Chapter Seven

1. Activity-Based Costing: A Tool to Aid Decision Making Chapter Seven

2. ABC is a good supplement to our traditional cost system 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. I agree!

3. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Manufacturingcosts Nonmanufacturingcosts Traditionalproduct costing ABCproduct costing  ABC assigns both types of costs to products.

4. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Manufacturingcosts Non manufacturingcosts Some Most, butnot all All Traditionalproduct costing ABCproduct costing • ABC does not assign all manufacturing costs to products.

5. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Activity–Based Costing Departmental Overhead Rates Level of complexity Plantwide Overhead Rate Number of cost pools • ABC uses more cost pools.

6. How Costs are Treated UnderActivity–Based Costing ABC differs from traditional cost accounting in three ways. Each ABC cost pool has itsown unique measure of activity. Traditional cost systems usually relyon volume measures such as direct laborhours and/or machine hours to allocateall overhead costs to products. • ABC uses more cost pools.

7. A “cost bucket” in which costs related to a particular activity measure are accumulated. Activity Cost Pool $ $ $ $ $ $ How Costs are Treated UnderActivity–Based Costing An event that causes the consumption of overhead resources. Activity

8. The term cost driver is also used to refer to an activity measure. How Costs are Treated UnderActivity–Based Costing Activity Measure An allocation basein an activity-basedcosting system.

9. Transactiondriver Durationdriver Simple countof the number oftimes an activityoccurs. A measureof the amountof time neededfor an activity. How Costs are Treated UnderActivity–Based Costing Two common types of activity measures:

10. How Costs are Treated UnderActivity–Based Costing ABC definesfive levels of activitythat largely do not relateto the volume of unitsproduced. Traditional cost systems usually rely on volumemeasures such as direct labor hours and/or machinehours to allocate all overhead costs to products.

11. How Costs are Treated UnderActivity–Based Costing Unit-Level Activity Batch-Level Activity Manufacturingcompanies typically combinetheir activities into fiveclassifications. Product-Level Activity Customer-Level Activity Organization-sustaining Activity

12. Classic Brass – An ABC Example Manufacturing overhead is allocated to products usinga single plantwide overhead rate based on machine hours.

13. Define Activities, Activity Cost Pools,and Activity Measures At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

14. Define Activities, Activity Cost Pools,and Activity Measures • 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.

15. Assign Overhead Coststo Activity Cost Pools

16. Assign Overhead Coststo Activity Cost Pools Direct materials, direct labor, and shipping are excludedbecause Classic Brass’ existing cost system can directlytrace these costs to products or customer orders.

17. Assign Overhead Coststo Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity cost pools is determined.

18. Assign Overhead Coststo Activity Cost Pools Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

19. Assign Overhead Coststo Activity Cost Pools Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

20. Assign Overhead Coststo Activity Cost Pools

21. Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . . • 1,000 customer orders, • 400 new designs, • 20,000 machine-hours, • 250 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.

22. Calculate Activity Rates

23. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Traced Traced Traced Cost Objects: Products, Customer Orders, Customers

24. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Cost Objects: Products, Customer Orders, Customers

25. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation CustomerOrders OrderSize Customer Relations Other Product Design Second-Stage Allocations $/Order $/Design $/MH $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated

26. Assigning Overhead to Products Classic Brass Information • Standard Stanchions • Requires no new design resources. • 30,000 units ordered with 600 separate orders. • Each stanchion requires 35 minutes of machinetime for a total of 17,500 machine-hours. • Custom Compass Housing • Requires new design resources. • 400 separate orders. • 400 custom designs prepared. • 1,250 compass housings produced, requiring 2machine-hours each for a total of 2,500 machine-hours.

27. Assigning Overhead to Products

28. Assigning Overhead to Customers Let’s take a look at how Classic Brass system works for just one of the 250 customers – Windward Yachts who placed a total of three orders. • Orders • Two orders for 150 standard stanchions per order. • One order for a custom compass housing. • Machine-hours • The 300 standard stanchions required 175 machine-hours. • The custom compass housing required 2 machine hours.

29. Assigning Overhead to Customers

30. Prepare Management Reports Product Margin Calculations The first step in computing product margins is togather each product’s sales and direct cost data.

31. Prepare Management Reports Product Margin Calculations The second step in computing product margins is toincorporate the previously computed activity-basedcost assignments pertaining to each product.

32. Prepare Management Reports Product Margin Calculations The third step in computing productmargins is to deduct each product’sdirect and indirect costs from sales.

33. Prepare Management Reports Product Margin Calculations The product margins can be reconciled withthe company’s net operating income as follows:

34. Prepare Management Reports Customer Profitability Analysis The first step in computing Windward Yachts’ customer margin is to gather its sales and direct cost data.

35. Prepare Management Reports Customer Profitability Analysis The second step is to incorporate Windward Yachts’ previously computed activity-based cost assignments.

36. Prepare Management Reports Customer Profitability Analysis The third step is to compute Windward Yachts’ customer margin ($699) by deducting all its direct and indirect costs from its sales.

37. Activity-Based Costing and External Reporting Most companies do not use ABCfor external reporting because . . . • External reports are less detailed than internal reports. • It may be difficult to make changes to the company’s accounting system. • ABC does not conform to GAAP. • Auditors may be suspect of the subjective allocation process based on interviews with employees.

38. End of Chapter 8