lecture 9 abc, cvp

8/11/2019 Lecture 9 ABC, Cvp

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BU8101 Accounting: A User Perspective

Lecture 9

ACTIVITY-BASED COSTING (ABC)

COST-VOLUME-PROFIT ANALYSIS (CVP)

Compulsory Reading:

WHB Chapter 17 & 20

Other Reference:

Financial & Managerial Accounting

Wild and Chiappetta

Chapters 17, 18

9-1Lecture date: 18 March, 2013


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Lecture Outline

I. ACTIVITY-BASED COSTING (ABC)

a. Traditional Plant-wide, Single Overhead Rate

b. ABC Multiple Overhead Rates

c. Comparison between Traditional Costing vs. ABC

II. COST-VOLUME-PROFIT ANALYSIS (CVP)

a. Costs and Cost Behaviors

b. Contribution Margin Income Statementc. Break-even Analysis

d. Business Applications of CVP

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ManufacturingOverhead

(estimate)

Job No. 1

Job No. 2

Job No. 3

Charge directmaterial anddirect labor

costs to each job

as work isperformed

Direct Materials

(actual)

Direct Labor

(actual)

I. Activity-Based Costing (ABC)

Apply overheadto each job using

a predeterminedrate (POHR)

RECAP: Manufacturing Cost Flow

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Traditional Costing System

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Traditional cost systems were created when manufacturingprocesses were labor intensive.

A single, company-wide overhead rate based on direct labor hours

may be used to allocate overhead costs to products in these labor-

intensive processes.

Today, manufacturing processes are highly automated and direct

labor costs have become less significant.

Is it still appropriate to use direct labor hours to allocate overhead

costs?


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Overhead CostIndirectCosts

CostAllocationBase

Single Plant-WideOverhead Rate

CostObjects

Product 1 Product 2 Product 3

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Advantages

Information is readily

available Easy to implement

Often sufficient to meet

external financial

reporting needs

Disadvantages

Overhead costs may

not bear anyrelationship with direct

labor hours

All products may not

use overhead costs inthe same proportion

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How to improve OH allocation?


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TraditionalCosting

Traditional vs. ABC Method

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ABC Costing


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ActivityBased Costing

In the ABC method, we recognize that many activitieswithin a department drive overhead costs.

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Activity An event that causes theconsumption of overheadresources.

A cost bucket in which

costs related to a singleactivity measure areaccumulated.

Activities and Cost Pools

ActivityCostPool

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Repair and Maintenance of

Equipment

$100,000


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POHR

=

Multiple Overhead

Categories

Multiple POHR

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Cost Pools Cost DriversMaterials purchasing Number of purchase orders

Materials handling Number of materials

requisitions

Personnel processing Number of employees hired or laid off

Equipment depreciation Number of products

produced or hours of use

Quality inspection Number of units inspected

Indirect labor for Number of setups required equipment setups

Engineering costs for Number of modifications

product modifications

Cost Driver: activity that leads to the incurrence of costs

Cost Pools and Cost Drivers

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Overhead Actual

Rate Activity

Rate =

Estimated overhead costs in activity cost pool

Estimated number of activity units

ABC: 5-step Computation

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1. Identify activities that consume resources.

2. Assign costs to a cost pool for each activity.

3. Identify cost drivers / cost allocation base

associated with each activity.4. Compute overhead rate for each cost pool:

5. Assign costs to products:


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Example: Traditional Costing vs. ABC

Pear Company manufactures a product in regular anddeluxe models. Overhead is assigned on the basis of

direct labor hours. Budgeted overhead for the current

year is $2,000,000. Other information:

Deluxe Regular

Model Model

Direct Material 150$ 112$

Direct Labor Cost 16 8

Direct Labor Time 1.6 hours 0.8 hoursExpected Volume (units) 5,000 40,000

Lets determine the unit cost of each model using

traditional costing methods.9-13

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DirectLabor Hours

Deluxe Model 5,000 units @ 1.6 hours 8,000

Regular Model 40,000 units @ 0.8 hours 32,000

Total Direct Labor Hours (DLH) 40,000

Overhead Estimated overhead costs

Rate Estimated activity base=

$2,000,00040,000 DLH

=

$50 per DLH

Traditional Costing

=

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Deluxe Regular

Model Model

Direct Material 150$ 112$

Direct Labor 16 8

Manufacturing Overhead

$50 per hour 1.6 hours 80

$50 per hour 0.8 hours 40

Total Unit Cost 246$ 160$

ABC will have differentoverhead per unit.

