Activity-Based Costing: A Decision-Making Tool

1. Activity-Based Costing: A Tool to Aid Decision Making Chapter EightACCT7110-Dr. Bailey-Spring 2008and ACCT7320-Fall 2009

2. ABC is a good supplement to our traditional cost system Activity Based Costing (ABC) ABC is designed to provide managers with cost information for decisions. • What products/services profitable? • What customers? • Where is the waste from non-value-added activities? I agree!

3. Learning Objective 1 Understand activity-based costing and how it differs from a traditional costing system.

4. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Manufacturingcosts Nonmanufacturingcosts Traditionalproduct costing ABCproduct costing  ABC assigns both types of costs to products.

5. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Manufacturingcosts Nonmanufacturingcosts Some Most, butnot all All Traditionalproduct costing ABCproduct costing • ABC does not assign all manufacturing costs to products.

6. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Activity–Based Costing Departmental Overhead Rates Level of complexity Plantwide Overhead Rate Number of cost pools • ABC uses more cost pools.

7. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Each ABC cost pool has itsown unique measure of activity. Traditional cost systems usually relyon volume measures such as direct laborhours and/or machine hours to allocateall overhead costs to products. • ABC uses more cost pools.

8. A “cost bucket” in which costs related to a particular activity measure are accumulated. Activity Cost Pool $ $ $ $ $ $ How Costs are Treated UnderActivity–Based Costing An event that causes the consumption of overhead resources. Activity

9. The term cost driver is also used to refer to an activity measure. Activity Measure An allocation basein an activity-basedcosting system. How Costs are Treated UnderActivity–Based Costing

10. Transactiondriver Durationdriver Simple countof the number oftimes an activityoccurs. A measureof the amountof time neededfor an activity. How Costs are Treated UnderActivity–Based Costing Two common types of activity measures:

11. How Costs are Treated UnderActivity–Based Costing ABC definesfive levels of activitythat largely do not relateto the volume of unitsproduced. Traditional cost systems usually rely on volumemeasures such as direct labor hours and/or machinehours to allocate all overhead costs to products.

12. Unit-Level Activity Batch-Level Activity Manufacturingcompanies typically combinetheir activities into fiveclassifications. Product-Level Activity Customer-Level Activity Organization-sustaining Activity How Costs are Treated UnderActivity–Based Costing

13. Strong topmanagement support Link to evaluationsand rewards Cross-functionalinvolvement Characteristics of SuccessfulABC Implementations

14. Classic Brass – An ABC Example Manufacturing overhead is allocated to products usinga single plantwide overhead rate based on machine hours.

15. Define Activities, Activity Cost Pools,and Activity Measures At Classic Brass, the ABC team, selected the followingactivity cost pools and activity measures:

16. Define Activities, Activity Cost Pools,and Activity Measures • Customer Orders– This activity is assigned all costs of resources that are consumed by taking and processing customer orders. • Product Designs - assigned all costs of resources consumed by designing products. • Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. [per-unit cost other than DM, DL?] • Customer Relations – assigned all costs associated with maintaining relations with customers. • Other – assigned all overhead costs that are not associated with the other cost pools.

17. Learning Objective 2 Assign costs to cost pools using a first-stage allocation.

18. Assign Overhead Coststo Activity Cost Pools

19. Assign Overhead Coststo Activity Cost Pools Direct materials, direct labor, and shipping are excludedbecause Classic Brass’ existing cost system can directlytrace these costs to products or customer orders.

20. Assign Overhead Coststo Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity cost pools is determined.

21. Assign Overhead Coststo Activity Cost Pools Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

22. Assign Overhead Coststo Activity Cost Pools Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

23. Assign Overhead Coststo Activity Cost Pools

24. Learning Objective 3 Compute activityrates for cost pools.

25. Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . . • 1,000 customer orders, • 400 new designs, • 20,000 machine-hours, • 250 customer relations activities. Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

26. Calculate Activity Rates

27. Traced Traced Traced Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers

28. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Cost Objects: Products, Customer Orders, Customers

29. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation CustomerOrders OrderSize Customer Relations Other Product Design Second-Stage Allocations $/Order $/Design $/MH $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated

30. Learning Objective 4 Assign costs to a cost object using a second-stage allocation.

31. Assigning Overhead to Products Classic Brass Information • Standard Stanchions • Requires no new design resources. • 30,000 units ordered with 600 separate orders. • Each stanchion requires 35 minutes of machinetime for a total of 17,500 machine-hours. • Custom Compass Housing • Requires new design resources. • 400 separate orders. • 400 custom designs prepared. • 1,250 compass housings produced, requiring 2machine-hours each for a total of 2,500 machine-hours.

32. Quick Check • What is a stanchion!? • An upright bar, post, prop, brace, or support • A medical instrument to control bleeding • A large rivet used in steel construction • A brass organ pipe

33. Assigning Overhead to Products

34. Assigning Overhead to Customers Let’s take a look at how Classic Brass system works for just one of the 250 customers – Windward Yachts who placed a total of three orders. • Orders • Two orders for 150 standard stanchions per order. • One order for a custom compass housing. • Machine-hours • The 300 standard stanchions required 175 machine-hours. • The custom compass housing required 2 machine hours.

35. Assigning Overhead to Customers

36. Learning Objective 5 Use activity-based costing to compute product and customer margins.

37. Prepare Management Reports Product Margin Calculations The first step in computing product margins is togather each product’s sales and direct cost data.

38. Prepare Management Reports Product Margin Calculations The second step in computing product margins is toincorporate the previously computed activity-basedcost assignments pertaining to each product.

39. Prepare Management Reports Product Margin Calculations The third step in computing productmarginsis to deduct each product’sdirect and indirect costs from sales.

40. Prepare Management Reports Product Margin Calculations The product margins can be reconciled withthe company’s net operating income as follows:

41. Prepare Management Reports Customer Profitability Analysis The first step in computing Windward Yachts’ customer margin is to gather its sales and direct cost data.

42. Prepare Management Reports Customer Profitability Analysis The second step is to incorporate Windward Yachts’ previously computed activity-based cost assignments.

43. Prepare Management Reports Customer Profitability Analysis The third step is to compute Windward Yachts’ customer margin ($699) by deducting all its direct and indirect costs from its sales.

44. Product Margins Computed Usingthe Traditional Cost System The first step in computing product margins is togather each product’s sales and direct cost data.

45. Plantwide manufacturing overhead rate $1,000,000 20,000 MH = = $50 per machine-hour Product Margins Computed Usingthe Traditional Cost System The second step in computing product marginsis to compute the plantwide overhead rate.

46. 17,500 hours × $50 per hour = $875,000 Product Margins Computed Usingthe Traditional Cost System The third step in computing product margins isallocate manufacturing overhead to each product.

47. Product Margins Computed Usingthe Traditional Cost System The fourth step is to actuallycompute the product margins.

48. The Differences Between ABCand Traditional Product Costs The traditional costsystem overcosts thestandard stanchionsand reports a lowerproduct marginfor this product. The traditional costsystem undercosts thecustom compasshousings and reportsa higher productmargin for this product.

49. Differences Between ABC and Traditional Product Costs There are three reasons why thereported product margins for the twocosting systems differ from one another. Traditional costing allocates all manufacturing overhead to products. ABC costing only assigns manufacturing overhead costs consumed by products to those products.

50. Differences Between ABC and Traditional Product Costs There are three reasons why thereported product margins for the twocosting systems differ from one another.  Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. ABC costing also uses non-volume related allocation bases.