways.

17. Departmental Overhead Rate Method Two stages of allocating overhead rates: First stage: Overhead costs are determined separately for each production department.Cost Object is the ‘Department’. Second stage:An overhead rate is computed for each production department to allocate the overhead costs to products passing through that department. Cost Object is the ‘Product’.

18. Departmental Overhead Rate Method C3 Overhead Cost Indirect Costs First Stage Department A Department B Cost Objects Department A Overhead Rate Department B Overhead Rate Second Stage Allocation Base Cost Objects Product 3 Product 1 Product 2

19. Departmental Overhead Rate Method: First Stage P2 Overhead Cost $4,800,000 First Stage Machining Dept. $4,200,000 Assembly Dept. $600,000

20. Departmental Overhead Rate Method: Second Stage P2 Department A Overhead Rate Department B Overhead Rate Second Stage Product 1 Product 2 Product 3

21. Departmental Overhead Rate Method: Second Stage P2

22. Total departmental overhead costs Total unit number in departmental allocation base Departmental Overhead Rate Method: Second Stage P2 Departmental Overhead Rate =

23. Machining Department Overhead Rate $4,200,000 70,000 MH = = $60/MH $600,000 30,000 DLH Assembly Department Overhead Rate $20/DLH = = Departmental Overhead Rate Method: Second Stage P2

24. Departmental Overhead Rate Method: Second Stage P2

25. Advantages of Departmental Overhead Rate Method • Advantages • More accurate overhead allocations • More refined than the plant-wide overhead rate method

26. Disadvantages of Departmental Overhead Rate Method • Since different products within the department may differ in batch size and complexity, Departmental Overhead Rate method: • Can distort product costs • Assumes that products are similar in volume, complexity, batch size • Assumes that departmental overhead costs are proportional to the allocation base

27. Activity-Based Costing (ABC) Method Activity-Based Costing (ABC) Rates and methodattempts to more accurately assign overhead costs by focusing on activities. The premise of ABC is that it takes activities to make products and provide services.  These activities drive cost. For example, costs are incurred and resources are used when we perform activities:-Cutting Raw Materials; -Inspecting parts; -Processing Invoices

28. Activity-Based Costing (ABC) Method Activity is the basic principle underlying ABC method. Activity is a TASK, OPERATION, or PROCEDURE which causes costs to be incurred => Cost Driver. Example: Warehousing Products consumes resources (drives costs) such as: -Employee time for driving forklift; -Electricity to power forklift; -Wear & tear (depreciation) on a forklift. Training employees consumes resources (drives costs) such as: -Trainers’ salaries; -Training supplies

29. Activity-Based Costing (ABC) Method There are two basic stages to ABC: The first stage of ABC cost assignment is to Identify the activities (cost objects) involved in manufacturing products and match those activities with the costs that they cause (cost driver).To reduce the total number of activities that must be assigned costs, the homogeneous activities (those caused by the same factors such as cutting metal) are grouped into activity cost pool. The second stage of ABC is to compute an activityrate for each cost pool and use this rate to allocate overhead costs to products(cost objects).

30. Activity Cost Pool A “cost bucket” in which costs related to a particular activity measure are accumulated. $ $ $ $ $ $ ABC: Activity (Cost Driver) and Activity Cost Pool An event that causes the consumption of overhead resources. ActivityCost Driver

31. Cost Flows Under Activity-Based Costing Method Indirect Costs Overhead Cost First Stage Activity Cost Pool X Activity Cost Pool Y Activity Cost Pool Z Cost Objects Second Stage Activity Overhead rate Activity Overhead rate Cost Allocation Base Activity Overhead rate Cost Objects Product 1 Product 2 Product 3

32. Applying Activity-Based Costing P3 4 steps: • Identify activities and the costs they cause. • Group similar activities into activity pools. • Determine an activity rate for each activity cost pool. • Allocate overhead costs to products using those activity rates.

33. Step one: Identify activities and cost pools. Activities causing overhead cost are typically separated into four levels reflecting control: (1) Unit level activities are performed on each product unit, (2) Batch level activities are performed only on each batch or group of units, (3) Product level activities are performed on each product line independent of the number of units or batches, and (4) Facility level activities are performed to sustain facility capacity as a whole.

34. Unit level Batch level Product level Facility level Levels of types of activities P3

35. Unit level Levels of activities P3 Unit level activities are performed on each product unit. Example: Providing electricity to power machinery in the machining department is needed to produce each unit of product.

36. Batch level Levels of Activities Batch level activities are performed only on each batch or group of units. Example: Machine setup is needed only for each batch regardless of the units in that batch.

37. Product level Levels of Activities Product level activities are performed on each product line and are not affected by either numbers of units or batches. Example: Product design is needed only for each product line . Product level costs do not vary with the number of units or batches produced.

38. Facility level Facility Level Activities Facility level activities are performed to sustain facility capacity as a whole and are not caused by any specific product. Example: Rent or factory maintenance costs are incurred no matter what is produced. Factory level costs do not vary with what is manufactured, how many batches are produced, or the output quality.

39. Step Two: Trace Overhead Costs to Cost Pools Overhead Cost Activity Cost Pool X Activity Cost Pool Y Activity Cost Pool Z

40. Step Two: Trace Overhead Costs to Cost Pools Four Cost Pools for KartCo: -Craftsmanship -Setup -Design Modification-Plant Services

41. Step Two: Trace Overhead Costs to Cost Pools P3

42. Step Two: Assigning Overhead to Activity Cost Pools P3

43. Step Three: Determine Activity Rate P3 Activity Cost Pool X Activity Cost Pool Y Activity Cost Pool Z Step 3 is to compute the activity rates used to assign overhead costs to final cost objects such as products. Activity Overhead rate Activity Overhead rate Activity Overhead rate

44. Proper determination of activity rates depends on: and Step Three: Determine Activity Rate P3 Proper identification of the factor that drives the cost Proper measures of activities

45. Step Three: Determine Activity Rate P3 Total cost in activity pool Measure of the activity Activity rate For example: Set-up cost pool activity rate = $2,000,000 / 200 batches = $10,000 per batch Craftsmanship cost pool activity rate = $600,000/30,000 DLH = $20 per DLH =

46. Step Three: Determine Activity Rate P3

47. Step Four: Assign Overhead Costs to Cost Objects P3 Step 4 is to assign overhead costs in each activity cost pool to final cost objects using activity rates. Activity Overhead rate Activity Overhead rate Activity Overhead rate Product 1 Product 2 Product 3

48. Step Four: Assign Overhead Costs to Cost Objects P3 • To illustrate, the overhead costs in the craftsmanship pool are allocated to standard go-karts as follows: Overhead allocated to standard go-kart = Activities consumed X Activity rate= 25,000 DLH x $20 / DLH = $500,000

49. Step Four: Assign Overhead Costs to Cost Objects P3

50. Step Four: Assign Overhead Costs to Cost Objects P3