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ACTIVITY-BASED COSTING

ACTIVITY-BASED COSTING. Chapter 4. CHAPTER 4 Objectives. Describe the basics of plantwide and departmental overhead costing Explain why plantwide and departmental overhead costing may not be accurate Provide a detailed description of activity-based product costing

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ACTIVITY-BASED COSTING

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  1. ACTIVITY-BASED COSTING Chapter 4

  2. CHAPTER 4 Objectives • Describe the basics of plantwide and departmental overhead costing • Explain why plantwide and departmental overhead costing may not be accurate • Provide a detailed description of activity-based product costing • Explain how ABC can be simplified

  3. Exhibit 4.1—Unit-based Product Costing model LO-1

  4. Unit-Level Product Costing Predetermined overhead rate Budgeted annual overhead Budgeted annual driver level = Applied overhead = Overhead rate  Actual driver usage Overhead costs are assigned to products using predetermined overhead rates LO-1

  5. Unit-Level Product Costing Unit level drivers: factors that measure the demands placed on unit-level activities by products Unit level activities: activities performed each and every time a unit of a product is produced Five most commonly used unit level drivers • Units produced • Direct labor hours • Direct labor dollars • Machine hours • Direct material dollars LO-1

  6. Unit-Level Product Costing LO-1 The difference between actual overhead and applied overhead If actual overhead > applied overhead: underapplied overhead If actual overhead < applied overhead: overapplied overhead Overhead Variances

  7. Unit-Level Product Costing LO-1 Disposal of Variance • If immaterial, assign to cost of goods sold • If material, allocate among work-in-process inventory, finished goods inventory, and cost of goods sold Overhead Variances

  8. Unit-Level Product Costing Overhead Application: Departmental Rates Costs assigned to individual production department, creating departmental overhead cost pools Unit level drivers are used to compute predetermined overhead rates for each department Overhead is assigned to products by multiplying the departmental rates by the amount of the driver used in the respective departments LO-1

  9. Limitations of Plantwide and Departmental Rates Non-Unit-Related Overhead Costs Plantwide and department rates assume that a product’s consumption of overhead is directly related to units produced Some costs, however, such as setups cost a certain amount no matter how many products are produced Other costs, such as engineering hours, may depend on something entirely different, such as work orders, not units Non-unit-based drivers are factors, other than the number of units produced, that measure the demands that cost objects place on activities LO-2

  10. Limitations of Plantwide and Departmental Rates Product Diversity Even if there are significant non-unit driven overhead costs, it will not cause distorted costing if the products all consume overhead in the same proportion as unit-level driven overhead costs LO-2

  11. Limitations of Plantwide and Departmental Rates Product Diversity Products consume overhead activities in different proportions • Caused by differences in product size, complexity, setup time, batch size, etc. • The proportion of each activity consumed by a product is called the consumption ratio LO-2

  12. Limitations of Plantwide and Departmental Rates Two producing departments: molding and Assembly Two products: race cars and robots Five times more race cars than robots are produced making race cars a high-volume product and robots a low-volume product The molds for robots are larger and more varied than those for race cars Four types of overhead activities are performed: setups, machining, inspection, and moving batches LO-2

  13. EXHIBIT 4.2—Product-costing data LO-2

  14. EXHIBIT 4.2—Product-costing data (Continued) LO-2

  15. EXHIBIT 4.3—Unit Product Cost: Plantwide and Departmental Rates LO-2

  16. Limitations of Plantwide and Departmental Rates LO-2 Problems with Costing Accuracy The main problem with using either plantwide or departmental rates is the assumption that machine hours and/or direct labor hours drive or cause all overhead costs Race cars, the high-volume product, use four times the direct labor hours used by robots, the low-volume product If a plantwide rate is used, the race cars will receive four times more overhead cost than will the robots • This might not be reasonable

  17. Limitations of Plantwide and Departmental Rates LO-2 The data in Exhibit 4.2 suggest that a significant portion of overhead costs is not driven or caused by the units produced The high-volume product, race cars, uses three times the number of setups of robots, about 2.33 times as many inspection hours, and only one and one-half times as many moves Use of direct labor hours, a unit-based activity driver, and a plantwide rate assigns four times more overhead costs to the race cars than to the robots

