Managerial Accounting, Hilton, 7e

Chapter 5 Activity-Based Costing

McGraw-Hill/Irwin

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

Learning Objective 1

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Traditional, Volume-Based Product-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:

Production: Units Runs

Mode I

Mode II

Mode III

10,000 1 run of 10,000 units

20,000 4 runs of 5,000 units

4,000 10 runs of 400 units

Traditional, Volume-Based Product-Costing System Direct materials Direct labor Manufacturing overhead Total

$

$

Mode I 50.00 60.00 99.00 209.00

Mode II $ 90.00 80.00 132.00 $ 302.00

Mode III $ 20.00 40.00 66.00 $ 126.00

Additional information includes: Direct materials Direct labor (hr/board) Setup time (hr/run) Machine time (hr/board)

$

Mode I 50.00 3 10 1

Mode II $ 90.00 4 10 1.25

Mode III $ 20.00 2 10 2

Manufacturing overhead is determined as follows

Traditional, Volume-Based Product-Costing System Mode I 10,000 3 30,000

Units produced Direct labor (hr/unit) Total hours

Mode II 20,000 4 80,000

Total hours required

118,000

Budgeted manufacturing overhead Budgeted direct-labor hours

$3,894,000 118,000

Mode I Direct labor (hr/unit) Overhead rate per hour Overhead per unit

Mode III 4,000 2 8,000

$ $

= $33 per hour

Mode II 3 33 99

$ $

Mode III 4 33 132

$ $

2 33 66

Traditional, Volume-Based Product-Costing System With these product costs, Aerotech established target selling prices (Cost × 125%). Direct materials Direct labor Manufacturing overhead Total

Cost per unit Target selling price

209.00 x 1.25

$

$

$

Mode I Mode II Mode III 50.00 $ 90.00 $ 20.00 60.00 80.00 40.00 99.00 132.00 66.00 209.00 $ 302.00 $ 126.00

Mode I 209.00 261.25

Mode II $ 302.00 377.50

Mode III $ 126.00 157.50

Learning Objective 2

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

Activity Based Costing System (ABC) ABC systems follow a twostage procedure to assign overhead costs to products.

Assigning overhead to products is a difficult process.

I agree!

Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products.

Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.

Let’s begin by identifying our major activities.

Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products.

Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products.

Overhead assigned to activities are called “activity cost pools.”

Learning Objective 3

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Overhead Costs Total budgeted cost = $3,894,000 Activity must be done on each unit produced.

Activity Cost Pools

Unit Level

Batch Level

ProductSustaining Level

Machinery cost pool $1,212,600

Setup cost pool $3,000

Engineering cost pool $700,000

Activity performed on each batch produced.

Activities needed to support an entire product line

Identification of Activity Cost Pools

Facility Level Facility cost pool $507,400

Activity required in order for the production process to occur.

Unit Level

Batch Level

ProductSustaining Level

Machinery cost pool $1,212,600

Setup cost pool $3,000

Engineering cost pool $700,000

Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000

Facility Level Facility cost pool $507,400

Learning Objective 4

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

STAGE ONE Various overhead costs related to machinery

Activity cost pool

Maintenance

Lubrication

Depreciation

Electricity

Computer Support

Calibration

Machinery Cost Pool Total budgeted cost = $1,212,600

STAGE TWO Calculate the pool rate

Cost Assignment

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

Mode I: $28.20 per hr. 1 hr. per unit $28.20 per unit

Mode II: $28.20 per hr. 1.25 hr. per unit $35.25 per unit

Mode III: $28.20 per hr. 2 hr. per unit $56.40 per unit

STAGE ONE Calculation of total setup cost

Activity cost pool

Total budgeted setup cost $20 per hour 10 hr. per setup $200 cost per setup 15 production runs $ 3,000 Total

Setup Cost Pool Total budgeted cost = $3,000

STAGE TWO Calculate the pool rate

Cost Assignment

Budgeted Setup Costs Planned Production Runs

Mode I: (1 Run) $200 per run 10,000 units per run = $.02 per unit

= $3,000 15 runs = $200 per run

Mode II: (4 Runs) $200 per run 5,000 units per run = $.04 per unit

Mode III: (10 Runs) $200 per run 400 units per run = $.50 per unit

STAGE ONE Various overhead costs related to engineering

Activity cost pool

Engineering salaries

Engineering software

Engineering supplies

Depreciation

Engineering Cost Pool Total budgeted cost = $700,000

STAGE TWO Allocate based on engineering transactions

Cost Assignment

Engineering Cost Pool Total budgeted cost = $700,000

Mode I: 25% × $700,000 10,000 units = $17.50 per unit

Mode II: 45% × $700,000 20,000 units = $15.75 per unit

Mode III: 30% × $700,000 4,000 units = $52.50 per unit

Exh. 5-9

STAGE ONE Various overhead costs related to general operations

Activity cost pool

Plant depr.

Property taxes

Plant mgmt.

Insurance

Plant maint.

