Managerial accounting garrison norren 11th ed chap008

 Identify and Define Activitiesand Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures: At Classic Brass, the ABC team,

11th Edition Chapter 8

Activity-Based Costing: A

Tool to Aid Decision Making

Chapter Eight

Activity Based Costing (ABC)

ABC is designed to

provide managers with

cost information for

strategic and other

decisions that potentially affect capacity and therefore

affect fixed as well as

variable costs.

ABC is a good supplement

to our traditional cost system

I agree!

How Costs are Treated Under

ABCproduct costing

How Costs are Treated Under

ABCproduct costing

How Costs are Treated Under

Activity–Based Costing

Plantwide Overhead Rate

Plantwide Overhead Rate

Departmental Overhead Rates

Departmental Overhead Rates

How Costs are Treated Under

Activity–Based Costing

“Best practice” ABC differs from traditional costing in five ways

 ABC uses more allocation bases

Volume measures plus other bases.

How Costs are Treated Under

Activity–Based Costing

“Best practice” ABC differs from traditional costing in five ways

The most commonly used allocation base

in traditional costing is direct labor hours

The most commonly used allocation base

in traditional costing is direct labor hours

Direct labor hours workwell when overheadincreases as directlabor hours increase

How Costs are Treated Under

Activity–Based Costing

Problems:

 In many processes, overhead is increasing while direct labor is decreasing

 Variety and complexity of products is increasing

The most commonly used allocation base

in traditional costing is direct labor hours

The most commonly used allocation base

in traditional costing is direct labor hours

“Best practice” ABC differs from traditional costing in five ways

 ABC uses more allocation bases

How Costs are Treated Under

Activity–Based Costing

“Best practice” ABC differs from traditional costing in five ways

All overheadcosts are not related

to volume measures like

direct laborhours

ABC usesvolume as well asother allocation bases notrelated to the volume

of production

How Costs are Treated Under

This results in applying

all overhead costs

This results in applying

all overhead costs

including unused, or

idle capacity costs to

products.

Products are charged

for the costs of capacity they use – not

for the costs of capacity they don’t use Unused capacity costs are treated as period expenses.

ABC

Products are charged

for the costs of capacity they use – not

for the costs of capacity they don’t use Unused capacity costs are treated as period expenses.

 ABC bases level of activity on capacity

Cross-functional involvement

Link to evaluations

and rewards Link to evaluations

and rewards

Designing an ABC System

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

Cost Objects (e.g., products

Designing an ABC System

Steps for Implementing ABC

 Identify and define activities and activity cost

pools.

 Trace costs to activities and cost objects.

 Assign costs to activity cost pools.

 Calculate activity rates.

 Assign costs to cost objects.

 Prepare management reports.

 Identify and Define Activities

and Activity Cost Pools

Manufacturing companies typically combine

their activities into five

classifications.

Unit-LevelActivity

Batch-Level Activity

Organization- Identify and Define Activities

and Activity Cost Pools

Activities should only becombined within a level

if they are highly

correlated

When combiningactivities, they should be grouped together only at

the appropriate

level

 Identify and Define Activities

and Activity Cost Pools

 Identify and Define Activities

and Activity Cost Pools

Duration driver

Two types of activity measures:

 Identify and Define Activities

and Activity Cost Pools

At Classic Brass, the ABC team, selected the following

activity cost pools and activity measures:

At Classic Brass, the ABC team, selected the following

activity cost pools and activity measures:

Activity Cost Pool Activity Measure Customer orders Number of customer orders Product design Number of product designs

Customer relations Number of active customers

Activity Cost Pools at Classic Brass

 Identify and Define Activities

and Activity Cost Pools

• Customer Orders - assigned all costs of resources

that are consumed by taking and processing customer orders

• Product Designs - assigned all costs of resources

consumed by designing products

• Order Size - assigned all costs of resources

consumed as a consequence of the number of units produced

• Customer Relations – assigned all costs associated

with maintaining relations with customers

• Other – assigned all overhead costs that are not

associated with the other cost pools

• Customer Orders - assigned all costs of resources

that are consumed by taking and processing customer orders

• Product Designs - assigned all costs of resources

consumed by designing products

• Order Size - assigned all costs of resources

consumed as a consequence of the number of units produced

• Customer Relations – assigned all costs associated

with maintaining relations with customers

• Other – assigned all overhead costs that are not

associated with the other cost pools

Production Department

Indirect factory wages $ 500,000 Factory equipment depreciation 300,000 Factory utilities 120,000 Factory building lease 80,000 $ 1,000,000 Shipping costs traced to customer orders 40,000