  18. Limitations of Plantwide and Departmental Rates Activity Rates: A Better Approach Instead of using a single pool or department pools based on units, expand the number of pools and rates and base them on activities The rates are based on causal factors that measure consumption – both unit and non-unit level activity drivers Costs are assigned to each product by multiplying the activity rates by the amount consumed by each activity LO-2

  19. EXHIBIT 4.4—Comparison of Unit Costs LO-2

  20. Limitations of Plantwide and Departmental Rates The activity-based cost assignment follows a cause-and-effect pattern of overhead consumption and is therefore the most accurate of the three costs In the presence of significant non-unit overhead costs and product diversity, using only unit-based activity drivers can lead to one product subsidizing another LO-2

  21. EXHIBIT 4.5—Activity based costing model LO-3

  22. EXHIBIT 4.6—design steps for an abc system LO-3

  23. Activity-Based Costing System Identify, define, and classify activities and key attributes • Activity inventory: a simple list of activities identified • Activity attributes: nonfinancial and financial information items that describe individual activities • Activity dictionary: lists the activities in an organization along with desired attributes • Primary activity: consumed by the final cost object • Secondary activity: consumed by intermediate cost objects • Interviews, questionnaires, surveys, and observation are means of gathering data for an ABC system LO-3

  24. EXHIBIT 4.7—Sample Activity Inventory LO-3

  25. Activity-Based Costing System Assign the cost of resources to activities • The cost of an activity is the resources consumed by that activity • If a resource is exclusive to an activity, assign 100% of the cost to the activity • If the resource is split between more than one activity, determine a resource driver • Resource drivers are factors that measure the consumption of resources by activities LO-3

  26. Activity-Based Costing System Assign the cost of secondary activities to primary activities • Treat the secondary activity like a resource from the previous step LO-3

  27. Activity-Based Costing System Identify cost objects and specify the amount of each activity consumed by them • Assign costs consumed by more than one activity in proportion to their usage of the activity as measured by the activity driver • Transaction drivers measure the number of times an activity is performed • Duration drivers measure the demands in terms of the amount of time it takes to perform an activity LO-3

  28. Activity-Based Costing System A bill of activities specifies the product, expected product quantity, activities, and amount of each activity expected to be consumed by each product LO-3

  29. Activity-Based Costing System Calculate primary activity rates • Primary activity rates are computed by dividing budgeted activity costs by practical activity capacity • Practical activity capacity is the activity output that can be produced when the activity is performed efficiently LO-3

  30. Activity-Based Costing System Assign activity costs to cost objects • Multiply the activity rate by the actual number of activity drivers consumed. LO-3

  31. Activity-Based Costing System Classifying activities into categories aids in product costing because the cost behavior differs by level • Unit-level • Batch-level • Product-level • Facility-level LO-3

  32. EXHIBIT 4.8—Activity Dictionary: Cardiology Unit LO-3

  33. EXHIBIT 4.9—Unbundling of General Ledger Costs LO-3

  34. EXHIBIT 4.10—Bill of Activities: Cardiology Unit LO-3

  35. EXHIBIT 4.11—Assigning Costs: Final Cost Objects LO-3

  36. Reducing the Size and Complexity of an ABC System LO-4 A before-the-fact simplification method, eliminates the need to identify resource drivers, eliminating the need for much of the detailed implementation interviews Before-the-Fact Simplification: TDABC

  37. Reducing the Size and Complexity of an ABC System Activity cost = Capacity cost rate × Time to perform one unit of activity × Total activity output = Activity rate × Total activity output LO-4 First, it calculates total operating cost of a department or process Second, it calculates a capacity cost rate by dividing the total resource cost by the practical capacity of resources supplied Third, it estimates the time to perform one unit of activity Before-the-Fact Simplification: TDABC

  38. Reducing the Size and Complexity of an ABC System LO-4 Approximately Relevant ABC Systems • Calculate the cost of your activities • Combine the less expensive activity costs into the more expensive activity costs making fewer categories Equally Accurate Reduced ABC Systems • Use expected consumption ratios to reduce the number of drivers After-the-Fact Simplification: TDABC

  39. EXHIBIT 4.12—Data for Patterson Company LO-4

  40. End of Chapter 4

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