lecture 5 accting 255 mgt acc ii 2011
TRANSCRIPT
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Week 5 LectureActivity-Based
Costing
Chapter 7:
Activity-Based Costing (ABC)
and
Activity-Based Management
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Cost Allocation
Assigning indirect costs to costobjects
These costs are not traced
Indirect costs often comprise a largepercentage of total costs
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Purposes of Cost Allocation
1. To provide information for economicdecisions
2. To motivate managers/employees
3. To compute/justify costs
4. To measure income and assets
Traditional costing systems may not yield thecosts necessary to meet the four-purposes for
cost allocation (above)
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(c) 2009 Pearson Prentice Hall. All rights reserved.
Six-Function Value Chain
Costs necessary for decision-making maypull costs from some or all of the abovesix value chain functions
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5Criteria for Guiding
Cost-Allocation Decisions
1. Cause-and-effect: variables areidentified that cause resources to beconsumed
Most credible to operating managers
Integral part of activity based costing(ABC)
2. Benefits received: the beneficiariesof the outputs of the cost object arecharged with costs in proportion tothe benefits received
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6Criteria for Guiding
Cost-Allocation Decisions
3. Fairness (Equity): the basis for establishing aprice satisfactory to the customer
Cost allocation here is viewed as areasonable or fair means of
establishing selling price
4. Ability to bear: costs are allocated inproportion to the cost objects ability to bear
them:
Generally, larger or more profitableobjects receive proportionally more of theallocated costs
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Background
Recall that factory overhead is applied toproduction in a rational systematic mannerusing some type of averaging
There are a variety of methods to accomplishthis goal:These methods often involve trade-offs between
simplicity and realism
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Broad Averaging
Historically, firms produced a limitedvariety of goods while their indirect costswere relatively small
Allocating overhead costs was simple:
Use broad averages to allocate costsuniformly regardless of how they areactually incurred
Peanut butter costing
End-result:
overcosting and undercosting
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Over and Undercosting
Overcosting: a product consumes a lowlevel of resources but is allocated highcosts per unit
Undercosting: a product consumes a highlevel of resources but is allocated low costsper unit
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Slide
10Limitations of Traditional Costing Systems
Volume-BasedPlantwide
Rate
DepartmentalRate Activity
BasedCosting
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11Limitations of Traditional Costing Systems
Plantwideallocation
is simple but doesnot consider other
activities
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12Limitations of Traditional Costing Systems
A Departmental rateprovides more detailed cost
measures, particularly ifthe departments performquite different activities
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13Limitations of Traditional Costing Systems
I need to know more about ABCbefore I make my decision. It lookslike my decision will be based on
a careful cost-benefit analysis
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In the past, the direct cost component (e.g.direct labour) constituted a high percentage of the
total product cost, whereas the indirect costcomponent constituted a small percentage:
Thus, the allocation of indirect costsaccording to the traditional approach (e.g.
direct work hours or machine hours) did not
cause significant distortion in the decision
about pricing of products
Weight of indirect costs in product costs in the past
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Recently, the weight of indirect costs has
increased, now reaching a crucial part of total
production costs:
So, the allocation of indirect costs according
to the traditional approach has caused
considerable distortion in the costing of
products
Weight of indirect costs in product costsat present time
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Problems with traditional cost allocation
Arbitrariness:usually no single correct base
Smell test:managers know instinctively that simple
allocations are deficient
Cost cross-subsidization:products that use proportionately more of
allocation basis bear unfair share. Subsidizeother products
Spiral Death: retained products must carry more excess
capacity costs and may be dropped due toreduced profitability
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17Reasons for increased demand for
improved cost allocation
Increased competition with declining margins:Emphasis on improved productivityNeed for more accurate measurements
Increased automation and service content:Overhead a larger percentage of total costs
Deregulation, globalization of competition, and rapid
technological change: Increase demand for precise, timely profitabilityinformation for strategic purposes
Computerized information systems:Reduces cost of more detailed cost allocation
Decentralization of profit responsibility:Requires accurate measurement of subunit profits
