Chapter 5

1. Chapter 5 Activity-Based Costing

2. Traditional, Volume-Based Product-Costing System • Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. • The following information is obtained from company records:

3. Traditional, Volume-Based Product-Costing System Additional information includes: Manufacturing overhead is determined as follows

4. Budgeted manufacturing overhead $3,894,000 Budgeted direct-labor hours 118,000 = $33 per hour Traditional, Volume-Based Product-Costing System

5. Traditional, Volume-Based Product-Costing System With these product costs, Aerotech established target selling prices (Cost × 125%). 209.00 x 1.25

6. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Assigning overhead to products is a difficult process. I agree!

7. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Let’s begin by identifying our major activities. Stage OneIdentify significant activities and assign overhead costs to each activity in proportion to resources used.

8. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Overhead assigned to activities are called “activity cost pools.” Stage TwoIdentify cost drivers appropriate to each activity and allocate overhead to the products.

9. Activity must be done on each unit produced. Activity performed on each batch produced. Activities needed to support an entire product line Activity required in order for the production process to occur. Overhead Costs Total budgeted cost = $3,894,000 Identification of Activity Cost Pools Activity Cost Pools Product- Sustaining Level Batch Level Facility Level Unit Level Machinery cost pool $1,212,600 Setup cost pool $3,000 Engineering cost pool $700,000 Facility cost pool $507,400

10. Product- Sustaining Level Unit Level Batch Level Facility Level Machinery cost pool $1,212,600 Setup cost pool $3,000 Engineering cost pool $700,000 Facility cost pool $507,400 Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000

11. Maintenance Lubrication Depreciation Electricity Computer Support Calibration STAGE ONE Various overhead costs related to machinery Activity cost pool Machinery Cost Pool Total budgeted cost = $1,212,600

12. STAGE TWO Calculate the pool rate Budgeted Machinery Costs$1,212,600 Budgeted Machine Hours 43,000 $28.20/hour = = Cost Assignment

13. STAGE ONE Calculation of total setup cost Activity cost pool Setup Cost Pool Total budgeted cost = $3,000

14. STAGE TWO Calculate the pool rate Budgeted Setup Costs $3,000 Planned Production Runs 15 runs $200 per run = = Cost Assignment

15. STAGE ONE Various overhead costs related to engineering Engineering salaries Engineering software Engineering supplies Depreciation Activity cost pool Engineering Cost Pool Total budgeted cost = $700,000

16. STAGE TWO Engineering Cost Pool Total budgeted cost = $700,000 Allocate based on engineering transactions Cost Assignment

17. Exh. 5-9 STAGE ONE Various overhead costs related to general operations Plant depr. Property taxes Plant mgmt. Insurance Plant maint. Security Activity cost pool Facility Cost Pool Total budgeted cost = $507,400

18. Exh. 5-9 STAGE TWO Calculate the pool rate Budgeted Facilities Cost $507,400 Budgeted Direct-Labor Hours 118,000 $4.30/hour = = Cost Assignment

19. Other Overhead Costs $14.82

20. Product Cost from ABC These are the new product costs when Aerotech uses ABC.

21. Distorted Product Costs Both original and ABC target selling prices are based on (Cost × 125%). The selling price of Mode I and II are reduced and the selling price for Mode III is increased. [$209.00 × 1.25] [$183.44 × 1.25]

22. Distorted Product Costs Can you identify any problems Aerotech is likely to face as a result of this distortion? Traditional costing understates the cost of complex, low volume products.

23. A large proportion of non-unit-level activities A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately. Product diversity When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs. Two Key Points

24. Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . . Degree of Correlation Behavioral Effects Cost of Measurement

25. Methods of Data Collection Interview & Paper Trails: The information for ABC systems initially comes from interviews with employees in the support departments and a review of each department’s records. Storyboarding: A procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities.

26. Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. Direct versus Indirect Costs Indirect Costs

27. Indicators of Need for ABC Direct labor is a small percentage of total costs Product-line profit margins are hard to explain Line managers do not believe the product costs reports Sales are increasing, but profits are declining. Some products that have reported high profit margins are not sold by competitors Marketing does not use costs reports for pricing decisions

28. Exh. 5-13 Optimal Product-Costing System Cost Total Cost High Cost of inferior decisions resulting from inaccurate information. Design, implementation and maintenance costs Information System Accuracy Low Low High Optimal system

29. Chapter 6 Activity-Based Management and Cost Management Tools

30. The use Of ABCinformationto helpmanagementmake decisions Activity-Based Management Activity-based costingestablishes relationshipsbetween overhead costs and activities so thatwe can better allocate overhead costs. Activity-based managementfocuses on managing activities to reduce costs.

31. Cost Assignment View Resource costs Process View Activity Analysis Activity Evaluation Performance Measures Root Causes Activity Triggers Activities Cost Objects Two-Dimensional ABC and Activity-Based Management

32. Elimination of Non-Value-Added Costs Activities Nonvalue-added activities Unnecessary Necessary Reduce orEliminate Continually Evaluate and Improve

33. Using ABM to Eliminate Non-Value-Added Activities and Costs • Identify Activities. • Identify Non-Value-Added Activities. • Understand Activity Linkages, Root Causes, and Triggers. • Establish Performance Measures. • Report Non-Value-Added Costs. Specify parts Select vendor Receive parts Produce goods Inspect finished goods Rework defective products

34. Using ABM to Eliminate Non-Value-Added Activities and Costs Process time Storage time Inspection time Move time Waiting time

35. Achieving Cost Reduction Activity Reduction Activity Selection Reduce Non-Value-Added Costs Activity Sharing Activity Elimination

36. Customer Profitability Analysis Customer profitability analysis uses ABC to determine the activities, costs, and profit associated with serving particular customers. Requiredspecialpackaging. Orderssmallquantities. Demandfastservice. Oftenchangesorders. Ordersfrequently. A costly customer

37. Customer Profitability Analysis A company may use these customerrelated costs to help determine theprofitability of each customer.

38. Target Costing Design a product, and the manufacturing process, so that the product can be manufactured at a cost that will enable the firm to make a profit when the product is sold at an estimated market-driven price. Value engineering is used to achieve a product design that meets the target cost. Number of parts Quality of materials Change methods Change components

39. Kaizen Costing • The process of cost reduction during the manufacturing phase of an existing product • Kaizen cost goal is established to help achieve continuous cost reduction. Product cost . Kaizen goal cost-reduction amount. } . 3/31/x1 3/31/x2

40. Benchmarking The continual search for the most effective method of accomplishing a task, by comparing existing methods and performance levels with those of other organizations. Here are the best practices in our industry. . .

41. Re-engineering The complete redesign of a process, with an emphasis on finding creative new ways to accomplish an objective.

42. Theory of Constraints A management approach seeking to maximize long-run profit through proper management of organizational bottlenecks or constrained resources.

43. Just-in-Time Inventory and Production Management No materials are purchased and no products are manufactured until they are needed. The primary goal of a JIT production system is to reduce or eliminate inventories at every stage of production.

44. Key Features of the JIT Approach Smooth, uniform production rate Pull method of production Purchase is small lot sizes Quick, inexpensive setups High quality materials Effective preventive maintenance Teamwork Multiskilled workers

45. JIT Purchasing Long-term contracts with suppliers. Parts delivered in small lots. Only a few suppliers. Grouped payments to vendor. Minimal inspection of materials.