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-level costs 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 factory machinery

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-level costs 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-level costs 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: 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

12. 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

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 to Motivate Behavior Cost drivers should generally be chosen based on a cause-and-effect relationship between the driver and the specific cost being considered. However, cost drivers may have motivational effects that must be considered as well. Example: Taking customers’ orders by phone.

15. Choosing Cost Drivers to Motivate Behavior Step 2: Identify Objectives Minimize cost, thus spending as little time on the phone as possible or increase sales, thus spending more time on the call to make the sale

16. Choosing Cost Drivers to Motivate Behavior Step 3: Identify and Analyze Available Options If less time is spent per call, perhaps employees will answer more calls or by not cutting a call short, perhaps customers will be more satisfied and more sales will occur.

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

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

19. 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

20. 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

21. 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 Direct Labor Hours Standard Houses (20) 400 600 2,500 600 200 48,000 Custom Houses (10) 1,000 600 1,500 600 300 40,000 Totals 1,400 1,200 4,000 1,200 500 88,000

22. TraditionalVolume Based Costing Activity Total Overhead Cost / Cost Driver $485,000 / 88,000 = POR = $5,51/DLH

23. 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/inspection 1200 = $25/order 4000 = $25/hour 1200 = $187.50/delivery 500 = $160/order

24. 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

25. 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

26. 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.

27. ABC Key Concept Volume-based costing systems often result in overcosting high-volume products and undercosting low-volume products. This cross subsidy is eliminated by the use of ABC.

28. More ABC Topics ABC Systems in Service Industries ABC and Selling Administrative Activities ABC and JIT Cost Flows and ABC Benefits and Limitations of ABC The ABM Life Cycle

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

30. 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

31. ABC Systems and Administrative Activities ABC is used to determine the cost of providing a selling or administrative service. Example: The U.S. Post Office used ABC to help determine the costs and benefits of allowing customers to pay usingdebit and credit cards.

32. ABC and Just in Time Since factories are typically redesigned in a JIT environment so that all machinery and equipment needed to make a product is available in one area, overhead costs are more likely to be traced to products as unit-level, batch-level, or product-level costs.

33. 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.

34. Benefits of ABC Using ABC in the budgeting process provides more accurate estimates of resources Provides more accuracy of cost information for day-to-day decision making Costs that appeared to be indirect using volume-based costing systems are now traced to specific activities using cost drivers

35. Limitations of ABC High measurement costs are significant limitations. 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

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

37. Activity-Based Management Topics Activity-Based Management and ABC ABM and the Value Chain Value-Added and Non-Value-Added Activities Successful Implementation of ABC and ABM

38. Activity-Based Management Topics Key Concept Activity-based management focuses on managing activities to reduce costs and make better decisions.

39. ABM and the Value Chain 1. Research and Development: The creation and development of ideas that lead to new products and services 2. Design: The detailed development of the research and development ideas that results in new products and services 3. Production: The use of resources to produce a product or provide a service

40. ABM and the Value Chain 4. Marketing: Providing potential customers with information about the attributes of products or services available that results in customers purchasing the products or services 5. Distribution: The actual delivery of products or services to customers 6. Customer Service: Providing customers with needed support and service during and after the sale.

41. 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

42. Value-Added and Non-Value-Added Activities Pause and Reflect: Can you think of a situation in which you would consider quality inspections to increase the value of a product or service?

43. Successful Implementation of ABC and ABM Utilize activity-based costing information to reduce costs, eliminate non-value-added activities, and manage more effectively required the cooperation of all functional areas of business organization and top management.

44. 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.

45. 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.

46. The ABM Life Cycle Cost Focus (1-2 years) Performance Focus (1-2 years) Value-Added Focus (ongoing)

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