Management Accounting Process Costing and ABC Costing By: Associate Professor Dr. GholamReza Zandi zandi@segi.edu.my Similarities Between Job-Order and Process Costing • Both systems assign material, labor and overhead costs to products and they provide a mechanism for computing unit product cost. • Both systems use the same manufacturing accounts, including Manufacturing Overhead, Raw Materials, Work in Process, and Finished Goods. • The flow of costs through the manufacturing accounts is basically the same in both systems. Differences Between Job-Order and Process Costing • Process costing is used when a single product is produced on a continuing basis or for a long period of time. Job-order costing is used when many different jobs are worked on each period. • Process costing systems accumulate costs by department. Job-order costing systems accumulated costs by individual jobs. • Process costing systems compute unit costs by department. Job-order costing systems compute unit costs by job on the job cost sheet. Quick Check Process costing is used for products that are: a. Different and produced continuously. b. Similar and produced continuously. c. Individual units produced to customer specifications. d. Purchased from vendors. Quick Check Process costing is used for products that are: a. Different and produced continuously. b. Similar and produced continuously. c. Individual units produced to customer specifications. d. Purchased from vendors. Processing Departments Any location in an organization where materials, labor or overhead are added to the product. The activities performed in a processing department are performed uniformly on all units of production. Furthermore, the output of a processing department must be homogeneous. Flow of Materials, Labor and Overhead Costs Direct Materials Direct Labor ManufacturingO verhead Work in Process Finished Goods Cost of Goods Sold Flow of Materials, Labor and Overhead Costs Costs are traced and applied to individual jobs in a job-order cost system. Direct Materials Direct Labor ManufacturingO verhead Jobs Finished Goods Cost of Goods Sold Flow of Materials, Labor and Overhead Costs Direct Materials Direct Labor ManufacturingO verhead Costs are traced and applied to departments in a process cost system. Processing Department Finished Goods Cost of Goods Sold T-Account and Journal Entry Views of Process Cost Flows For purposes of this example, assume there are two processing departments – Departments A and B. We will use T-accounts and journal entries. Process Cost Flows (in T-Account form) Raw Materials •Direct Materials Work in Process Department A •Direct Materials Work in Process Department B •Direct Materials Process Cost Flows (in journal entry form) GENERAL JOURNAL Date Description Post. Ref. Page 4 Debit Work in Process - Department A XXXXX Work in Process - Department B XXXXX Raw Materials To record the use of direct material. Credit XXXXX Process Cost Flows (in T-Account form) Salaries and Wages Payable •Direct Labor Work in Process Department A •Direct Materials •Direct Labor Work in Process Department B •Direct Materials •Direct Labor Process Cost Flows (in journal entry form) GENERAL JOURNAL Date Description Post. Ref. Page 4 Debit Work in Process - Department A XXXXX Work in Process - Department B XXXXX Salaries and Wages Payable To record direct labor costs. Credit XXXXX Process Cost Flows (in T-Account form) Work in Process Department A Manufacturing Overhead •Actual Overhead •Overhead Applied to Work in Process •Direct Materials •Direct Labor •Applied Overhead Work in Process Department B •Direct Materials •Direct Labor •Applied Overhead Process Cost Flows (in journal entry form) GENERAL JOURNAL Date Description Post. Ref. Page 4 Debit Work in Process - Department A XXXXX Work in Process - Department B XXXXX Manufacturing Overhead To apply overhead to departments. Credit XXXXX Process Cost Flows (in T-Account form) Work in Process Department A •Direct Transferred Materials to Dept. B •Direct Labor •Applied Overhead Work in Process Department B •Direct Materials •Direct Labor •Applied Overhead •Transferred from Dept. A Process Cost Flows (in journal entry form) GENERAL JOURNAL Date Description Work in Process - Department B Work in Process - Department A To record the transfer of goods from Department A to Department B. Post. Ref. Page 4 Debit Credit XXXXX XXXXX Process Cost Flows (in T-Account form) Work in Process Department B •Direct Materials •Direct Labor •Applied Overhead •Transferred from Dept. A •Cost of Goods Manufactured Finished Goods •Cost of Goods Manufactured Process Cost Flows (in journal entry form) GENERAL JOURNAL Date Description Finished Goods Work in Process - Department B To record the