Overview managerial accounting chapter 08

The activity rates are then used to assign costs to cost objects such as products and customers.. In the text one activity cost pool is usually labeled “Other.” Costs are allocated to t

LO3 Compute activity rates for cost pools

LO4 Assign costs to a cost object using a second-stage allocation

LO5 Prepare a report showing activity-based costing margins from an activity view

LO6 Compare product costs computed using traditional and activity-based costing methods LO7 (Appendix 8A) Prepare an action analysis report using activity-based costing data and

interpret the report

New in this Edition

• New In Business boxes have been added

• Many new exercises have been added to the end of chapter materials

Chapter Overview

A Background for the Instructor A few general comments will help set the stage for the

chapter

1 ABC and GAAP Some ABC systems are used for external as well as for internal financial

reports However, in most cases, a company’s ABC system is not integrated with the company’s regular costing system We agree with experts who argue against integrating the two systems because of their very different purposes We have chosen to emphasize the use

of activity-based costing as a decision-making tool, although a number of exercises and problems at the end of the chapter permit an instructor to explore the use of ABC as an alternative to traditional costing systems for external reporting

2 The ABC approach taken in the chapter In practice activity-based costing comes in

many variations We have consciously combined the best elements from practice and have added some innovations of our own As a consequence, the material in the chapter should

be regarded as ABC as it should be rather than a description of ABC as it is commonly

implemented in practice

B Differences Between ABC and Traditional Costing (Exercise 8-16) The product

costs computed in this chapter differ in major ways from the product costs in Chapters 2, 3, and

4 that describe traditional costing systems

1 Manufacturing costs in ABC In the ABC system described in the chapter, some

manufacturing costs are excluded from product costs This treatment follows recommendations by Cooper and Kaplan and others

a The chapter advocates excluding the costs of idle capacity from product costs, but without getting into the details of how this is done It would be helpful, but not absolutely necessary, for your students to have read Appendix 3A, which goes into this subject in greater depth

b We also exclude organization-sustaining costs from activity-based costing product costs These costs will be discussed in more detail below Basically, organization-sustaining costs are excluded from product costs because they are not caused by individual products and are not relevant in decisions concerning those products

2 Non-manufacturing costs in ABC Strictly speaking, non-manufacturing costs are

excluded from product costs under GAAP However, to the extent that these costs are caused by specific products, excluding them results in misleading information for making decisions It is true that these non-manufacturing costs can be deducted from product revenues in addition to unit product costs when decisions are made, but this is not always done It is probably safer to build these costs right into product costs, which is the approach taken in this chapter (Remember, these costs are to be used for making decisions, not valuing inventory and cost of goods sold.)

3 Multiple overhead cost pools in ABC Traditional overhead costing systems are described

in Chapters 2, 3, and 4 In these traditional systems, an entire plant may have a single overhead cost pool or each production department may have a separate overhead cost pool

In nearly all cases, overhead costs are applied to products using either direct labor-hours, direct labor cost, or machine-hours In activity-based costing, each major activity has its own separate overhead cost pool An activity is any event that causes the consumption of resources The activities tracked in the ABC system may cut across many departments and the measures of activity (i.e., allocation bases) may be quite different from the traditional allocation bases

C Cost Hierarchy in Activity-Based Costing (Exercises 8-8, 8-13, and 8-15.)

Thousands of activities are carried out in most organizations It would not be practical to track all of them in an activity-based costing system A great deal of simplification is necessary Activities and their costs must be combined to reduce complexity and record-keeping requirements One way to simplify is to group activities into a hierarchy Activities, and their costs, can be combined within each level of the hierarchy into activity cost pools—hopefully with minimal loss in accuracy The cost hierarchy used in the text is not the only scheme that could be used, but it is reasonably comprehensive The levels in the hierarchy are as follows:

1 Unit-level activities These activities are performed each time a unit is produced For

example, providing power to run processing equipment is likely to be a unit-level activity

2 Batch-level activities These activities are performed each time a batch is handled or

processed, regardless of how many units are in the batch For example, tasks such as placing purchase orders, setting up equipment, and arranging for shipments to customers are batch-level activities

3 Product-level activities These activities relate to specific products and must be carried out

regardless of how many batches or units of product are produced or sold For example, designing a product, advertising a product, and maintaining a product manager and staff are all product-level activities

