ACCTG 221 / ABC Costing

ACCTG 221 / ABC Costing ACTIVITY BASED COSTING SYSTEMS First identifies activities in an organization and then assigns the cost of each activity to products and services based on actual consumption The aim is to classify and allocate overheads in such a way that better reflects the consumption of manufacturing/service resources One of the problems with traditional costing systems is suggested to be their lack of accuracy (in allocating costs to cost objects) which could lead to flawed decision making Can be used for both goods and services ABC: costs > activities > g/s Traditional: costs > departments > products Traditional costing systems vs ABC traditional systems are usually volume based (allocate costs to individual products on unit level basis, e.g. direct labour hours, units produced, etc) the ABC method classifies costs into a cost hierarchy: 1. Unit Level where we allocate on a volume basis (ie same as volume based) 2. Batch Level allocate according to batch activity 3. Product Level allocate products responsible for these costs on a volume basis 4. Facility Level allocate on volume basis Traditional systems are appropriate when: direct costs are the dominant cost (low overheads) information costs are expensive (lack of computerized systems meant it was costly to implement ABC) where there is a lack of intense global competition (more competition means businesses need to lower prices) a limited range of products is produced (no need for accurate separation of costs for different products) EXAMPLE: Traditional Costing System traditional systems will usually use a volume based driver such as labour hours, machine hours, number of units, etc to allocate overhead to products for example, Job 1 took 2 labour hours and Job took 6 hours to complete if overhead is allocated to jobs using direct labour hours, and the overhead (depreciation) was $120; $120 8 hours = $15 per labour hour Job 1 = 2 x 15 = $30 Job 2 = 6 x 15 = $90 automation increases have meant overheads have increased to $420 and have reduced Job 2 s labour hours from 6 to only 1 hour using the traditional costing system, cost would be allocated; $420 3 = $140 per labour hour Job 1 = 2 x 140 = $280 Job 2 = 1 x 140 = $140 is this reasonable? the increase in overheads only benefitted Job 2 but Job 1 has been allocated more overhead - clearly we need another cost driver to allocate overhead we need to look at the ABC method as obviously there is no cause & effect relationship between our overheads and labour hours the initial $120 of depreciation should be split evenly between the two jobs, as neither incur or use more depreciation the additional $300 only benefits Job 2 and so all $300 should be added there Job 1 = $60 Job 2 = $360 we could say, as a result of the traditional costing system, Job 1 was initially over costed as Job 1 had absorbed too much cost, making it seem less profitable than it is

we could say, as a result of the traditional costing system, Job 2 was initially under costed as it had absorbed too little cost, making it seem more profitable than it really is TRADITIONAL direct costs COST ITEMS cost of direct materials ABC costs of unit-level activities cost of direct labor cost of batch level activities indirect costs (overhead) variable manufacturing overhead costs cost of product line activities fixed manufacturing overhead costs cost of facility support activities costs of unit-level activities e.g. material, packaging, labour, assembly cost of batch level activities e.g. number of setups, setup hours, movements of materials, inspections cost of product line activities e.g. engineering and design changes, warehousing of product line materials, production line dedicated supervisors, purchasing, receiving and shipping cost of facility support activities e.g. property taxes, plant security, general administrative salaries Value added vs. non-value added activities a value added activity increases the worth of a g/s to a customer, the customer is willing to pay for it, and are essential; e.g. a GPS module in a phone a non-value added activity increases me spent on g/s but doesn t increase its worth to the customer, and is considered unnecessary from the customer s perspective; they can be reduced, redesigned, or eliminated without affecting market value or quality; e.g. shipping costs from another warehouse for materials Steps in ABC Costing 1. Identify and Define Activities and Activity Cost Pools 2. Assign Costs to Activity Cost Pools 3. Calculate Activity Rates 4. Assign Activity Costs to Products

EXAMPLE of ABC Costing 1. Identify and Define Activities and Activity Cost Pools At a publishing company, the ABC team, selected the following activity cost pools and activity measures: Activity Cost Pool Activity Measure customer orders - assigned all cost 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 customer orders -> number of customer orders product design -> number of product designs order size -> machine hours customer relations -> number of active customers other -> not applicable 2. Assign Costs to Activity Cost Pools assign the costs to the activity cost pools e.g. $500,000 of indirect factory wages 25% of which is used in customer orders so, 25% of 500,000 = 125,000 and $125,000 worth of indirect factory wages should be assigned to the customer orders activity pool ** note that there are no shipping costs as the cost is directly attributed to the customer