completion of goods and their transfer from Department B to finished goods inventory. Post. Ref. Page 4 Debit Credit XXXXX XXXXX Process Cost Flows (in T-Account form) Work in Process Department B •Direct Materials •Direct Labor •Applied Overhead •Transferred from Dept. A Finished Goods •Cost of Goods Manufactured Cost of Goods Sold •Cost of Goods Sold •Cost of Goods Manufactured •Cost of Goods Sold Process Cost Flows (in journal entry form) GENERAL JOURNAL Date Description Cost of Goods Sold Finished Goods To record cost of goods sold. Post. Ref. Page 4 Debit Credit XXXXX XXXXX Equivalent Units of Production Equivalent units are the product of the number of partially completed units and the percentage of completion of those units. We need to calculate equivalent units because a department usually has some partially completed units in its beginning and ending inventory. Equivalent Units – The Basic Idea Two half completed products are equivalent to one completed product. + = 1 So, 10,000 units 70% complete are equivalent to 7,000 complete units. Quick Check For the current period, Jones started 15,000 units and completed 10,000 units, leaving 5,000 units in process that are 30 percent complete. How many equivalent units of production did Jones have for the period? a. 10,000 b. 11,500 c. 13,500 d. 15,000 Quick Check For the current period, Jones started 15,000 units and completed 10,000 units, leaving 5,000 units in process that are 30 percent complete. How many equivalent units of production did Jones have for the period? a. 10,000 10,000 units + (5,000 units × 0.30) b. 11,500 = 11,500 equivalent units c. 13,500 d. 15,000 Calculating Equivalent Units Equivalent units can be calculated two ways: The First-In, First-Out Method (FIFO). The Weighted-Average Method. Characteristics of the Weighted Average Method The weighted-average method . . . • Makes no distinction between work done in prior or current periods. • Blends together units and costs from prior and current periods. The equivalent units of production for a department are the number of units transferred to the next department (or finished goods) plus the equivalent units in the department’s ending work in process inventory. Treatment of Direct Labor Dollar Amount Direct Materials Conversion Direct Labor Type of Product Cost Direct labor costs may be small in comparison to other product costs in process costing systems. Treatment of Direct Labor Direct Materials Dollar Amount Conversion Direct labor costs may be small in comparison to other product costs in process costing systems. Type of Product Cost Direct labor and manufacturing overhead may be combined into one product cost called conversion. Weighted-Average Example Double Diamond Skis reported the following activity in Shaping and Milling Department for the month of May: Percent Completed Shaping and Milling Department Beginning work in process Units 200 Materials Conversion 55% 30% Units started into production in May 5,000 Units completed during May and transferred to the next department 4,800 100% 100% 400 40% 25% Ending working process Weighted-Average Example The first step in calculating the equivalent units is to identify the units completed and transferred out of the Department in May (4,800 units). Materials Units completed and transferred to the next department 4,800 Conversion 4,800 Weighted-Average Example The second step is to identify the equivalent units of production in ending work in process with respect to materials for the month (160 units) and add this to the 4,800 units from step one. Materials Units completed and transferred to the next department 4,800 Work in process, June 30: 400 units × 40% Equivalent units of Production in during the month of May 160 4,960 Conversion 4,800 Weighted-Average Example The third step is to identify the equivalent units of production in ending work in process with respect to conversion for the month (100 units) and add this to the 4,800 units from step one. Materials Units completed and transferred to the next department 4,800 Conversion 4,800 Work in process, June 30: 400 units × 40% 160 400 units × 25% Equivalent units of Production in during the month of May 100 4,960 4,900 Weighted-Average Example Equivalent units of production always equals: Units completed and transferred + Equivalent units remaining in work in process Materials Units completed and transferred to the next department 4,800 Conversion 4,800 Work in process, June 30: 400 units × 40% 160 400 units × 25% Equivalent units of Production in during the month of May 100 4,960 4,900 Weighted-Average Example Materials Beginning Work in Process 200 Units 55% Complete 5,000 Units Started 4,800 Units Started and Completed 4,800 Units Completed 160 