Activity-Based Costing and

1. Activity-Based Costing and Chapter 5

2. Present three guidelines for refining a costing system. Learning Objective 2

3. 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 rate job costing system. Cost objects: 80,000 (NL) and 20,000 (CL).

4. Existing Single Indirect-Cost Pool System Example Normal Lenses (NL) Direct materials $1,520,000 Direct mfg. labor 800,000 Total direct costs $2,320,000 Direct cost per unit: $2,320,000 ÷ 80,000 = $29 Complex Lenses (CL) Direct materials $ 920,000 Direct mfg. labor 260,000 Total direct costs $1,180,000 Direct cost per unit: $1,180,000 ÷ 20,000 = $59

5. Existing Single Indirect-Cost Pool System Example INDIRECT-COST POLL All Indirect Costs $2,900,000 INDIRECT COST-ALLOCATION BASE 50,000 Direct Manufacturing Labor-Hours $58 per Direct Manufacturing Labor-Hour

6. Existing Single Indirect-Cost Pool System Example COST OBJECT: NL AND CL LENSES Indirect Costs Direct Costs Direct Materials Direct Manufacturing Labor DIRECT COSTS

7. Existing Single Indirect-Cost Pool System Example Kole uses 36,000 direct manufacturing labor-hours to make NL and 14,000 direct manufacturing labor-hours to make CL. How much indirect costs are allocated to 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

8. Existing Single Indirect-Cost Pool System Example 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

9. Existing Single Indirect-Cost Pool System Example Normal lenses sell for $60 each and complex lenses for $142 each. NormalComplex Revenue $60.00 $142.00 Cost 55.10 99.60 Income $ 4.90 $ 42.40 Margin 8.2% 29.9%

10. Refining a Costing System Direct-cost tracing Indirect-cost pools Cost-allocation basis

11. Refining a Costing System 1. Design of Products and Process The Design Department designs the molds and defines processes needed (details of the manufacturing operations). 2. Manufacturing Operations Lenses are molded, finished, cleaned, and inspected. 3. Shipping and Distribution Finished lenses are packed and sent to the various customers.

12. Distinguish between the traditional and the activity-based costing approaches to designing a costing system. Learning Objective 3

13. Activity-Based Costing System Fundamental Cost Objects Assignment to Other Cost Objects Activities Cost of: • Product • Service • Customer Costs of Activities

14. Activity-Based Costing System A cross-functional team at Kole Corporation identified key activities: Design products and processes. Set up molding machine. Operate machines to manufacture lenses. Maintain and clean the molds.

15. Activity-Based Costing System Set up batches of finished lenses for shipment. Distribute lenses to customers. Administer and manage all processes.

16. Activity-Based Costing System NLCL Quantity produced 80,000 20,000 No. produced/batch 250 50 Number of batches 320 400 Setup time per batch 2 hours 5 hours Total setup-hours 640 2,000 Total setup costs are $409,200.

17. Activity-Based Costing System What is the setup cost per setup-hour? $409,200 ÷ 2,640 hours = $155 What is the setup cost per direct manufacturing labor-hour? $409,200 ÷ 50,000 = $8.184

18. Activity-Based Costing System Allocation using direct labor-hours: NL: $8.184 × 36,000 = $294,624 CL: $8.184 × 14,000 = $114,576 Total $409,200 Allocation using setup-hours: NL: $155 × 640 = $ 99,200 CL: $155 × 2,000 = $310,000 Total $409,200

19. Describe a four-part cost hierarchy. Learning Objective 4

20. Cost Hierarchies A cost hierarchy is a categorization of costs into different cost pools. Cost drivers bases (cost-allocation bases) Degrees of difficulty in determiningcause-and-effect relationships ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: 1. Output unit-level costs 2. Batch-level costs 3. Product-sustaining costs 4. Facility-sustaining costs

21. Output Unit-Level Costs These are resources sacrificed on activities performed on each individual unit of product or service. Energy Machine depreciation Repairs

22. 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. Setup-hours Procurement costs

23. Product-Sustaining Costs These are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services. Design costs Engineering costs

24. 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 – rent – building security

25. Cost products or services using activity-based costing. Learning Objective 5

26. ImplementingActivity-Based Costing Step 1 Step 2 Identify cost objects. Identify the direct costs of the products. NL CL Direct material Direct labor Mold cleaning and maintenance

27. ImplementingActivity-Based Costing Cleaning and maintenance costs of $360,000 are direct batch-level costs. Why? Because these costs consist of workers’ wages for cleaning molds after each batch of lenses is run.

28. Normal Lenses (NL) Cost Hierarchy DescriptionCategory Direct materials Unit-level $1,520,000 Direct mfg. labor Unit-level 800,000 Cleaning and maint. Batch-level 160,000 Total direct costs $2,480,000 ImplementingActivity-Based Costing

29. Complex Lenses (CL) Cost Hierarchy DescriptionCategory Direct materials Unit-level $ 920,000 Direct mfg. labor Unit-level 260,000 Cleaning and maint. Batch-level 200,000 Total direct costs $1,380,000 ImplementingActivity-Based Costing

30. ImplementingActivity-Based Costing Step 3 Select the cost-allocation bases to use for allocating indirect costs to the products. (1) (2) (3) ActivityCost HierarchyTotal Costs Design Product-sustaining $450,000 Setups Batch-level $409,200 Operations Unit-level $637,500

31. ImplementingActivity-Based Costing Step 4 Identify the indirect costs associated with each cost-allocation base. Overhead costs incurred are assigned to activities, to the extent possible, on the basis of a cause-and-effect relationship.

32. ImplementingActivity-Based Costing Step 5 Compute the rate per unit. (1) (5) NLCLTotal Setup-hours: 640 2,000 2,640 $409,200 ÷ 2,640 = $155

33. ImplementingActivity-Based Costing Step 6 Compute the indirect costs allocated to the products. NL: $155 × 640 = $ 99,200 CL: $155 × 2,000 = 310,000 Total $409,200

34. ImplementingActivity-Based Costing Step 7 Compute the costs of the products. NL and CL would show three direct cost categories. 1. Direct materials 2. Direct manufacturing labor 3. Cleaning and maintenance

35. ImplementingActivity-Based Costing 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

36. Compare activity-based costing systems and department- costing systems. Learning Objective 7

37. ABC and DepartmentIndirect-Cost Rates Many companies have evolved their costing system from using a single cost pool to using separate indirect-cost rates for each department: Design Manufacturing Distribution

38. ABC and DepartmentIndirect-Cost Rates Why? Because the cost drivers of resources in each department or subdepartment differ from the single, company-wide, cost-allocation base. ABC systems are a further refinement of department costing systems.

39. Evaluate the costs and benefits of implementing activity-based costing systems. Learning Objective 8

40. Benefits of ABC Systems Significant amounts of indirect costs are allocated using only one or two cost pools. All or most costs are identified as output unit-level costs. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.

41. Benefits of ABC Systems Products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits. Complex products appear to be very profitable and simple products appear to be losing money.

42. Benefits of ABC Systems Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.

43. Limitations of ABC Systems The main limitations of ABC are the measurements necessary to implement the system. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.

44. Limitations of ABC Systems Activity-cost rates also need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand.

45. ABC In Service andMerchandising Companies The general approach to ABC in the service and merchandising areas is very similar to the approach in manufacturing. Costs are divided into homogeneous cost pools and classified as output unit-level, batch-level, product- or service-sustaining, and facility-sustaining costs.

46. ABC In Service andMerchandising Companies The cost pools correspond to key activities. Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool.