Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter 5Chapter 5

Activity-Based Costing

Activity-Based Costing

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

1

Learning Objective

1

Traditional, Volume-Based Traditional, Volume-Based Product-Costing SystemProduct-Costing System

• Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.

• The following information is obtained from company records:

• Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.

• The following information is obtained from company records:

Mode I Mode I I Mode I I IProduction: Units 10,000 20,000 4,000 Runs 1 run of 10,000

units 4 runs of

5,000 units 10 runs of 400 units

Traditional, Volume-Based Traditional, Volume-Based Product-Costing SystemProduct-Costing System

Additional information includes:Mode I Mode I I Mode I I I

Direct materials 50.00$ 90.00$ 20.00$ Direct labor (hr/board) 3 4 2 Setup time (hr/run) 10 10 10 Machine time (hr/board) 1 1.25 2

Manufacturing overhead is determined as follows

Traditional, Volume-Based Traditional, Volume-Based Product-Costing SystemProduct-Costing System

Budgeted manufacturing overhead Budgeted manufacturing overhead $3,894,000 $3,894,000 Budgeted direct-labor hours 118,000Budgeted direct-labor hours 118,000 = $33 per hour= $33 per hour

Traditional, Volume-Based Traditional, Volume-Based Product-Costing SystemProduct-Costing System

With these product costs, Aerotech established target selling prices (Cost × 125%).

209.00 x 1.25

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

2

Learning Objective

2

Activity Based Costing System Activity Based Costing System (ABC)(ABC)

ABC systems follow a two-two-

stage stage procedure to assign

overhead costs to products.

Assigningoverhead to

products is adifficult process.

I agree!

Activity Based Costing System Activity Based Costing System (ABC)(ABC)

ABC systems follow a two-stage procedure to assign overhead costs to products.

Let’s beginby identifying

our major activities.

Stage OneIdentify significant

activities and assign overheadcosts to each activity in

proportion to resources used.

Activity Based Costing System Activity Based Costing System (ABC)(ABC)

Overhead assigned to activities are called

“activity cost pools.”

Stage TwoIdentify cost drivers

appropriate to each activityand allocate overhead to

the products.

ABC systems follow a two-stage procedure to assign overhead costs to products.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

3

Learning Objective

3

Overhead CostsOverhead CostsTotal budgeted cost = $3,894,000Total budgeted cost = $3,894,000

ActivityActivityCostCostPoolsPools

MachineryMachinerycost poolcost pool

$1,212,600$1,212,600

SetupSetupcost poolcost pool$3,000$3,000

EngineeringEngineeringcost poolcost pool$700,000$700,000

FacilityFacilitycost poolcost pool$507,400$507,400

UnitLevel

BatchLevel

Product-Sustaining

Level

FacilityLevel

Identificationof ActivityCost Pools

Identificationof ActivityCost Pools

ActivityActivitymust bemust bedone ondone oneach uniteach unitproduced.produced.

ActivityActivityperformedperformedon eachon eachbatchbatch

produced.produced.

Activities needed to supportActivities needed to supportan entire product linean entire product line

Activity required in orderActivity required in orderfor the productionfor the productionprocess to occur.process to occur.

Receiving/InspectionReceiving/Inspectioncost pool cost pool $200,000$200,000

Material-HandlingMaterial-Handlingcost pool cost pool $600,000$600,000

Quality-AssuranceQuality-Assurancecost pool cost pool $421,000$421,000

Packaging/ShippingPackaging/Shippingcost pool cost pool $250,000$250,000

MachineryMachinerycost poolcost pool

$1,212,600$1,212,600

SetupSetupcost poolcost pool$3,000$3,000

EngineeringEngineeringcost poolcost pool$700,000$700,000

FacilityFacilitycost poolcost pool$507,400$507,400

UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

4

Learning Objective

4

Machinery Cost PoolMachinery Cost PoolTotal budgeted cost = $1,212,600

Maintenance

Depreciation

Computer Support

Lubrication

Electricity

Calibration

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

Various overheadVarious overheadcosts relatedcosts relatedto to machinerymachinery

CalculateCalculatethe poolthe pool

raterate

Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hour$28.20/hour

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

=

=

Calculation ofCalculation oftotal total setup costsetup cost

Setup Cost PoolSetup Cost PoolTotal budgeted cost = $3,000

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

CalculateCalculatethe poolthe pool

raterate

Budgeted Setup Costs $3,000Planned Production Runs 15 runs $200 per run$200 per run

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

=

=

Various overheadVarious overheadcosts relatedcosts related

to to engineeringengineering

Engineering salaries

Engineering supplies

Engineering software

Depreciation

Engineering Cost PoolEngineering Cost PoolTotal budgeted cost = $700,000

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

Allocate basedAllocate basedon on engineeringengineering

transactionstransactions

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

Engineering Cost PoolEngineering Cost PoolTotal budgeted cost = $700,000

Exh.5-9

Various overheadVarious overheadcosts relatedcosts related

to to generalgeneraloperationsoperations

Plant depr.

Plant mgmt.

Plant maint.