Equivalent Units 4,960 Equivalent units of production Ending Work in Process 400 Units 40% Complete 400 × 40% Weighted-Average Example Conversion Beginning Work in Process 200 Units 30% Complete 5,000 Units Started 4,800 Units Started and Completed 4,800 Units Completed 100 Equivalent Units 4,900 Equivalent units of production Ending Work in Process 400 Units 25% Complete 400 × 25% Computing Cost Per Equivalent Unit The following table includes some additional facts for Double Diamond Skis’ Shaping and Milling Department for May. Beginning work in process: Materials: 55% complete Conversion: 30% complete 200 units $ 9,600 5,575 Production started during May 5,000 units Production completed during May 4,800 units Costs added to production in May Materials cost Conversion cost Ending work in process Materials: 40% complete Conversion: 25% complete $ 368,600 350,900 400 units Compute and Apply Costs The formula for computing the cost per equivalent unit is : Cost per equivalent unit = Cost of beginning work in process + inventory Cost added during the period Equivalent units of production Compute and Apply Costs Here is a schedule with the cost and equivalent unit information. Total Cost Cost to be accounted for: Work in process, May 1 Costs added in the Shipping and Milling Department Total cost Equivalent units Cost per equivalent unit $ 15,175 Materials Conversion $ $ 9,600 5,575 719,500 368,600 350,900 $ 734,675 $ 378,200 $ 356,475 4,960 4,900 Compute and Apply Costs Here is a schedule with the cost and equivalent unit information. $356,475 ÷ 4,900 units = $72.75 Total Cost Cost to be accounted for: Work in process, May 1 Costs added in the Shipping and Milling Department Total cost Equivalent units $ 15,175 Materials Conversion $ $ 9,600 5,575 719,500 368,600 350,900 $ 734,675 $ 378,200 $ 356,475 4,960 4,900 Cost per equivalent unit $ 76.25 Total cost per equivalent unit = $76.25 + $72.75 = $149.00 $ 72.75 $378,200 ÷ 4,960 units = $76.25 Computing the Cost of Ending Work in Process Inventory Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Total Ending work in process inventory: Equivalent units of production 160 100 Cost of ending work in process inventory Units completed and transferred out: Units transferred to the next department Cost per equivalent unit Cost of units transferred out $ $ $ - 4,800 76.25 366,000 $ $ $ - 4,800 72.75 349,200 $ $ Step 1: Record the equivalent units of production in ending work in process inventory. - 715,200 Computing the Cost of Ending Work in Process Inventory Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Total Ending work in process inventory: Equivalent units of production 160 100 Cost per equivalent unit $ 76.25 $ 72.75 Cost of ending work in process inventory $ 12,200 $ 7,275 $ 19,475 Units completed and transferred out: Units transferred to the next department Cost per equivalent unit Cost of units transferred out $ $ 4,800 76.25 366,000 $ $ 4,800 72.75 349,200 Step 2: Record the cost per equivalent unit. $ 715,200 Computing the Cost of Ending Work in Process Inventory Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Total Ending work in process inventory: Equivalent units of production 160 100 Cost per equivalent unit $ 76.25 $ 72.75 Cost of ending work in process inventory $ 12,200 $ 7,275 $ 19,475 Units completed and transferred out: Units transferred to the next department Cost per equivalent unit Cost of units transferred out $ $ 4,800 76.25 366,000 $ $ 4,800 72.75 349,200 Step 3: Compute the cost of ending work in process inventory. $ 715,200 Computing the Cost of Units Transferred Out Shaping and Milling Department Cost of Ending Work in Porcess Inventory and the Units Transferred Out Materials Conversion Total Ending work in process inventory: Equivalent units of production 160 100 Cost per equivalent unit $ 76.25 $ 72.75 Cost of ending work in process inventory $ 12,200 $ 7,275 $ 19,475 Units completed and transferred out: Units transferred to the next department Cost per equivalent unit Cost of units transferred out $ $ 4,800 76.25 366,000 $ $ 4,800 72.75 349,200 Step 1: Record the units transferred out to the next department. $ 715,200 Computing the Cost of Units Transferred Out Shaping and Milling Department Cost of Ending Work in Porcess Inventory and the Units Transferred Out Materials Conversion Total Ending work in process inventory: Equivalent units of production 160 100 Cost per equivalent unit $ 76.25 $ 72.75 Cost of ending work in process inventory $ 12,200 $ 7,275 $ 19,475 Units completed and transferred out: Units transferred to the next department Cost per equivalent unit Cost of units transferred out $ $ 4,800 76.25 366,000 $ $ 4,800 72.75 349,200 Step 2: Record the cost per equivalent unit. $ 