Advanced Management Accounting -Chap 003

7/30/2019 Advanced Management Accounting -Chap 003

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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIA

Cynthia J. Rooney, Ph.D., CPACopyri ght 2013 by The McGraw-H il l Companies, In c. All ri ghts reserved.McGraw-Hill/Irwin

Activity-Based Costing

Chapter 03


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When cost systems were developed in the 1800s, theemphasis was on simplicity because:

1. Cost and activity data had to be collected byhand and all calculations were done with paperand pencil.

2. Most companies produced a limited variety of

similar products, so there was little differencein the overhead costs consumed by eachproduct.

Assigning Overhead Costs to Products


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Plantwide Overhead Rate

Plantwide Overhead RateA single overhead rate usedthroughout an entire factory.

Direct labor has often been used as the allocationbase 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 costswere highly correlated.


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Plantwide Overhead Rate

A plantwide overhead allocation system may not be optimal

for many companies in todays business environment.

Today, direct labor may no longer be a satisfactory basefor allocation of overhead.

1. Most companies sell a large variety of products thatconsume differing amounts of overhead.

2. As a percentage of total costs, direct labor has beenshrinking and overhead has been increasing. Many ofthese growing overhead costs may not be correlatedwith direct labor.

3. Technology advancements have reduced the cost andcomplexity of gathering diverse sources of data.


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Departmental Overhead Rates

Machining Department

Shipping Department

Assembly Department

Many companies have a system in which eachdepartment has its own overhead rate.

The allocation base dependson the nature of the work

performed in each department.In the machining department,

overhead may be based onmachine-hours, but in theassembly department,

overhead may be based on

labor-hours.


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Activity-based costing is required to account for

these other factors.

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.

Departmental rates will not correctly assign overheadin situations where a company has a range of

products and complex overhead costs.

Departmental Overhead Rates


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A number of allocation bases are usedfor assigning costs to products.

Activity-Based Costing (ABC)


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Cost


Consumption of Resources

Activities

Cost Objects(e.g., products and customers)


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ActivityAn event that causesthe consumption ofoverhead resources

Setting upmachines

Examples of Activities

Admittinghospitalpatients

Opening abank account

Billingcustomers



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ActivityCost Pool

A cost bucket in whichcosts related to a particular

activity are accumulated.

ActivityMeasure

Expresses how much of theactivity is carried out and isused as the allocation base

for applying overhead costs.


ActivityRate

A predetermined overheadrate for each activitycost pool.


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For each activity inisolation, this system works exactly

like 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 activity

consumed by the job or product.


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Designing an Activity-BasedCosting System

The challenge is to select a reasonably

small number of activities that explain thebulk of the variation in overhead costs.

Activities are usually chosen by interviewing abroad range of managers to find out whatactivities they think consume most of the

organizations resources.


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An activity dictionary defines each of the activitiesthat will be included in the activity-based costing

system and how the activities will be measured.

For example, several actions maybe involved in handling and moving

raw materials, but these may be

combined into a single activitytitled material handling.

Designing an Activity-BasedCosting System

Related activities arefrequently combined to reduce

the amount of detail andrecord-keeping costs.


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Hierarchy of Activities

Level Activities Activity MeasureUnit-level Processing units on machines Machine-hours

Processing units by hand Direct labor-hours

Consuming factory supplies Units produced

Batch-level Processing purchase orders Purchase orders processedProcessing production orders Production orders processed

Setting up equipment Number of setups

Handling materials Pounds of material handled

Product-level Testing new products Hours of testing time

Administering parts inventories Number of part typesDesigning products Hours of design time

Facility-level General factory administration Direct labor-hours

Plant building and grounds Direct labor-hours


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Graphic Example ofActivity-Based Costing

Various Manufacturing Overhead Costs

LaborRelated Pool

MachineRelated Pool

SetupPool

ProductionOrder Pool

GeneralFactory Pool

PartsAdmin. Pool

First-Stage Cost Assignment


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3-16Unit-LevelActivity

Batch-LevelActivit

Facility-LevelActivit

Product-LevelActivit

Graphic Example ofActivity-Based Costing

Various Manufacturing Overhead Costs

Products

$/DLH $/MH $/Setup $/Order $/MH$/Part Type

Second-Stage Allocations

LaborRelated Pool

MachineRelated Pool

SetupPool

ProductionOrder Pool

GeneralFactory Pool

PartsAdmin. Pool

First-Stage Cost Assignment


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Using Activity-Based CostingComtek Sound, Inc.