Traditional Costing

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Activity-Based CostingPear Company plans to adopt activity-based costing. Using

the following activity center data, determine the unit cost ofthe two products using activity-based costing.

Overhead

Activity Cost for Cost Units of Activity

Cost Pool Activity Driver Deluxe Regular

Purchasing 84,000$ Orders 400 800Scrap Rework 216,000 Orders 300 600

Testing 450,000 Tests 4,000 11,000

Machine Related 1,250,000 Hours 20,000 30,000

Total Overhead 2,000,000$

Step 1Identify

Activities

Step 2Assign cost to

Cost Pools

Step 3Identify

Cost Driver

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Overhead Units

Activity Cost Cost for of

Cost Pool Driver Activity Activity Rate

Purchasing Orders 84,000$ 1,200 $ 70 per order

Scrap Rework Orders 216,000 900 $240 per order

Testing Tests 450,000 15,000 $ 30 per test

Machine Related Hours 1,250,000 50,000 $ 25 per hour

Total Overhead 2,000,000$

Rate = Overhead Cost for Activity Units of Activity

Step 4Compute

POHR

Activity-Based Costing

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400 deluxe + 800 regular = 1,200


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Deluxe Model Regular Model

Actual Cost Actual Cost

Activity Units of Allocated Units of AllocatedCost Pool Rate Activity to Product Activity to Product

Purchasing $ 70/order 400 28,000$ 800 56,000$

Scrap Rework $240/order 300 ? 600 ?

Testing $ 30/test 4,000 ? 11,000 ?

Machine Related $ 25/hour 20,000 ? 30,000 ?

Total Overhead ? ?

Cost Allocated to Product = Rate (POHR) x Actual Units of Activity

Step 5Allocate cost

to product


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Deluxe Model Regular Model

Actual Cost Actual Cost

Activity Units of Allocated Units of Allocated

Cost Pool Rate Activity to Product Activity to Product

Purchasing $ 70/order 400 28,000$ 800 56,000$

Scrap Rework $240/order 300 72,000 600 144,000

Testing $ 30/test 4,000 120,000 11,000 330,000

Machine Related $ 25/hour 20,000 500,000 30,000 750,000

Total Overhead 720,000$ 1,280,000$

Cost Allocated to Product = Rate (POHR) Actual Units of Activity

Total overhead = $720,000 + $1,280,000 = $2,000,000

Recall that $2,000,000 was the original amount of overhead

assigned to the products using traditional costing.

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Overhead Costs Assigned to Products:

Deluxe Model $720,000 5,000 units = $144 per unit

Regular Model $1,280,000 40,000 units = $32 per unit

Deluxe Regular

Model Model

Direct Materials 150$ 112$

Direct Labor 16 8Manufacturing Overhead 144 32


Overhead Costs Assigned to Products:

Deluxe Model $720,000 5,000 units = $144 per unit

Regular Model $1,280,000 40,000 units = $32 per unit

Deluxe Regular

Model Model

Direct Materials 150$ 112$

Direct Labor 16 8Manufacturing Overhead 144 32



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This result is not uncommon when ABC is used.

Many companies have found that low-volume, specialized products

have greater overhead costs than previously realized.