715,200 Computing the Cost of Units Transferred Out Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Total Ending work in process inventory: Equivalent units of production 160 100 Cost per equivalent unit $ 76.25 $ 72.75 Cost of ending work in process inventory $ 12,200 $ 7,275 $ 19,475 Units completed and transferred out: Units transferred to the next department Cost per equivalent unit Cost of units transferred out $ $ 4,800 76.25 366,000 $ $ 4,800 72.75 349,200 Step 3: Compute the cost of units transferred out. $ 715,200 Reconciling Costs Shaping and Milling Department Cost Reconciliation Costs to be accounted for: Cost of beginning work in process inventory $ Costs added to production during the period Total cost to be accounted for $ 15,175 719,500 734,675 Step 1: Compute the costs to be accounted for by adding the cost of beginning work in process and the production costs added in May. Reconciling Costs Shaping and Milling Department Cost Reconciliation Costs to be accounted for: Cost of beginning work in process inventory $ Costs added to production during the period Total cost to be accounted for $ 15,175 719,500 734,675 Cost accounted for as follows: Cost of ending work in process inventory Cost of units transferred out Total cost accounted for 19,475 715,200 734,675 $ $ Step 2: Compute the costs to accounted for by adding the cost of ending work in process and the cost of units transferred out in May. FIFO vs. Weighted-Average Method The FIFO method (generally considered more accurate that the weighted-average method) differs from the weighted-average method in two ways: 1. The computation of equivalent units. 2. The way in which the costs of beginning inventory are treated. Equivalent Units – FIFO Method Let’s revisit the Double Diamond Skis example. Assume the following activity is reported in the Shaping and Milling Department for May: Percent Completed Units Work in process, June 1 200 Units started into production in June 5,000 Units completed and transferred out of Department A during June 4,800 Work in process, June 30 400 Materials Conversion 55% 30% 40% 25% Equivalent Units – FIFO Method Step 1: Determine equivalent units needed to complete beginning inventory. Materials To complete beginning work in process: Materials: 200 units × (100% - 55%) Conversion: 200 units × (100% - 30%) Conversion 90 140 Equivalent Units – FIFO Method Step 2: Determine units started and completed during the period. Materials To complete beginning work in process: Materials: 200 units × (100% - 55%) 90 Conversion: 200 units × (100% - 30%) Units started and completed during May Conversion 140 4,600 4,600 Equivalent Units – FIFO Method Step 3: Add the equivalent units in ending working in process inventory. Materials To complete beginning work in process: Materials: 200 units × (100% - 55%) 90 Conversion: 200 units × (100% - 30%) Units started and completed during May Conversion 140 4,600 4,600 Ending work in process Materials: 400 units × 40% complete Conversion: 400 units × 25% complete Equivalent units of production 160 100 4,850 4,840 FIFO Example Materials Beginning Work in Process 200 Units 55% Complete 200 × 45% 5,000 Units Started 4,600 Units Started and Completed 90 Equivalent Units 4,600 Units Completed 160 Equivalent Units 4,850 Equivalent units of production Ending Work in Process 400 Units 40% Complete 400 × 40% FIFO Example Conversion Beginning Work in Process 200 Units 30% Complete 200 × 70% 5,000 Units Started 4,600 Units Started and Completed 140 Equivalent Units 4,600 Units Completed 100 Equivalent Units 4,840 Equivalent units of production Ending Work in Process 400 Units 25% Complete 400 × 25% Equivalent Units: Weighted Average vs. FIFO As shown below, the equivalent units in beginning inventory are subtracted from the equivalent units of production per the weighted-average method to obtain the equivalent units of production under the FIFO method. Equivalent units - weighted average method Less equivalent units in beginning inventory: 200 units × 55% 200 units × 30% Equivalent units - FIFO method Materials 4,960 Conversion 4,900 110 4,850 60 4,840 Cost per Equivalent Unit - FIFO The following table includes some additional facts for Double Diamond Skis’ Shaping and Milling Department for May. Beginning work in process: Materials: 55% complete Conversion: 30% complete 200 units $ 9,600 5,575 Production started during May 5,000 units Production completed during May 4,800 units Costs added to production in May Materials cost Conversion cost Ending work in process Materials: 40% complete Conversion: 25% complete $ 368,600 350,900 400 units Cost per Equivalent Unit - FIFO The formula for computing the cost per equivalent unit under FIFO method is: Cost per equivalent unit = Cost added during the period Equivalent units of production Cost per Equivalent Unit - FIFO Total Cost Costs added in the Shaping and Milling Department Equivalent units $ 719,500 Materials Conversion $ 368,600 4,850 $ 350,900 4,840 Cost per equivalent unit $ 76.00 Total cost per equivalent unit = $76.00 + $72.50 = $148.50 $ 72.50 Computing the Cost of Ending Work in Process Inventory Step 1: Record the equivalent units of production in ending work in process inventory. Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Total Ending work in process inventory: Equivalent units of production 160 100 Cost per equivalent unit $ 76.25 $ 72.75 Cost of ending work in process inventory $ 12,200 $ 7,275 $ 19,475 Units completed and transferred out: Units transferred to the next department Cost per equivalent unit Cost of units transferred out $ $ 4,800 76.25 366,000 $ $ 4,800 72.75 349,200 $ 715,200 Computing the Cost of Ending Work in Process Inventory Step 2: Record the cost per equivalent unit. Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Total Ending work in process inventory: Equivalent units of production 160 100 Cost per equivalent unit $ 76.00 $ 72.50 Cost of ending work in process inventory $ 12,160 $ 7,250 $ 19,410 Units completed and transferred out: Units transferred to the next department Cost per equivalent unit Cost of units transferred out $ $ 4,800 76.25 366,000 $ $ 4,800 72.75 349,200 $ 715,200 Computing the Cost of Ending Work in Process Inventory Step 3: Compute the cost of ending work in process inventory. Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Total Ending work in process inventory: Equivalent units of production 160 100 Cost per equivalent unit $ 76.00 $ 72.50 Cost of ending work in process inventory $ 12,160 $ 7,250 $ 19,410 Units completed and transferred out: Units transferred to the next department Cost per equivalent unit Cost of units transferred out $ $ 4,800 76.25 366,000 $ $ 4,800 72.75 349,200 $ 715,200 Computing the Cost of Units Transferred Out Step 1: Record the cost in beginning work in process inventory. Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Units transferred out: Cost in beginning work in process (WIP) $ 9,600 $ 5,575 Cost to complete beginning WIP: Equivalent units to complete 90 140 Cost per equivalent unit $ 76.00 $ 72.50 Cost to complete beginning WIP $ 6,840 $ 10,150 Cost of units started and completed in May Units started and completed in May 4,600 4,600 Cost per equivalent unit $ 76.00 $ 72.50 Cost of units started and completed in May $ 349,600 $ 333,500 Cost of units transferred out Total $ 15,175 $ 16,990 $ $ 683,100 715,265 Computing the Cost of Units Transferred Out Step 2: Determine the cost to complete the units in beginning work in process inventory. Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Units transferred out: Cost in beginning work in process (WIP) $ 9,600 $ 5,575 Cost to complete beginning WIP: Equivalent units to complete 90 140 Cost per equivalent unit $ 76.00 $ 72.50 Cost to complete beginning WIP $ 6,840 $ 10,150 Cost of units started and completed in May Units started and completed in May 4,600 4,600 Cost per equivalent unit $ 76.00 $ 72.50 Cost of units started and completed in May $ 349,600 $ 333,500 Cost of units transferred out Total $ 15,175 $ 16,990 $ $ 683,100 715,265 Computing the Cost of Units Transferred Out Step 3: Determine the cost of units started and completed this period. Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Total Units transferred out: Cost in beginning work in process (WIP) $ 9,600 $ 5,575 $ 15,175 Cost to complete beginning WIP: Equivalent units to complete 90 140 Cost per equivalent unit $ 76.00 $ 72.50 Cost to complete beginning WIP $ 6,840 $ 10,150 $ 16,990 Cost of units started and completed in May Units started and completed in May 4,600 4,600 Cost per equivalent unit $ 76.00 $ 72.50 Cost of units started and completed in May $ 349,600 $ 333,500 $ 683,100 Computing the Cost of Units Transferred Out Step 4: Determine the total cost of units transferred out. Shaping and Milling Department Cost of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Units transferred out: Cost in beginning work in process (WIP) $ 9,600 $ 5,575 Cost to complete beginning WIP: Equivalent units to complete 90 140 Cost per equivalent unit $ 76.00 $ 72.50 Cost to complete beginning WIP $ 6,840 $ 10,150 Cost of units started and completed in May Units started and completed in May 4,600 4,600 Cost per equivalent unit $ 76.00 $ 72.50 Cost of units started and completed in May $ 349,600 $ 333,500 Cost of units transferred out Total $ 15,175 $ 16,990 $ $ 683,100 715,265 Reconciling Costs Shaping and Milling Department Cost Reconciliation Costs to be