Activity Based Costing: A Tool to Aid Decision Making

1. Activity Based Costing: A Tool to Aid Decision Making UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee Chapter

2. Direct Materials Direct Labor Work-in- Process Finished Goods Cost-of Goods Sold Mfg. Overhead Cost Measurement Remember this? Cost Accumulation Cost Assignment Goal: Accurately costed products.

3. Measuring Costs Actual DM Actual DL Actual MOH Actual Costing System Normal Costing System Actual DM Actual DL Estimated MOH Standard Costing System Standard DM Standard DL Standard MOH

4. Cost Accounting Systems Product Costs Job-Order Costing Process Costing Total/Unit Cost

5. Functional Based Costing Activity Based Costing Assigning Manufacturing Costs

6. ABC is a good supplement to our traditional cost system 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. I agree!

7. 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.

8. How Costs are Treated Under Activity-Based Costing Activity Based Costing Departmental Overhead Rates Level of Complexity Plantwide Overhead Rate Overhead Allocation

9. Functional Based (Traditional) Costing

10. Raw Materials Cost Direct Labor Hours Machine Hours Stage Two: Costs applied to products Products Departmental Allocation Bases Departmental Overhead Rates Indirect Labor Indirect Materials Other Overhead Stage One: Costs assigned to pools Department 1 Department 2 Department 3 Cost pools

11. Peanut-butter costing describes a cost approach that uniformly assigns (“spreads” or “smooths out”) the cost of resources to cost objects.

12. Functional-Based Management Model Cost View Resources Operational View Efficiency Analysis Functions Performance Analysis Products

13. The problem with this approach is that individual products, services, etc., may use those resources in a nonuniform way. The end result is that some products will be overcosted while others will be undercosted.

14. Refining a Cost System • Reclassify indirect costs as direct costs. • Define more cost pools. • Identify cost drivers. • Use Activity-Based Costing.

15. Activity-Based Management Model Cost View Resources Operational View Driver Analysis Activities Performance Analysis Products & Customers

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

17. Designing an ABC System • Identify and define activities and activity cost pools. • Whenever possible, directly trace costs to activities and cost objects. • Assign costs to activity cost pools. • Calculate activity rates.

18. Designing an ABC System • Assign costs to cost objects using the activity rates and activity measures. • Prepare management reports.

19. Step 1 Identify and Define Activities and Activity Cost Pools

20. An Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system. $ $ $ $ $ $ Step #1:Identify and Define Activities and Activity Cost Pools

21. Activity Levels (Step #1) Batch Level Product Level Activity Levels Unit Level Customer Level Organization-Sustaining Level

22. Step #1: Identify and Define Activities and Activity Cost Pools Step #1 For Classic Brass At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

23. Step #1: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.

24. Step #1:Identify and Define Activities and Activity Cost Pools • 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.

25. Step 2 Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects.

26. The overhead costs at Classic Brass Exhibit 8-2

27. Step 3 Assign Costs to Activity Cost Pools

28. The overhead costs at Classic Brass Exhibit 8-2

29. Assign Costs to Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity cost pools is determined. **Not included because they are directly traced to customer orders.

30. Assign Costs to Activity Cost Pools Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

31. Assign Costs to Activity Cost Pools Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

32. Assign Costs to Activity Cost Pools

33. Step 4 Calculate the Activity Rates

34. Step #1: Identify and Define Activities and Activity Cost Pools Activity Cost Pools For Classic Brass At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

35. Calculate Activity Rates The ABC team determines that Classic Brass 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.

36. Calculate Activity Rates ÷

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

38. 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

39. Activity-Based Costing at Classic Brass 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 Second-Stage Allocations $/MH $/Order $/Design $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated

40. Step 5 Assign Costs to Cost Objects

41. Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer – Windward Yachts. Standard Stanchions (no design required) 1. 400 units ordered with 2 separate orders. 2. Each stanchion 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 Compass Housing (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.

42. Standard Stanchions (no design required) 1. 400 units ordered with 2 separate orders. 2. Each stanchion 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.

43. Custom Compass Housing (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.

44. Step 6 Prepare Management Reports

47. Predetermined manufacturing overhead rate $1,000,000 20,000 MH = = $50/MH Product Margins Traditional Cost Accounting System 400 units x 0.5 MH/unit x $50/MH = $10,000