Traditional Costing ABC

Deluxe Regular Deluxe Regular

Model Model Model Model

Direct materials 150$ 112$ 150$ 112$

Direct labor 16 8 16 8

Overhead 80 40 144 32

Total cost 246$ 160$ 310$ 152$

Traditional Costing vs. ABC

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Cost

Distortions


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Activity Levels

Activity Cost Consumption Consumption

Cost Pool Driver Deluxe Ratio Regular Ratio

Purchasing Orders 400 33% 800 67%

Scrap Rework Orders 300 33% 600 67%

Testing Tests 4,000 27% 11,000 73%

Machine Related Hours 20,000 40% 30,000 60%

ABCConsumption Ratios

Proportion of each activity consumed by a product.

Physical Units

Deluxe Regular

5,000 40,000

1 : 8

11% 89%

Deluxe model consumes more

overhead resoures and should be

allocated more overhead costs!

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Advantages and Disadvantages of ABC

Advantages

More accurateoverhead cost allocation

More effective overheadcost control

Many uses: servicefirms, customer

profitability studies (eg,marketing/distribution/customer service costs)

Disadvantages

Costs to implement andmaintain

Complexity may hampersupport forimplementation

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II. Cost-Volume-Profit Analysis (CVP)

Understanding Costs

Fixed Costs

Variable Costs

Semivariable /

Mixed Costs

Cost behavior

Relationship between cost and activity level (eg, output).

How a cost behaves or changes as the amount of output changes

within the relevant range.

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Total fixed costs

remain constant asactivity increases.

Number of Local Calls

MonthlyBasic

TelephoneBill

Cost per calldeclines as

activity increases.

Number of Local Calls

MonthlyBa

sicTelephone

Billper

LocalCall

Fixed Costs

Total FC FC per unit

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Variable Costs

Total variablecosts increase asactivity increases.

Minutes Talked

CostperMinute

Minutes Talked

Cost per Minuteis constant as

activity increases.

TotalLongDistance

Telep

honeBill

Total VC VC per unit

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Variable Costs Fixed costs

Per UnitRemains the same even when

activity level changes.

Changes as activity level

changes.

Total Changes as activity level

changes.

Remains the same over wide

ranges of activity.

Variable Cost vs. Fixed Cost

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Quick Check

Which of the following statements about costbehavior are true?

a. Fixed costs per unit vary with the level of activity.

b. Variable costs per unit are constant within therelevant range.

c. Total fixed costs are constant within the relevant

range.

d. Total variable costs are constant within the relevant

range.

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Semivariable Costs (Mixed Costs)

Mixed costs contain a fixed portion that isincurred even when facility is unused, and avariable portion that increases with usage.

Example: monthly electric utility charge

Fixed service fee

Variable charge perkilowatt hour used

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Variable

Utility Charge

Activity (Kilowatt Hours)

To

talUtilityCo

st

Fixed Monthly

Utility Charge

Slope isvariable cost

per unit

of activity.

Semivariable Costs (Mixed Costs)

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Separating Semivariable Cost

Accounting records typically show only the total cost and theassociated amount of activity of a semivariable (mixed) costitem.

Separate mixed costs into their fixed and variable components

for cost estimation purposes. E.g. Budgeting, CVP analysis.

Methods: High-low Scattergraph method

Method of least squares (regression analysis) Managerial judgments

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Total Cost = Total Fixed Cost + Total Variable Cost

Total Cost = Total Fixed Cost + Variable Rate x Output

Separating Semivariable Cost

The Cost Formula

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The High-Low Method

Matrix, Inc. recorded the following production activity andmaintenance costs for two months:

Using these two levels of activity, compute:1. the variable cost per unit.

2. the total fixed cost.3. total cost formula.

Units Cost

High activity level 9,000 9,700$

Low activity level 5,000 6,100Change / Difference 4,000 3,600$

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Units CostHigh activity level 9,000 9,700$

Low activity level 5,000 6,100

Change 4,000 3,600$

1. Unit variable cost = = = $0.90 per unit

2. Fixed cost = Total costTotal variable cost

Using High activity levelFixed cost = $9,700($0.90 per unit 9,000 units)

Fixed cost = $9,700$8,100 = $1,600

3. Total cost = $1,600 + $.90 per unit

in cost in units

$3,6004,000

The High-Low Method

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Used primarily forexternal reporting

Used primarily forinternal decision making

Both formats report the same Operating Income!

