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Appendix 21B: Activity-based Costing

Appendix 21B: Activity-based Costing. Objectives Describe and develop activity-based costs (ABC) Decide when ABC is most likely to pass the cost-benefit test. Refining Cost Systems. David, Matt, and Marc: Total expenses = $900. Rent and Electricity $570 Cable TV 50

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Appendix 21B: Activity-based Costing

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  1. Appendix 21B: Activity-based Costing Objectives • Describe and develop activity-based costs (ABC) • Decide when ABC is most likely to pass the cost-benefit test

  2. Refining Cost Systems David, Matt, and Marc: Total expenses = $900 Rent and Electricity $570 Cable TV 50 High speed Internet access 40 Groceries 240 Total $900 Cost allocated = $300 per person

  3. Refining Cost Systems More Refined Allocation DavidMattMarcTotal Rent and Electricity $190 $190 $190 $570 Cable TV 25 – 25 50 Internet access – 40 – 40 Groceries – 80 160 240 Total costs allocated $215 $310 $375 $900 Original cost allocation 300 300 300 900 Difference $(85) $ 10 $ 75 $ 0

  4. Sharpening the Focus: From Business Functions to Activities PANEL A—Companywide Business Functions in the Value Chain R&D Design Production Marketing Distribution Customer Service Inventoriable costs for financial reporting PANEL B—Production Departments/Product Lines Servers Notebook Computers Desktop Computers Inventoriable costs for financial reporting

  5. Sharpening the Focus: From Business Functions to Activities PANEL C—Activities for Desktop Product Line 1. Kitting—preparing all items for assembly 2. Motherboard preparation—snapping in CPU and memory modules 3. Assembly into chassis 4. Software downloading 5. Testing 6. Boxing Inventoriable costs for financial reporting

  6. Describe and develop activity-based costs (ABC). Objective 1

  7. Activity-Based Costing Example of Activities and Cost Drivers: Activities: Material purchasing Material handling Production scheduling Quality inspections Photocopying Warranty service Cost Drivers: No. of purchase orders No. of parts No. of batches No. of inspections No. of pages copied No. of service calls

  8. Traditional versus Activity-BasedCosting Systems • Chemtech produces large quantities of “commodity” chemicals. • It also manufactures small quantities of specialty chemicals. • In the past, Chemtech’s manufacturing department has used direct labour hours as its single allocation base at a 200% rate.

  9. Traditional versus Activity-BasedCosting Systems • Among its many products, the department produces Aldehyde (a commodity chemical used by producing plastics) and... • Phenylephrine Hydrochloride (PH), which is a specialty chemical. • A single customer uses PH in manufacturing blood-pressure medications.

  10. Traditional versus Activity-BasedCosting Systems Departmental Indirect Cost Pool Chemical Manufacturing Department Overhead Direct Labour Cost Cost Allocation Base Chemical A Chemical B Chemical C Product Cost Objects

  11. Traditional versus Activity-BasedCosting Systems Departmental Indirect Cost Pool Chemical Manufacturing Department Overhead Activity Indirect Cost Pool Mixing Processing Testing No. of Batches No. of Machine Hours No. of Samples Taken Cost Allocation Base Chemical A Chemical B Chemical C Product Cost Objects

  12. Traditional versus Activity-BasedCosting Systems Chemtech Traditional Cost System AldehydePH Sale price per Kg $10 $70 Less: manufacturing cost per Kg Direct materials 5 20 Direct labour 1 10 Manufacturing overhead 2 20 Gross profit per Kg $ 2 $20

  13. Traditional versus Activity-BasedCosting Systems • Assume that the company produced 7,000 Kg of Aldehyde and 5 Kg of PH. • What is the total labour cost per product? • 7,000 Kg × $1 = $7,000 (Aldehyde) • 5 Kg × $10 = $50 (PH) • What is the total manufacturing overhead allocated to each product?

  14. Traditional versus Activity-Based Costing Systems • $7,000 × 200% = $14,000 to Aldehyde • $50 × 200% = $100 to PH Chemtech assigns 140 times as much overhead to Aldehyde as to PH.

  15. Activity-Based Costing System Step 1 Step 2 Estimate the total indirect costs of each activity. Identify activities. Mixing Processing Testing Labour $150,000 Depreciation 200,000 Other 250,000 Total $600,000

  16. Activity-Based Costing System Step 3 Identify the primary cost driver for each activity’s indirect costs. (1) (2) (3) Activity Estimated Costs Cost Driver Mixing $600,000 # of batches Processing $300,000 # of hours (MH) Testing $600,000 # samples

  17. Activity-Based Costing System Step 4 Estimate the total quantity of each allocation base. (1) (4) Activity Estimated Quantity of Cost Driver Mixing 4,000 batches Processing 5,000 machine hours (MH) Testing 3,000 samples

  18. Activity-Based Costing System Step 5 Calculate the allocation rate for each activity. (1) (5) ActivityCost Allocation Rate Mixing $600,000 ÷ 4,000 = $150/batch Processing $300,000 ÷ 5,000 = $60/MH Testing $600,000 ÷ 3,000 = $200/sample

  19. Activity-Based Costing System Step 6 Obtain the actual quantity of each allocation base used by each product. During the year, Chemtech produced 60 batches of Aldehyde and 1 batch of PH. The remaining batches consist of Chemtech’s other chemicals.

  20. Activity-Based Costing System Step 7 Allocate the costs to each product. Mixing Cost Allocation: Aldehyde: 60 batches × $150 per batch = $9,000 PH: 1 batch × $150 per batch = $150

  21. Activity-Based Costing System Activity Cost Driver Units Cost Allocated to: Used By: Aldehyde PH Aldehyde PH Mixing 60 batches 1 batch $ 9,000 $150 Processing 30.5 MH 2 MH 1,830* 120 Testing 14 samples 1 sample 2,800 200 Total $13,630 $470 *30.5 MH × $60 per MH = $1,830 The ABC system allocates 29 times as much overhead to Aldehyde as to PH.

  22. Activity-Based Costing System • What is the overhead cost per kg? • Aldehyde: $13,630 ÷ 7,000 = $1.95 • PH: $470 ÷ 5 = $94 Cost/kg Traditional ABC (Overhead) System System Aldehyde $ 2.00 $ 1.95 PH $20.00 $94.00

  23. Activity-Based Costing System Chemtech Gross Profit per Kg. Aldehyde PH Sale price per kg $10.00 $ 70.00 Less: manufacturing cost per kg Direct materials 5.00 20.00 Direct labour 1.00 10.00 Manufacturing overhead 1.95 94.00 Gross profit per kg $ 2.05 $(54.00)

  24. Decide when ABC is most likely to pass the cost-benefit test. Objective 2

  25. The Cost-Benefit Test • ABC’s benefits are higher when... • the company produces many different products that use different amounts of resources. • the company has high overhead costs. • the company produces high volumes of some products, and low volumes of other products.

  26. The Cost-Benefit Test • The costs of adopting ABC are lower when the company has... • accounting and information system expertise to develop the system. • information technology (bar coding, optical scanning) to record cost driver data.

  27. Signs That the Cost SystemMay Be Broken Managers don’t understand costs and profits. The cost system is outdated.

  28. End of Chapter 21B

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