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Companies more likely to benefit from
ABC
produce multiple, heterogeneous products
highly decentralized
have diverse customers and markets
use a variety of distribution channels
have relatively stable production andmarket environment
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How Costs are Treated UnderActivityBased Costing
ABC differs from traditional cost accounting in three ways
Manufacturingcosts
Nonmanufacturing
costs
ABC assigns both types of costs to products
Traditionalproduct costing
ABCproduct costing
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How Costs are Treated UnderActivityBased Costing
ABC does not assign all manufacturing costs to products
Manufacturingcosts
Nonmanufacturing
costs
Traditionalproduct costing
ABCproduct costing
All
Som
e
ABC differs from traditional cost accounting in three ways
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How Costs are Treated UnderActivityBased Costing
PlantwideOverhead
Rate
DepartmentalOverhead
Rates
ActivityBasedCosting
Number of cost pools
Levelofcomplexity
ABC uses more cost pools
ABC differs from traditional cost accounting in three ways
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How Costs are Treated UnderActivityBased Costing
ABC uses more cost pools
Each ABC cost pool has itsown unique measure of activity
ABC differs from traditional cost accounting in three ways
Traditional cost systems usually relyon volume measures such as direct laborhours and/or machine hours to allocate
all overhead costs to products
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Activity-Based Costing
ABC is a costingapproach thatassigns costs toproducts or servicesbased on theirconsumption of theresource caused bythe activities
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Single Plantwide Overhead Rate
Dole Company has two factories Alpha and Beta. Alphais a highly automated factory while Beta is a labor-
intensive factory. The company uses a single plantwideoverhead rate based upon labor hours
Annual Budget Data
Alpha
Division
Beta
Division Total
Budgeted overhead 400,000$ 200,000$ 600,000$
Budgeted labor hours 10,000 50,000 60,000
Budgeted machine hours 20,000 40,000 60,000
Single PlantwideOverhead Rate
$600,00060,000
= $10 per labor hour=
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Single Plantwide Overhead Rate
During the first month of operations the company has thefollowing information for it two products Widget and Gidget
Alpha
Division
Beta
Division
Widget:
Labor hours 500 4,000
Machine hours 800 200
Gidget:
Labor hours 500 1,000
Machine hours 1,200 400
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Single Plant-wide Overhead Rate
Using the plantwide rate, factory overhead is applied to thetwo products as shown below.
Widget Gidget
Alpha Division:
$10 x 500 5,000$
$10 x 500 5,000$Beta Division:
$10 x 4,000 40,000
$10 x 1,000 10,000
Ove rhe ad a ppl ie d 45,000$ 15,000$
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Departmental Overhead Rates
To obtain more accurate product costing the companydecided to use departmental overhead rates. The overhead
in Alpha is to based on machine hours, and Beta will uselabor hours.
Alphas Departmental
Overhead Rate$400,000
20,000= $20 per machine hour=
Betas Departmental
Overhead Rate
$200,000
50,000
= $4 per labor hour=
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Departmental Overhead Rates
Using the new departmental overhead rates, overhead
would be allocated to the two products as shown below:Widget Gidget
Alpha Disision:
$20 x 800 16,000$
$20 x 1,200 24,000$
Beta Division:
$4 x 4,000 16,000
$4 x 1,000 4,000
Overhead applied 32,000$ 28,000$
Applied overhead will be $13,000 lower for Widget and$13,000 higher for Gidget as a result of using departmental
rates rather than a plantwide rate
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First stage
Second stage
Traditional
Resource Costs
Cost Pools:Plants or
Departments
Cost Objects
First stage
Second stage
Activity-Based
Resource Costs
Cost Objects
Cost Pools:Activities or
Activity Centers
Two-Stage Allocation Procedures
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Summary
Activity 1 Activity 2 Activity 5Activity 3 Activity 4Indirect
Cost pool
Activity
Cost
Driver 1
Activity
Cost
Driver 2
Activity
Cost
Driver 3
Activity
Cost
Driver 4
Activity
Cost
Driver 5
Allocation
Rate 1
Allocation
Rate 2
Allocation
Rate 3
Allocation
Rate 4
Allocation
Rate 5
COST OBJECT
DIRECT
LABOUR
DIRECT
MATERIALS
Activity 1Total # Driver 1
Activity 2Total # Driver 2
Activity 3Total # Driver 3
Activity 4Total # Driver 4
Activity 5Total # Driver 5
DIRECT
Up-stream
Down streamProcurement costs
Transaction processing costs
Indirect
Cost
Allocation
Base
DirectCosts
Resource Indirect Cost Pool
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31Steps in Designing an
ABC System
Identify resource costs andactivities
Assign resource costs to activities
Assign activity costs to cost objects
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Cost Hierarchies
ABC uses a four-level cost structure todetermine how far down the productioncycle costs should be pushed:
Unit-level (output-level)
Batch-level
Product-sustaining-level
Facility-sustaining-level
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33Activity-based hierarchy of costs and
activities
