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Activity-Based Costing
Accy211: Management Accounting IIAutumn 2013
Week 5 1
Learning Objectives
1. Explain undercosting and overcosting of products or services
2. Understand a traditional product costing system3. Understand guidelines for refining a costing
system4. Understand an Activity Based Costing System 5. Understand how ABC differs from traditional
costing system6. Prepare ABC analysis (Comprehensive example)7. Limitations of activity-based costing systems
2
3
Cost AllocationDirect
MaterialsDirect Labour
Direct Costs
Indirect Costs
Manufacturing Overhead
Cost Allocation Base
z One of the most difficult tasks in computing accurate unit costs lies in determining the proper amount of overhead cost to assign to each job.
z Factory overhead is applied to production in a rational systematic manner.
z The methods used often involve tradeoffs between simplicity and realism
z Historically, firms produced a limited variety of goods while their indirect costs were relatively small.
z Used broad averages to allocate costs (Peanut-butter Costing)
Learning Objective
1Explain undercosting and overcosting of products or
services
4
Cost Smoothing(Peanut butter costing)
The term cost smoothing describes a particular costing approach that uses broad averages for assigning the cost of resources uniformly to cost objects when the products/services use those resources in a non-uniform way.
Cost smoothing can lead to undercosting or overcosting of product and services
5
Undercosting and Overcosting ExampleJose, Rob, and Nancy order separate items for lunch.
Joses order amounts to $14Rob consumed 30Nancys order is 16Total $60What is the average cost per lunch?
$60 3 = $20
Jose and Nancyare overcosted.
Rob isundercosted.
6
Page 1 of 13
Learning Objective2
Understand a Traditional Product Cost System.
7
Identify MOH costs
Select MOH cost allocation base
Compute MOH cost allocation rate
(1) Identify cost objects
(2) Identify direct costs
MOH costs allocated to the cost object
Product Cost
Direct Materials
Direct Labour
Direct Costs
Indirect Costs (MOH)
Period Costs
(4)Total Costs
(3) Compute the indirect costs of the job
8
See example on page 8 for Single Plant Wide Indirect
Cost Pool System (Traditional Costing)
9
Learning Objective
3Understand a guidelines for
refining a costing system
10
The PresentzNumerous products with
more and complicated production requirements.zLabor is becoming an ever
smaller part component of total production costs.zIncrease in indirect costszAdvances in information
technologyzCompetition in foreign
markets
Rationale for selecting a more refined costing system
The PastzSmall number of
products which did not differ much in required manufacturing support.zLabor was the
dominant element in the cost structure.
11
Guidelines for Refining a Costing System
Direct-cost tracing
Indirect-cost pools
Cost-allocation bases
12
Page 2 of 13
Learning Objective
4Understand Activity Based
Costing system
13
Activity Based Costing
Refines a costing system by identifying individual activities as the fundamental objects.
Attempts to provide a more precise indirect cost allocation by tracing costs from activities to products.
Uses multiple cost drivers.
14
Activities and Product CostsProducts require
activities.
Activities consumeresources.
Resources havecosts.
(1) Design products and processes. (2) Set up molding machine. (3) Operate machines to manufacture lenses. (4) Maintain and clean the molds. (5) Set up batches of finished lenses for shipment(6) Distribute lenses to customers. (7) Administer and manage all processes.
Activities-Example
15
ActivityAn event that causes the consumption of
overhead resources.
Activity Cost Pool
A cost bucket in which costs related to a single
activity measure are accumulated.
$
$
$ $
$$
Activity Measure
An allocation basein an activity-based
costing system. The term cost driver is also used
to refer to an activity measure.
16
Simple countof the number oftimes an activity
occurs.
Transactiondriver
A measureof the amountof time neededfor an activity.
Durationdriver
Two common types of activity measures:
17
FundamentalCost Objects
Activity 1 Cost of Activity 1
Assignment toCost Objects
Cost of: Product Service
CustomerActivity 2
Activity 3
Cost of Activity 2
Cost of Activity 3
Cost Pools based on
Cost Hierarchy
Cost driver 2
Cost driver 1
Cost
drive
r 3
18
Page 3 of 13
Traditional cost systems usually rely on volumemeasures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.
ABC definesfive levels of activity
that largely do not relateto the volume of units
produced.
19
Cost Hierarchy (Activity Levels)
Manufacturingcompanies typically combine
their activities into fiveclassifications.