4 Customer-level activities These activities relate to specific customers and include sales

calls, catalog mailings, and general technical support not tied to any specific product

5 Organization-sustaining activities These activities are carried out regardless of which

products are produced, how many batches are run, or how many units are made This category of activities includes cleaning executive offices, providing a computer network, arranging for loans, preparing annual reports to shareholders, and so on

D Mechanics of Activity-Based Costing (Exercises 9, 10, 11, 18, 20, and

8-16.) Exhibit 8-6 is a useful Exhibit for summarizing the mechanics of activity-based costing You may want to refer to it frequently as you walk students through the steps of assigning costs using ABC

1 Overview Once the activity cost pools and their activity measures have been defined, costs

are allocated to the activity cost pools The costs in the activity cost pools are then divided

by their activity measures to determine activity rates (Activity rates are like the overhead rates of Chapter 3.) The activity rates are then used to assign costs to cost objects such as products and customers For example, if a customer generates five orders and the activity rate for orders is $15 per order, then the customer would be assigned $75 in order costs The mechanics are fundamentally no different from the mechanics covered in Chapter 3 for applying overhead to products The main difference is that instead of one predetermined overhead rate, many activity rates are used

2 First-stage allocations (Exhibits 8-13, 8-15, and 8-9.) The first stage in the allocation

process is based on a table showing the distribution of resource consumption across activities for each category of cost in the company’s bookkeeping system For example, if indirect factory wages is one of the accounts in the company’s bookkeeping system, the table would show what percentage of indirect wages is attributable to each of the activities

in the company’s ABC system The text describes how interviews can be used to elicit these percentage distributions, but these percentage distributions are always given in all examples and problems

The first-stage allocation is accomplished by multiplying the total cost of each account by the percentages in its row in the table showing the distribution of resource consumption across activities For example, if the table shows that 20% of indirect factory wages are attributable to processing batches, then 20% of the cost of indirect factory wages would be allocated to that activity cost pool

The end product of the first stage of the allocation process is a table showing how each cost such as indirect factory wages is divided up among activity cost pools

3 The “Other” activity cost pool In the text one activity cost pool is usually labeled

“Other.” Costs are allocated to this activity cost pool in the first stage of the allocation process but they are not subsequently allocated to products, customers, or other cost objects This activity cost pool is supposed to capture costs of idle capacity and organization-sustaining costs that should not be allocated to cost objects because they are not caused by the cost objects In practice, these costs are almost always allocated to cost

objects—the costs of idle capacity and organization-sustaining costs are seldom segregated from other costs

4 Computation of activity rates (Exhibit 8-5.) The total cost assigned to an activity cost

pool in the first-stage allocation is divided by the total amount of activity for the cost pool

to determine the activity rate for that cost pool Each activity cost pool has its own activity rate

5 Second-stage allocations of costs to cost objects (Exhibit 8-8.) The activity rates can be

used to assign costs to any cost object The activity rate is simply multiplied by the amount

of activity for the cost object

6 Product and customer margins—activity view (Exhibit 8-9) Margins for products,

customers, and other cost objects can be easily constructed using the costs in Exhibit 8-8 These costs are combined with whatever costs are directly traced to the cost object (for example, direct materials), and deducted from the sales attributable to the cost object This

is the conventional approach in activity-based costing

E Activity Rates and Activity-Based Management (Exercise 8-10.) Activity rates (i.e.,

the cost per unit of activity) can be useful to managers in targeting business process improvements If activity rates are available from other organizations, an unusually high cost for carrying out a particular activity can signal room for improvement Also, if similar activities are carried out at different locations within the same organization, activity rates can help identify which locations are most efficient The methods used at the most efficient locations can then be applied to other locations

F The Impact on Product Costs of Adopting an ABC System (Exercise 8-21.) Unit

product costs are different under activity-based costing and traditional cost systems for a number

of reasons First, some manufacturing costs (i.e., the costs of idle capacity and sustaining costs) are excluded from product costs under the activity-based costing approach described in the text Second, some non-manufacturing costs are included in product costs under

organization-activity-based costing These two differences affect the total amount of cost allocated to

products However, even if these differences are ignored or suppressed, the unit product costs will still differ between activity-based costing and traditional costing systems For example, if a company switches to activity-based costing for external financial reports, the total costs allocated to products will remain the same, but the pattern of allocation will differ

