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5 - 1©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Activity-Based Costing andActivity-Based Management
Chapter 5
5 - 2©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 1
Explain undercostingand overcosting of
products and services.
5 - 3©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Undercosting andOvercosting Example
Jose, Roberta, and Nancy orderseparate items for lunch.
Jose’s order amounts to $14Roberta consumed 30Nancy’s order is 16Total $60
What is the average cost per lunch?
5 - 4©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Undercosting andOvercosting Example
$60 ÷ 3 = $20
Jose and Nancyare overcosted.
Roberta isundercosted.
5 - 5©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 2
Present three guidelines forrefining a costing system.
5 - 6©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Existing Single Indirect-Cost Pool System Example
Kole Corporation manufactures a normal lens(NL) and a complex lens (CL).
Kole currently uses a single indirect-cost ratejob costing system.
Cost objects: 80,000 (NL) and 20,000 (CL).
5 - 7©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Existing Single Indirect-Cost Pool System Example
Normal Lenses (NL)Direct materials $1,520,000Direct mfg. labor 800,000Total direct costs $2,320,000Direct cost per unit: $2,320,000 ÷ 80,000 = $29
5 - 8©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Existing Single Indirect-Cost Pool System Example
Complex Lenses (CL)Direct materials $ 920,000Direct mfg. labor 260,000Total direct costs $1,180,000Direct cost per unit: $1,180,000 ÷ 20,000 = $59
5 - 9©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Existing Single Indirect-Cost Pool System Example
All Indirect Costs$2,900,000
50,000 DirectManufacturingLabor-Hours
INDIRECT-COSTPOLL
INDIRECTCOST-ALLOCATIONBASE
$58 per DirectManufacturing
Labor-Hour
5 - 10©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Existing Single Indirect-Cost Pool System Example
Indirect Costs
Direct Costs
COST OBJECT:NL AND CLLENSES
DIRECTCOSTS
DirectMaterials
DirectManufacturing
Labor
5 - 11©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Existing Single Indirect-Cost Pool System Example
Kole uses 36,000 direct manufacturinglabor-hours to make NL and 14,000 directmanufacturing labor-hours to make CL.How much indirect costs are allocated
to each product?
5 - 12©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Existing Single Indirect-Cost Pool System Example
NL: 36,000 × $58 = $2,088,000CL: 14,000 × $58 = $812,000
What is the total cost of normal lenses?Direct costs $2,320,000 +
Allocated costs $2,088,000 = $4,408,000What is the cost per unit?
$4,408,000 ÷ 80,000 = $55.10
5 - 13©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Existing Single Indirect-Cost Pool System Example
What is the total cost of complex lenses?Direct costs $1,180,000 + Allocated costs
$812,000 = $1,992,000What is the cost per unit?
$1,992,000 ÷ 20,000 = $99.60
5 - 14©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Existing Single Indirect-Cost Pool System Example
Normal lenses sell for $60 each andcomplex lenses for $142 each.
Normal Complex Revenue $60.00 $142.00 Cost 55.10 99.60 Income $ 4.90 $ 42.40 Margin 8.2% 29.9%
5 - 15©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Refining a Costing System
Direct-cost tracing
Indirect-cost pools
Cost-allocation basis
5 - 16©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Refining a Costing System
1. Design of Products and ProcessThe Design Department designs the moldsand defines processes needed (details of
the manufacturing operations).
5 - 17©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Refining a Costing System
2. Manufacturing OperationsLenses are molded, finished,
cleaned, and inspected.3. Shipping and Distribution
Finished lenses are packed andsent to the various customers.
5 - 18©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 3
Distinguish between thetraditional and the
activity-based costingapproaches to designing
a costing system.
5 - 19©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Activity-Based Costing System
FundamentalCost Objects
Activities
Costs of Activities
Assignment to OtherCost Objects
Cost of:• Product• Service• Customer
5 - 20©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Activity-Based Costing System
A cross-functional team at KoleCorporation identified key activities:
Design products and processes.Set up molding machine.