Unit-LevelActivity
Batch-Level Activity
Product-LevelActivity
Customer-LevelActivityOrganization-
sustainingActivity
20
Unit-Level Activity CostsThese are resources sacrificed on activities performed on each individual unit of product or service. Examples: Energy, Machine deprecation, Repairs.
21
Batch-Level Activity CostsThese are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. Examples: Setup hours, procurement cots.
Product-Level Activity CostsThese are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services. Examples: Design costs Engineering costs.
Facility Level Activity CostThese are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. Examples: General Administration, rent, building security
22
Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009.
Indirect manufacturing labor costs such as supervision that supports direct manufacturing labor, $1,000,000(A)unit-level costs.(B)batch-level costs.(C)product-sustaining costs(D) facility-sustaining costs.
Quiz -1
23
Teleport, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009.
Procurement costs of placing purchase orders, receiving materials, and paying suppliers related to the number of purchase orders placed, $500,000.
(A) unit-level costs.(B) batch-level costs.(C) product-sustaining costs(D)facility-sustaining costs.
Quiz - 2
24
Page 4 of 13
Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009.Costs incurred to set up machines each time a different product needs to be manufactured, $600,000.
(A)unit-level costs.(B)batch-level costs.(C)product-sustaining costs(D) facility-sustaining costs.
Quiz - 3
25
Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009.
Designing processes, drawing process charts, making engineering process changes for products, $800,000.
(A)unit-level costs.(B)batch-level costs.(C)product-sustaining costs(D) facility-sustaining costs.
Quiz - 4
26
Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009.
Plant management, plant rent, and plant insurance, $900,000.
(A)unit-level costs.(B)batch-level costs.(C)product-sustaining costs(D) facility-sustaining costs.
Quiz - 5
27
28
Learning Objective
5Understand how activity-based
costing differs from a traditional costing system.
29
How ABC differs from traditional cost accounting
Manufacturingcosts
Nonmanufacturingcosts
n ABC assigns both types of costs to products.
Traditionalproduct costing
ABCproduct costing
30
Page 5 of 13
o ABC does not assign all manufacturing costs to products.
Manufacturingcosts
Nonmanufacturingcosts
Traditionalproduct costing
ABCproduct costing
All Most, butnot all
Som
e
31
PlantwideOverhead
Rate
DepartmentalOverhead
Rates
ActivityBasedCosting
Number of cost pools
Leve
l of c
ompl
exity
p ABC uses more cost pools.
Each ABC cost pool has its own unique measure of activity.
Traditional cost systems usually rely on volume measures such as direct laborhours and/or machine hours to allocateall overhead costs to products.
32
(4) Assign overhead costs to activity cost pools
(3) Define activities, Activity Cost Pools, and Activity Measures
(5) Calculate activity rates
(1) Identify cost objects
(2) Identify direct costs
(6) Assign overhead costs to cost object using activity rates and activity measures
(7) Compute the total
costs
Product costing with Activity Based Costing System
Direct Materials
Direct Labour
Direct Costs
Indirect Costs
33
Activity 1
Total cost
Product costing with Activity Based Costing System
Direct Materials
Direct Labour
Direct Costs
Indirect Costs
Activity 2 Activity 3 Activity 4 Activity 5
In this process it is possible to trace some indirect costs as direct costs 34
Learning Objective
6Prepare ABC analysis
(Comprehensive example)
35
See Activity Based Costing System Example
on page 9
36
Page 6 of 13
ActivityBased Costing ExampleBaxter Battery Company
DirectMaterials
DirectLabor
ShippingCosts Overhead Costs
First-Stage Allocation
Second-Stage Allocations
$/Order $/Change $/MH
UnallocatedSS LL
CustomerOrders
OrderSize Other
DesignChanges
37
zCustomer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.zDesign Changes - assigned all costs of
resources consumed by customer requested design changes.zOrder Size - assigned all costs of resources
consumed as a consequence of the number of units produced.zOther assigned all organization-sustaining
costs and unused capacity costs
Activities, Activity Cost Pools and Activity Measures at Baxter Battery Company
38
SureStarts LongLifesProduct margins traditional 7,600,000$ 1,400,000$ Product margins ABC 9,290,000 (5,230,000) Change in reported margins 1,690,000$ (6,630,000)$
The traditional cost system overcosts the SureStarts and
reports a lower product margin for this product.