The biggest changes in product costs from switching to an ABC system occur when the ABC system includes batch or product-level costs In this case, costs ordinarily shift from high-volume products to low-volume products Consequently, the total and per unit costs of the high-volume products decrease and the total and per unit costs of the low-volume products increase When overhead costs are shifted from one product to another, a given dollar amount is implicitly subtracted from the total cost of one product and added to the total cost of the other product Since the total cost of all products remains the same, what is taken away from one product must

be added to another product However, the effects on unit costs are not symmetrical The unit costs of the low-volume products must go up more than the per-unit costs of the high-volume products go down

G Appendix 8A: ABC Action Analysis (Exercises 8-12, 8-19, and 8-21) The

conventional ABC analysis discussed in the chapter has some important drawbacks for decision-making Most importantly, with a product margin analysis such as the one shown

in Exhibit 8-9, it is unclear who is actually responsible for a cost For example, if a product

is dropped because of a negative margin, it is unclear who would be responsible for actually carrying out reductions in costs An activity cost pool may contain costs from many departments If a product is dropped, the activities associated with the product will presumably disappear, but will the costs? If it is unclear who would be responsible for reducing the costs, no one may actually take any action This is particularly true for personnel costs What manager will voluntarily give up personnel if there is no accountability?

Be sure to reinforce the idea that the costs assigned to a product, customer, or whatever in

an activity-based costing system are relevant in a decision only if the costs would actually change if the decision were taken For example, in a product drop decision, the costs of

resources are relevant only if spending would decrease as a result of the decision or the resources would be redeployed to more profitable uses In the latter case, this means that

the resources would have to be redeployed to the constraint

An action analysis report makes it much clearer what costs are likely to be relevant in a decision and who in the organization would be responsible for the cost if an action is taken Unfortunately, preparing an action analysis report requires considerably more work than the more conventional analysis

1 Activity rates (Exhibit 8A-2) The action analysis approach differs from the conventional

ABC approach beginning with the computation of the activity rates In the conventional analysis, a single activity rate is computed for each activity cost pool In an action analysis,

a rate is computed for each cost category within an activity cost pool Looking at Exhibit 8A-2, only the rates at the bottom of the Exhibit would be computed in a conventional analysis In an action analysis, the entire table is filled out

2 Second-stage allocations (Exhibit 8A-3) In an action analysis, an entire matrix of costs is

computed rather than just a total cost for each activity cost pool Looking at Exhibit 8A-3, only the costs at the bottom of the Exhibit would be computed in a conventional analysis

In an action analysis, the entire table is filled out by multiplying activities by the activity rates in each cell

3 The conventional activity analysis From the action analysis cost matrix in Exhibit 8A-3,

it is easy to construct the conventional activity analysis report showing product margins Just take the totals from the bottom of the cost matrix Note that these costs are identical to the costs computed earlier in the chapter in Exhibit 8-8

However, using the row totals from Exhibit 8A-3, it is possible to look at the margins of products and other cost objects from a different perspective Instead of abstract labels like

“order processing costs” for the various activity cost pools, the costs are labeled using the account titles from the company’s bookkeeping system This makes it clear what the costs actually consist of and who in the organization would be responsible for taking action if a decision is made

4 Ease of adjustment codes (Exhibit 8A-4) Some costs, such as direct materials, are much

easier to adjust than other costs, such as the total wages of experienced supervisors As a consequence, some costs are more likely to be relevant in a decision than others The ease

of adjustment codes provide a way of assisting managers in making these distinctions

a Green These costs adjust automatically to changes in activity without any

management action Examples include direct materials and the cost of power to run

b Yellow These costs could, in principle, be adjusted to changes in activity, but

management action would be required Direct labor is usually such a cost, as are many discretionary expenses

c Red These costs would be very difficult to adjust to changes in activity and

management action would be required Examples include time-based depreciation and many salaries

5 Action analysis report (Exhibit 8A-5) The action analysis report combines the cost

information from the row totals in Exhibit 8A-3 with the ease of adjustment codes in Exhibit 8A-4 This report makes it much clearer where costs would need to be adjusted in the organization as the result of an action, who would be responsible for the change in costs, and which costs are likely to be relevant and which costs are likely to be irrelevant in decisions Such an action analysis report is not the final step in the decision-making process Further analysis, such as illustrated in Chapter 13, would be necessary before making any major decision

