Accounting 231: Chapter 4- Activity Based Costing
Activity-Based Costing (ABC) Examples of Activities: Activity -->
--> An event that causes the consumption of overhead resources.
Designing an Activity-Based Costing System - Challenges:
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.
Activity-Based Costing (ABC) Examples of Activities: Examples of Activities:
- Setting up machines - Admitting hospital patients - Billing customers - Opening a bank account
Direct Labor-Hours as a Base - Total Unit Cost: Since each product requires two hours of direct labor, $40 of overhead is assigned to each product.
*Manufacturing overhead: (2 DHLs x $20 per DHL)= 40 PHONE UNITS: - Direct materials: $90 - Direct labor: $20 - Manufacturing Overhead: $40 ---------------------------- - Unit product cost: $150 GPS Units: - Direct materials: $50 - Direct labor: $20 - Manufacturing overhead: $40 ----------------------------- - Unit product cost: $110
Computing Overhead Cost per Unit - Phone Units:
*PICTURE W/ INFO ON SLIDE 27* Activity and Activity Measures: Expected Activity x Activity Rate = Amount
Computing Overhead Cost per Unit - GPS Units
*PICTURE W/ INFO ON SLIDE 28* Activity and Activity Measures: Expected Activity x Activity Rate = Amount
Comparing the Two Approaches: Activity-Based Costing vs. Direct Labor Costing
*PICTURE W/ INFO ON SLIDE 29* Note that the unit product cost of a GPS unit decreased from $110 to $95.55 . . . . . . . . while the unit cost of a phone unit increased from $150 to $207.80.
Comparing the Two Approaches - GPS Units:
*PICTURE W/ INFO ON SLIDE 31* Looking at Manufacturing overhead, GPS Units... ABC= 25.55 DLC= 40 The ABC system assigns $14.45 less overhead than the traditional system to each GPS unit.
Comparing the Two Approaches - Phone Units:
*PICTURE W/ INFO ON SLIDE 32* Looking at Manufacturing overhead, Phone Unit... ABC= 97.80 DLC= 40 The ABC system assigns $57.80 more overhead than the traditional system to each phone unit.
Computing Activity Rates - Basic Information: The ABC project team at Comtek has developed the following basic information.
*picture w/ info on Slide 24*
Activity-Based Costing (ABC) - Definition:
- A technique that attempts to assign overhead costs more accurately to products. - It uses multiple allocation bases for assigning costs to products. - Each base represents a major activity. - Activity is an event that causes consumption of overhead resources.
Graphic Example of Activity-Based Costing - Stage 2: ... > Second-Stage Allocations: 1/2
- Labor-Related Pool $/DLH - Machine-Related Pool $/MH - Machine Setup Pool $/Setup - Production Order Pool $/Order - Parts Admin. Pool $/Part Type - General Factory Pool $/MH
Graphic Example of Activity-Based Costing - Stage 1: Various Manufacturing Overhead Costs: > First-Stage Cost Assignment:
- Labor-Related Pool - Machine-Related Pool - Machine Setup Pool - Production Order Pool - Parts Admin. Pool - General Factory Pool
Departmental Overhead Rates- Definition: Many companies have a system in which each department has its own overhead rate.
- Matching Department - Assembly Department - Shipping Department The allocation base depends on the nature of the work performed in each department. In the machining department, overhead may be based on machine-hours, but in the assembly department, overhead may be based on direct labor-hours.
Using Activity-Based Costing Comtek, Inc.- Items (1-3):
1. Comtek, Inc., makes two products: GPS systems and Phone systems. 2. The company has been losing bids to supply GPS systems to lower-priced competitors. 3. The company has been winning all bids to supply Phone systems.
Activity-Based Costing (ABC) Process:
1. Cost Objects (e.g., products and customers) 2. Activities 3. Consumption of Resources 4. Consumption of Resources Incur Cost
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.
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.
Benefits of Activity-Based Costing: ABC improves the accuracy of product costing by:
1. Increasing the number of cost pools used to accumulate overhead costs. 2. Using activity cost pools that are more homogeneous than departmental cost pools. 3. Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor-hours. 4. Activity-based costing also highlights activities that could benefit most from process improvement efforts.
Plantwide Overhead Rate - Disadvantages: 1/2 Today, direct labor may no longer be a satisfactory base for allocation of overhead.
1. Most companies sell a large variety of products that consume differing amounts of overhead. 2. As a percentage of total costs, direct labor has been declining and overhead has been increasing. Many of these growing overhead costs may not be correlated with direct labor. 3. Technology advancements have reduced the cost and complexity of gathering diverse sources of data.
Limitations of ABC Model - (1-4): Costs of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when:
1. Products differ substantially in volume, batch size, and in activities required. 2. Conditions have changed substantially since the existing cost system was established. 3. Overhead costs are high and increasing and no one seems to understand why. 4. Management does not trust the existing cost system and it ignores data from it when making decisions.
