ACG 2071: Test 2

dollar sales to attain the target profit

target profit + fixed expenses/ CM ratio

Bench-marking

is a systematic approach to identifying the activities with the greatest room for improvement. It is based on comparing the performance in an organization with the performance of other, similar organizations known for their outstanding performance. If a particular part of the organization performs far below the world-class standard, managers will target that area for improvement.

An activity cost pool

s a "cost bucket" in which costs related to a particular activity measure are accumulated.

dollar sales for a segment to break even

segment traceable fixed expenses/ segment CM ratio

unit sales to attain the target profit

target profit + fixed expenses/ unit CM

The contribution income statement emphasizes

the behavior of costs and therefore is extremely helpful to managers in judging the impact on profits of changes in selling price, cost, or volume.

If the contribution margin is not sufficient to cover the fixed expenses

hen a loss occurs for the period.

Product-level activities

(sometimes called product-sustaining activities) relate to specific products and typically must be carried out regardless of how many batches or units of the product are manufactured. Product-level activities include maintaining inventories of parts for a product, issuing engineering change notices to modify a product to meet a customer's specifications, and developing special test routines when a product is first placed into production.

CM ratio

= Unit contribution margin/ unit selling price

CM ratio

= contribution margin/ sales

Predetermined overhead rate

= estimated total manufacturing overhead/ estimated total amout of the allocation base

profit

=(sales-variable expenses)-fixed expenses

Activity-Based Costing and Service Industries

Although initially developed as a tool for manufacturing companies, activity-based costing is also being used in service industries. Successful implementation of an activity-based costing system depends on identifying the key activities that generate costs and tracking how many of those activities are performed for each service the organization provides. Activity-based costing has been implemented in a wide variety of service industries including railroads, hospitals, banks, and data services companies.

this chapter describes two applications of the contribution format income statements that were introduced in earlier chapters.

First, it explains how manufacturing companies can prepare variable costing income statements, which rely on the contribution format, for internal decision making purposes. The variable costing approach will be contrasted with absorption costing income statements, which are generally used for external reports. Ordinarily, variable costing and absorption costing produce different net operating income figures, and the difference can be quite large. In addition to showing how these two methods differ, we will describe the advantages of variable costing for internal reporting purposes and we will show how management decisions can be affected by the costing method chosen.

Implementing ABC is a major project that requires substantial resources.

First, the cost system must be designed—preferably by a cross-functional team. This requires taking valued employees away from other tasks for a major project. In addition, the data used in the activity-based costing system must be collected and verified. In some cases, this requires collecting data that has never been collected before. In short, implementing and maintaining an activity-based costing system can present a formidable challenge, and management may decide that the costs are too great to justify the expected benefits. Nevertheless, it should be kept in mind that the costs of collecting and processing data have dropped dramatically over the last several decades due to bar coding and other technologies, and these costs can be expected to continue to fall.

Limitations of the ABC Model

The activity-based costing model relies on a number of critical assumptions.1 Perhaps the most important of these assumptions is that the cost in each activity cost pool is strictly proportional to its activity measure. What little evidence we have on this issue suggests that overhead costs are less than proportional to activity.2 Economists call this increasing returns to scale—as activity increases, the average cost drops. As a practical matter, this means that product costs computed by a traditional or activity-based costing system will be overstated for the purposes of making decisions. The product costs generated by activity-based costing are almost certainly more accurate than those generated by a conventional costing system, but they should nevertheless be viewed with caution. Managers should be particularly alert to product costs that contain allocations of facility-level costs. As we shall see later in the book, product costs that include facility-level or organization-sustaining costs can easily lead managers astray.

Modifying the ABC Model

The discussion in this chapter has assumed that companies use an absorption costing approach when they design an activity-based costing system. If the product costs are to be used by managers for internal decisions, some modifications should be made to the absorption approach. For example, for decision-making purposes, the distinction between manufacturing costs on the one hand and selling and administrative expenses on the other hand is unimportant. Managers need to know what costs a product causes, and it doesn't matter whether the costs are manufacturing costs or selling and administrative expenses. Consequently, for decision-making purposes, some selling and administrative expenses should be assigned to products as well as manufacturing costs. Moreover, as mentioned above, facility-level and organization-sustaining costs should be removed from product costs when making decisions. Nevertheless, the techniques covered in this chapter provide a good basis for understanding the mechanics of activity-based costing. For a more complete coverage of the use of activity-based costing in decisions, see more advanced texts.3

Different products place different demands on resources.

This is not recognized by conventional costing systems, which assume that overhead resources are consumed in direct proportion to direct labor-hours or machine-hours. The following example illustrates the distortions in product costs that can result from using a traditional costing system.

Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted.

Thus, it is the amount available to cover fixed expenses and then to provide profits for the period. Notice the sequence here—contribution margin is used first to cover the fixed expenses, and then whatever remains goes toward profits.

The preceding chapter assumed that a single overhead rate, called a plantwide overhead rate, was used throughout an entire factory. This simple approach to overhead assignment can result in distorted unit product costs, as we shall see below.