General Administrative Department

Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60,000 510,000 Marketing Department

Marketing wages and salaries 250,000 Selling expenses 50,000 300,000

Overhead Costs at Classic Brass (Manufacturing and NonManufacturing)

Costs to Activities and Cost Objects

 Assign Costs to Activity Cost Pools

Customer Orders

Product Design

Order Size

Customer Relations Other Total Production Department

Shipping costs **

General Administrative Department

Marketing Department

Activity Cost Pools

At Classic Brass the following distribution of resource

consumption across activity cost pools is determined.

Customer Orders

Product Design

Order Size

Customer Relations Other Total Production Department

Indirect factory wages $ 125,000

Factory equipment depreciation

Factory utilities

Factory building lease

General Administrative Department

Administrative wages and salaries

Office equipment depreciation

Administrative building lease

Marketing Department

Marketing wages and salaries

Selling expenses

Total

Activity Cost Pools

Indirect factory wages $500,000 Percent consumed by customer orders 25%

Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60,000 510,000 Marketing Department

Marketing wages and salaries 250,000 Selling expenses 50,000 300,000 Total overhead costs $ 1,850,000

Overhead Costs at Classic Brass (Manufacturing and NonManufacturing)

Customer Orders

Product Design

Order Size

Customer Relations Other Total Production Department

Indirect factory wages $ 125,000

Factory equipment depreciation 60,000

Factory utilities

Factory building lease

General Administrative Department

Administrative wages and salaries

Office equipment depreciation

Administrative building lease

Marketing Department

Marketing wages and salaries

Selling expenses

Total

Activity Cost Pools

Factory equipment depreciation $300,000 Percent consumed by customer orders 20%

Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60,000 510,000 Marketing Department

Marketing wages and salaries 250,000 Selling expenses 50,000 300,000 Total overhead costs $ 1,850,000

Overhead Costs at Classic Brass (Manufacturing and NonManufacturing)

Customer Orders

Product Design

Order Size

Customer Relations Other Total Production Department

Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000 Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000 Factory utilities - 12,000 60,000 - 48,000 120,000 Factory building lease - - - - 80,000 80,000 General Administrative Department

Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000 Office equipment depreciation 15,000 - - 12,500 22,500 50,000 Administrative building lease - - - - 60,000 60,000 Marketing Department

Marketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000 Selling expenses 5,000 - - 35,000 10,000 50,000

Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000

Activity Cost Pools

 Assign Costs to Activity Cost Pools

 Calculate Activity Rates

The ABC team determines that Classic Brass will have these total activities for each activity cost

pool

 100 customer relations activities.

Now the team can compute the individual activity rates by dividing the total cost for

each activity by the total activity levels.

Now the team can compute the individual

activity rates by dividing the total cost for

each activity by the total activity levels.

 Calculate Activity Rates

Activity Cost Pools Total Cost Total Activity Activity Rate

Customer orders $ 315,000 1,000 orders $315 per order

Product design 257,000 200 designs $1,285 per design

Order size 380,000 20,000 MHs $19 per MH

Customer relations 367,500 100 customer $3,675 per customer Other 490,500 Not applicable Not applicable

Computa tion of Ac tivity Ra te s

Traced Traced Traced

Activity-Based Costing at Classic Brass

Direct Materials

Direct Materials

Direct Labor

Direct Labor

Shipping Costs

Shipping Costs Overhead Costs

Cost Objects:

Cost Objects:

Activity-Based Costing at Classic Brass

Direct Materials

Direct Materials

Direct Labor

Direct Labor

Shipping Costs

Shipping Costs

Order Size

Customer Orders

Customer Orders

Product Design

Product Design

Customer Relations

Customer Relations Other

Overhead Costs

First-Stage Allocation

Activity-Based Costing at Classic Brass

Direct Materials

Direct Materials

Direct Labor

Direct Labor

Shipping Costs

Shipping Costs

Cost Objects:

Cost Objects:

Order Size

Order Size

Customer Orders

Customer Orders

Product Design

Product Design

Customer Relations

Customer Relations Other

 Assigning Costs to Cost Objects

Let’s take a look at how our system works for just one customer – Windward Yachts.