The traditional cost system undercosts the LongLifes and
reports a higher product margin for this product.
Differences Between ABC and Traditional Product Costs and Major
Reasons for the differences
Can you see how different allocation methods might lead to making different management decisions? 39
40 60
0 100
60 40
0% 20% 40% 60% 80% 100%
Customer Orders
Design Changes
Order Size
SS LL
$6,350,000 Customer Orders
$6,040,000 Design changes
$3,450,000 Machine Hours
$15,840,000
1. traditional cost system allocates all manufacturing overhead costs using a volume-related allocation base (machine-hours). The ABC system uses volume-related and non-volume related allocation bases to assign manufacturing overhead to products
40
SS LL
2. The ABC did not assign the manufacturing overhead costs included in the other activity ($3.7million) to products because these organization-sustaining and unused capacity costs are not caused by products.
3. traditional cost system disregards selling and administrative expenses because they are assumed to be period expenses. The ABC system directly traces shipping costs ($3,000,000) to products and includes nonmanufacturing overhead costs caused by products ($5,540,000)in the activity cost pools that are assigned to products
41
Learning Objective
7Limitations of ABC costing
system
42
Page 7 of 13
Activity-Based Costing and External Reporting
Most companies do not use ABCfor external reporting because . . .1. External reports are less detailed than internal
reports.2. It may be difficult to make changes to the
companys accounting system.3. ABC does not conform to GAAP.4. Auditors may be suspect of the subjective
allocation process based on interviews with employees.
43
ABC LimitationsSubstantial resourcesrequired to implement
and maintain.
Resistance tounfamiliar numbers
and reports.
Desire to fullyallocate all costs
to products.
Potentialmisinterpretation ofunfamiliar numbers.
Does not conform toGAAP. Two costing
systems may be needed.
44
Signs that indicate ABC system is likely to provide most benefits
Significant amounts of indirect costs are allocated using only one or two cost pools. All or most costs are identified as output unit-level costs. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.Products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits.Complex products appear to be very profitable and simple products appear to be losing money. Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.
45
ABC In Service andMerchandising Companies
z The general approach is very similar to the approach in manufacturing.
z Costs are divided into homogeneous cost pools and classified as output unit-level, batch-level, product-or service-sustaining, and facility-sustaining costs.
z The cost pools correspond to key activities. z Costs are allocated to products or customers using
activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool.
46
Activity-Based Management
z A method of management that used ABC as an integral part in critical decision-making situations, including:z Pricing and product-mix decisionsz Cost reduction and process improvement
decisionsz Design decisionsz Planning and managing activities
47
There is ABCin your future!
End
48
Page 8 of 13
Sales 50,000,000$ Cost of goods sold
Direct materials 15,000,000$Direct labor 12,000,000 Manufacturing overhead Indirect factory wages 6,000,000$ Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 14,000,000$ 41,000,000
Gross margin 9,000,000 Selling and administrative expenses
Shipping expenses 3,000,000 Marketing expenses 2,000,000 General administrative expenses 6,000,000 11,000,000
Net operating loss (2,000,000)$
Calculate the profit margin of each product using traditional costing system.
