Supplementary Slides - Activity Based Costing Systems Design: Activity Based Costing McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objective 1 Understand the basic approach in activity-based costing and how it differs from conventional costing. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Plantwide Overhead Rate Plantwide Overhead Rate A 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. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Plantwide Overhead Rate Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1. Most companies sell a large variety of products that consume differing amounts of overhead. 2. 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. 3. Technology advancements have reduced the cost and complexity of gathering diverse sources of data. A plantwide overhead allocation system may not be optimal for many companies in today’s business environment. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity-Based Costing (ABC) A number of allocation bases are used for assigning costs to products. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity-Based Costing (ABC) Cost Objects (e.g., products and customers) Activities Consumption of Resources Cost McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity-Based Costing (ABC) An event that causes the consumption of overhead resources Activity Examples of Activities Setting up machines McGraw-Hill /Irwin Admitting hospital patients Billing customers Opening a bank account Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity-Based Costing (ABC) Activity Cost Pool A “cost bucket” in which costs related to a particular activity are accumulated Activity Measure Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs Activity Rate A predetermined overhead rate for each activity cost pool. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity-Based Costing (ABC) For each activity in isolation, this system works exactly like the job-order costing system. A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Designing an Activity-Based Costing System The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Designing an Activity-Based Costing System Related activities are frequently combined to reduce the amount of detail and record-keeping costs. For example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling. An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment Labor Related Pool McGraw-Hill /Irwin Machine Related Pool Setup Pool Production Order Pool Parts Admin. Pool General Factory Pool Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment Labor Related Pool Machine Related Pool Setup Pool Production Order Pool Parts Admin. Pool General Factory Pool Second-Stage Allocations $/DLH $/MH $/Setup $/Order $/Part Type $/MH Products Unit-Level Activity McGraw-Hill /Irwin Batch-Level Activity Product-Level Facility-Level Activity Activity Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Using Activity-Based Costing Comtek Sound, Inc. 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. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Using Activity-Based Costing Comtek Sound, Inc. For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units. Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor hours. Both products require two direct labor-hours to complete, 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 McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Using Activity-Based Costing Comtek Sound, Inc. Unit costs for materials and labor are: Direct materials Direct Labor McGraw-Hill /Irwin DVD Units $ 90 $ 20 CD Units $ 50 $ 20 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Direct Labor-Hours as a Base Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon labor-hours: Predetermined $10,000,000 = overhead rate 500,000 DLHs McGraw-Hill /Irwin = $20 per DLH Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Direct Labor-Hours as a Base Since each product requires two hours of direct labor, $40 of overhead is assigned to each product. Direct materials Direct labor Manufacturing overhead DVD Unit $ 90 20 40 CD Unit $ 50 20 40 $ $ (2 DLHs x $20 per DLH) Unit product cost McGraw-Hill /Irwin 150 110 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objective 2 Compute activity rates for an activity-based costing system. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Computing Activity Rates The ABC project team at Comtek has developed the following basic information. Activity and Activity Measures Estimated Overhead Cost Labor related (DLH) $ 800,000 Machine related (MH) 2,100,000 Machine setups (setups) 1,600,000 Production orders (orders) 3,150,000 Parts administration (part types) 350,000 General factory (MH) 2,000,000 $ 10,000,000 McGraw-Hill /Irwin Expected Activity Total DVD CD 500,000 100,000 400,000 1,000,000 300,000 700,000 4,000 3,000 1,000 1,200 800 400 700 400 300 1,000,000 300,000 700,000 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Computing Activity Rates We can calculate the following activity rates: Estimated Overhead Activity and Activity Measures Cost Labor related (DLHs) $ 800,000 Machine related (MHs) 2,100,000 Machine setups (setups) 1,600,000 Production orders (orders) 3,150,000 Parts administration (part types) 350,000 General factory (MHs) 2,000,000 $ 10,000,000 ÷ ÷ ÷ ÷ ÷ ÷ Total Expected Activity 500,000 1,000,000 4,000 1,200 700 1,000,000 = = = = = = Activity Rate $ 1.60 per DLH 2.10 per MH 400.00 per setup 2,625.00 per order 500.00 per part type 2.00 per MH Using the new activity rates, let’s assign overhead to the two products based upon expected activity. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objective 3 Compute product costs using activity-based costing. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Computing Overhead Cost per Unit DVD Units Expected Activity and Activity Measures Activity Labor related (DLHs) 100,000 Machine related (MHs) 300,000 Machine setups (setups) 3,000 Production orders (orders) 800 Parts administration (part types) 400 General factory (MHs) 300,000 Total overhead cost assigned Number of units produced Overhead cost per unit McGraw-Hill /Irwin × × × × × × Activity Rate $ 1.60 2.10 400.00 2,625.00 500.00 2.00 = = = = = = Amount $ 160,000 630,000 1,200,000 2,100,000 200,000 600,000 $ 4,890,000 50,000 $ 97.80 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Computing Overhead Cost per Unit CD Units Expected Activity and Activity Measures Activity Labor related (DLHs) 400,000 Machine related (MHs) 700,000 Machine setups (setups) 1,000 Production orders (orders) 400 Parts administration (part types) 300 General factory (MHs) 700,000 Total overhead cost assigned Number of units produced Overhead cost per unit McGraw-Hill /Irwin × × × × × × Activity Rate $ 1.60 2.10 400.00 2,625.00 500.00 2.00 = = = = = = Amount $ 640,000 1,470,000 400,000 1,050,000 150,000 1,400,000 $ 5,110,000 200,000 $ 25.55 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Comparing the Two Approaches Activity-Based Costing DVD Unit CD Unit Direct material $ 90.00 $ 50.00 Direct labor 20.00 20.00 Manufacturing overhead 97.80 25.55 Unit product cost $ 207.80 $ 95.55 Direct-Labor Costing DVD Unit CD Unit $ 90.00 $ 50.00 20.00 20.00 40.00 40.00 $ 150.00 $ 110.00 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. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Shifting of Overhead Cost Activity-Based Costing DVD Unit CD Unit Direct material $ 90.00 $ 50.00 Direct labor 20.00 20.00 Manufacturing overhead 97.80 25.55 Unit product cost $ 207.80 $ 95.55 Direct-Labor Costing DVD Unit CD Unit $ 90.00 $ 50.00 20.00 20.00 40.00 40.00 $ 150.00 $ 110.00 Low-volume product When a company implements activity-based costing, overhead cost often shifts from high-volume to lowvolume products with a higher unit product cost resulting for the low-volume products. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Shifting of Overhead Cost Activity-Based Costing DVD Unit CD Unit Direct material $ 90.00 $ 50.00 Direct labor 20.00 20.00 Manufacturing overhead 97.80 25.55 Unit product cost $ 207.80 $ 95.55 Direct-Labor Costing DVD Unit CD Unit $ 90.00 $ 50.00 20.00 20.00 40.00 40.00 $ 150.00 $ 110.00 High-volume product The traditional system assigns the same amount of all overhead costs to each CD or DVD player ($40 per unit). McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Targeting Process Improvements An ABC system can help identify areas where the company can benefit from improving its current processes. Activity-Based Management Focuses on managing activities to eliminate waste and reduce delays and defects. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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 process improvement efforts, such as Six Sigma. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Limitations Activity-Based Costing Costs of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when: 1. Products differ substantially in volume, batch size, and in activities required. 2. Conditions have changed substantially since the existing cost system was established. 3. Overhead costs are high and increasing and no one seems to understand why. 4. Management does not trust the existing cost system and it ignores data from it when making decisions. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.