Security

Facility Cost Pool Total budgeted cost = $507,400

Exh. 5-9

STAGE TWO Calculate the pool rate

Cost Assignment

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

Mode I: $4.30 per hr. × 3 hr. per unit $12.90 per unit

Mode II: $4.30 per hr. × 4 hr. per unit $17.20 per unit

Mode III: $4.30 per hr. × 2 hr. per unit $8.60 per unit

Other Overhead Costs Re c e ivin g an d In s pe c t ion Cos t P ool Board Mode I Mode II Mode III

Ove rh e ad $ 200,000 200,000 200,000

× × × ×

% 6% 24% 70%

÷ ÷ ÷ ÷

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 1.20 = 2.40 = 35.00

Mat e rial-Han dlin g Cos t P ool Board Mode I Mode II Mode III

Ove rh e ad $ 600,000 600,000 600,000

× × × ×

% 7% 30% 63%

÷ ÷ ÷ ÷

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 4.20 = 9.00 = 94.50

Qu alit y-As s u ran c e Cos t P ool Board Mode I Mode II Mode III

Ove rh e ad $ 421,000 421,000 421,000

× × × ×

% 20% 40% 40%

÷ ÷ ÷ ÷

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 8.42 = 8.42 = 42.10

P ac kagin g an d Sh ippin g Cos t P ool Board Mode I Mode II Mode III

Ove rh e ad $ 250,000 250,000 250,000

× × × ×

% 4% 30% 66%

÷ ÷ ÷ ÷

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 1.00 = 3.75 = 41.25

Other Overhead Costs Re c e ivin g an d In s pe c t ion Cos t P ool Board Mode I Mode II Mode III

Ove rh e ad $ 200,000 200,000 200,000

× × × ×

% 6% 24% 70%

÷ ÷ ÷ ÷

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 1.20 = 2.40 = 35.00

Mat e rial-Han dlin g Cos t P ool Board Mode I Mode II Mode III

$14.82

Ove rh e ad $ 600,000 600,000 600,000

× × × ×

% 7% 30% 63%

÷ ÷ ÷ ÷

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 4.20 = 9.00 = 94.50

Qu alit y-As s u ran c e Cos t P ool Board Mode I Mode II Mode III

Ove rh e ad $ 421,000 421,000 421,000

× × × ×

% 20% 40% 40%

÷ ÷ ÷ ÷

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 8.42 = 8.42 = 42.10

P ac kagin g an d Sh ippin g Cos t P ool Board Mode I Mode II Mode III

Ove rh e ad $ 250,000 250,000 250,000

× × × ×

% 4% 30% 66%

÷ ÷ ÷ ÷

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 1.00 = 3.75 = 41.25

Product Cost from ABC These are the new product costs when Aerotech uses ABC. Mode I Direct materials $ 50.00 Direct labor 60.00 Machinery 28.20 Setup 0.02 Engineering 17.50 Facilities 12.90 Other 14.82 Total $ 183.44

Mode II $ 90.00 80.00 35.25 0.04 15.75 17.20 23.57 $ 261.81

Mode III $ 20.00 40.00 56.40 0.50 52.50 8.60 212.85 $ 390.85

Learning Objective 5

McGraw-Hill/Irwin

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

Distorted Product Costs Both original and ABC target selling prices are based on (Cost × 125%). Tradition al cos tin g ABC cos tin g Origin al targe t s e llin g price ABC targe t s e llin g price

Mode I $ 209.00 183.44

Mode II $ 302.00 261.81

Mode III $ 126.00 390.85

261.25 229.30

377.50 327.26

157.50 488.56

The selling price of Mode I and II are reduced and the selling price for Mode III is increased. [$209.00 × 1.25]

[$183.44 × 1.25]

Distorted Product Costs Can you identify any problems Aerotech is likely to face as a result of this distortion? Mode I Tradition al cos tin g $ 209.00 ABC cos tin g 183.44 Cos t dis tortion pe r u n it 25.56 Un its produ ce d 10,000 Total cos t dis tortion 255,600

Mode II $ 302.00 261.81 40.19 20,000 803,800

Mode III $ 126.00 390.85 (264.85) 4,000 (1,059,400)

Traditional costing understates the cost of complex, low volume products.

Two Key Points A large proportion of nonunit-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.

Learning Objective 6

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

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

Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . . Degree of Correlation

Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . . Degree of Correlation Cost of Measurement

Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . . Degree of Correlation

Behavioral Effects Cost of Measurement

Learning Objective 7

McGraw-Hill/Irwin

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

Interviewing 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.

Storyboarding A procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities. Step 1 Step 2 Step 3 Step 4

These are the steps we follow to build a memory board.

Direct versus Indirect Costs Volume-Based Costing Activity-Based Costing All production costs An effort is made to except direct account for as many materials and direct costs as possible as labor are lumped direct costs of together in one production. overhead cost pool. Indirect Costs

Indicators of Need for ABC Direct labor is a small percentage of total costs

Product-line profit margins are hard to explain

Sales are increasing, but profits are declining.

Line managers do not believe the product costs reports

Marketing does not use costs reports for pricing decisions

Some products that have reported high profit margins are not sold by competitors

Exh. 5-13

Optimal Product-Costing System Cost High

Total Cost

Cost of inferior decisions resulting from inaccurate information.

Design, implementation and maintenance costs

Low Low

Optimal system

Information System High Accuracy

Learning Objective 8

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

ABC in the Service Industry

Objectives

End of Chapter 5 This is my kind of cost pool!