Different Income Statement Formats

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Total UnitSales Revenue 100,000$ 50$

Less: Variable costs 60,000 30

Contribution margin 40,000$ 20$

Less: Fixed costs 30,000

Operating income 10,000$

The contribution margin format emphasizes cost behavior.

Contribution margin covers fixed costsand provides for income.

Contribution Margin (CM) = SalesVariable Costs

The Contribution Margin Format

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Contribution Margin Ratio (CMR) =

Contribution Margin

Sales

Contribution Margin Ratio (CMR) =

Contribution Margin

Sales

The Contribution Margin Format

Now that youve learnt Cost Behaviors and CM format income

statement, lets start making some decisions.. 9-37


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CVP for Decision Making

Cost-volume-profit (CVP) analysis is used to

answer questions such as:

How will income be affected if I increase selling

prices or reduce costs? (cost) What will happen to profitability if I expand

capacity? (volume)

How much must I sell to earn my desired income?

(profit) How will income be affected if I reduce selling

prices to increase sales volume?

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CVP: Computing Break-Even Point

The break-even point (expressed in units ofproduct or dollars of sales) is the unique

sales level at which a company neither

earns a profit nor incurs a loss.

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k


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Volume in Units

CostsandRevenu

e

in

Dollars

Break-evenPoint

Profit

Loss

Break-Even Point

A Graphical Representation

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Total Revenue

Total Cost


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How Many Units Must We Sell to Break-Even?

Break-even

point in units

Fixed costs

Contribution margin per unit

Unit sales price - unit variable cost

($50$30 = $20 in previous example)

=

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The break-even formula may also beexpressed in sales dollars.

Unit contribution margin

Unit sales price

How Much Sales Dollars to Break-Even?

Break-evenpoint in dollars

Fixed costsContribution margin ratio

=

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ABC Co. sells product XYZ at $5.00 per unit. Iffixed costs are $200,000 and variable costs are$3.00 per unit, how many units must be sold tobreak even?

a. 100,000 units

b. 40,000 units

c. 200,000 units

d. 66,667 units

Computing Break-Even Sales Units

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Use the contribution margin ratio formula to

determine the amount of sales revenue ABC must

have to break even. All information remains

unchanged: fixed costs are $200,000; unit sales

price is $5.00; and unit variable cost is $3.00.a. $200,000

b. $300,000

c. $400,000d. $500,000

Computing Break-Even Sales Dollars

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Computing Sales Needed to Achieve


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Target Operating Income

Break-even formulas may be adjusted to

show the sales volume needed to earn

any amount of operating income.

Break-even

Units =Fixed costs + Target income

Contribution margin per unit

Fixed costs + Target income

Contribution margin ratio

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Break-even

Sales Dollars =



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ABC Co. sells product XYZ at $5.00 per unit. If fixed

costs are $200,000 and variable costs are $3.00 per

unit, how many units must be sold to earn

operating income of $40,000?a. 100,000 units

b. 120,000 units

c. 80,000 units

d. 200,000 units


Target OperatingIncome

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Related Concept: Margin of Safety

Margin of safety is the amount by which sales may

decline before reaching break-even sales:

The dollar amount by which Sales can decrease beforethe company incurs a loss.

Margin of safety = Actual sales Break-even sales

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Total Per Unit Percent

Sales (500 bikes) 250,000$ 500$ 100%

Less: variable expenses 150,000 300 60%

Contribution margin 100,000$ 200$ 40%

Less: fixed expenses 80,000Operating income 20,000$

Business Applications of CVP

Consider the following information developed by theaccountant at Speedo, a bicycle retailer:

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Should Speedo spend $12,000 on advertising to

increase sales by 10 percent?

