CHAPTER 7 Accounting 1B. Activity-Based Costing(ABC): A tool to Aid Decision Making

CHAPTER 7 Accounting 1B Activity-Based Costing(ABC): A tool to Aid Decision Making

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

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.

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.

Activity Based Costing: A Tool to Aid Decision Making

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!

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.

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.

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

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.

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

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

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

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.

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

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.

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

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.

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.

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.

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

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

Identify and Define Activities and Activity Cost Pools At Zap Manufacturing, the ABC team, selected the following activity cost pools and activity measures: Activity Cost Pools at Classic Brass Activity Cost 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

Identify and Define Activities and Activity Cost Pools Activity Cost Pool is a bucket in which costs are accumulated that relate to a single activity measure in the ABC system. $ $ $ $ $ $

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.

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 60,000 510,000 Marketing Department Marketing wages and salaries 250,000 Selling expenses 50,000 300,000 Total overhead costs $ 1,850,000

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.

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 60,000 510,000 Marketing Department Marketing wages and salaries 250,000 Customer Relations Other Total Selling expenses 50,000 300,000 Total overhead costs $ 1,850,000 Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

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 60,000 510,000 Marketing Department Marketing wages and salaries 250,000 Customer Relations Other Total Selling expenses 50,000 300,000 Total overhead costs $ 1,850,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

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 60,000-180,000-60,000 300,000 Factory utilities - 12,000 60,000-48,000 120,000 Factory building lease - - - - 80,000 80,000 General Administrative Department Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000 Office equipment depreciation 15,000 - - 12,500 22,500 50,000 Administrative building lease - - - - 60,000 60,000 Marketing Department Marketing wages and salaries 50,000 25,000-150,000 25,000 250,000 Selling expenses 5,000 - - 35,000 10,000 50,000 Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000

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.

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 257,000 200 designs $1,285 per design Order size 380,000 20,000 MachHrs $19 per MH Customer relations 367,500 100 customer $3,675 per customer Other 490,500 Not applicable Not applicable

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

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

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) 1. 400 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 $2,110. 5. Direct labor totals $1,850. 6. 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 $13. 5. Direct labor totals $50. 6. Shipping costs total $25.

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) $ 315 2 $ 630 Product design (per design) 1,285 0 - Order size (MH) 19 200 3,800 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 1 $ 315 Product design 1,285 1 1,285 Order size 19 4 76 Customer relations 3,675 N/A

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 $ 5,030 400 * $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)

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

Product Margins Standard Electric Motor Sales 13,600 Costs Traditional Cost Accounting System Compass Gear Reduction Telemetry $ $ 650 4 units x $50/MH = $200 Direct materials (2,110) (13) Direct labor (1,850) (50) Manufacturing overhead (10,000) (200) Product margin $ (360) $ 387 400 units x 0.5 MH/unit x $50/MH = $10,000 Predetermined manufacturing overhead rate = $1,000,000 20,000 MachineHr = $50/MachineHr

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.

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.

Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because... 1. 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.

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.

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.

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