Acct 1B Week 8, Chap 7

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1 Acct 1B Week 8, Chap 7 Activity Based Costing (ABC) Instructor: Michael Booth Cabrillo College

2 Activity Based Costing: A Tool to Aid Decision Making

3 Global Business Situation Using technology and productivity More emphasis on cost measurement and control Increasingly competitive global business environment Eliminating nonvalue added activities More emphasis on quality

4 The Development of a Single Companywide Cost Driver Traditional cost systems were created when manufacturing processes were labor intensive. A single company-wide overhead rate, based on direct labor hours, is used to allocate overhead to products in these labor intensive processes.

5 The Development of a Single Companywide Cost Driver Labor Intensive Process Overhead costs are relatively small. Overhead allocations may be inaccurate, but the amounts are relatively insignificant. Automated Process Overhead costs are relatively large. Inaccurate overhead allocation can lead to questionable product cost information.

6 Activity Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore fixed costs. ABC is a good supplement to our traditional cost system I agree!

7 All Some How Costs are Treated Under Activity Based Costing ABC differs from traditional cost accounting in three ways. Manufacturing costs Nonmanufacturing costs Traditional product costing ABC product costing ABC does not assign all manufacturing costs to products.

8 Activity Based Costing (ABC) Both manufacturing and nonmanufacturing costs may be assigned to products. A number of cost pools each allocated to a product or cost object. Some manufacturing costs may be excluded from product costs. Allocation bases often differ from traditional costing systems. Overhead rates may be based on activity at capacity.

9 Activity-Based Cost Drivers Many companies are using activitybased cost drivers to improve product costing. Activity Based Costing Companywide Overhead Rate Overhead Allocation

10 Plantwide Overhead Rate Companies tended to use direct labor as the overhead allocation base. There was a belief that direct labor and overhead costs were highly correlated.

11 In class activity Martinez Furniture Company(MFC) makes desk and chairs. Desks require 5 hours of direct labor per unit and chairs require 2 hours per unit. Each month MFC normally uses 500,000 hrs of direct labor making 100,000 desks. Sub-assembly and parts used as a material cost per desk is 3 times greater than chairs Each month MFC normally uses 300,000 hrs of direct labor making 150, 000 chairs MFC incurs $1,088,000 of material handling cost each month

12 First Allocation Methodology Use direct hours to allocated the material handling cost $1,088,000 Desks, 100,000 units, 5 hr/unit, 500,000 hrs total Chairs, 150,000 units, 2 hr/unit, 300,000 hrs total. Total direct labor hours (DLH) of 800,000 (500, ,000) is the more appropriate allocation base. The allocation rate is: Materials Handling Cost Cost Driver = Allocation Rate $1,088, ,000 DLH = $1.36/DLH Allocated Materials Handling Cost Product Allocation Rate x No. of DL Hours = Allocated Cost Desks $1.36/DLH x 500,000 = $ 680,000 Chairs $1.36/DLH x 300,000 = 408,000 Total $1,088,000

13 Second Allocation Method Use direct hours to allocated the material handling cost $1,088,000 MFC install industrial robots for making desks, and this changes direct labor hour from 5hr/unit to.4 hr/unit Desks, 100,000 units,.4 hr/unit, 40,000 hrs total Chairs, 150,000 units, 2 hr/unit, 300,000 hrs total

14 Second Allocation Method With automation, total direct labor hours (DLH) drops to 340,000 (40, ,000). The allocation rate is: Materials Handling Cost Cost Driver = Allocation Rate $1,088, ,000 DLH = $3.20/DLH Allocated Materials Handling Cost Product Allocation Rate x No. of DL Hours = Allocated Cost Desks $3.20/DLH x 40,000 = $ 128,000 Chairs $3.20/DLH x 300,000 = 960,000 Total $1,088,000 ca Note: the shift in cost, would this change the pricing if the company uses cost plus Pricing methods?

15 Adoption of ABC costing Methods Activities associated with Material handling: Locating a supplier Placing an order Transporting materials from supplier to MFC Inspecting the materials for defects Storing the materials in warehouse Preparing production requisitions Issuing production requisitions to manufacturing for materials required Issuing production requisitions is the primary activity that drive the costs of material handling Desks, 2,500 requisitions Chairs, 1,500 requisitions Assume the same material handling cost of $1,088,000, and allocate based on requistions

16 Adoption of ABC costing Methods Using the number of materials requisitions prepared as the allocation base, the allocation rate is: Materials Handling Cost Cost Driver = Allocation Rate $1,088,000 4,000 req. = $272/req. Allocated Materials Handling Cost Product Allocation Rate x No. of Req. = Allocated Cost Desks $272/req. x 2,500 = $ 680,000 Chairs $272/req. x 1,500 = 408,000 Total $1,088,000 Question: Does this method align closer to the materials usage?

17 Using JIT and ABC Methodology Activities associated with Material handling: Locating a supplier Placing an order Transporting materials from supplier to MFC Inspecting the materials for defects Storing the materials in warehouse Preparing production requisitions Issuing production requisitions to manufacturing for materials required MFC has determined that warehousing, transporting, and storage costs can be reduced if materials are demanded as required. Implementation of JIT will reduced Material Handling from $1,088,000 to $816,000 Use of digital notification for placement of order based on demand indicates Desks, 3000 orders placed Chairs, 2000 orders placed Allocate the new overhead rate using the revised material handling costs

18 JIT and ABC Methodology Using the number of purchase orders filed as the allocation base, the allocation rate is: Materials Handling Cost Cost Driver = Allocation Rate $816,000 5,000 Pos = $163.20/PO Allocated Materials Handling Cost Product Allocation Rate x No. of Pos = Allocated Cost Desks $163.20/PO x 3,000 = $489,600 Chairs $163.20/PO x 2,000 = 326,400 Total $816,000 Note: the overall change in costs is significantly different than the direct labor hours. In addition, shifting to JIT has reduced the overall costs; this is referred to as continuous improvement Non-value add steps to be reduced or eliminated (ordering, transporting, inspections

19 Kanban Materials requirement planning technique developed by Toyota Corporation (as a part of just-in-time inventory system) in which work-centers signal with a card when they wish to withdraw parts from feeding operations or the supply bins. Kanban means a visible record (such as a billboard, card, label, or sign) in Japanese.

20 Kanban/JIT

21

22 JIT (Just In Time Mfg) JIT Auto Seat Production

23 Departmental Overhead Rates Finishing Department Painting Department Shipping Department Many companies have a system in which each department has its own overhead rate.

24 Departmental Overhead Rates Stage One: Costs assigned to pools Cost pools Indirect Labor Department 1 Indirect Materials Department 2 Other Overhead Department 3

25 Departmental Overhead Rates Stage One: Costs assigned to pools Cost pools Indirect Labor Department 1 Indirect Materials Department 2 Other Overhead Department 3 Stage Two: Costs applied to products Products

26 Departmental Overhead Rates Stage One: Costs assigned to pools Cost pools Indirect Labor Department 1 Indirect Materials Department 2 Other Overhead Department 3 Stage Two: Costs applied to products Direct Labor Hours Machine Hours Products Raw Materials Cost Departmental Allocation Bases

27 Cost of Idle Capacity Traditional Cost Accounting The predetermined overhead rate is based on budgeted activity. This results in applying overhead costs of unused, or idle, capacity. Activity Based Costing Products are charged for the costs of capacity they use not for the costs of capacity they don t use.

28 Designing an ABC System Cost Objects (e.g., products and customers) Activities Consumption of Resources Cost

29 Designing of an ABC System Steps for Implementing ABC Identify and define activities and activity cost pools. Trace costs to activities and cost objects. Assign costs to activity cost pools. Calculate activity rates. Assign costs to cost objects. Prepare management reports.

30 Activity-Based Costing A B C Activity-based costing (ABC) is a two-stage allocation process that employs a variety of cost drivers.

31 Activity-Based Costing Stage 1 Assign costs to pools according to activities that cause costs to be incurred. The first step is to identify essential activities and costs required to perform the activities. Stage 2 Allocate costs in the activity pools to products. Activity-based costing (ABC) is a two-stage allocation process that employs a variety of cost drivers.

