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Chapter 3

Chapter 3. System Design: Activity Based Costing. PowerPoint Authors: Jon A. Booker, Ph.D., CPA, CIA Charles W. Caldwell, D.B.A., CMA Susan Coomer Galbreath, Ph.D., CPA. 3- 2. Learning Objective 1.

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Chapter 3

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  1. Chapter 3 System Design: Activity Based Costing PowerPoint Authors: Jon A. Booker, Ph.D., CPA, CIA Charles W. Caldwell, D.B.A., CMA Susan Coomer Galbreath, Ph.D., CPA

  2. 3-2 Learning Objective 1 Understand the basic approach in activity-based costing and how it differs from conventional costing.

  3. 3-3 Assigning Overhead Costs to Products When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2.   Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

  4. 3-4 Plantwide Overhead Rate Plantwide Overhead RateA single overhead rate used throughout an entire factory. Direct labor has often been used as the allocation base for overhead because: 1.    Direct labor information was already being recorded. 2.    Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated.

  5. 3-5 Plantwide Overhead Rate • Today, direct labor may no longer be a satisfactory base for allocation of overhead. • Most companies sell a large variety of products that consume differing amounts of overhead. • As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor. • Technology advancements have reduced the cost and complexity of gathering diverse sources of data. A plantwide overhead allocation system may not be optimalfor many companies in today’s business environment.

  6. 3-6 Departmental Overhead Rates Many companies have a system in which each department has its own overhead rate. The allocation base depends on the nature of the workperformed in each department. In the machining department,overhead may be based on machine-hours, but in the assembly department, overhead may be based on labor-hours. Machining Department Assembly Department Shipping Department

  7. The departmental approach reliesexclusively on volume-related allocation bases while some overhead costs may be caused by factorsthat are not related to the volume of production. Activity-base costing is required to account for these other factors. 3-7 Departmental Overhead Rates Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs.

  8. 3-8 Activity-Based Costing (ABC) A number of allocation bases are used for assigning costs to products.

  9. Activities Consumption of Resources Cost 3-9 Activity-Based Costing (ABC) Cost Objects (e.g., products and customers)

  10. 3-10 Activity-Based Costing (ABC) An event that causes the consumption of overhead resources Activity Examples of Activities Setting upmachines Admitting hospitalpatients Billingcustomers Opening a bank account

  11. A “cost bucket” in which costs related to a particular activity are accumulated. Activity Cost Pool Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs. Activity Measure A predetermined overhead rate for each activity cost pool. Activity Rate 3-11 Activity-Based Costing (ABC)

  12. 3-12 Activity-Based Costing (ABC) For each activity inisolation, this system works exactlylike the job-order costing systemdescribed in Chapter 2. A predetermined overhead rate is computed foreach activity and then applied to jobs andproducts based on the amount of activityconsumed by the job or product.

  13. 3-13 Designing an Activity-BasedCosting 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.

  14. For example, several activities maybe involved in handling and movingraw materials, but these may becombined into a single activityentitled material handling. 3-14 Designing an Activity-BasedCosting System Related activities arefrequently combined to reducethe amount of detail andrecord-keeping costs. An activity dictionary defines each of the activitiesthat will be included in the activity-based costingsystem and how the activities will be measured.

  15. 3-15 Hierarchy of Activities

  16. 3-16 Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment LaborRelated Pool MachineRelated Pool SetupPool ProductionOrder Pool PartsAdmin. Pool GeneralFactory Pool

  17. Second-Stage Allocations $/DLH $/MH $/Setup $/Order $/Part Type $/MH Products Unit-LevelActivity Batch-LevelActivity Product-LevelActivity Facility-LevelActivity 3-17 Graphic Example ofActivity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment LaborRelated Pool MachineRelated Pool SetupPool ProductionOrder Pool PartsAdmin. Pool GeneralFactory Pool

  18.  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. 3-18 Using Activity-Based CostingComtek Sound, Inc.

  19.  For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units. Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor hours.  Both products require two direct labor-hours to complete, for a total of 500,000 direct labor hours. 3-19 Using Activity-Based CostingComtek Sound, Inc.