Using Activity-Based Costing Comtek, Inc.- Items (4-6):
4. For the current year, Comtek has budgeted sales of 50,000 phone units and 200,000 GPS units. 5. Comtek's traditional cost system applies manufacturing overhead to products based on direct labor-hours. 6. Both products require two direct labor-hours to complete. Phones: 50,000 units @ 2hrs per unit= 100,000 hours GPSs: 200,000 units @ 2hrs per unit= 400,000 Total direct labor-hours: 500,000 hours
Using Activity-Based Costing Comtek, Inc. - Item (7):
7. Unit costs for materials and labor are: PHONE UNITS: - Direct materials: $90 - Direct labor: $20 GPS Units: - Direct materials: $50 - Direct labor: $20
Activity-Based Costing (ABC) 3 categories:
> Activity Cost Pool > Activity Measure > Activity Rate
Hierarchy of Activities: Levels-
> Unit-level > Batch-level > Product-level > Facility-level
> Activity Cost Pool:
A "cost bucket" in which costs related to a particular activity are accumulated.
Plantwide Overhead Rate - Disadvantages: 2/2
A plantwide overhead allocation system may not be optimal for many companies in today's business environment.
> Activity Rate:
A predetermined overhead rate for each activity cost pool.
Activity-Based Costing (ABC) Similarities to Job-Order Costing: For each activity in isolation, this system works exactly like the job-order costing system described in previous chapters.
A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product.
Plantwide Overhead Rate:
A single overhead rate that is used throughout an entire factory.
> Facility-level:
ACTIVITIES: 1. General factory administration 2. Plant building and grounds. ACTIVITY MEASURE: 1. Direct labor-hours 2. Direct labor-hours
> Batch-level:
ACTIVITIES: 1. Processing purchase orders 2. Processing production orders 3. Setting up equipment 4. Handling Materials ACTIVITY MEASURE: 1. Purchase orders processed 2. Production orders processed 3. Number of setups 4. Pounds of material handled
> Unit-level:
ACTIVITIES: 1. Processing units on machines 2. Processing units by hand 3. Consuming factory supplies ACTIVITY MEASURE: 1. Machine-hours 2. Direct labor-hours 3. Unites Produces
> Product-level:
ACTIVITIES: 1. Testing new products 2. Administering part inventories 3. Maintaining inventories ACTIVITY MEASURE: 1. Hours of testing time 2. Number of part types 3. Hours of design time
Targeting Process Improvements - Step 1: The first step in any improvement program is deciding what to improve:
Activity Rates: can be used to target areas where costs seem excessively high Benchmarking: can be used to compare activity cost information with world-class standards of performance achieved by other organizations
LO2:
Compute activity rates for an activity-based costing system.
LO3:
Compute product costs using activity-based costing.
LO4:
Contrast the product costs computed under activity-based costing and conventional costing methods.
Departmental Overhead Rates - Disadvantages:
Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs. ... The departmental approach relies on a single measure of activity as allocation base while some overhead costs may be caused by factors that are not directly proportional to the volume of production. ... Activity-based costing is used to account for these other factors and more accurately assigns overhead costs to products.
> Activity Measure:
Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs.
Shifting of Overhead Cost - ABC vs. Traditional System: High-volume product=
GPS Units The traditional system assigns the same amount of all overhead costs to each Phone or GPS unit ($40 per unit).
Shifting of Overhead Cost Volume Products: Low-volume product=
Phone-Unit When a company implements activity-based costing, overhead cost shifts FROM HIGH-VOLUME TO LOW-VOLUME PRODUCTS with a higher unit product cost resulting for the low-volume products.
Direct Labor-Hours as a Base - DLH: Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon direct labor-hours:
Predetermined overhead rate = $10,000,000 / $500,00 DLHs= $20 per DLH
Designing an Activity-Based Costing System - Combining Activities:
Related activities are frequently combined to reduce the amount of detail and record-keeping costs. - For example, several actions may be involved in handling and moving raw materials, but these may be combined into a single activity titled material handling.
Graphic Example of Activity-Based Costing - Stage 2: ... > Second-Stage Allocations: 2/2 ---> Products:
UNIT-LEVEL ACTIVITY: - Labor-Related Pool - Machine-Related Pool BATCH-LEVEL ACTIVITY: - Machine Setup Pool - Production Order Pool PRODUCT-LEVEL ACTIVITY: - Parts Admin. Pool FACILITY-LEVEL ACTIVITY: - General Factory Pool
LO1:
Understand the basic approach in activity-based costing and how it differs from conventional costing.
Activity dictionary:
defines each of the activities that will be included in the activity-based costing system and how the activities will be measured.
Computing Activity Rates - Activity Rates: How to calculate an activity rate for each of the 6 activities:
estimated overhead for an activity / the total expected activity
Targeting Process Improvements Activity-Based Management: An ABC system can help:
identify areas where the company can benefit from improving its current processes.
Targeting Process Improvements Activity-Based Management: Activity-Based Management focuses on:
managing activities to eliminate waste and reduce processing time and defects