accounted for: Cost of beginning work in process inventory Costs added to production during the period Total cost to be accounted for Cost accounted for as follows: Cost of ending work in process inventory Cost of units transferred out Total cost accounted for $ 15,175 719,500 $ 734,675 $ 19,475 715,200 $ 734,675 Reconciling Costs Shaping and Milling Department Cost Reconciliation Costs to be accounted for: Cost of beginning work in process inventory Costs added to production during the period Total cost to be accounted for Cost accounted for as follows: Cost of ending work in process inventory Cost of units transferred out Total cost accounted for 15,175 719,500 $ 734,675 $ 19,410 715,265 $ 734,675 $ A Comparison of Costing Methods In a lean production environment, FIFO and weighted-average methods yield similar unit costs. When considering cost control, FIFO is superior to weighted-average because it does not mix costs of the current period with costs of the prior period. Activity-Based Costing (ABC) Cost Objects (e.g., products and customers) Activities Consumption of Resources Cost Activity-Based Costing (ABC) A number of allocation bases are used for assigning costs to products. Activity-Based Costing (ABC) An event that causes the consumption of overhead resources Activity Examples of Activities Setting up machines Admitting hospital patients Billing customers Opening a bank account 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. Activity-Based Costing (ABC) For each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2. 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. 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. 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. Hierarchy of Activities Level Activities Activity Measure Unit-level Processing units on machines Processing units by hand Consuming factory supplies Machine-hours Direct labor-hours Units produced Batch-level Processing purchase orders Processing production orders Setting up equipment Handling materials Purchase orders processed Production orders processed Number of setups Pounds of material handled Product-level Testing new products Administering parts inventories Designing products Hours of testing time Number of part types Hours of design time Facility-level General factory administration Plant building and grounds Direct labor-hours Direct labor-hours 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 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 $/Part Type $/MH Second-Stage Allocations $/DLH $/MH $/Setup $/Order Products Unit-Level Activity Batch-Level Activity Product-Level Activity Facility-Level Activity 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. 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 Hours complete, for a total of 500,000 direct labor DVDs: 50,000 units @ 2 hours per unit = 100,000 hours. CDs: 200,00 units @ 2 hours per unit = Total direct labor-hours 400,000 500,000 Using Activity-Based Costing Comtek Sound, Inc. Unit costs for materials and labor are: Direct materials Direct Labor DVD Units $ 90 $ 20 CD Units $ 50 $ 20 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 overhead rate = $10,000,000 500,000 DLHs = $20 per DLH 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 150 110 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 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 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. 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 × × × × × × 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 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 × × × × × × 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 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. 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 The ABC system assigns $14.45 less overhead than the traditional system to each CD player. Direct-Labor Costing DVD Unit CD Unit $ 90.00 $ 50.00 20.00 20.00 40.00 40.00 $ 150.00 $ 110.00 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 The ABC system assigns $57.80 more overhead than the traditional system to each DVD player. Direct-Labor Costing DVD Unit CD Unit $ 90.00 $ 50.00 20.00 20.00 40.00 40.00 $ 150.00 $ 110.00 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. 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). Shifting of Overhead Cost Production Orders Activity Cost Pool (a batch-level cost pool) The ABC system assigns different amounts of Production Order-related overhead costs to each product. This fact can be illustrated in a two-step process. 