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Chapter 6

Chapter 6. It’s as simple as…. A B C A ctivity B ased C osting. Quick Review. Direct Materials are easy to accurately assign to products Direct Labor is easy to accurately assign to product. Overhead is often difficult to accurately assign to products. Common Sense. Total OH Cost

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Chapter 6

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  1. Chapter 6

  2. It’s as simple as…. ABC Activity Based Costing

  3. Quick Review Direct Materials are easy to accurately assign to products Direct Labor is easy to accurately assign to product. Overhead is often difficult to accurately assign to products.

  4. Common Sense Total OH Cost # of Units Made = OH Cost per Unit

  5. Why may this not work? • Think back to Your House / My House MY HOUSE - #1 YOUR HOUSE - #3 HOUSE #2

  6. Why may this not work? You told me that you didn’t want to divide the overhead between the three houses. Why? Because My House used more overhead than Your House.

  7. DANGER BIG Overhead $$$$ = Semi-sensible Cost Driver Potentially misleading OH rate

  8. Who Cares? When you go to a fancy restaurant doesn’t it make you nervous when there are no prices on the menu? You want to know how much your meal is going to cost before you order.

  9. Who Cares? Companies want to know the cost of the product before it is produced. Companies have to estimate their costs.

  10. The Normal Process Estimate Overhead Costs & Cost Driver Amounts. This provides the companies with a predetermined overhead rate. The companies then “apply” the overhead. At the end of the period, they will compare “actual” to “applied” – we will discuss this in Chapter 8.

  11. Overhead needs to be allocated in “some logical way” Historically, the most common “logical” way to assign overhead was to use direct labor hours as a cost driver.

  12. Old Days In the “old days” most things were made with a lot of Direct Labor Hours was a good way to allocate overhead Many companies used direct labor hours as the sole base for establishing a companywide allocation rate.

  13. The Development of a Single Company-Wide Cost Driver Traditional cost systems were created whenmanufacturing processes were labor intensive. A single company-wide overhead rate,based on direct labor hours, is usedto allocate overhead to products inthese labor intensive processes.

  14. The Development of a Single Company-Wide Cost Driver Overhead is allocated to jobs using directlabor hours. If overhead is $120, how muchoverhead is allocated to each job?

  15. The Development of a Single Company-Wide Cost Driver Overhead Rate = $120 ÷ 8 direct labor hours Overhead Rate = $15 per direct labor hour Job 1 = 2 hours × $15 per hour = $30 Job 2 = 6 hours × $15 per hour = $90

  16. Labor Intensive Process Overhead costs are relatively small. Overhead allocations may be inaccurate,but the amounts are relatively insignificant. Automated Process Overhead costs are relatively large. Inaccurate overhead allocation can lead to questionable product cost information. The Development of a Single Company-Wide Cost Driver

  17. Automation increasesoverhead from $120 to $420and reduces the Job 2 laborhours from 6 to 1. Allocatethe $420 overhead to the two jobs using direct labor. The Effects of Automation on the Selection of a Cost Driver

  18. The Effects of Automation on the Selection of a Cost Driver Overhead Rate = $420 ÷ 3 direct labor hours Overhead Rate = $140 per direct labor hour Job 1 = 2 hours × $140 per hour = $280 Job 2 = 1 hour × $140 per hour = $140

  19. The Effects of Automation on the Selection of a Cost Driver Is this reasonable? Automation benefited Job 2, but Job 1 isallocated more overhead. Clearly, we needanother cost driver to allocate overhead.

  20. Today • Today automation has cut down on the number of direct labor hours used. • So, direct labor hours is not the best allocation base to use.

  21. Martinez Furniture Company (MFC) makes desks and chairs. Desks require 5 hours of direct labor per unit and chairs require 2 hours per unit. Each month MFC normally uses 500,000 hours of direct labor making desks and 300,000 hours of direct labor making chairs in the course of starting and completing work on 100,000desks and 150,000 chairs. The company incurs $1,088,000 of materials handling cost each month.

  22. What is the most appropriate allocation base? • Labor Hours or Units • Total Direct Labor Hours is most appropriate allocation base = 800,000 hrs • What needs to be allocated? • $1,088,000 – Materials Handling Cost • The allocation is rate is: • $1,088,000 / 800,000 hrs = $1.36 / DLH Desks = $1.36 * 500,000 = $680,000 Chairs = $1.36 * 300,000 = $408,000 $1,088,000

  23. Traditional Cost System OVERHEAD $1,088,000 DESKS $608,000 CHAIRS $408,000

  24. Direct labor hours is a good allocation base as long as both products are labor intensive. • What happens if the production of one of the two products become automated?