Assignment Materials

Assignment Topic

Level of Difficulty

Suggested Time

Exercise 8-1 ABC cost hierarchy Basic 10 min Exercise 8-2 First-stage allocation Basic 15 min Exercise 8-3 Compute activity rates Basic 10 min Exercise 8-4 Compute ABC product costs Basic 10 min Exercise 8-5 Product and customer profitability analysis Basic 30 min Exercise 8-6 Contrasting traditional and ABC product costs Basic 30 min Exercise 8-7 (Appendix 8A) Preparing an action analysis report Basic 20 min Exercise 8-8 Cost hierarchy Basic 10 min Exercise 8-9 First-stage allocations Basic 10 min Exercise 8-10 Computing and interpreting activity rates Basic 20 min Exercise 8-11 Second-stage allocation to an order Basic 10 min Exercise 8-12 (Appendix 8A) Second-stage allocation to an order using

the action analysis approach Basic 30 min Exercise 8-13 Activity measures Basic 10 min Exercise 8-14 Computing ABC product costs Basic 20 min Exercise 8-15 Cost hierarchy and activity measures Basic 15 min Exercise 8-16 Calculating and interpreting activity-based costing data Basic 30 min Exercise 8-17 Activity-based costing as an alternative to traditional

product costing Basic 45 min Exercise 8-18 Second-stage allocation and margin calculations Basic 15 min Exercise 8-19 (Appendix 8A) Second-stage allocation and margin

calculations using the action analysis approach Basic 45 min Exercise 8-20 Comprehensive activity-based costing exercise Basic 30 min Exercise 8-21 (Appendix 8A) Comprehensive activity-based costing

exercise Basic 60 min Problem 8-22 Activity-based costing as an alternative to traditional

product costing Medium 60 min Problem 8-23 (Appendix 8A) Activity rates and activity-based

management Medium 45 min Problem 8-24 Evaluating the profitability of services Medium 45 min Problem 8-25 (Appendix 8A) Evaluating the profitability of services using

an action analysis approach Medium 75 min Problem 8-26 Activity-based costing as an alternative to traditional

product costing Medium 60 min Problem 8-27 Activity-based costing and bidding on jobs Medium 45 min Problem 8-28 Second-stage allocations and product margins Medium 20 min Problem 8-29 (Appendix 8A) Second-stage allocations and product

margins Medium 30 min Problem 8-30 Activity-based costing as an alternative to traditional

product costing Medium 45 min Case 8-31 Activity-based costing and pricing Difficult 90 min Case 8-32 Contrasting activity-based costing and traditional costing Difficult 90 min Case 8-33 (Appendix 8A) Comprehensive activity-based costing case Difficult 120 min Case 8-34 Activity-based costing as an alternative to traditional

product costing Difficult 90 min

Essential Problems: Problem 8-22 or Problem 8-26, Problem 8-24, Problem 8-27, Problem 8-28 Supplementary Problems: Problem 8-30, Case 8-31, Case 8-32, Case 8-34

Linked Exercises: Exercise 8-10 should be assigned only if Exercise 8-9 is also assigned Exercise 8-12 should only be assigned if Exercise 8-11 is assigned

Appendix 8A Essential Problems: Problem 8-23, Problem 8-25, Problem 8-29

Appendix 8A Supplementary Problems: Case 8-33

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Chapter 8 Lecture Notes

Helpful Hint: Before beginning the lecture, show students the seventh and eighth segments from the second tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library These segments introduce students to many of the concepts discussed in chapter 8 The lecture notes reinforce the concepts in the video

Chapter theme: This chapter introduces students to

activity-based costing (ABC) which is a tool that has been embraced by a wide variety of service,

manufacturing, and non-profit organizations

ABC is a costing method that is designed to provide

managers with cost information for strategic and other

decisions that potentially affect capacity and therefore

“fixed” as well as variable costs It is ordinarily used as a

supplement to, rather than as a replacement for, the

company’s usual costing system

I How costs are treated under activity-based costing

A “Best practice” ABC differs from traditional cost

accounting in five ways:

i ABC assigns both manufacturing and

nonmanufacturing costs to products

Traditional cost systems only assign manufacturing costs to products

1 For example, ABC systems can assign sales commissions, shipping costs, and warranty repair costs to specific products

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ii ABC systems do not assign all

manufacturing costs to products, while

traditional cost systems do assign all manufacturing costs to products

1 This is because ABC only assigns a cost to a product if decisions concerning that product will cause changes in the cost