Standard Stanchions (no design required)

1 400 units ordered with 2 separate orders.

2 Each stanchion required 0.5 machine-hours.

3 Selling price is $34 each.

4 Direct materials total $2,110.

5 Direct labor totals $1,850.

6 Shipping costs total $180.

Custom Compass Housing (requires new design)

1 One order during the year.

2 Each housing required 4 machine-hours.

3 Selling price is $650 each.

4 Direct materials total $13.

5 Direct labor totals $50.

6 Shipping costs total $25.

 Assigning Costs to Cost Objects

Customer relations 3,675 N/A

Ove rhe a d Cost for the Sta nda rd Sta nc hions

Ove r he a d Cost for the Custom Housing

 Prepare Management Reports

Windward Yachts

Product margins:

 Prepare Management Reports

Customer Profitability Analysis

Product Margins

Standard Stanchions

Compass Housing

Sales $ 13,600 $ 650 Costs

Direct materials (2,110) (13) Direct labor (1,850) (50) Manufacturing overhead (10,000) (200) Product margin $ (360) $ 387

Traditional Cost Accounting System

Differences Between ABC and

Traditional Product Costs

Product margins are different for four reasons:

based on machine hours ABC assigns product design

costs to a product only if product design work is required

level cost, using a unit-level allocation base, machine hours ABC assigns these batch-level costs using a batch-level

activity measure

products ABC also assigns nonmanufacturing costs to

products

 Traditional costing assigns all manufacturing costs to

products The ABC system does not assign

organization-Differences Between ABC and

Traditional Product Costs

When batch-level and product-level costs are present, ABC will usually shift costs from high volume products, produced in large batches,

to low volume products produced in small batches.

This cost shifting will usually have its

greatest impact on the per

unit cost of the low volume products

Targeting Process Improvement

Activity-based management is

used in conjunction with ABC to

identify areas that would benefit

from process improvements

Activity-based management is

used in conjunction with ABC to

identify areas that would benefit

from process improvements

While the theory of constraints approach discussed in Chapter 1 is a

powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on

While the theory of constraints approach discussed in Chapter 1 is a

powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on

Activity-Based Costing and External Reporting

Most companies do not use ABCfor external reporting because

1 External reports are less detailed than internal

reports.

2 It may be difficult to make changes to the company’s

accounting system.

3 ABC does not conform to GAAP.

4 Auditors may be suspect of the subjective allocation

process based on interviews with employees.

1 External reports are less detailed than internal

reports.

2 It may be difficult to make changes to the company’s

accounting system.

3 ABC does not conform to GAAP.

4 Auditors may be suspect of the subjective allocation

process based on interviews with employees.

and reports.

Desire to fullyallocate all costs

to products

Potentialmisinterpretation ofunfamiliar numbers

Does not conform toGAAP Two costingsystems may be needed

Appendix 8A: ABC Action Analysis

Conventional ABC analysis does not identify potentially relevant costs An action analysis report helps because it:

• Shows what costs have been assigned to a cost object.

• Indicates how difficult it would be to adjust those costs in response to

changes in the level of activity.

Conventional ABC analysis does not identify potentially relevant costs An

• Shows what costs have been assigned to a cost object.

• Indicates how difficult it would be to adjust those costs in response to

changes in the level of activity.

Appendix 8A: ABC Action Analysis

Constructing an action analysis report begins with the first-stage allocation process In addition to computing an overall activity rate for each activity cost

pool, an activity rate is computed for each

type of overhead cost that is consumed

supporting a given activity

Let’s revisit the stage-one allocations from the Classic Brass example that we

discussed earlier.