Chapter 4

1. Chapter 4 Product Costing for Management Decisions: Activity-Based Costing and Activity-Based Management

2. Topics to be Discussed Introduction Activity-Based Costing Choosing Cost Drivers to Motivate Behavior

3. Introduction Overhead costs have soared to 60 percent or more of total product costs in heavily automated manufacturing environments. As overhead costs increase and make up a larger portion of the total costs of products, accuracy in overhead application has become much more important.

4. Activity-Based Costing Overhead Allocation Methods Using Volume-Based Cost Drivers Using Activity-Based Cost Drivers

5. Types of Overhead Costs Unit-levelcosts are incurred each time a unit is produced. Examples: Supplies for factory Depreciation on factory machinery Energy costs for factory machinery Repairs and maintenance of factorymachinery

6. Types of Overhead Costs Batch-level costs are incurred each time a batch of goods is produced. Examples: Salaries related to purchasing and receiving Salaries related to moving material Quality control costs Depreciation of setup equipment

7. Types of Overhead Costs Product-levelcosts are incurred as needed to support the production of each different type of product. Examples: Salaries of engineers Depreciation of engineering equipment Product development costs (testing) Quality control costs

8. Types of Overhead Costs Facility-levelcosts simply sustain a facility’s general manufacturing process. Examples: Depreciation of factory building or rent Salary of plant manager Insurance, taxes, etc. Training

9. Activity-Based Costing (ABC) Key Concept Overhead costs are assigned to products in an ABC system in two stages: Stage 1: Activities are identified and overhead costs are traced to each activity Stage 2: Cost drivers are determined for each activity and costs are assigned to products

10. Activities and Cost Drivers: Unit Level Activity Machining Maintenance of machines Potential Cost Driver Machine hours, labor hours or number of units Machine hours

11. Activities and Cost Drivers:Product Level Activity Product Testing Supervision Potential Cost Driver Number of change orders, number of tests, hours of testing time Number of supervision hours

12. Activities and Cost Drivers: Batch Level Activity Purchasing Receiving Machine setups Customer orders Potential Cost Driver Number of purchase orders or number of parts Amount of material or number of receipts Number of setups Number of orders, number of customers

13. Activities and Cost Drivers: Facility Level Activity Plant Occupancy Potential Cost Driver Square footage, number of employees, labor hours, machine hours

14. Choosing Cost Drivers Cost drivers should generally be based on a cause-and-effect relationship between the driver and the specific cost being considered.

15. Traditional Overhead Allocation and ABC - An Example Beach Housing Contractor Builds standard houses and custom houses

16. Estimated Overhead Costs for 2002 Manufacturing Overhead Item Indirect Materials Construction Supervisors Office Staff Part-time Workers Office Expenses Tools Trucks and Other Equipment Rent on Construction Trailers Total Manufacturing Overhead Estimated Cost $180,000 130,000 30,000 30,000 48,000 15,000 40,000 12,000 $485,000

17. Stage 1: Identification of Activities Activity Inspections Purchasing Supervision Material delivery & handling Processing change orders Total Estimated Cost $50,000 30,000 100,000 225,000 80,000 $485,000

18. Stage 2: Identification of Cost Drivers & Allocation of Costs Activity Inspections Purchasing Supervision Material delivery & handling Change orders Cost Driver Number of inspections Number of purchase orders Hours of supervisor time Number of deliveries Number of change orders

19. Estimated Cost Driver Activity Cost Driver Number of Houses Number of inspections Number of purchase orders Supervision hours Number of deliveries Number of change orders Standard Houses (20) 400 600 2,500 600 200 Custom Houses (10) 1,000 600 1,500 600 300 Totals 1,400 1,200 4,00 1,200 500

20. Activity-Based Costing Activity Inspections Purchasing Supervision Material delivery & handling Processing change orders Total Overhead Cost $50,000 30,000 100,000 225,000 80,000 $485,000 / / / / / / Cost Driver = PDR 1400 = $35.71/hour 1200 = $25/order 4000 = $25/hour 1200 = $187.50/delivery 500 = $160/order

21. Standard House Cost Direct materials Direct labor Inspections Purchasing Supervision Material H&D Processing change orders Total Costs ABC $75,000 60,000 714 750 3,125 5,625 1,600 $146,814 Vol-Based $75,000 60,000 overhead 13,224 $148,224

22. Custom House Cost Direct materials Direct labor Inspections Purchasig Supervision Material H&D Processing change orders Total Costs ABC $112,500 100,000 3,571 1,500 3,750 11,250 4,800 $237,371 Vol-Based $112,500 100,000 overhead 22,040 $234,540

23. ABC Allocating overhead costs using and activity-based costing system results in greater allocations of overhead to the custom house because it consumes more of the purchasing, inspection, supervision, material handling, and processing change order activities than the standard house.

24. ABC Key Concept Volume-based costing systems often result inovercosting high-volume productsandundercosting low-volume products. This cross subsidy is eliminated by the use of ABC.

25. ABC Systems in Service Industries Although ABC was developed for use primarily be manufacturing companies, it has gained widespread acceptance in the service sector.

26. ABC Systems in Service Industries Problems Type of work tends to be non-repetitive Activities differ greatly for each customer or service Have proportionately more facility-level costs

27. Cost Flows and ABC The flow of costs from raw materials to work in process to finished goods and cost of goods sold is not affected by the implementation of ABC.

28. Need for ABC The higher the potential for cost distortions, the more likely the company will benefit from ABC. Distortions result from diverse products. Diverse products: products that consume resources in different proportions

29. Diverse Products Pause and Reflect: Are the standard houses and custom houses built by TopSail Construction diverse products?

30. Activity-Based Management Topics Key Concept Activity-based management focuses on use of ABC to make better decisions.

31. Value-Added and Non-Value-Added Activities Non-value-added activitiesdon’t add value to the finished product or service. Storage of inventory Moving of materials and parts from storage to the factory Idle time of employees while waiting for work

32. Successful Implementation of ABC and ABM Perhaps nowhere else is cooperation among accountants, marketing managers, production managers, human resource managers, and finance managers more critical than in the implementation of activity-based costing and management systems.

33. Successful Implementation of ABC and ABM Key Concept The successful implementation of ABC and ABM requires a long-term commitment by top management and the cooperation of all functional areas of business organization.

34. End of Chapter 4 How do I allocate all of this overhead?