When cost systems were developed in the 1800s, cost and activity data had to be collected by hand and all calculations were done with paper and pen. Consequently, the emphasis was on simplicity. Companies often established a single overhead cost pool for an entire facility or department as described in Chapter 2. Direct labor was the obvious choice as an allocation base for overhead costs. Direct labor-hours were already being recorded for purposes of determining wages. In the labor-intensive production processes of that time, direct labor was a large component of product costs—larger than it is today. Moreover, managers believed direct labor and overhead costs were highly correlated. (Two variables, such as direct labor and overhead costs, are highly correlated if they tend to move together.) And finally, most companies produced a very limited variety of similar products, so in fact there was probably little difference in the overhead costs attributable to different products. Under these conditions, it was not cost-effective to use a more elaborate costing system. Conditions have changed. Many companies now sell a large variety of products that consume significantly different amounts of overhead resources. Consequently, a costing system that assigns essentially the same overhead cost to every product may no longer be adequate. Additionally, factors other than direct labor often drive overhead costs. On an economywide basis, direct labor and overhead costs have been

dollar sales to break even

fixed expenses/ CM ratio

Batch-level activities

consist of tasks that are performed each time a batch is processed, such as processing purchase orders, setting up equipment, packing shipments to customers, and handling material. Costs at the batch level depend on the number of batches processed rather than on the number of units produced. For example, the cost of processing a purchase order is the same no matter how many units of an item are ordered.

degree of operating leverage

contribution margin/ net operating income

percentage change in net operating income

degree of operating leverage * percentage change in sales

activity-based management

involves focusing on activities to eliminate waste, decrease processing time, and reduce defects. Activity-based management is used in organizations as diverse as manufacturing companies, hospitals, and the U.S. Marine Corps.

common fixed cost

is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Even if a segment were entirely eliminated, there would be no change in a true common fixed cost. For example: The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors. The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the store's various departments—groceries, produce, bakery, meat, and so forth. The cost of the receptionist's salary at an office shared by a number of doctors is a common fixed cost of the doctors. The cost is traceable to the office, but not to individual doctors.

Activity-based costing (ABC)

is a technique that attempts to assign overhead costs more accurately to products than the simpler methods discussed thus far.

break-even point

is the level of sales at which profit is zero.

traceable fixed cost

of a segment is a fixed cost that is incurred because of the existence of the segment—if the segment had never existed, the fixed cost would not have been incurred; and if the segment were eliminated, the fixed cost would disappear. Examples of traceable fixed costs include the following: The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo. The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing. The liability insurance at Disney World is a traceable fixed cost of the Disney World business segment of The Walt Disney Corporation.

break even comuted by

profit= unit CM * Q - Fixed expense

While these assumptions may be violated in practice

the results of CVP analysis are often "good enough" to be quite useful. Perhaps the greatest danger lies in relying on simple CVP analysis when a manager is contemplating a large change in sales volume that lies outside the relevant range. However, even in these situations the CVP model can be adjusted to take into account anticipated changes in selling prices, variable costs per unit, total fixed costs, and the sales mix that arise when the estimated sales volume falls outside the relevant range.

margin of safety in dollars

total budgeted ( or actual) sales - Break-even sales

dollars sales for company to break even

traceable foxed expenses+ common fixed expenses/overall CM ratio

absorption costing

treats all manufacturing costs as product costs, regardless of whether they are variable or fixed. The cost of a unit of product under the absorption costing method consists of direct materials, direct labor, and both variable and fixed manufacturing overhead. Thus, absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing costs. Because absorption costing includes all manufacturing costs in product costs, it is frequently referred to as the full cost method.

variable expenses ratio

variable expenses/ sales

unit sales to break even

fixed expenses/ unit CM

The activity measure

expresses how much of the activity is carried out and it is used as the allocation base for assigning overhead costs to products and services. For example, the number of patients admitted is a natural choice of an activity measure for the activity admitting patients to the hospital.

sales mix

refers to the relative proportions in which a company's products are sold.

Facility-level activities

(also called organization-sustaining activities) are activities that are carried out regardless of which products are produced, how many batches are run, or how many units are made. Facility-level costs include items such as factory management salaries, insurance, property taxes, and building depreciation. These costs cannot be traced on a cause-and-effect basis to individual products. Therefore, companies that choose to implement an activity-based absorption costing system will be required to arbitrarily allocate facility-level cost to products. As we will see later in the book, these types of arbitrary allocations can lead to bad decisions.

Note that this contribution income statement

has been prepared for management's use inside the company and would not ordinarily be made available to those outside the company.

change in contribution margin

=CM ratio* change in sales

change in profit

=CM ratio* change in sales - change in fixed expenses

Activity-based costing improves the accuracy of product costs in three ways.