Comtek Sound, Inc., makes two products: CD playersand DVD players.

The company has been losing bids to supply CDplayers to lower-priced competitors.

The company has been winning all bids to supplyDVD players.


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For the current year, Comtek has budgeted salesof 50,000 DVD units and 200,000 CD units.

Comteks traditional cost system appliesmanufacturing overhead to products based on direct-labor hours.

Both products require two direct labor-hours tocomplete, for a total of 500,000 direct labor-hours.

Hours

DVDs: 50,000 units @ 2 hours per unit = 100,000

CDs: 200,00 units @ 2 hours per unit = 400,000

Total direct labor-hours 500,000


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Unit costs for materials and labor are:DVD CD

Units Units

Direct materials 90$ 50$

Direct labor 20$ 20$


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Total manufacturing overhead costs for thecurrent year are estimated to be $10,000,000.The company develops the following overhead

rate based upon labor-hours:

Predetermined

overhead rate = $20 per DLH=

$10,000,000

500,000 DLHs

Direct Labor-Hours as a Base


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DVD Unit CD Unit

Direct materials 90$ 50$

Direct labor 20 20Manufacturing overhead 40 40

(2 DLHs x $20 per DLH)

Unit product cost 150$ 110$

Direct Labor-Hours as a Base

Since each product requires two hours ofdirect labor, $40 of overhead is assigned to

each product.


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The ABC project team at Comtek hasdeveloped the following basic information.

Activity and Activity Measures

Estimated

OverheadCost

Total DVD CD

Labor-related (DLH) 800,000$ 500,000 100,000 400,000

Machine-related (MH) 2,100,000 1,000,000 300,000 700,000

Machine setups (setups) 1,600,000 4,000 3,000 1,000

Production orders (orders) 3,150,000 1,200 800 400Parts administration (part types) 350,000 700 400 300

General factory (MH) 2,000,000 1,000,000 300,000 700,000

10,000,000$

Expected Activity

Computing Activity Rates


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Estimated

Overhead

Cost

Total

Expected

Activity

Labor-related (DLHs) 800,000$ 500,000 = 1.60$ per DLH

Machine-related (MHs) 2,100,000 1,000,000 = 2.10 per MH

Machine setups (setups) 1,600,000 4,000 = 400.00 per setup

Production orders (orders) 3,150,000 1,200 = 2,625.00 per order

Parts administration (part types) 350,000 700 = 500.00 per part type

General factory (MHs) 2,000,000 1,000,000 = 2.00 per MH

10,000,000$

Activity Rate

We can calculate an activity rate for each of the six activitiesby dividing the estimated overheard for an activity by the

total expected activity.

Computing Activity Rates


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Computing Overhead Cost per Unit


Expected

Activity

Activity

Rate

Labor-related (DLHs) 100,000 1.60$ = 160,000$Machine-related (MHs) 300,000 2.10 = 630,000Machine setups (setups) 3,000 400.00 = 1,200,000Production orders (orders) 800 2,625.00 = 2,100,000Parts administration (part types) 400 500.00 = 200,000General factory (MHs) 300,000 2.00 = 600,000Total overhead cost assigned 4,890,000$

Number of units produced 50,000

Overhead cost per unit 97.80$

Amount

DVD Units


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Computing Overhead Cost per Unit


Expected

Activity

Activity

Rate

Labor-related (DLHs) 400,000 1.60$ = 640,000$Machine-related (MHs) 700,000 2.10 = 1,470,000Machine setups (setups) 1,000 400.00 = 400,000Production orders (orders) 400 2,625.00 = 1,050,000Parts administration (part types) 300 500.00 = 150,000

General factory (MHs) 700,000 2.00 = 1,400,000Total overhead cost assigned 5,110,000$Number of units produced 200,000

Overhead cost per unit 25.55$

Amount

CD Units


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Note that the unit product cost of a CDunit decreased from $110 to $95.55 . . . .