32 Identify and Define Activities and Activity Cost Pools Unit-Level Activity Batch-Level Activity A part of the production process for which management wants a separate reporting of the costs of the activity involved. Product-Level Activity Organizationsustaining Activity Customer-Level Activity

33 How Costs are Treated Under Activity Based Costing ABC defines five levels of activity that largely do not relate to the volume of units produced. Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products.

34 How Costs are Treated Under Activity Based Costing Two common types of activity measures: Transaction driver Simple count of the number of times an activity occurs. Duration driver A measure of the amount of time needed for an activity.

35 Characteristics of Successful ABC Implementations Strong top management support Link to evaluations and rewards Cross-functional involvement

36 Identify and Define Activities and Activity Cost Pools At Zap Manufacturing, the ABC team, selected the following activity cost pools and activity measures: Activity Pool Customer orders Product design Order Size Customer Relations Other Activity Measure Number of customer orders Number of product designs Machine hours Number of active customers Not applicable

37 Identify and Define Activities and Activity Cost Pools Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product Designs - assigned all costs of resources consumed by designing products. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations assigned all costs associated with maintaining relations with customers. Other assigned all overhead costs that are not associated with the other cost pools.

38 Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects Overhead Costs at Zap Inc. (Manufacturing and NonManufacturing) Production Department Indirect factory wages $ 500,000 Factory equipment depreciation 300,000 Factory utilities 120,000 Factory building lease 80,000 $ 1,000,000 Shipping costs traced to customer orders 40,000 General Administrative Department Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60, ,000 Marketing Department Marketing wages and salaries 250,000 Selling expenses 50, ,000 Total overhead costs $ 1,850,000

39 Assign Costs to Activity Cost Pools At Zap Inc. the following distribution of resource consumption across activity cost pools is determined. Activity Cost Pools Customer Product Orders Design Order Size Customer Relations Other Total Production Department Indirect factory wages 25% 40% 20% 10% 5% 100% Factory equipment depreciation 20% 0% 60% 0% 20% 100% Factory utilities 0% 10% 50% 0% 40% 100% Factory building lease 0% 0% 0% 0% 100% 100% Shipping costs ** General Administrative Department Administrative wages and salaries 15% 5% 10% 30% 40% 100% Office equipment depreciation 30% 0% 0% 25% 45% 100% Administrative building lease 0% 0% 0% 0% 100% 100% Marketing Department Marketing wages and salaries 20% 10% 0% 60% 10% 100% Selling expenses 10% 0% 0% 70% 20% 100% **Not included because they are directly traced to customer orders.

40 Assign Costs to Activity Cost Pools Production Department Indirect factory wages $ 125,000 Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total Activity Cost Pools Customer Product Orders Design Overhead Costs at Zap Inc. (Manufacturing and NonManufacturing) Production Department Indirect factory wages $ 500,000 Factory equipment depreciation 300,000 Order Factory utilities 120,000 Factory building Size lease 80,000 $ 1,000,000 Shipping costs traced to customer orders 40,000 General Administrative Department Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60, ,000 Marketing Department Marketing wages and salaries 250,000 Customer Relations Other Total Selling expenses 50, ,000 Total overhead costs $ 1,850,000 Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

41 Assign Costs to Activity Cost Pools Production Department Indirect factory wages $ 125,000 Factory equipment depreciation 60,000 Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total Production Department Activity Cost Pools Customer Orders Product Design Order Size Overhead Costs at Zap Inc. (Manufacturing and NonManufacturing) Indirect factory wages $ 500,000 Factory equipment depreciation 300,000 Factory utilities 120,000 Factory building lease 80,000 $ 1,000,000 Shipping costs traced to customer orders 40,000 General Administrative Department Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60, ,000 Marketing Department Marketing wages and salaries 250,000 Customer Relations Other Total Selling expenses 50, ,000 Total overhead costs $ 1,850,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

42 Assign Costs to Activity Cost Pools At Zap Inc. the following distribution of resource consumption across activity cost pools is determined. Activity Cost Pools Customer Product Orders Design Order Size Customer Relations Other Total Production Department Indirect factory wages 25% 40% 20% 10% 5% 100% Factory equipment depreciation 20% 0% 60% 0% 20% 100% Factory utilities 0% 10% 50% 0% 40% 100% Factory building lease 0% 0% 0% 0% 100% 100% Shipping costs ** General Administrative Department Administrative wages and salaries 15% 5% 10% 30% 40% 100% Office equipment depreciation 30% 0% 0% 25% 45% 100% Administrative building lease 0% 0% 0% 0% 100% 100% Marketing Department Marketing wages and salaries 20% 10% 0% 60% 10% 100% Selling expenses 10% 0% 0% 70% 20% 100% **Not included because they are directly traced to customer orders.