Operate machines to manufacture lenses.Maintain and clean the molds.
5 - 21©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Activity-Based Costing System
Set up batches of finished lenses for shipment.Distribute lenses to customers.
Administer and manage all processes.
5 - 22©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Activity-Based Costing System
No. ofSetupHours
LensesNL
LensesCL
LensesOther
CostAllocationBase
ProductCostObjects
No. ofShipments
Parts-Square
feet
SetupDesign ShippingActivityIndirect CostPool
5 - 23©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Activity-Based Costing System
NL CL Quantity produced 80,000 20,000 No. produced/batch 250 50 Number of batches 320 400 Setup time per batch 2 hours 5 hours Total setup-hours 640 2,000
Total setup costs are $409,200.
5 - 24©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Activity-Based Costing System
What is the setup cost per setup-hour? $409,200 ÷ 2,640 hours = $155
What is the setup cost perdirect manufacturing labor-hour?
$409,200 ÷ 50,000 = $8.184
5 - 25©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Activity-Based Costing System
Allocation using direct labor-hours:NL: $8.184 × 36,000 = $294,624CL: $8.184 × 14,000 = $114,576Total $409,200
Allocation using setup-hours:NL: $155 × 640 = $ 99,200CL: $155 × 2,000 = $310,000Total $409,200
5 - 26©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 4
Describe a four-partcost hierarchy.
5 - 27©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Cost Hierarchies
A cost hierarchy is a categorizationof costs into different cost pools.
Cost drivers bases (cost-allocation bases)Degrees of difficulty in determining
cause-and-effect relationships
5 - 28©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Cost Hierarchies
ABC systems commonly use afour-part cost hierarchy to
identify cost-allocation bases:1. Output unit-level costs2. Batch-level costs3. Product-sustaining costs4. Facility-sustaining costs
5 - 29©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Output Unit-Level Costs
These are resources sacrificedon activities performed on each
individual unit of product or service.Energy
Machine depreciationRepairs
5 - 30©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Batch-Level Costs
These are resources sacrificed onactivities that are related to a groupof units of product(s) or service(s)rather than to each individual unit
of product or service.Setup-hours
Procurement costs
5 - 31©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Product-Sustaining Costs
These are often called service-sustainingcosts and are resources sacrificed on
activities undertaken to supportindividual products or services.
Design costsEngineering costs
5 - 32©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Facility-Sustaining Costs
These are resources sacrificed onactivities that cannot be traced to
individual products or services butsupport the organization as a whole.
General administration– rent – building security
5 - 33©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 5
Cost products or services usingactivity-based costing.
5 - 34©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ImplementingActivity-Based Costing
Identify cost objects.
NLCL
Identify the direct costsof the products.
Direct materialDirect labor
Mold cleaning and maintenance
Step 1 Step 2
5 - 35©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ImplementingActivity-Based Costing
Cleaning and maintenance costs of$360,000 are direct batch-level costs.
Why?Because these costs consist of workers’
wages for cleaning molds after eachbatch of lenses is run.
5 - 36©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ImplementingActivity-Based Costing
Normal Lenses (NL)Cost HierarchyDescription Category
Direct materials Unit-level $1,520,000Direct mfg. labor Unit-level 800,000Cleaning and maint. Batch-level 160,000Total direct costs $2,480,000
5 - 37©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ImplementingActivity-Based Costing
Complex Lenses (CL)Cost HierarchyDescription Category
Direct materials Unit-level $ 920,000Direct mfg. labor Unit-level 260,000Cleaning and maint. Batch-level 200,000Total direct costs $1,380,000
5 - 38©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ImplementingActivity-Based Costing
Select the cost-allocation bases to use forallocating indirect costs to the products.
(1) (2) (3)Activity Cost Hierarchy Total CostsDesign Product-sustaining $450,000Setups Batch-level $409,200Operations Unit-level $637,500
Step 3
5 - 39©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ImplementingActivity-Based Costing
Identify the indirect costs associatedwith each cost-allocation base.
Overhead costs incurred are assignedto activities, to the extent possible, on
the basis of a cause-and-effect relationship.