First, activity-based costing usually increases the number of cost pools used to accumulate overhead costs. Rather than accumulating all overhead costs in a single, plantwide pool, or accumulating them in departmental pools, the company accumulates costs for each major activity. Second, the activity cost pools are more homogeneous than departmental cost pools. In principle, all of the costs in an activity cost pool pertain to a single activity. In contrast, departmental cost pools contain the costs of many different activities carried out in the department. Third, activity-based costing uses a variety of activity measures to assign overhead costs to products, some of which are correlated with volume and some of which are not. This differs from conventional approaches that rely exclusively on direct labor-hours or other measures of volume such as machine-hours to assign overhead costs to products.

Under activity-based costing, the manufacturing overhead costs at the top of EXHIBIT 3-3 are allocated to products via a two-stage process

In the first stage, overhead costs are assigned to the activity cost pools. In the second stage, the costs in the activity cost pools are allocated to products using activity rates and activity measures. For example, in the first-stage cost assignment, various manufacturing overhead costs are assigned to the production-order activity cost pool. These costs could include the salaries of engineers who modify products for individual orders, the costs of scheduling and monitoring orders, and other costs that are incurred as a consequence of the number of different orders received and processed by the company. We will not go into the details of how these first-stage cost assignments are made. In all of the examples and assignments in this book, the first-stage cost assignments have already been completed. Once the amount of cost in the production-order activity cost pool is known, the activity rate for the cost pool is computed by dividing the total cost in the production-order activity cost pool by the anticipated number of orders for the upcoming year. For example, the total cost in the production-order activity cost pool might be $450,000 and the company might expect to process a total of 1,200 orders. In that case, the activity rate would be $375 per order. Each order would be charged $375 for production-order costs. This is no different from the way overhead was assigned to products in Chapter 2 except that the number of orders is the allocation base rather than direct labor-hours.

When are the benefits of activity-based costing most likely to be worth the cost? Companies that have some of the following characteristics are most likely to benefit from activity-based costing:

Products differ substantially in volume, batch size, and in the activities they require. 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 ignores cost data from the system when making decisions.

To simplify CVP calculations, managers typically adopt the following assumptions with respect to these factors:

Selling price is constant. The price of a product or service will not change as volume changes. Costs are linear and can be accurately divided into variable and fixed elements. The variable element is constant per unit. The fixed element is constant in total over the entire relevant range. In multiproduct companies, the mix of products sold remains constant.

ost-volume-profit (CVP) analysis helps managers make many important decisions such as what products and services to offer, what prices to charge, what marketing strategy to use, and what cost structure to maintain. Its primary purpose is to estimate how profits are affected by the following five factors:

Selling prices. Sales volume. Unit variable costs. Total fixed costs. Mix of products sold

Its primary purpose is to estimate how profits are affected by the following five factors:

Selling prices. Sales volume. Unit variable costs. Total fixed costs. Mix of products sold.

An activity in activity-based costing is an event that causes the consumption of overhead resources. Examples of activities in various organizations include the following:

Setting up machines. Admitting patients to a hospital. Scheduling production. Performing blood tests at a clinic. Billing customers. Maintaining equipment. Ordering materials or supplies. Stocking shelves at a store. Meeting with clients at a law firm. Preparing shipments. Inspecting materials for defects. Opening an account at a bank.

Companies use three common approaches to assign overhead costs to products.

The simplest method is to use a plantwide overhead rate. A slightly more refined approach is to use departmental overhead rates. The most complex method is activity-based costing, which is the most accurate of the three approaches to overhead cost assignment.

An activity rate is

an overhead rate in an activity-based costing system. Each activity has its own activity rate that is used to assign overhead costs to cost objects.

Unit-level activities

are performed each time a unit is produced. The costs of unit-level activities should be proportional to the number of units produced. For example, providing power to run processing equipment is a unit-level activity because power tends to be consumed in proportion to the number of units produced.

segment margin

is obtained by deducting the traceable fixed costs of a segment from the segment's contribution margin. It represents the margin available after a segment has covered all of its own costs. The segment margin is the best gauge of the long-run profitability of a segment because it includes only those costs that are caused by the segment. If a segment can't cover its own costs, then that segment probably should be dropped (unless it has important side effects on other segments). Notice, common fixed costs are not allocated to segments.

While this method of computing costs is fast and simple,

it is accurate only in those situations where other factors affecting overhead costs are not significant.

cost-volume-profit (CVP) analysis helps

managers make many important decisions such as what products and services to offer, what prices to charge, what marketing strategy to use, and what cost structure to maintain.

margin of safety percentage

margin of safety in dollars/ total budgeted (or actual) sales in dollars

variable costing

only those manufacturing costs that vary with output are treated as product costs. This would usually include direct materials, direct labor, and the variable portion of manufacturing overhead. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and, like selling and administrative expenses, it is expensed in its entirety each period. Consequently, the cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost. Variable costing is sometimes referred to as direct costing or marginal costing.

When a company implements activity-based costing,

overhead cost often shifts from high-volume products to low-volume products, with a higher unit product cost resulting for the low-volume products