  25. New Technology • MFC can now make one desk in 0.4 hrs 40,000 DL hrs to make 100,000 desks 300,000 DL hrs to make 150,000 chairs • Still have $1,088,000 of overhead • Allocate materials using DL hrs

  26. New Results • DLH is now 340,000 (40,000 + 300,000) • Allocation Rate is: • $1,088,000 / 340,000 DLH = $3.20 DLH • Allocated Overhead Costs: • Desks: $3.20 * 40,000 = $128,000 • Chairs: $3.20 * 300,000 = $960,000

  27. Let’s Compare Before Automation Desks = $680,000 Allocated Overhead Chairs = $408,000 Allocated Overhead After Automation Desks = $128,000 Allocated Overhead Chairs = $960,000 Allocated Overhead The desks still require the same amount of materials after automation as they did before automation. So does this seem correct?

  28. Let’s Analyze This caused a shift of $552,000 of overhead cost to the chairs, even though desks still require more materials handling than chairs. Chairs are overcosted Desks are undercosted What happens if this isn’t fixed? Chairs will be sold for too much Desks will be sold for too little

  29. A C B Activity-Based Costing Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.

  30. Activity Based Costing • 2-stage process • 1st – Costs are assigned to pools based on the activities that cause the costs to be incurred Note: Costs are pooled by activity centers • 2nd – Costs in the activity cost pools are allocated to products using a variety of cost drivers • GOAL – Calculate costs in a sensible & accurate manner

  31. ABC System • Must identify essential activities and the costs of performing the activities • Activities • Acquire Raw Materials • Transform Raw Materials • Deliver Products to the Customers

  32. ABC Costing System OVERHEAD $900,000 ACQUIRE RAW MATERIALS $300,000 TRANSFORM RAW MATERIALS $300,000 DELIVERY OF PRODUCTS $300,000 PRODUCT A $300,000 PRODUCT B $300,000 PRODUCT C $300,000

  33. MFC adopts ABC system • Mgmt identified the following activities associated with the materials handling cost • Locating a supplier • Placing an order • Transporting materials from supplier • Inspecting materials for defects • Storing materials in a warehouse • Preparing production requisitions • Issuing materials to the production department

  34. ABC Costing Systems Step 1 Allocation All Overhead $1,088,000 Production Requisitions Storage Issuing Materials Placing an Order Locating a Supplier Step 2 Allocation Product C Product A Product B

  35. It’s the # of Production Requistitions • After analysis MFC concludes it’s the number of production requisitions prepared that is the primary activity that drives the cost of handling materials. • After counting – 4,000 requisitions a month • 2,500 for materials for desks • 1,500 for materials for chairs

  36. New Allocation Base • Now let’s use the # of requisitions as the allocation base • Allocation Rate: • $1,088,000 / 4,000 = $272 / req. • Allocated Materials Handling Cost • Desks: $272 * 2,500 = $680,000 • Chairs: $272 * 1,500 = $408,000 • These allocations are more accurate

  37. ABC Costing System OVERHEAD $1,088,000 PURCHASE REQUISITIONS $1,088,000 DESKS $680,000 CHAIRS $408,000

  38. Let’s Compare • Using Direct Labor Hours • Desks = $128,000 • Chairs = $960,000 • Using # of Purchase Requisitions • Desks = $680,000 • Chairs = $408,000

  39. Some activities don’t add value • MFC’s mgmt team found that the cost incurred by storing materials in a warehouse was a non-value added activity • MFC implemented a Just-in-Time inventory system • This eliminated inventory storage costs such as warehouse rental cost, reporting cost, costs of lost and damaged materials, and processing costs

  40. Monthly Materials Handling Cost Fell from $1,088,000 to $816,000 • MFC filed 5,000 purchase orders / month • 3,000 for materials for desks • 2,000 for materials for chairs • Allocation Rate: • $816,000 / 5,000 orders = $163.20 / order • Allocate Materials Handling Cost • Desks: 3,000 * $163.20 = $489,600 • Chairs: 2,000 * $163.20 = $326,400

  41. A Good Cost Assignment GOAL • Assign resource costs to resource users. As an example, when you go out to eat, the person who orders steak should pay more than the person who orders soup…splitting the bill is unfair.

  42. Putting What We’ve Learned Into Perspective • Traditional costing systems (aka functional-based systems) often work well. • Traditional systems can lead to poor decisions…if you think a product is a money-loser, you disfavor it. • Activity-based costing (ABC) systems improve decision making ability…but ABC systems are costly to operate.

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