Property taxes

Insurance

Security

Facility Cost PoolFacility Cost PoolTotal budgeted cost = $507,400

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

Exh.5-9

Budgeted Facilities Cost $507,400Budgeted Direct-Labor Hours 118,000 $4.30/hour$4.30/hour

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

=

=

CalculateCalculatethe poolthe pool

raterate

Other Overhead CostsOther Overhead CostsBoard Overhead × % ÷ Units = Cost/UnitMode I 200,000$ × 6% ÷ 10,000 = 1.20$ Mode II 200,000 × 24% ÷ 20,000 = 2.40 Mode III 200,000 × 70% ÷ 4,000 = 35.00

Receiving and Inspection Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 600,000$ × 7% ÷ 10,000 = 4.20$ Mode II 600,000 × 30% ÷ 20,000 = 9.00 Mode III 600,000 × 63% ÷ 4,000 = 94.50

Material-Handling Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 421,000$ × 20% ÷ 10,000 = 8.42$ Mode II 421,000 × 40% ÷ 20,000 = 8.42 Mode III 421,000 × 40% ÷ 4,000 = 42.10

Quality-Assurance Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 250,000$ × 4% ÷ 10,000 = 1.00$ Mode II 250,000 × 30% ÷ 20,000 = 3.75 Mode III 250,000 × 66% ÷ 4,000 = 41.25

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 250,000$ × 4% ÷ 10,000 = 1.00$ Mode II 250,000 × 30% ÷ 20,000 = 3.75 Mode III 250,000 × 66% ÷ 4,000 = 41.25

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 421,000$ × 20% ÷ 10,000 = 8.42$ Mode II 421,000 × 40% ÷ 20,000 = 8.42 Mode III 421,000 × 40% ÷ 4,000 = 42.10

Quality-Assurance Cost Pool

Other Overhead CostsOther Overhead Costs

Board Overhead × % ÷ Units = Cost/UnitMode I 200,000$ × 6% ÷ 10,000 = 1.20$ Mode II 200,000 × 24% ÷ 20,000 = 2.40 Mode III 200,000 × 70% ÷ 4,000 = 35.00

Receiving and Inspection Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 600,000$ × 7% ÷ 10,000 = 4.20$ Mode II 600,000 × 30% ÷ 20,000 = 9.00 Mode III 600,000 × 63% ÷ 4,000 = 94.50

Material-Handling Cost Pool

$14.82$14.82

Product Cost from ABCProduct Cost from ABCThese are the new product costs when Aerotech

uses ABC.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

5

Learning Objective

5

Distorted Product CostsDistorted Product CostsBoth original and ABC target selling prices are

based on (Cost × 125%).

[$209.00 × 1.25] [$183.44 × 1.25]

The selling price of Mode I and II are reducedThe selling price of Mode I and II are reducedand the selling price for Mode III is increased.and the selling price for Mode III is increased.

Can you identify any problems Aerotech is likely to face as a result of this distortion?

Traditional costing understates the costTraditional costing understates the costof complex, low volume products.of complex, low volume products.

Distorted Product CostsDistorted Product Costs

Two Key PointsTwo Key Points

A large proportion of non-unit-level activities

A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately.

A large proportion of non-unit-level activities

A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately.

Product diversity

When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs.

Product diversity

When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

6

Learning Objective

6

Cost DriversCost Drivers

A characteristic of an event or activity that results in the incurrence of costs.

Cost DriversCost Drivers

A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost

driver, we must consider . . .

Degree ofDegree ofCorrelationCorrelation

Cost DriversCost Drivers

A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost

driver, we must consider . . .

Degree ofDegree ofCorrelationCorrelation

Cost ofCost ofMeasurementMeasurement

Cost DriversCost Drivers

A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost

driver, we must consider . . .

Degree ofDegree ofCorrelationCorrelation

Cost ofCost ofMeasurementMeasurement

BehavioralBehavioralEffectsEffects

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

7

Learning Objective

7

Interviewing and Paper TrailsInterviewing and Paper Trails

The information for ABC systems initially comes from interviews with employees in the support departments and a review of each department’s records.

StoryboardingStoryboarding

A procedure used to develop a detailed process flow chart, which visually

represents activities and the relationships among activities.

Step1

Step1

Step2

Step2

Step3

Step3

Step4

Step4

These are the steps wefollow to build amemory board.

These are the steps wefollow to build amemory board.

Direct versus Indirect CostsDirect versus Indirect Costs

Volume-Based Costing

All production costs except direct

materials and direct labor are lumped together in one

overhead cost pool.

Volume-Based Costing

All production costs except direct

materials and direct labor are lumped together in one

overhead cost pool.

Activity-Based Costing

An effort is made to account for as many costs as possible as

direct costs of production.

Activity-Based Costing

An effort is made to account for as many costs as possible as

direct costs of production.

IndirectIndirectCostsCosts

Indicators of Need for ABCIndicators of Need for ABC

Line managers do notbelieve the product

costs reports

Line managers do notbelieve the product

costs reports

Marketing does notuse costs reports for

pricing decisions

Marketing does notuse costs reports for

pricing decisions

Product-line profitmargins are hard

to explain

Product-line profitmargins are hard

to explain

Sales are increasing,but profits are declining.Sales are increasing,

but profits are declining.

Some products thathave reported high

profit margins are notsold by competitors

Some products thathave reported high

profit margins are notsold by competitors

Direct labor is asmall percentage

of total costs

Direct labor is asmall percentage

of total costs

Optimal Product-Costing SystemOptimal Product-Costing System

HighHigh

HighHigh

LowLow

LowLow

CostCost

InformationInformationSystemSystemAccuracyAccuracyOptimalOptimal

systemsystem

Total CostTotal Cost

Design, implementationDesign, implementationand maintenance costsand maintenance costs

Cost ofCost ofinferiorinferior

decisionsdecisionsresultingresulting

fromfrominaccurateinaccurate

information.information.

Exh.5-13

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

8

Learning Objective

8

ABC in the Service IndustryABC in the Service Industry

ObjectivesObjectives

End of Chapter 5End of Chapter 5This is

my kind of cost pool!