Total Per Unit Percent

Sales (500 bikes) 250,000$ 500$ 100%

Less: variable expenses 150,000 300 60%

Contribution margin 100,000$ 200$ 40%

Less: fixed expenses 80,000Operating income 20,000$

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500 550

Bikes BikesSales 250,000$ 275,000$

Less: variable expenses 150,000 165,000

Contribution margin 100,000$ 110,000$

Less: fixed expenses 80,000 92,000

Operating income 20,000$ 18,000$

550 $300

$80K + $12K

No!Income has decreased.

550 $500

Should Speedo spend $12,000 on advertising to

increase sales by 10 percent?

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N i bi ti ith th d ti i


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500 625






625 $300

$80K + $12K

No!

Income has decreased even more.

625 $450

Now, in combination with the advertising,Speedo is considering a 10 percent price reduction that will

increase sales by 25 percent.

What is the effect on income ?

1.25 500

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500 750






Yes!The combination of advertising, a price cut,

and change in compensation increases income.

750 ($300+25)

$80K+$12K-$50K

750 $450

Now, in combination with advertising and a 10% price cut,Speedo will replace $50,000 in sales salaries with

a $25 per bike commission, increasing sales by 50 percentabove the original 500 bikes. What is the effect on income?

1.5 500

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CVPMultiple Products

Sales mix is the relative combination in whicha companys different products are sold.

Different products have different selling prices,costs, and contribution margins.

If Speedo sells bikes and roller blades, how

will we deal with break-even analysis?

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M lti l P d t


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Multiple Products

Break-even in Sales Dollars

The overall contribution margin ratio is:

= 48% (rounded)

Bikes Roller Blades Total

Sales 250,000$ 100% 300,000$ 100% 550,000$ 100%

Var. exp. 150,000 60% 135,000 45% 285,000 52%

Contrib. margin 100,000$ 40% 165,000$ 55% 265,000$ 48%

Fixed exp. 170,000

Net income 95,000$

$265,000$550,000

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Weighted

CMR=

M lti l P d t


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Bikes Roller Blades TotalSales 250,000$ 100% 300,000$ 100% 550,000$ 100%

Var. exp. 150,000 60% 135,000 45% 285,000 52%

Contrib. margin 100,000$ 40% 165,000$ 55% 265,000$ 48%

Fixed exp. 170,000

Operating income 95,000$

Multiple Products

Break-even in Sales Dollars

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= $354,167(combined sales)

$170,000.48

BE Sales

Dollars=

Description

Breakeven

Sales

% of

Total

Individual

Sales

Bikes $354,167 45.0% $159,375

Roller Blades $354,167 55.0% $194,792

Total units $354,167

$250k/550k = 45% $300k/550k = 55%

M lti l P d t


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Multiple Products

Break-even in Units

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Bikes Roller Blades Total UnitsSales 250,000$ 300,000$ 550,000$ 500

Var. exp. 150,000 135,000 285,000 300

CM 100,000$ 165,000$ 265,000$ 800

Fixed exp. 170,000

Net income 95,000$

CM / unit$265,000

800= = $331.25 (combined)

BE Sales

Units== FC $170,000

$331.25513.20 (combined)

M lti l P d t


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Multiple Products

Break-even in Units

Description

Number of

Units

% of

Total

Bikes 500 62.5% (500 800)

Roller Blades 300 37.5% (300 800)

Total sold 800 100.0%

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BE Sales (Units) = 513.20 (combined)

Description

Breakeven

Units

% of

Total

Individual

Sales

Units

Bikes 513.20 62.5% 321

Roller Blades 513.20 37.5% 192

Total units 513

Ch k Li t


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Check List

Do you have a good understanding of:

ABC

Activity-based costing (ABC) methodologies

Difference between traditional vs. ABC costing

CVP

Types of cost behaviour

Breakout mixed costs by using High-Low method

Break-even and CVP computations

Break-even computations for single product andmultiple products

lecture 9 abc, cvp

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