Step 4
5 - 40©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ImplementingActivity-Based Costing
Compute the rate per unit. (1) (5)NL CL Total
Setup-hours: 640 2,000 2,640
Step 5
$409,200 ÷ 2,640 = $155
5 - 41©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ImplementingActivity-Based Costing
Compute the indirect costs allocatedto the products.
NL: $155 × 640 = $ 99,200CL: $155 × 2,000 = 310,000Total $409,200
Step 6
5 - 42©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ImplementingActivity-Based Costing
Compute the costs of the products.NL and CL would show three
direct cost categories.
Step 7
1. Direct materials2. Direct manufacturing labor3. Cleaning and maintenance
5 - 43©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ImplementingActivity-Based Costing
NL and CL would show six indirect cost pools.1. Design2. Molding machine setups3. Manufacturing operations4. Shipment setup5. Distribution6. Administration
5 - 44©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 6
Use activity-basedcosting systems for
activity-based management.
5 - 45©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Activity-Based Management
ABM describes management decisions that useactivity-based costing information to satisfy
customers and improve profits.Product pricing and mix decisions
Cost reduction and process improvement decisionsDesign decisions
5 - 46©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Product Pricing andMix Decisions
ABC gives management insight into the coststructures for making and selling diverse products.
It provides more accurate product costinformation and more detailed information
on costs of activities and the drivers of those costs.
5 - 47©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Cost Reduction and ProcessImprovement Decisions
Manufacturing and distribution personnel useABC systems to focus on cost-reduction efforts.Managers set cost-reduction targets in terms of
reducing the cost per unit of the cost-allocation base.
5 - 48©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Design Decisions
Management can identify and evaluate new designsto improve performance by evaluating how product
and process designs affect activities and costs.Companies can work with their customers to
evaluate the costs and prices of alternative designs.
5 - 49©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 7
Compare activity-based costingsystems and department-
costing systems.
5 - 50©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ABC and DepartmentIndirect-Cost Rates
Many companies have evolved theircosting system from using a single
cost pool to using separate indirect-costrates for each department:
DesignManufacturing
Distribution
5 - 51©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ABC and DepartmentIndirect-Cost Rates
Why?Because the cost drivers of resources in eachdepartment or subdepartment differ from thesingle, company-wide, cost-allocation base.
ABC systems are a further refinement ofdepartment costing systems.
5 - 52©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 8
Evaluate the costs and benefitsof implementing activity-based
costing systems.
5 - 53©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Benefits of ABC Systems
Significant amounts of indirect costs areallocated using only one or two cost pools.
All or most costs are identifiedas output unit-level costs.
Products make diverse demands onresources because of differences involume, process steps, batch size,
or complexity.
5 - 54©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Benefits of ABC Systems
Products that a company is well-suited tomake and sell show small profits whileproducts for which a company is less
suited show large profits.Complex products appear to be very
profitable and simple productsappear to be losing money.
5 - 55©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Benefits of ABC Systems
Operations staff have significantdisagreements with the accounting
staff about the costs of manufacturingand marketing products and services.
5 - 56©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Limitations of ABC Systems
The main limitations of ABC are themeasurements necessary to
implement the system.ABC systems require managementto estimate costs of activity poolsand to identify and measure cost
drivers for these pools.
5 - 57©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Limitations of ABC Systems
Activity-cost rates also need to beupdated regularly.
Very detailed ABC systems are costlyto operate and difficult to understand.
5 - 58©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ABC In Service andMerchandising Companies
The general approach to ABC in theservice and merchandising areas is very
similar to the approach in manufacturing.Costs are divided into homogeneous costpools and classified as output unit-level,
batch-level, product- or service-sustaining,and facility-sustaining costs.
5 - 59©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
ABC In Service andMerchandising Companies
The cost pools correspond to key activities.Costs are allocated to products or customers
using activity drivers or cost-allocationbases that have a cause-and-effect
relationship with the cost in the cost pool.
5 - 60©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
End of Chapter 5