Assigning Overhead Costs to Products

1. 3-1 Assigning Overhead Costs to Products When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2.   Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

2. 3-2 Plantwide Overhead Rate Plantwide Overhead RateA single overhead rate used throughout an entire factory. Direct labor has often been used as the allocation base for overhead because: 1.    Direct labor information was already being recorded. 2.    Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated.

3. 3-3 Plantwide Overhead Rate • Today, direct labor may no longer be a satisfactory base for allocation of overhead. • Most companies sell a large variety of products that consume differing amounts of overhead. • As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor. • Technology advancements have reduced the cost and complexity of gathering diverse sources of data. A plantwide overhead allocation system may not be optimalfor many companies in today’s business environment.

4. 3-4 Departmental Overhead Rates Many companies have a system in which each department has its own overhead rate. The allocation base depends on the nature of the workperformed in each department. In the machining department,overhead may be based on machine-hours, but in the assembly department, overhead may be based on labor-hours. Machining Department Assembly Department Shipping Department

5. The departmental approach reliesexclusively on volume-related allocation bases while some overhead costs may be caused by factorsthat are not related to the volume of production. Activity-base costing is required to account for these other factors. 3-5 Departmental Overhead Rates Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs.

6. 3-6 Activity-Based Costing (ABC) A number of allocation bases are used for assigning costs to products.

7. Activities Consumption of Resources Cost 3-7 Activity-Based Costing (ABC) Cost Objects (e.g., products and customers)

8. 3-8 Activity-Based Costing (ABC) An event that causes the consumption of overhead resources Activity Examples of Activities Setting upmachines Admitting hospitalpatients Billingcustomers Opening a bank account

9. A “cost bucket” in which costs related to a particular activity are accumulated. Activity Cost Pool Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs. Activity Measure A predetermined overhead rate for each activity cost pool. Activity Rate 3-9 Activity-Based Costing (ABC)

10. 3-10 Activity-Based Costing (ABC) For each activity inisolation, this system works exactlylike the job-order costing systemdescribed in Chapter 2. A predetermined overhead rate is computed foreach activity and then applied to jobs andproducts based on the amount of activityconsumed by the job or product.

11. For example, several activities maybe involved in handling and movingraw materials, but these may becombined into a single activityentitled material handling. 3-11 Designing an Activity-BasedCosting System Related activities arefrequently combined to reducethe amount of detail andrecord-keeping costs. An activity dictionary defines each of the activitiesthat will be included in the activity-based costingsystem and how the activities will be measured.

12. 3-12 Hierarchy of Activities

13. 3-13 Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment LaborRelated Pool MachineRelated Pool SetupPool ProductionOrder Pool PartsAdmin. Pool GeneralFactory Pool

14. Second-Stage Allocations $/DLH $/MH $/Setup $/Order $/Part Type $/MH Products Unit-LevelActivity Batch-LevelActivity Product-LevelActivity Facility-LevelActivity 3-14 Graphic Example ofActivity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment LaborRelated Pool MachineRelated Pool SetupPool ProductionOrder Pool PartsAdmin. Pool GeneralFactory Pool

15.  Comtek Sound, Inc. makes two products: CD players and DVD players.  The company has been losing bids to supply CD players, its main product, to lower priced competitors.  The company has been winning all bids to supply DVD players, its secondary product. 3-15 Using Activity-Based CostingComtek Sound, Inc.

16. 3-16 Comparing the Two Approaches Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . . . . . . while the unit cost of a DVD unit increased from $150 to $207.80.

17. 3-17 Targeting Process Improvements An ABC system can help identifyareas where the company can benefitfrom improving its current processes. Activity-Based ManagementFocuses on managing activities to eliminate waste and reduce delays and defects.

18. The Theory of Constraintsapproach targets thehighest impactimprovement opportunities. Activity rates can beused to target areaswhere costs seemexcessively high. Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations. 3-18 Targeting Process Improvements The first step in any improvementprogram is deciding what to improve.

19. 3-19 Benefits of Activity-Based Costing ABC improves the accuracy of product costing by: • Increasing the number of cost pools used to accumulate overhead costs. • Using activity cost pools that are more homogeneous than departmental cost pools. • Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. Activity-based costing also highlights activities that could benefit most from processimprovement efforts, such as Six Sigma.

20. 3-20 Limitations of Activity-Based Costing • Costs of implementing an ABC system may outweighthe benefits. However, the benefits are more likely to be worth the costs when: • Products differ substantially in volume, batch size, and in activities required. • Conditions have changed substantially since the existing cost system was established. • Overhead costs are high and increasing and no one seems to understand why. • Management does not trust the existing cost system and it ignores data from it when making decisions.

21. 3-21 Cost Flows in an ABC System Activity rates are determined as follows:

22. 3-22 Cost Flows in an ABC System Overhead is applied on the basis of actual activities during the year.