Introduction to Accounting

1. Introduction to Accounting Activity Based Costing:A Tool to Aid Decision Making Session 10 February 7,2002 A&MIS 525

2. ABC is a good supplement to our traditional cost system Activity Based Costing (ABC) The objective of activity-based costing is to understand overhead and the profitability of products and customers. I agree! A&MIS 525

3. Activity Based Costing (ABC) Activity-Based Costing Both manufacturing and nonmanufacturing costs may be assigned to products. There are a number of cost pools each ofwhich is allocated using a unique measure of activity. 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. A&MIS 525

4. How Costs are Treated Under Activity-Based Costing Activity Based Costing Departmental Overhead Rates Level of Complexity Plantwide Overhead Rate Overhead Allocation A&MIS 525

5. Plantwide Overhead Rate Companies tend to use direct labor as the overhead allocation base. A&MIS 525

6. Finishing Department Painting Department Shipping Department Departmental Overhead Rates A two stage process is necessary because costsare allocated to departmentsand then to products. A&MIS 525

7. Departmental Overhead Rates Indirect Labor Indirect Materials Other Overhead Stage One: Costs assigned to pools Department 1 Department 2 Department 3 Cost pools A&MIS 525

8. Departmental Overhead Rates Indirect Labor Indirect Materials Other Overhead Stage One: Costs assigned to pools Department 1 Department 2 Department 3 Cost pools Stage Two: Costs applied to products Products A&MIS 525

9. Departmental Overhead Rates Indirect Labor Indirect Materials Other Overhead Stage One: Costs assigned to pools Department 1 Department 2 Department 3 Cost pools Direct Labor Hours Machine Hours Raw Materials Cost Stage Two: Costs applied to products Products Departmental Allocation Bases A&MIS 525

10. Designing an ABC System Cost Objects (e.g., products and customers) Consumption of Resources Activities Cost A&MIS 525

11. Designing an ABC System Steps for Implementing ABC • Identify and define activities and activity pools. • Where possible, trace costs to activities and cost objects. • Assign costs to activity cost pools. • Calculate activity rates. • Assign costs to cost objects. • Prepare management reports. A&MIS 525

12. Identifying Activity to Include Unit-Level Activity Batch-Level Activity A part of the production process for which management wants a separate reporting of the costs of the activity involved. Product-Level Activity Customer-Level Activity Organization-sustaining Activity A&MIS 525

13. Identifying Activity to Include $ $ Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity in the ABC system. $ $ $ $ A&MIS 525

14. The Mechanics of ABC At Classic Brass, the ultimate cost objects are: • Products, • Customer orders, and • Customers. One overhead cost - shipping - can be traced directly to customer orders. The company’s overhead costs are shown on the next slide. A&MIS 525

15. A&MIS 525

16. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Traced $/DLH Traced Cost Objects: Products, Customer Orders, Customers A&MIS 525

17. 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 A&MIS 525

18. 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 A&MIS 525

19. Assigning Costs to Activity Cost Pools Management at Classic Brass believes overhead should be distributed as follows: A&MIS 525

20. Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools. Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 A&MIS 525

21. Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools. Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000 A&MIS 525

22. Assigning Costs to Activity Cost Pools Using the total costs and percentage consumption of overhead, costs are assigned to activity pools. A&MIS 525

23. Computation of Activity Rates The ABC team has determined that Classic Brass has the following total activities for each activity cost pool . . . • 1,000 customer orders, • 200 new designs, • 20,000 machine-hours • 100 customers. Now the team can compute the individual activity rates. A&MIS 525

24. Computation of Activity Rates A&MIS 525

25. Computation of Activity Rates A&MIS 525

26. Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer - Windward Yachts. • Windward ordered two products - Stanchions and customer compass housings. Here are the details: 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. A&MIS 525

27. Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer - Windward Yachts. • Windward ordered two products - Stanchions and customer compass housings. Here are the details: 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. A&MIS 525

28. Assigning Costs to Cost Objects Overhead cost of two orders for standard stanchions. $125 per order × 2 orders = $250 A&MIS 525

29. Assigning Costs to Cost Objects Overhead cost of two orders for standard stanchions. A&MIS 525

30. Assigning Costs to Cost Objects Overhead cost of one order for custom compass housing. $125 per order × 1 order = $125 A&MIS 525

31. Assigning Costs to Cost Objects Overhead cost of one order for custom compass housing. A&MIS 525

32. Product Margins A&MIS 525

33. Product Margins A&MIS 525

34. Predetermined manufacturing overhead rate $1,000,000 20,000 MH = = $50/MH Product Margins Traditional Cost Accounting System A&MIS 525

35. Product Margins Traditional Cost Accounting System 400 units x 0.5 MH/unit x $50/MH = $10,000 A&MIS 525

36. Difference Between ABC and Traditional Product Costs ABC will ordinarily shift batch-level and product-level overhead costs from high-volume products produced in large batches to low-volume products produced in small batches. A&MIS 525

37. Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organization-sustaining costs and the costs of idle capacity are not assigned to products. Difference Between ABC and Traditional Product Costs A&MIS 525

38. Ease of Adjustment Costs that adjust automatically to changes in activity: • Direct materials. • Shipping. Costs that could be adjusted to changes in activity: • Direct labor. • Factory utilities. • Administrative wages and salaries. • Office equipment depreciation. • Marketing wages and salaries. • Selling expenses. Costs that are difficult to adjust to changes in activity: • Factory equipment depreciation. • Factory building lease. • Administrative building lease. A&MIS 525

39. A&MIS 525

40. Simplified Approach to ABC After the first-stage allocation is complete, computation of activity rates for each activity cost pool can be simplified as follows: ÷ ÷ ÷ ÷ A&MIS 525

41. Simplified Approach to ABC 2 orders @ $315 per order A&MIS 525

42. Simplified Approach to ABC 1 design @ $1,285 per design A&MIS 525

43. Simplified Approach to ABC Customer margin for Windward Yachts is shown below: A&MIS 525

44. End of Chapter 8 I call this quality time! A&MIS 525

45. Puzzle A shipping company had trouble determining how much it should cost to ship materials from Ohio to a point near the Atlantic ocean. In spite of numerous trips within the Great Lakes area, the company still found it difficult to predict costs. What do you suppose was making cost estimation difficult? A&MIS 525

46. Agenda Today • Clarify our views of the activity paradigm • Discuss efficiency & effectiveness • Summarize the basics about the relationship of standards to the costs incurred • Review some problems A&MIS 525

47. Basic Activity View Inputs Outputs Activity A&MIS 525

48. Activities • Activities are about actions, doing something, effort, work done, not the consequences of the work or effort. • Metrics or measures are the ways we are going to quantify the volume of activity during a time period. Different activities require different metrics. A&MIS 525

49. Activity Terminology • Statistics represent the numeric values assigned to the metrics for a period. • Data sources are the primary or secondary sources of the statistics. A&MIS 525

50. Thinking About Activities InputsActivitiesOutputs • Labor Assembling Products • Materials Processing Intermediate products 3. Parts Assembling Assembly 4. Equipment Stamping Steel part 5. Services Insurance Risk reduction 6. Warehouse Storing Availability A&MIS 525