43 Assign Costs to Activity Cost Pools Activity Cost Pools Customer Orders Product Design Order Size Customer Relations Other Total Production Department Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000 Factory equipment depreciation 60, ,000-60, ,000 Factory utilities - 12,000 60,000-48, ,000 Factory building lease ,000 80,000 General Administrative Department Administrative wages and salaries 60,000 20,000 40, , , ,000 Office equipment depreciation 15, ,500 22,500 50,000 Administrative building lease ,000 60,000 Marketing Department Marketing wages and salaries 50,000 25, ,000 25, ,000 Selling expenses 5, ,000 10,000 50,000 Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000

44 In class Exercise 7-2 Organize into pairs Complete first stage allocation per exhibit 7-4 & 7-5

45 In class Exercise 7-2 Organize into pairs Complete first stage allocation per exhibit 7-4 & 7-5

46 Exercise 7-2 SecuriCorp operates a fleet of armored cars that make scheduled pickups and deliveries in the Los Angeles area. The company is implementing an activity-based costing system that has four activity cost pools: Travel, Pickup and Delivery, Customer Service, and Other. The activity measures are miles for the Travel cost pool, number of pickups and deliveries for the Pickup and Delivery cost pool, and number of customers for the Customer Service cost pool. The Other cost pool has no activity measure because it is an organization-sustaining activity. The following costs will be assigned using the activity-based costing system:

47 Calculate Activity Rates The ABC team determines that Zap Inc. will have these total activities for each activity cost pool... 1,000 customer orders 200 new designs 20,000 machine-hours 100 customer relations activities Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

48 Calculate Activity Rates Computation of Activity Rates (a) (b) (a) (b) Activity Cost Pools Total Cost Total Activity Activity Rate Customer orders $ 315,000 1,000 orders $315 per order Product design 257, designs $1,285 per design Order size 380,000 20,000 MachHrs $19 per MH Customer relations 367, customer $3,675 per customer Other 490,500 Not applicable Not applicable

49 Activity-Based Costing at Zap Inc. Direct Materials Direct Labor Shipping Costs Overhead Costs Traced Traced Traced Cost Objects: Products, Customer Orders, Customers

50 Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Cost Objects: Products, Customer Orders, Customers

51 Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Second-Stage Allocations $/MH $/Order $/Design $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated

52 Work in pairs In class Exercise 7-3 Complete the activity rate for each of the activity cost pools

53 EXERCISE 7-3 Green Thumb Gardening is a small gardening service that uses activity-based costing to estimate costs for pricing and other purposes. The proprietor of the company believes that costs are driven primarily by the size of customer lawns, the size of customer garden beds, the distance to travel to customers, and the number of customers. In addition, the costs of maintaining garden beds depends on whether the beds are low maintenance beds (mainly ordinary trees and shrubs) or high maintenance beds (mainly flowers and exotic plants). Accordingly, the company uses the five activity cost pools listed below: Activity Rate

54 Assigning Costs to Cost Objects Let s take a look at how our system works for just one customer Windward Turbine Systems. Standard Electric Motor (no design required) units ordered with 2 separate orders. 2. Each electric motor required 0.5 machine-hours. 3. Selling price is $34 each. 4. Direct materials total $2, Direct labor totals $1, Shipping costs total $180. Custom Gear Reduction telemetry (requires new design) 1. One order during the year. 2. Each housing required 4 machine-hours. 3. Selling price is $650 each. 4. Direct materials total $ Direct labor totals $ Shipping costs total $25.

55 Assigning Costs to Cost Objects Overhead Cost for the Standard Electric Motor (a) (b) (a) (b) Activity Cost Pools Activity Rate Activity ABC Cost Customer orders (per order) $ $ 630 Product design (per design) 1, Order size (MH) ,800 Customer relations 3,675 N/A The customer-level cost is assigned to customers directly; it is not assigned to products. Overhead Cost for the Custom Gear Reduction Telemetry (a) (b) (a) (b) Activity Cost Pools Activity Rate Activity ABC Cost Customer orders $ $ 315 Product design 1, ,285 Order size Customer relations 3,675 N/A

56 Work in pairs In class Exercise 7-4 Determine the overhead cost that would be assigned to each of the products using activity based costing systems

57 EXERCISE 7-4 Klumper Corporation is a diversified manufacturer of industrial goods. The company s activity-based costing system contains the following six activity cost pools and activity rates: Total ABC Cost Total ABC Cost

58 Prepare Management Reports Standard Electric Motor Sales $ 13,600 Cost: Direct materials $ 2,110 Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570 Product margin $ 5, * $34/unit = $13,600 2 orders * $315/order= $630 $19 * 200 machine hours= $3,800 1* $650/unit = $650 1 orders* $315/order= $315 1 new design x $1,285 = $1,285 $19* 4 machine hours = $76 Custom Gear Reduction Telemetry Sales $ 650 Cost: Direct materials $ 13 Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285 Order size 76 1,764 Product margin $ (1,114)

59 Prepare Management Reports Customer Profitability Analysis Windward Turbine Inc Product margins: 1 customer * $3,675 Standard Electric Motor $ 5,030 Custom Gear Reduction Telemetry (1,114) Total product margin 3,916 Less: Customer relations 3,675 Customer margin $ 241

60 Product Margins Standard Electric Motor Sales 13,600 Costs Traditional Cost Accounting System Compass Gear Reduction Telemetry $ $ units x $50/MH = $200 Direct materials (2,110) (13) Direct labor (1,850) (50) Manufacturing overhead (10,000) (200) Product margin $ (360) $ units x 0.5 MH/unit x $50/MH = $10,000 Predetermined manufacturing overhead rate = $1,000,000 20,000 MachineHr = $50/MachineHr

61 Difference Between ABC and Traditional Product Costs Traditional: Batch-level or product-level costs will ordinarily shift overhead costs from high-volume products produced in large batches to low-volume products produced in small batches. Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organizationsustaining costs and the costs of idle capacity are not assigned to products.

62 Targeting Process Improvement Activity-based costing can be used to identify areas that would benefit from process improvements. Theory of Constraints: any manageable system is limited in achieving more of its goal by a very small number of constraints, and that there is always at least one constraint. The TOC process seeks to identify the constraint and restructure the rest of the organization around it The theory of constraints approach is a powerful tool for targeting the area in an organization whose improvement will yield the greatest benefits.

63 Measurement using ABC Green Costs that adjust automatically to changes in activity without management action - Direct materials Yellow Costs that could, in principle, be adjusted to changes in activity, but management action would be required - Direct Labor, Indirect labor wages Red Costs that would be very difficult to adjust to changes in activity and management action would be required - Other manufacturing overhead, Selling and Administrative expense

64 Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because External reports are less detailed than internal reports. 2. It may be difficult to make changes to the company s accounting system. 3. ABC does not conform to GAAP. 4. Auditors may be suspect of the subjective allocation process based on interviews with employees.

65 Limitations of ABC ABC systems are a major project requiring substantial resources. The benefits of increased accuracy must outweigh these additional costs. ABC produces numbers, like product margins, that are at odds with numbers produced by traditional costing system. Some managers find it difficult to adjust to this change. ABC data can be misinterpreted and must be used with care when making decisions.

66 Employee Attitudes and the Availability of Data ABC implementation may lead to cost-cutting measures that result in job losses. Loss of jobs will impact... Employees personal lives Morale of retained employees It may be difficult to get employ cooperation for successful implementation under these conditions.

67 In class exercise Organize into pairs Lambert Fabrication, Inc Working papers provided ABC Allocations Product Margin Analysis

68 Assignments: See web: http//cabrillo.blackboard.com This will be updated weekly Note: Use McGrawHill CONNECT on BLACKBOARD to submit assignments

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