Helpful Hint: Emphasize that ABC systems that are used to support internal decision making do not need to conform to GAAP Therefore, while GAAP requires treating S, G & A as a period expense and it requires assigning all manufacturing costs to products, ABC systems can assign S, G & A expenses to products and they can exclude manufacturing costs from product costs where appropriate

iii ABC uses more cost pools than traditional cost

systems which often use a single plantwide

overhead pool or just one overhead pool per department

1 ABC cost pools are created to correspond to

the activities performed in an organization

that cause the consumption of overhead resources

a The total number of ABC cost pools will definitely exceed one (as in the plantwide approach) and it is likely to exceed the number of departments within a company (as in the

departmental approach) since more

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than one activity is often performed within each department

“In Business Insights”

The insights revealed by creating a larger number of cost pools as in an ABC system can change the focus of

a manager’s attention For example:

“ABC Changes the Focus” (page 317)

• Euclid Engineering makes parts and components for automobile manufacturers As a result of its ABC study, its managers realized that the

company was spending more on launching new products than on direct labor expenses to produce existing products

• Product development and launch expenses were 10% of expenses whereas, direct labor costs were only 9% Rather than focusing on reducing direct labor costs, managers turned their attention to reducing product launch costs

• Euclid’s ABC information was shared with customers who used the detailed breakdown of the costs of design and engineering activities to

compare the cost of product design features with the increase in functionality offered by those features

“Peddling to Oblivion” (page 319)

• Claudia Post started a small bicycle-messenger service, Diamond Courier, in Philadelphia Her business eventually expanded to include truck deliveries, airfreight services, a parts-distribution division, and a legal service that served

subpoenas and prepared court filings

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• Within three years Diamond was booking $3.1 million dollars in annual sales and had 40 bike messengers, an office staff of 25 employees, and about 50 independent drivers However, the company was losing money!

• An ABC analysis revealed that the average cost of

a bike delivery, including overhead, was $9.24, but she was charging only $4.60 She decided to drop the bicycle messenger service and

concentrate on other profitable lines of business

• Further analysis later led to closing down the airfreight and parts-distribution divisions Today,

13 years after making its first local messenger delivery, the company now known as the Diamond Transportation Group is a leading national

provider of transportation logistics management

iv ABC uses more allocation bases than

traditional cost systems which rely solely on

volume as the base for allocating overhead

costs

1 The most common allocation bases in

traditional cost systems are direct labor hours and machine hours

a These bases work correctly when changes in the quantity of the base are correlated with changes in the

overhead costs being assigned using the base

b Relying exclusively on these bases to assign overhead costs to products has come under increased scrutiny since,

on an economywide basis, direct labor and overhead costs have been moving

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in opposite directions and the variety

of products produced by companies has increased

2 ABC systems often use direct labor hours, machine hours, or other unit-level allocation bases to assign the portion of overhead costs that move in tandem with the volume of production However, unlike traditional systems, ABC also uses additional allocation

bases that are not related to the volume of production to assign overhead costs that are

not correlated with volume

“In Business Insights”

ABC systems usually include a larger number of allocation bases than traditional cost systems For example:

“Shedding Light on Product Profitability” (page 315)

• Reichhold, Inc., a leading supplier of synthetic materials, adopted ABC to shed light on the profitability of its various products

• Reichhold’s prior cost system used one allocation base, reactor hours, to assign overhead costs to products

• The ABC system uses four additional activity measures – preprocess preparation hours, thin- tank hours, filtration hours, and waste disposal costs per batch – to assign overhead costs to products

• Reichhold has rolled out ABC to all 19 of its North American plants to help improve decision making

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v ABC systems may base the level of activity for

each cost pool on the capacity of the activity rather than the budgeted level of activity

which is always used in traditional cost systems

1 Using the budgeted level of activity to compute a predetermined overhead rate

results in unused capacity costs being assigned to products

2 Using activity capacity to compute

predetermined overhead rates isolates unused capacity costs as a period expense

rather than assigning them to products

II Designing an activity-based costing (ABC)