Finished product: 3. Calculate Activity Rates The ABC team determines that the company 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 In order to calculate the activity rates, we divide the total cost for each activity by total activity levels: e.g. Customer Order Total: 315,000 Customer Orders: 1,000 315,000 1,000 Customer Order rate = $315 per order 4. Assign Activity Costs to Products - first, identify all the activities related to a given product or service - second, determine how many units of each activity are used per unit of product - third, assign costs to products using the cost-driver rates for each activity Assume we want to calculate the costs of two jobs: Job 1 and Job 2 are received by one customer as follows: JOB 1-400 units ordered with 2 separate orders - Each stanchion required 0.5 machine hours - Selling price is $34 each - Direct materials total $2,110 - Direct labor total $1,850 - Shipping costs total $180 JOB 2 - One order during the year - Each housing required 4 machine hours - Selling price is $650 each - Direct materials total $13 - Direct labor total $50 - Shipping costs total $25

What if we had done the previous example with a Traditional Costing System? Job 1 Job 2 Sales 13,600 650 Costs: Direct Materials (2,110) (13) Direct Labor (1,850) (50) Manufacturing Overhead (10,000) (200) How is the overhead calculated? - Manufacturing Overhead Rate? $1,000,000 20,000 Machine Hours = $50 per MH Job 1? 400 units x 0.5MH/unit x $50 per MH = $10,000 Job 2? 1 unit x 4MH/unit x $50 per MH = $200 Product Margin $ (360) $ 387 Customer Profitability Analysis: Margin for Job 1 -$360 Margin for Job 2 387 Total Margin 17 Less: Customer Relations 3,675 Customer Margin $3,648

EXAMPLE of ABC Costing for a service company Erin Sacks CPA provides accounting, tax, and legal services to her clients. She charges a fee of $85.40 per hour (including labour costs and overhead) for accounting and $125.40 (also including labour costs and overhead) per hour for tax and legal services. Erin has four categories of overhead and the expected overhead costs for each category for next year are as follows: Activity Costs Expected Activity Advertising and Miscellaneous $56,000 2000 pages Computer Fees 48,000 1000 computer hrs Secretary s Salary 50,000 200 clients Fixed Overhead 100,000 10000 labour hrs $254,000 Currently overhead is applied using a predetermined overhead rate based upon budgeted direct labour hours. Overhead rates per hour are the same for both services but direct labour rates are different. As with last year, for next year, 10,000 direct labour hours are budgeted (for both services). Operating profits declined last year and Ms Sacks has decided to use ABC procedures to evaluate her hourly fees. She has gathered the following information from last year s records: Activity Accounting Tax and Legal Services Advertising and Miscellaneous (in pages) 1000 1000 Computer Fees (in computer hours) 250 750 Secretary s Salary (number of clients) 32 168 Direct Labour Hours 4000 6000 Required; a) What is the total cost allocated to Accounting Services using the traditional costing system? the $85.40 Sacks charges includes the labour fee $254,000 10,000 direct labour hours = $25.40 so $85.40 = $25.40 + $60.00 (the direct labour charge) there were in total 4000 direct labour hours for accounting services Overhead costs: 4000 x 25.40 = 101,600 Direct Labour Costs: 4000 x 60.00 = 240,000 Total allocated costs: 101,600 + 240,000 = $341,600 b) What is the total cost allocated to Accounting Services using the ABC system? Activity Total Cost Cost Driver Rate per unit Units Cost Allocation Advertising and Miscellaneous 56,000 2,000 28 1,000 28,000 Computer Fees 48,000 1,000 48 250 12,000 Secretary s Salary 50,000 200 250 32 8,000 Fixed Overhead 100,000 10,000 10 4,000 40,000 Direct Labour Hours n/a n/a n/a n/a 240,000 328,000