. . . . while the unit cost of a DVD unit

increased from $150 to $207.80.

Comparing the Two Approaches

DVD Unit CD Unit DVD Unit CD Unit

Direct material 90.00$ 50.00$ 90.00$ 50.00$

Direct labor 20.00 20.00 20.00 20.00

Manufacturing overhead 97.80 25.55 40.00 40.00

Unit product cost 207.80$ 95.55$ 150.00$ 110.00$

Activity-Based Costing Direct Labor Costing


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Direct material 90.00$ 50.00$ 90.00$ 50.00$

Direct labor 20.00 20.00 20.00 20.00





The ABC system assigns $14.45less overhead than the traditional

system to each CD player.


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Direct material 90.00$ 50.00$ 90.00$ 50.00$

Direct labor 20.00 20.00 20.00 20.00





The ABC system assigns $57.80more overhead than the traditional

system to each DVD player.


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Direct material 90.00$ 50.00$ 90.00$ 50.00$

Direct labor 20.00 20.00 20.00 20.00

Manufacturing overhead 97.80 25.55 40.00 40.00Unit product cost 207.80$ 95.55$ 150.00$ 110.00$


When a company implements activity-based costing,overhead cost often shifts from high-volume to low-

volume products with a higher unit product cost

resulting for the low-volume products.

Low-volume product

Shifting of Overhead Cost


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Direct material 90.00$ 50.00$ 90.00$ 50.00$

Direct labor 20.00 20.00 20.00 20.00




High-volume product


The traditional system assigns the same amountof all overhead costs to each CD or DVD player

($40 per unit).


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DVD Units CD Units

Number of units produced per year 50,000 200,000

Number of production orders issued per year 800 400

Number of units processed per production order 62.5 500

1. Compute the number of units processedper production order for each product.

Production Orders Activity Cost Pool(a batch-level cost pool)

The ABC system assigns different amounts ofProduction Order-related overhead costs to each product.

This fact can be illustrated in a two-step process.


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2. Compute production order cost per unit for each product.

DVD Units CD UnitsCost to issue a production order 2,625$ 2,625$

Average number of units processed per

production order 62.5 500

Production order cost per unit 42.00$ 5.25$

Notice, the costs are being shifted from the high-volume CD players to the low-volume DVD players.


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Activity-Based ManagementFocuses on managing activities to eliminate

waste and reduce delays and defects.

Targeting Process Improvements

An ABC system can help identifyareas where the company can benefit

from improving its current processes.


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The first step in any improvementprogram is deciding what to improve.

Targeting Process Improvements

The Theory of Constraintsapproach targets the

highest impactimprovement opportunities.

Activity rates can beused to target areaswhere costs seemexcessively high.

Benchmarking can be used to compare activity costinformation with world-class standards of performance

achieved by other organizations.


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Benefits of Activity-Based Costing

ABC improves the accuracy of product costing by:

1. Increasing the number of cost pools used to accumulateoverhead costs.

2. Using activity cost pools that are more homogeneousthan departmental cost pools.

3. Assigning overhead costs using activity measures thatcause those costs, rather than relying solely on directlabor hours.

Activity-based costing also highlights activitiesthat could benefit most from process

improvement efforts, such as Six Sigma.


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Costs of implementing an ABC system may outweighthe benefits. However, the benefits are more likely to beworth the costs when:

1. Products differ substantially in volume, batch size, and inactivities required.

2. Conditions have changed substantially since the existingcost system was established.

3. Overhead costs are high and increasing and no one seemsto understand why.

4. Management does not trust the existing cost system and itignores data from it when making decisions.

Limitations of Activity-Based Costing


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The cost in each activity pool is strictlyproportional to its activity measure. When this

assumption is violated, the accuracy of ABCdata can be called into question.

Activity-Based CostingCritical Assumption

For example, managers should be particularlyalert to product costs that contain allocated

facility-level costs.


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Modifying the ABC Model

The illustrations in the chapter assumethat ABC is being used for external reportingpurposes. If the system is used for internal

decision-making purposes, two importantmodifications should be made:

1. Selling and administrative costs should beassigned to products, where appropriate.

2. Facility-level costs should be removedfrom product costs.


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End of Chapter 03

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Advanced Management Accounting -Chap 003