Activity-Based Costing Chapter 3

1. Activity-Based CostingChapter 3 Introduction to ManagerialAccounting, Brewer, Garrison,Noreen Power Points fromwebsite - adapted by Cynthia Fortin, CPA, CMA http://highered.mheducation.com/sites/0078025419/student_view0/chapter3/index.html

2. Activity–Based Costing (ABC): Key Definition ABC is a costing method designed to provide managers with cost information for strategic and other decisions that potentially affect capacity, and therefore, “fixed” as well as variable costs. It is ordinarily used as a supplementto, rather than as a replacement for, the company’s usual costing system.

3. Allocation of Overhead Conventional Method (chap. 2) • Factory overhead applied to production using some type of averaging - labor-hours, machine-hours, etc.

4. Why Broad Averaging? • Historically • limited variety of goods indirect costs were relatively small compared to direct costs • Simplicity • To use broad averages to allocate costs uniformly regardless of how they are actually incurred

5. Conventional Costing leads to Overcosting Job actually consumed a low level of resources but allocated high costs per unit because the allocation base is not the relevant cost driver (does not cause the cost) Undercosting Consumed a high level of resources but is allocated low costs per unit.

6. The overcosted products are subsidizing the undercosted products

7. ABC proposes to refine a costing system, how? 1. Direct-cost tracing • Analyze costs in overhead and classifying them as direct costs. Could also use costs from non-manufacturing activities. 2. Indirect-cost pools • Expand the number of indirect-cost pools until the costs in each pool have a similar cause & effect relationship

8. Refining a Costing System 3. Cost-allocation bases • Consider using a different cost-allocation base for each indirect-cost pool. • Choose allocation base based on what causes the cost pool to change.

9. Notone but many allocation bases are used for assigning costs to products.

10. Activities Cost Activity-Based Costing (ABC) Cost Objects What causes the activities (e.g. number of orders, set-ups,)

11. 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

12. A “cost bucket” accumulating costs of a particular activity Activity Cost Pool • Measures how much of the activity is carried out • 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) Same process as conventional costing but more than one pool

13. Why establish an Hierarchy of Activities? Hundreds of activities cause overhead costs: • Rent • Indirect labour: engineers, managers, maintenance, security, cleaning • Depreciation of equipment, of infrastructure • Utilities: gas, electric • Telecom • Taxes, insurance

14. Why establish an Hierarchy of Activities? The challenge in designing ABC is to identify a small number of activities that cover most overhead costs. This is done by talking to managers and asking: What are the most important activities? The hierarchy serves as a guide in simplifying ABC system.

15. Hierarchy of Activities

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

17. 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 First-Stage Cost Assignment LaborRelated Pool MachineRelated Pool SetupPool ProductionOrder Pool PartsAdmin. Pool GeneralFactory Pool

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

19.  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. Comtek Sound, Inc.

20. Conventional Costing • Cost objectsCD DVD • Direct costs Labor 20 20 Materials 50 90 3.Cost allocation base: labor-hours 4.Overhead Pool $10,000,000 5. Total hours 250,000*2= 500,000 6. O/H rate 10,000,000/500,000=$20 4040 7. Total cost $110 $150

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

22. Computing Activity Rates A B C

23. Computing Overhead Cost per Unit DVD Units C D

24. Computing Overhead Cost per Unit CD Units

25. 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.

26. Comparing the Two Approaches The ABC system assigns $14.45 less overhead than the conventional system to each CD player.

27. Comparing the Two Approaches The ABC system assigns $57.80 more overhead than the conventional system to each DVD player.

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

29. Targeting Process Improvements Activity-Based ManagementFocuses on managing activities to eliminate waste and reduce delays and defects. Note: for real implementation read case study of Xu Ji Electric Co. Ltd http://www.cimaglobal.com/Documents/Thought_leadership_docs/6Activity-based-costing-China.pdf.

30. The Theory of Constraintsapproach targets thehighest impactimprovement opportunities. Activity rates can beused to target areaswhere costs seemexcessively high. Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations. Targeting Process Improvements The first step in any improvementprogram is deciding what to improve.

31. ABC improves the accuracy of product costing by: Increasing the number of cost pools. Using activity cost pools that are more uniform than departmental cost pools. Using activity measures that cause those costs. Benefits of Activity-Based Costing

32. Costs of implementing an ABC system may outweigh the benefits

33. Benefits more likely to be worth the costs when: • Products differ substantially 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. Benefits Costs