Supplementary Slides - Activity Based Costing

1. Supplementary Slides- Activity Based Costing Systems Design: Activity Based Costing

2. Learning Objective 1 Understand the basic approach in activity-based costing and how it differs from conventional costing.

3. Assigning Overhead Costs to Products When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2.    Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

4. Plantwide Overhead Rate Plantwide Overhead RateA single overhead rate used throughout an entire factory. Direct labor has often been used as the allocation base for overhead because: 1.    Direct labor information was already being recorded. 2.    Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated.

5. Plantwide Overhead Rate • Today, direct labor may no longer be a satisfactory base for allocation of overhead. • Most companies sell a large variety of products that consume differing amounts of overhead. • As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor. • Technology advancements have reduced the cost and complexity of gathering diverse sources of data. A plantwide overhead allocation system may not be optimalfor many companies in today’s business environment.

6. Activity-Based Costing (ABC) A number of allocation bases are used for assigning costs to products.

7. Activities Consumption of Resources Cost Activity-Based Costing (ABC) Cost Objects (e.g., products and customers)

8. Activity-Based Costing (ABC) An event that causes the consumption of overhead resources Activity Examples of Activities Setting upmachines Admitting hospitalpatients Billingcustomers Opening a bank account

9. A “cost bucket” in which costs related to a particular activity are accumulated Activity Cost Pool Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs Activity Measure A predetermined overhead rate for each activity cost pool. Activity Rate Activity-Based Costing (ABC)

10. Activity-Based Costing (ABC) For each activity inisolation, this system works exactlylike the job-order costing system. A predetermined overhead rate is computed foreach activity and then applied to jobs andproducts based on the amount of activityconsumed by the job or product.

11. Designing an Activity-BasedCosting System The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources.

12. For example, several activities maybe involved in handling and movingraw materials, but these may becombined into a single activityentitled material handling. Designing an Activity-BasedCosting System Related activities arefrequently combined to reducethe amount of detail andrecord-keeping costs. An activity dictionary defines each of the activitiesthat will be included in the activity-based costingsystem and how the activities will be measured.

13. First-Stage Cost Assignment LaborRelated Pool MachineRelated Pool SetupPool ProductionOrder Pool PartsAdmin. Pool GeneralFactory Pool Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs

14. First-Stage Cost Assignment LaborRelated Pool MachineRelated Pool SetupPool ProductionOrder Pool PartsAdmin. Pool GeneralFactory Pool Second-Stage Allocations $/DLH $/MH $/Setup $/Order $/Part Type $/MH Products Unit-LevelActivity Batch-LevelActivity Product-LevelActivity Facility-LevelActivity Graphic Example ofActivity-Based Costing Various Manufacturing Overhead Costs

15.  Comtek Sound, Inc. makes two products: CD players and DVD players.  The company has been losing bids to supply CD players, its main product, to lower priced competitors.  The company has been winning all bids to supply DVD players, its secondary product. Using Activity-Based CostingComtek Sound, Inc.

16.  For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units.  Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor hours.  Both products require two direct labor-hours to complete, for a total of 500,000 direct labor hours. Using Activity-Based CostingComtek Sound, Inc.

17.  Unit costs for materials and labor are: Using Activity-Based CostingComtek Sound, Inc.

18. Predeterminedoverhead rate $10,000,000500,000 DLHs = = $20 per DLH Direct Labor-Hours as a Base Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon labor-hours:

19. Direct Labor-Hours as a Base Since each product requires two hours of direct labor, $40 of overhead is assigned to each product.  

20. Learning Objective 2 Compute activity rates for an activity-based costing system.

21. Computing Activity Rates The ABC project team at Comtek hasdeveloped the following basic information.

22. Computing Activity Rates We can calculate the following activity rates: Using the new activity rates, let’s assign overheadto the two products based upon expected activity.

23. Learning Objective 3 Compute product costs using activity-based costing.

24. Computing Overhead Cost per Unit DVD Units

25. Computing Overhead Cost per Unit CD Units

26. Comparing the Two Approaches Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . . . . . . while the unit cost of a DVD unit increased from $150 to $207.80.

27. Shifting of Overhead Cost Low-volume product When a company implements activity-based costing, overhead cost often shifts from high-volume to low-volume products with a higher unit product cost resulting for the low-volume products.

28. Shifting of Overhead Cost High-volume product The traditional system assigns the same amount of all overhead costs to each CD or DVD player ($40 per unit).

29. Targeting Process Improvements An ABC system can help identifyareas where the company can benefitfrom improving its current processes. Activity-Based ManagementFocuses on managing activities to eliminate waste and reduce delays and defects.

30. Benefits of Activity-Based Costing ABC improves the accuracy of product costing by: • Increasing the number of cost pools used to accumulate overhead costs. • Using activity cost pools that are more homogeneous than departmental cost pools. • Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. Activity-based costing also highlights activities that could benefit most from processimprovement efforts, such as Six Sigma.

31. Limitations Activity-Based Costing • Costs of implementing an ABC system may outweighthe benefits. However, the benefits are more likely to be worth the costs when: • Products differ substantially in volume, batch size, and in activities required. • Conditions have changed substantially since the existing cost system was established. • Overhead costs are high and increasing and no one seems to understand why. • Management does not trust the existing cost system and it ignores data from it when making decisions.