Step 1: Identify the product that are the chosen cost objects
SETP-2: Identify direct costs of the products800,000 400,000
SureStart LongLifesSalesDirect CostsDirect materialsDirect labour
Plant-wide POHR = $14,000,000 = 17.5mh800,000mh
SS:LL:
SureStart LongLifesTotal direct costs [STEP-2]Total indirect costs [STEP-3]Total product costsProduct marginLess: Selling & admin expenses
Net operating profit / (loss)Profit Margin per unit SS LL
RevenueLess: CostGross profitMargin
STEP 4: Compute the Total cost and profit margin of the products
STEP 3: Compute the indirect costs of the products
Example-Single Plant-wide Indirect Cost Pool System [Traditional Cost Accounting]
Baxter Battery CompanyIncome Statement
Year Ended December 31, 2009
Baxter Company manufactures 800,000 Sure starts batteries (SS) and 400,000 LongLifes batteries (LL). Direct costs for SS are: Direct materials $9,000,000; Direct labor $7,000,000. Direct costs for the LL are: Direct materials $6,000,000; Direct labour $5,000,000.Baxter currently uses a single plantwide overhead rate based on machine hours to allocate manufacturing overhead costs and 480,000 machine hours and 320,000 machine hours were used respectively to make SS and LL batteries. Total manufacturing overhead and the selling and administrative expenses for the year were $14,000,000 and $11,000,000 respectively. SS sells for $40 each and LL for $45 each. The income statement of the company for the year ended 31 December 2009 is as follows:
Page 9 of 13
Sales 50,000,000$ Cost of goods sold
Direct materials 15,000,000$Direct labor 12,000,000 Manufacturing overhead Indirect factory wages 6,000,000$ Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 14,000,000$ 41,000,000
Gross margin 9,000,000 Selling and administrative expenses
Shipping expenses 3,000,000 Marketing expenses 2,000,000 General administrative expenses 6,000,000 11,000,000
Net operating loss (2,000,000)$
1
2Activity Cost Pool Activity Measure Total activitiesCustomer orders Number of customer orders 10,000 customer ordersDesign changes Number of design changes 4,000 design changesOrder size Machine-hours 800,000 machine hrsOther Not applicable Not applicable
Continued next page
Baxter Company manufactures 800,000 Sure starts batteries (SS) and 400,000 LongLifes batteries (LL). Direct costs for SS are: Direct materials $9,000,000; Direct labor $7,000,000. Direct costs for the LL are: Direct materials $6,000,000; Direct labour $5,000,000.Baxter currently uses a single plantwide overhead rate based on machine hours to allocate manufacturing overhead costs and 480,000 machine hours and 320,000 machine hours were used respectively to make SS and LL batteries. Total manufacturing overhead and the selling and administrative expenses for the year were $14,000,000 and $11,000,000 respectively. SS sells for $40 each and LL for $45 each. The income statement of the company for the year ended 31 December 2009 is as follows:
Example-Activity Based Costing System
All indirect cost items are now classified as follows:
The Company is implementing an activity based costing system that has four activity cost pools. You are provided the following information
Direct materials and direct labor are remained to be direct costs. With the ABC analysis, the costs of Shipping ($3,000,000) have also been traced to the two products directly as follows:SS $2,000,000 and LL $1,000,000
Baxter Battery CompanyIncome Statement
Year Ended December 31, 2009
Page 10 of 13
Production Department Indirect factory wages 6,000,000$ Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 14,000,000$General Administrative Department Administrative wages and salaries 4,000,000 Office equipment depreciation 900,000 Administrative building lease 1,100,000 6,000,000 Marketing Department Marketing wages and salaries 1,500,000 Selling expenses 500,000 2,000,000 Total overhead costs 22,000,000$
Customer Orders
Design changes
Order Size Other Total
Production DepartmentIndirect factory wages 40% 30% 20% 10% 100%Factory equipment depreciation 0% 60% 30% 10% 100%Factory utilities 0% 40% 30% 30% 100%Factory building lease 0% 0% 0% 100% 100%
General Administrative DepartmentAdministrative wages and salaries 60% 10% 10% 20% 100%Office equipment depreciation 50% 10% 0% 40% 100%Administrative building lease 0% 0% 0% 100% 100%
Marketing DepartmentMarketing wages and salaries 60% 30% 0% 10% 100%Selling expenses 40% 40% 10% 10% 100%
5)
Customer OrdersDesign changes
Order Size
Calculate the profit margin of each product using ABC system.
To
requires 36 minutes of machine time for a total
of 480,000 machine hours
requires 48 minutes of machine time for a total of 320,000 machine-hours
4000 custom designsRequires no new design changes
(Manufacturing and Nonmanufacturing)
Activity Cost Pools
SureStart LongLifeActivity usage by each product is as follows:
4) At Baxter Battery the following distribution of resource consumption across activity cost pools is determined.