  20.  Unit costs for materials and labor are: 3-20 Using Activity-Based CostingComtek Sound, Inc.

  21. Predeterminedoverhead rate $10,000,000500,000 DLHs = = $20 per DLH 3-21 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:

  22. 3-22 Direct Labor-Hours as a Base Since each product requires two hours of direct labor, $40 of overhead is assigned to each product.  

  23. 3-23 Learning Objective 2 Compute activity rates for an activity-based costing system.

  24. 3-24 Computing Activity Rates The ABC project team at Comtek hasdeveloped the following basic information.

  25. 3-25 Computing Activity Rates We can calculate the following activity rates: Using the new activity rates, let’s assign overheadto the two products based upon expected activity.

  26. 3-26 Learning Objective 3 Compute product costs using activity-based costing.

  27. 3-27 Computing Overhead Cost per Unit DVD Units

  28. 3-28 Computing Overhead Cost per Unit CD Units

  29. 3-29 Comparing the Two Approaches 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.

  30. 3-30 Learning Objective 4 Contrast the product costs computed under activity-based costing and conventional costing methods.

  31. 3-31 Comparing the Two Approaches The ABC system assigns $14.45 less overhead than the traditional system to each CD player.

  32. 3-32 Comparing the Two Approaches The ABC system assigns $57.80 more overhead than the traditional system to each DVD player.

  33. 3-33 Shifting of Overhead Cost Low-volume product When a company implements activity-based costing, overhead cost often shifts from high-volume to low-volume products with a higher unit product cost resulting for the low-volume products.

  34. 3-34 Shifting of Overhead Cost High-volume product The traditional system assigns the same amount of all overhead costs to each CD or DVD player ($40 per unit).

  35. Production Orders Activity Cost Pool (a batch-level cost pool) The ABC system assigns different amounts ofProduction Order-related overhead costs to each product.This fact can be illustrated in a two-step process. 3-35 Shifting of Overhead Cost 1. Compute the number of units processedper production order for each product.

  36. 3-36 Shifting of Overhead Cost 2. Compute production order cost per unit for each product. Notice, the costs are being shifted from the highvolume CD players to the low volume DVD players.

  37. 3-37 Targeting Process Improvements An ABC system can help identifyareas where the company can benefitfrom improving its current processes. Activity-Based ManagementFocuses on managing activities to eliminate waste and reduce delays and defects.

  38. The Theory of Constraintsapproach targets thehighest impactimprovement opportunities. Activity rates can beused to target areaswhere costs seemexcessively high. Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations. 3-38 Targeting Process Improvements The first step in any improvementprogram is deciding what to improve.

  39. 3-39 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 processimprovement efforts, such as Six Sigma.

  40. 3-40 Limitations of Activity-Based Costing • Costs of implementing an ABC system may outweighthe benefits. However, the benefits are more likely to be worth the costs when: • Products differ substantially in volume, batch size, and in activities required. • Conditions have changed substantially since the existing cost system was established. • Overhead costs are high and increasing and no one seems to understand why. • Management does not trust the existing cost system and it ignores data from it when making decisions.

  41. 3-41 Activity-Based CostingCritical 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.

  42. 3-42 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.

  43. 3-43 Learning Objective 5 Record the flow of costs in an activity-based costing system.

  44. 3-44 Cost Flows in an ABC System Sarvik Company uses activity-based costing. The company has five cost pools shown below.

  45. 3-45 Cost Flows in an ABC System Activity rates are determined as follows:

  46. 3-46 Cost Flows in an ABC System Overhead is applied on the basis of actual activities during the year.

  47. 3-47 Cost Flows in an ABC System • Selected transactions recorded by the company: • Raw materials purchased on account, $915,000. • Raw materials used in production, $900,000 ($810,000 direct and $90,000 indirect). • Factory labor costs, $370,000 ($95,000 direct and $275,000 indirect). • Depreciation of factory assets, $180,000. • Miscellaneous manufacturing overhead costs incurred on account, $230,000. • Manufacturing overhead applied, $761,000. • Goods costing $1,650,000 were manufactured.

  48. 3-48 Cost Flows in an ABC System The following journal entries would be usedto record transactions (a) and (b).

  49. 3-49 Cost Flows in an ABC System The following journal entries would be usedto record transactions (c) and (d).

  50. 3-50 Cost Flows in an ABC System The following journal entry would be used to record transaction (e).

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