2 Without top management support, the ABC implementation will be seen as unimportant

ii There should be cross-functional

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and be fully supported by them If the accounting department alone attempts to impose ABC on others, skepticism and resistance are inevitable

2 A well designed ABC system requires intimate knowledge of many parts of an organization This knowledge can only be learned from employees familiar with the various parts of an organization’s

operations

iii ABC data should be linked to how people are

evaluated and rewarded

1 If traditional non-ABC data continues to be used to evaluate employee performance, it sends the signal that ABC data is

unimportant and can even be ignored

B The activity-based costing model

i Cost objects such as products generate

activities

1 For example, a customer order generates the need to complete the activity of preparing a production order

ii Performing activities consumes resources

1 For example, preparing a production order uses a sheet of paper and it takes time to fill out

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iii The consumption of resources causes costs

1 For example, the greater the number of sheets of paper used to prepare a production order and the greater the amount of time devoted to preparing the production order, the greater the cost

C Steps for implementing ABC (provide an overview of all five steps)

i Identify and define activities and activity

cost pools (The activities are often identified

and defined by interviewing the employees that work in the respective overhead departments The lengthy list of activities that emerges from this process is usually reduced to a handful by combining similar activities.)

Helpful Hint: The cost-benefit concept should be reviewed when discussing the number of activities to track in an ABC system

1 A common framework for combining activities in manufacturing companies is as follows:

a Unit-level activities are performed

each time a unit is produced

• For example, providing power

to run processing equipment would be a unit-level activity

b Batch-level activities are performed

each time a batch is handled or processed, regardless of how many units are in the batch

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• For example, setting up equipment and shipping customer orders are batch-level activities

c Product-level activities relate to

specific products and must be carried out regardless of how many batches are run or units produced and sold

• For example, designing or advertising a product would be product-level activities

d Customer-level activities relate to

specific customers and are not tied to any specific product

• For example, sales calls and catalog mailings would be customer-level activities

e Organization-sustaining activities

are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made

• For example, heating a factory and cleaning executive offices are organization-sustaining activities

2 When combining these activities, they should be grouped together at the appropriate level Batch-level activities should not be combined with unit-level activities, and so on Furthermore, activities should only be combined within a level if they are highly correlated with each other

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3 Each combined group of activities forms

what is called an activity cost pool which is

defined as a “bucket” that accumulates costs related to a single allocation base In an ABC system the term allocation base is

replaced by the term activity measure, or the term cost driver is also used Two types

of activities measures include:

a Transaction driver – a simple count

of the number of times that an activity occurs This is the least accurate type

of activity measure

b Duration driver – measures the

amount of time needed to perform an activity This is more accurate than a transaction driver, but it takes more effort to record

Helpful Hint: Revisit the cost-benefit concept by explaining that transaction drivers are more prevalent

in practice than duration drivers because the data is much easier to obtain The additional accuracy provided by duration drivers often times does not pass the cost-benefit test

4 In the Classic Brass example from the

textbook, the ABC team selected the five activity cost pools and corresponding

activity measures as shown

a The definition for each of the activity cost pools is as shown

ii Whenever possible, directly trace overhead

costs to activities and cost objects

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1 The manufacturing and nonmanufacturing overhead costs for Classic Brass are as shown

a Notice, the shipping costs can be directly traced to customer orders

The remainder of the overhead costs will be assigned to customer orders using the ABC cost pools

“In Business Insights”

The ABC implementation steps that we are discussing apply not only to manufacturing companies, such as Classic Brass, but to all types of organizations For example:

“The Virtual Bakery” (page 324)

• Super Bakery, Inc founded by former Pittsburgh Steelers running back Franco Harris, supplies donuts and other baked goods to schools, hospitals, and other institutions

• The company’s master baker develops products, and then the company formulates and produces the appropriate dry mixes from ingredients it has purchased All other activities such as baking, warehousing and shipping are outsourced

• As much as possible, actual costs are traced to individual customer accounts The remaining costs of the company are assigned to customer accounts using the following four activity cost pools with corresponding activity measures shown

in parentheses: Advertising, trade shows, and bonds (projected number of cases sold), Order department (number of orders), Sales

management (time spent in each sales territory,)