3) The total overhead costs to be analyzed using ABC are as follows:
4000 separate orders 6000 separate orders
Overhead Costs at Baxter Battery
Page 11 of 13
Step 1: Identify the product that are the chosen cost objectsSS-800,000 LL-400,000
SETP-2: Identify direct costs of the products800,000 400,000
SureStart LongLifesSales $32,000,000 $18,000,000 $50,000,000Direct CostsDirect materials $9,000,000 $6,000,000 $15,000,000Direct labour $7,000,000 $5,000,000 $12,000,000Shipping expenses $2,000,000 $1,000,000 $3,000,000Total direct costs $18,000,000 $12,000,000 $30,000,000
Activity Cost Pool Activity Measure Total activitiesCustomer orders Number of customer orders 10,000 customer ordersDesign changes Number of design changes 4,000 design changesOrder size Machine-hours 800,000 machine hrsOther Not applicable Not applicable
Activity Cost Pools Total CostCustomer orders 6,350,000$ Design changes 6,040,000 Order size 3,450,000 Other 6,160,000 Total 22,000,000$
(a) (b) (a) (b)Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders 6,350,000$ 10,000 orders $635 per orderDesign changes 6,040,000 4,000 changes $1510 per changeOrder size 3,450,000 800,000 MHs $4.3125 per MHOther 6,160,000 Not applicable Not applicableTotal 22,000,000$
Quantitiy of allocation base SS LLCustomer orders 4000 orders 6000 ordersDesign changes 0 new designs 4000 new designsOrder size 480000 mh 320000 mh
Overehad costs for two products SS LL TotalCustomer orders $2,540,000 $3,810,000 $6,350,000Design changes $0 $6,040,000 $6,040,000Order size $2,070,000 $1,380,000 $3,450,000 Total indirect costs-STEP-6 $4,610,000 $11,230,000 $15,840,000
Sales $32,000,000 $18,000,000 $50,000,000Direct costs (STEP-2) $18,000,000 $12,000,000 $30,000,000Indirect costs (STEP-6) $4,610,000 $11,230,000 $15,840,000Total product costs $22,610,000 $23,230,000 $45,840,000Product margin $9,390,000 -$5,230,000 $4,160,000Less: Other 6,160,000 Net operating profit/ (loss) (2,000,000)
STEP 3: define activity cost pools and activity measures
Answer: Activity Based Costing Sample Question
STEP 4: Assign overhead costs to activity cost pools
STEP 5: Calculates activity rates
STEP 6: assigning overheads to products
STEP 7: Compute the product Margins
Page 12 of 13
Production Department Indirect factory wages 6,000,000$ Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 14,000,000$General Administrative Department Administrative wages and salaries 4,000,000 Office equipment depreciation 900,000 Administrative building lease 1,100,000 6,000,000 Marketing Department Marketing wages and salaries 1,500,000 Selling expenses 500,000 2,000,000 Total overhead costs 22,000,000$
Customer Orders
Design changes
Order Size Other Total
Production DepartmentIndirect factory wages 40% 30% 20% 10% 100%Factory equipment depreciation 0% 60% 30% 10% 100%Factory utilities 0% 40% 30% 30% 100%Factory building lease 0% 0% 0% 100% 100%
General Administrative DepartmentAdministrative wages and salaries 60% 10% 10% 20% 100%Office equipment depreciation 50% 10% 0% 40% 100%Administrative building lease 0% 0% 0% 100% 100%
Marketing DepartmentMarketing wages and salaries 60% 30% 0% 10% 100%Selling expenses 40% 40% 10% 10% 100%
Customer Orders
Design changes Order Size Other Total
Production DepartmentIndirect factory wages 2,400,000$ 1,800,000$ 1,200,000$ 600,000$ 6,000,000$ Factory equipment depreciation - 2,100,000 1,050,000 350,000 3,500,000 Factory utilities - 1,000,000 750,000 750,000 2,500,000 Factory building lease - - - 2,000,000 2,000,000
General Administrative Department - - - - - Administrative wages and salaries 2,400,000 400,000 400,000 800,000 4,000,000 Office equipment depreciation 450,000 90,000 - 360,000 900,000 Administrative building lease - - - 1,100,000 1,100,000
Marketing Department - - - - - Marketing wages and salaries 900,000 450,000 - 150,000 1,500,000
To Selling expenses 200,000 200,000 50,000 50,000 500,000 Total 6,350,000$ 6,040,000$ 3,450,000$ 6,160,000$ 22,000,000$
Activity Cost Pools Total CostCustomer orders 6,350,000$ Design changes 6,040,000 Order size 3,450,000 Other 6,160,000 Total 22,000,000$
SS LLRevenue $40.00 $45.00Less: Cost $28.26 $58.08Gross profit $11.74 -$13.08Margin 29% -29%
Workings-1: Step-4 assign overhead costs to activity cost
ABC Profit Margin per unit
Activity Cost Pools
Activity Cost Pools
Page 13 of 13