1. Compute the number of units processed per production order for each product. Number of units produced per year Number of production orders issued per year Number of units processed per production order DVD Units 50,000 800 62.5 CD Units 200,000 400 500 Shifting of Overhead Cost 2. Compute production order cost per unit for each product. Cost to issue a production order Average number of units processed per production order Production order cost per unit DVD Units CD Units $ 2,625 $ 2,625 $ 62.5 42.00 $ 500 5.25 Notice, the costs are being shifted from the high volume CD players to the low volume DVD players. 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. Targeting Process Improvements The first step in any improvement program is deciding what to improve. The Theory of Constraints approach targets the highest impact improvement opportunities. Activity rates can be used to target areas where costs seem excessively high. Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations. 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. 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. Activity-Based Costing Critical Assumption The cost in each activity pool is strictly proportional to its activity measure. When this assumption is violated, the accuracy of ABC data can be called into question. For example, managers should be particularly alert to product costs that contain allocated facility-level costs. Modifying the ABC Model The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: 1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs. Cost Flows in an ABC System Sarvik Company uses activity-based costing. The company has five cost pools shown below. Estimated Overhead Activity Cost Pool Activity Measure Cost Machine related Machine hours $ 175,000 Purchase orders Number of orders 63,000 Machine setups Number of setups 92,000 Product testing Number of tests 160,000 General factory Direct labor hours 300,000 $ 790,000 Expected Activity 5,000 MHs 700 orders 460 setups 200 tests 25,000 DLHs Cost Flows in an ABC System Activity rates are determined as follows: Estimated Overhead Activity Cost Pool Cost Machine related $ 175,000 Purchase orders 63,000 Machine setups 92,000 Product testing 160,000 General factory 300,000 $ 790,000 ÷ ÷ ÷ ÷ ÷ Total Expected Activity 5,000 MHs 700 orders 460 setups 200 tests 25,000 DLH = = = = = Activity Rate $ 35 per MH $ 90 per order $ 200 per setup $ 800 per test $ 12 per DLH Cost Flows in an ABC System Overhead is applied on the basis of actual activities during the year. Activity Activity Cost Pool Rate Machine related $35/MH Purchase orders $90/order Machine setups $200/setup Product testing $800/test General factory $12/DLH Total Overhead Applied × × × × × Actual Activity 4,600 MHs 800 orders 500 setups 190 tests 23,000 DLHs = = = = = Applied Overhead Cost $ 161,000 72,000 100,000 152,000 276,000 $ 761,000 Cost Flows in an ABC System Selected transactions recorded by the company: a. Raw materials purchased on account, $915,000. b. Raw materials used in production, $900,000 ($810,000 direct and $90,000 indirect). c. Factory labor costs, $370,000 ($95,000 direct and $275,000 indirect). d. Depreciation of factory assets, $180,000. e. Miscellaneous manufacturing overhead costs incurred on account, $230,000. f. Manufacturing overhead applied, $761,000. g. Goods costing $1,650,000 were manufactured. Cost Flows in an ABC System The following journal entries would be used to record transactions (a) and (b). Description a. Raw Materials Accounts Payable Debit 915,000 b. Work in Process Manufacturing Overhead Raw Materials 810,000 90,000 Credit 915,000 900,000 Cost Flows in an ABC System The following journal entries would be used to record transactions (c) and (d). Description c. Work in Process Manufacturing Overhead Salaries and Wages Payable Debit 95,000 275,000 d. Manufacturing Overhead Accumulated Depreciation 180,000 Credit 370,000 180,000 Cost Flows in an ABC System The following journal entry would be used to record transaction (e). Description e. Manufacturing Overhead Cash/Accounts Payable Debit 230,000 Credit 230,000 Cost Flows in an ABC System The following journal entry would be used to record transaction (f). f. Description Work in Process Manufacturing Overhead Debit 761,000 Credit 761,000 Cost Flows in an ABC System The following journal entry would be used to record transaction (g). Description g. Finished Goods Work in Process Debit 1,650,000 Credit 1,650,000 Cost Flows in an ABC System Manufacturing Overhead (b) (c) (d) (e) 90,000 275,000 180,000 230,000 Bal. 14,000 (g) 761,000 Underapplied Overhead Costs Cost Flows in an ABC System The flow of costs through Raw Materials, Work in Process, and other accounts is the same under activity based costing. The only difference in activity based costing is that more than one predetermined overhead rate is used to apply costs to products. The End