ch5.ppt

CHAPTER 5

Activity-Based Costing

and

Activity-Based Management

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 5-2

Learning Objective 1

Explain undercosting

and overcosting of

products and services.


BackgroundRecall that factory overhead is applied to

production in a rational systematic manner, using some type of averaging. There are a variety of methods to accomplish this goal.

These methods often involve trade-offs between simplicity and realism.

Simple Methods Complex Methods

Unrealistic Realistic


Broad Averaging costing

Historically, firms produced a limited variety of goods while their indirect costs were relatively small.

Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of how they are actually incurred Peanut-butter Costing

The end-result: overcosting and undercosting


Over- and Undercosting

Overcosting – a product consumes a low level of resources but is allocated high costs per unit

Undercosting – a product consumes a high level of resources but is allocated low costs per unit


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?


Undercosting andOvercosting Example

$60 ÷ 3 = $20

Jose and Nancyare overcosted.

Roberta isundercosted.


Cross-subsidization

If a company undercosts one of its products, then it will overcost at least one of its other products; and vice versa.

The overcosted product absorbs too much cost, making it seem less profitable than it really is.

The undercosted product is left with too little cost, making it seem more profitable than it really is.



Present three guidelines for

refining a costing system.


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: NL and CL.



Normal Lenses (NL)Direct materials $1,520,000Direct mfg. labor 800,000Total direct costs $2,320,000Units produced: 80,000

Direct cost per unit: $2,320,000 ÷ 80,000 = $29



Complex Lenses (CL)Direct materials $ 920,000Direct mfg. labor 260,000Total direct costs $1,180,000Units produced 20,000

Direct cost per unit: $1,180,000 ÷ 20,000 = $59



All Indirect Costs$2,900,000

All Indirect Costs$2,900,000

50,000 DirectManufacturingLabor-Hours

50,000 DirectManufacturingLabor-Hours

INDIRECT-COSTPOLL

INDIRECTCOST-ALLOCATIONBASE

$58 per DirectManufacturing

Labor-Hour



Indirect Costs

Direct Costs

Indirect Costs

Direct Costs

COST OBJECT:NL AND CLLENSES

DIRECTCOSTS

DirectMaterials

DirectMaterials

DirectManufacturing

Labor

DirectManufacturing

Labor



Kole uses 36,000 direct manufacturinglabor-hours to make NL and 14,000 directmanufacturing labor-hours to make CL.

How much indirect costs are allocatedto each product?



NL: 36,000 × $58 = $2,088,000

CL: 14,000 × $58 = $812,000

What is the total cost of normal lenses?

Direct costs $2,320,000 +Allocated costs $2,088,000 = $4,408,000

What is the cost per unit?

$4,408,000 ÷ 80,000 = $55.10



What is the total cost of complex lenses?

Direct costs $1,180,000 + Allocated costs $812,000 = $1,992,000

What is the cost per unit?

$1,992,000 ÷ 20,000 = $99.60



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%


Refining a Costing System

A new competitor who sells NL at a price of $53 occurred.

Kole’s managers’ usual choices:

1. Cut the costs of NL to a level below $53,or

2. Give up the production of NL

What about if the cost of NL is incorrect due to the simple approach in costing, and in fact its cost is below $53?


Refining a Costing System

Direct-cost tracing: Identify as many direct costs as is economically feasible.

Indirect-cost pools: Expand the number of indirect cost pool until each of these pool is more homogeneous

Cost-allocation base: whenever possible, use the cost driver as the cost allocation base for each homogeneous indirect cost pool.

Indirect-cost pools: Expand the number of indirect cost pool until each of these pools is more homogeneous.


Rationale for Selecting a More Refined Costing System Increase in product diversity Increase in Indirect Costs Competition in markets



Distinguish between simple and activity-based

costing systems.


Activity-Based Costing System

Activity-based costing (ABC): Identify individual activities as the fundamental cost objects.

An activity: an event, task, or unit of work with a specified purpose.

ABC identify activities in all functions of the value chain.



1. FundamentalCost Objects

Activities

Costs of Activities

2. Assignment to Other

Cost Objects

Cost of:• Product• Service• Customer



A cross-functional team at KoleCorporation identified 7 key activities:

a. Design products and processes.

b. Set up molding machine.

c. Operate machines to manufacture lenses.

d. Maintain and clean the molds.



e. Set up batches of finished lenses for shipment.

f. Distribute lenses to customers.

g. Administer and manage all processes.



No. ofSetupHours

LensesNL

LensesCL

CostAllocationBase

ProductCostObjects

No. ofShipments

Parts-Square

feet

SetupDesign ShippingActivityIndirect CostPool



NL CL Quantity produced 60,000 15,000 No. produced/batch 240 50 Number of batches 250 300 Setup time per batch 2 hours 5 hours Total setup-hours 500 1,500 Direct labor-hours 30,000 9,750

Total setup costs are $300,000.



What is the setup cost per setup-hour?

$300,000 ÷ 2,000 hours = $150

What is the setup cost perdirect manufacturing labor-hour?

$300,000 ÷ 39,700 = $7.54717



Allocation setup costs using direct labor-hours:NL: $7.54717 × 30,000 = $226,415CL: $ 7.54717 × 9,750 = $73,585

Total $300,000

Allocation setup costs using setup-hours:NL: $150 × 500 = $ 75,000CL: $150 × 1,500 = $225,000Total $300,000


A Cautionary TaleA number of critical decisions can be made

using this information: Should one product be “pushed” over another? Should one product be dropped?

Accounting for overhead costs is an imprecise science. Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable.


ConclusionsEach method is mathematically correct.Each method is acceptable.Each method yields a different cost figure, which

will lead to different gross margin calculations.Only overhead is involved. Total costs for the

entire firm remain the same—they are just allocated to different cost objects within the firm.

Selection of the appropriate method and drivers should be based on experience, industry practices, as well as a cost-benefit analysis of each option under consideration.



Describe a four-part

cost hierarchy.


Cost Hierarchies

A cost hierarchy is a categorization of costs into different cost pools based on cost drivers, or cost-allocation bases, or degrees of difficulty in determining cause-and-effect relationships.


Cost Hierarchies

ABC systems commonly use a four-level cost hierarchy to identify cost-allocation bases:

1. Output unit-level costs

2. Batch-level costs

3. Product-sustaining costs

4. Facility-sustaining costs


Output Unit-Level Costs

These are resources sacrificedon activities performed on each

individual unit of product or service.

Machine operations costs: Energy, Machine depreciation, Repairs

Cost allocation base: Machine-hours


Batch-Level Costs

These 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.

Cost allocation base: Setup-hours

Setup costs, Procurement costs


Product-Sustaining Costs

These are resources sacrificed on activities undertaken to support individual products or services regardless of the number of units or batches.

Design costs, Engineering costs Cost-allocation base: Parts-square feet


Facility-Sustaining Costs

These are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole.

General administration costs: top management compensation, rent, building security

Cost-allocation base: no allocation or manufacturing labor-hours



Cost products or services using

activity-based costing.


ImplementingActivity-Based Costing

Identify cost objects.

NL (60,000)CL(15,000)

Identify the direct costsof the products.

Direct materialDirect labor

Mold cleaning and maintenance

Step 1 Step 2



Cleaning and maintenance costs of$360,000 are direct batch-level costs,

because these costs consist of workers’wages for cleaning molds after each

batch of lenses is run.



Normal Lenses (NL)Cost Hierarchy

Description CategoryDirect materials Unit-level $1,520,000Direct mfg. labor Unit-level 800,000Cleaning and maint. Batch-level 160,000Total direct costs $2,480,000



Complex Lenses (CL)Cost Hierarchy

Description CategoryDirect materials Unit-level $ 920,000Direct mfg. labor Unit-level 260,000Cleaning and maint. Batch-level 200,000Total direct costs $1,380,000



a. Design: parts-square feet (100)

b. Setup molding machine: setup hours (2,000)

c. Machine operations: machine hours (12,750)

Select the activities and cost-allocation bases to use for allocating indirect costs to the products.

Step 3



e. Shipment setup: shipments (200)

f. Distribution: cubic feet delivered (67,500)

g. Administration: direct manufacturing labor hours (39,750)



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 4

Identify the indirect costs associatedwith each cost-allocation base.



Select the cost-allocation bases to use forallocating indirect costs to the products.

(1) (2) (3)Activity Cost Hierarchy Total CostsShipment Batch-level $810,000Distribution Unit-level $391,500Administrations Facility sustaining $255,000

Step 4

Identify the indirect costs associatedwith each cost-allocation base.



Compute the rate per unit of each cost allocation base.

Step 5



Compute the indirect costs allocatedto the products.

Design costs: total 450,000, Total parts-square feet: 100Design costs per part-square foot: 450,000 / 100 = 45,000NL parts-square:30, CL parts-square: 70Design costs allocated to NL: 45,000 * 30 =135,000Design costs allocated to CL: 45,000 * 70 =315,000

Step 6



Compute the costs of the products.

NL and CL would show threedirect cost categories.

Step 7

1. Direct materials

2. Direct manufacturing labor

3. Cleaning and maintenance



NL and CL would show six indirect cost pools.

1. Design

2. Molding machine setups

3. Manufacturing operations

4. Shipment setup

5. Distribution

6. Administration



The total cost of NL: $2,998,953The unit cost of NL: $49.98

The total cost of CL: $1,981,047The unit cost of CL: $132.07



Use activity-based

costing systems for

activity-based management.


Activity-Based Management

ABM is a method of management decision making that uses activity-based costing information

to satisfy customers and improve profits.Product pricing and mix decisions

Cost reduction and process improvement decisions

Design decisions

Planning and managing activities


Product Pricing andMix Decisions

ABC gives management insight into the coststructures for making and selling diverse products.

It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs.


Cost Reduction and ProcessImprovement Decisions

Manufacturing and distribution personnel use ABC systems to focus on how and where to reduce costs.

Managers set cost-reduction targets in terms ofreducing the cost per unit of the cost-allocation base in different activity areas and take out of those costs that are non-value added.


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 toevaluate the costs and prices of alternative designs.


Planning and Managing Activities

Companies specify budgeted costs for activities and use budgeted cost rates to cost products.

At year-end, budgeted costs and actual costs are compared to provide feedback on how well activities were managed.



Compare activity-based costing

systems and department-

costing systems.


ABC and DepartmentIndirect-Cost Rates

In many situations, department costing systems can be refined by ABC,

because the cost drivers of resources in eachdepartment or sub-department differ from thesingle, company-wide, cost-allocation base.


ABC and DepartmentIndirect-Cost Rates

e.g. manufacturing department overhead costTraditional: single cost pool; machine-hoursABC: two cost pools, setup cost pool and machine operation cost pool; setup-hours and operation-hours

ABC leads to more-focused and homogenous cost pools, identifies cost-allocation bases with better cause-effect relationship with cost pools, hence provides more accurate cost information.



Evaluate the costs and benefits

of implementing activity-based

costing systems.


Warning Signs That Suggest That ABC Could help a Firm

1. Significant amounts of indirect costs areallocated using only one or two cost pools.

2. All or most costs are identified as output unit-level costs.

3. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.


Warning Signs That Suggest That ABC Could help a Firm

4. Products that a company is well-suited tomake and sell show small profits whileproducts for which a company is less suited show large profits.

5. Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.


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.


Limitations of ABC Systems

Activity-cost rates also need to beupdated regularly.

Very detailed ABC systems are costlyto operate and difficult to understand.


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.


ABC In Service andMerchandising Companies

The cost pools correspond to key activities.

Costs are allocated to products or customersusing activity drivers or cost-allocation

bases that have a cause-and-effectrelationship with the cost in the cost pool.

ch5.ppt

Documents

cost accounting

pearson education

cost objects

little cost

average cost

indirect costs

low costs

high costs