ACCTG 221 / Process Costing and Spoilage PROCESS COSTING (chapters 17 & 18) Process Costing Systems are for masses of identical/similar units of product or service (e.g. food) where the unit cost of a product or service is obtained by assigning total costs to many identical units each unit receives the same or similar amounts of direct materials costs, direct labor costs, and manufacturing overhead unit costs are computed by dividing total costs incurred by the number of units of output from the production process Job Costing Systems are for distinct, identifiable units of a product or service (e.g. house) There are 2 methods for PROCESS COSTING: - Weighted Average all units and costs are considered together to determine average cost per equivalent unit this is regardless of whether the costs were incurred last period or currently - FIFO costs are accounted for by layer cost per equivalent unit for this period is computed separately from the cost per equivalent unit for the last period How to calculate an equivalent unit? - the calculation differs depending on whether you are using WA or FIFO - the WA method calculates cost per EU of all work done to date (regardless of the period in which it was done) assigns this cost to EUs completed & transferred out of the process, and to incomplete units still inprocess WA costs is the total of all costs in the work-in-process account divided by the total equivalent units of work done to date the beginning balance of the work-in-process account (work done in a prior period) is blended in with current period costs (note, in a service business, you will have NO BWIP/EWIP account and so can only apply WA method) Steps for costing out production in process costings (same for both methods) 1. Summarise the flow of physical units of output 2. Compute output in terms of equivalent units 3. Summarise total costs to account for 4. Compute cost per equivalent unit 5. Assign total costs to units completed and to units in EWIP (ending work-in-process)

Example: Armando Company produces MP3 players and uses a WA process costing system for its manufacturing department. Armando has NO BWIP inventory. All direct materials are added at the beginning of the process and conversion costs are added gradually. Units started 24,000 Unit completed and transferred out 20,000 Units in process (material 100%, cc 25%) 4,000 Costs: Materials $126,000 Conversion Costs 42,000 Total Costs $168,000 Solution (using steps) 1) Units to account for MUST = units accounted for Units to account for: units in BWIP + units started (BWIP 0 + units started 24,000) Units accounted for: units completed + units in EWIP + spoilage (UC 20,000 + EWIP 4,000 + S 0) 2) Calculate equivalent units Materials Conversion Units completed 20,000 20,000 EWIP 4,000 1,000 Total Equivalent Units 24,000 21,000 < as 100% of material is present < as only 25% of CC complete, so only 25% of the total 4,000 3) Summarise the total costs to account for Cost of BWIP $0 + costs added (materials $126,000 & CC $42,000) = Total Costs of $168,000 4) Compute cost per equivalent unit Unit cost for material? $126,000 24,000EU = $5.25 Unit cost for CC? $42,000 21,000EU = $2.00 Total? $5.25 + $2.00 = $7.25 5) Assign total costs to units completed and to units in EWIP Need to value inventories Goods transferred out? $7.25 x 20,000 units = $145,000 EWIP? ($5.25 x 4,000) + ($2.00 x 1,000) = $23,000

EXAMPLE: Shiraz Company produces CD players and wants to use a weighted average process costing system. Here is the information for last month: - there was a BWIP of 1000 units, $1000 cost (Materials 20% - $400 and CC 60% - $600) - there was NO damaged units Units started 10,500 Unit completed and transferred out 9,500 Units in process (material 25%, CC 37.5%)? Costs: Materials $19,600 Conversion Costs 9,650 Total Costs $30,250 remember! : units to account for = units accounted for BWIP - 1,000 Units completed - 9,500 Units started - 10,500 EWIP (plug) - 2,000 Solution (using steps) 1) Units to account for MUST = units accounted for Units to account for: units in BWIP + units started (BWIP 1,000 + units started 10,500) Units accounted for: units completed + units in EWIP + spoilage (UC 9,500 + EWIP 2,000 + S 0) 2) Calculate equivalent units (remem that in WA, the equiv units are not identified separately) Spoilage - 0 Materials Conversion BWIP <- IGNORE 200 600 Units completed 9,500 9,500 Spoilages 0 0 < see above for % completion of BWIP < see above for % completion of units EWIP 500 750 Total Equivalent Units 10,000 10,250 3) Summarise the total costs to account for BWIP (M$400, CC$600): $1000 Completed Goods: $? Costs added (M$19,600, CC$9,650): $29,250 EWIP: $? Total: $30,250 Total: MUST BE $30,250 4) Compute cost per equivalent unit Unit cost for material? ($400 + $19,600) 10,000EU = $2 per EU Unit cost for Conversion Costs? ($600 + $9,650) 10,250EU = $1 per EU Total? $2 + $1 = $3 full cost per unit 5) Assign total costs to units completed and to units in EWIP Need to value inventories Goods transferred out? $3 x 9,500 units = $28,500 EWIP? ($2 x 500) + ($1 x 750) = $1,750