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and, Research and development (hours of R&D for each product line)

iii Assign costs to activity cost pools (this is also

called first-stage allocation)

1 The cross-functional employee interviews resulted in the resource allocations as shown Notice:

a The indirect factory workers allocated

25% of their time to the customer orders activity, 40% of their time to the product design activity, 20% of

their time to the order size activity,

10% of their time to customer relations, and 5% of their time to the

“other” activity

b 100% of the factory building lease is

allocated to the “other” activity Since Classic Brass has a single production facility that it does not plan to contract

or expand the lease cost is an unavoidable organization-sustaining cost

c The shipping costs have no corresponding allocation percentages This is because the shipping costs will

be directly traced to customer orders

2 Once the percentage allocations have been determined, it is a simple matter to assign costs to activity cost pools

a For example, the indirect factory wages assigned to the customer orders

activity ($125,000) was computed by

multiplying the total amount of

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indirect factory wages ($500,000) by

the percentage of time that indirect factory workers spent on this activity

(25%)

b As another example, the factory equipment depreciation assigned to the

customer orders activity ($60,000) was

computed by multiplying the total amount of factory equipment

iv Calculate activity rates

1 The Classic Brass ABC team determined activity levels for each activity as shown This information enabled the team to compute ABC rates for each activity by dividing the total cost in each activity cost pool by the respective quantity of the activity measure

a The activity rate for each cost pool is

as shown For example, the customer orders activity cost pool has an activity

rate of $315 per order Importantly, this is an average figure

b Notice, the “other” cost pool does not have an activity rate This is because

these organization-sustaining costs will not be assigned to customer orders

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2 Before proceeding, let’s get a visual perspective of the Classic Brass ABC system

a The direct materials, direct labor and

shipping costs were directly traced to

customer orders

b The first-stage allocation process assigned the remaining overhead costs

to five activity cost pools

c Then, activity measures were identified, activity levels were determined, and activity rates were

computed for each activity These rates will be used in the next step to assign overhead costs to customer orders

v Assign costs to cost objects (this is also called

second stage allocation)

1 For each activity cost pool, the amount of activity consumed by the product (or customer) is multiplied by the activity rate

to arrive at the amount of overhead cost applied to the product (or customer)

a For example, let’s look at the following data for one Classic Brass customer (Windward Yachts) that

bought two products (standard stanchions and custom compass housings)

b The second stage allocations show that

$630 from the customer orders pool and $3,800 from the order size pool

were assigned to the standard

stanchions Similarly, $315 (from the

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customer orders pool), $1,285 (from the product design pool), and $76

(from the order size pool) were assigned to custom compass housings

vi Prepare management reports

1 Two management reports that can be prepared include a product margin report and a customer margin report

a The product margin is calculated by

deducting directly traceable costs and ABC costs from sales Notice, the product margins for standard stanchions and custom compass

housings are $5,030 and $(1,114),

respectively

b The customer margin ($241) is

calculated by subtracting the

customer-level costs ($3,675) from the combined

product margins for both products

($3,916)

“In Business Insights”

Preparing management reports can provide key insights that enable managers to target their most profitable customers For example, consider trends in the banking industry as well as the experiences of FedEx:

“Finding that Golden Top 20%” (page 330)

• According to Meridien Research of Newton, Massachusetts, 20% of a bank’s customers generate about 150% of its revenue Conversely,

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30% of a bank’s customers drain 50% of its profits

• Customer relationship management software coupled with ABC can enable companies to prepare management reports that help them identify which customers are in that golden top 20%

• Meridien Research estimates that large commercial banks are increasing their spending

on customer profitability systems by 14% a year with total annual expenditures exceeding $6 billion dollars

“Culling the Customer List” (page 335)

• FedEx classifies its customers as the good, the bad, and the ugly based on their profitability

• The “good” can expect a phone call if their shipping volume falters, which can head off defections before they occur

• As for the bad – those who spend but are expensive to the company – FedEx is turning them into profitable customers in many cases by

charging higher shipping prices

• As for the ugly, FedEx was quoted as saying “We just don’t market to them anymore.”

D Comparison of traditional and ABC product costs

i Product margins computed using the traditional

cost system

1 Continuing with the Classic Brass example,

assume that the company uses a plantwide

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