Unit-level activity An activity that isperformed for each unit of production(direct materials, direct labor hours,inserting a component)
Batch-level activity An activity that isperformed for each batch of products ratherthan for each unit of production (machinesetup, purchase ordering, productionscheduling)
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34Activity-based hierarchy of costs
and activities
Product-sustaining activity An activitythat is performed to support the productionof a given product (product design, partsadministration, issuance of engineeringchange orders, expediting)
Facility-sustaining activity An activity thatis performed to sustain the production ofproducts in general (security, safety, rent,maintenance, plant management)
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Materials purchasing
Direct labor support
Machine operation
Setup
Production orderMaterials handling
Parts administration
General and admin-
istrative
Identify these
activities as:
(1) Unit,
(2) Batch,
(3) Product, or
(4) Facility
Sample Activity Drivers at a Manufacturing Firm
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Sample Activity Drivers at a Manufacturing Firm
Materials purchasing
Direct labor support
Machine operation
Setup
Production order
Materials handling
Parts administration
General & administrative
UnitUnitUnitBatchBatchBatchProductFacility
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Identify resource costs andactivities
Assign resource costs to activities
Assign activity costs to cost objects
Steps in Designing an
Activity-Based Costing System
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Typical Resource Drivers
Meters for utilities
Number of employees for payroll-relatedactivities
Number of setups for the machine setup
activity Number of moves for the material handling
activity
Machine hours for machine power runningactivities
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Identify resource costs andactivities
Assign resource costs to activities
Assign activity costs to cost objects
Steps in Designing an
Activity-Based Costing System
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Activity Driver
Materials purchasing Material costDirect labor support Direct labor cost
Machine operation Machine hours
Setup Setup hours
Production orders Number of orders
Material handling Number of loads
Part administration Number of parts
General and administrative Amount of value-added
Activity Drivers at a Manufacturing Firm
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Expensive to developand implement
Time-consuming
Activity-Based Costing
It provides moreaccurate andinformative productcosts
It provides managerswith easier access torelevant costs
Benefits Limitations
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42Lecture example: Traditional Cost vs. ABC
Wombat company has identified the following overhead activities, costs and cost
drivers for the coming year:
Activity Expected
cost
Cost driver Activity
capacity
Setup costs $60 000 Number of setups 300
Ordering costs 45 000 Number of orders 4 500
Machine costs 90 000 Machine hours 18 000
Receiving 25 000 Number of parts 50 000
The following two jobs were completed during the year:
Job 600 Job 700
Direct material $750 $850
Direct labour (50 hours per job) $600 $600
Units completed 100 50
Number of setups 1 1
Number of orders 4 2
Machine hours 20 30
Parts used 20 40
The company's normal activity is 4000 direct labour hours (DLH).
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Traditional (volume-based) costing approach
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44Activity-based costing approach
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Conclusions
Each method is mathematically correct
Each method is acceptable (?)
Each method yields a different cost figure,which will lead to different gross margincalculations
Only overhead is involved:Total costs for the entire firm remain the
same (they are just allocated to differentcost objects within the firm)
Selection of the appropriate method andcost drivers should be based onexperience, and a cost-benefit analysis ofeach option under consideration
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A Cautionary Tale
A number of critical decisions can
be made using this information:Should one product be pushed over
another?
Should one product be dropped?
Accounting for overhead costs is animprecise science:
Best efforts should be put forward toarrive at a cost that is fair andreasonable
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Rationale for selecting a more refined
costing system:
Increase in product diversity:
Growing demand for customised productshas led to product diversity (i.e. productsdemand a different level of resources)
Increase in indirect costs:Due to modern technology
Advances in information technology:Makes it easier to assign/estimate costs to
products
Competition in foreign markets:
Need for more accurate cost information
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ABC vs. Simple Costing Schemes
ABC is generally perceived to producesuperior costing figures due to the use ofmultiple cost drivers across multiplelevels
But remember, ABC is only as good as thecost drivers selected and their actualrelationship to costs:
Poorly chosen cost drivers will produceinaccurate costs, even with ABC!
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Signals that suggest that ABC
implementation could help a
firm:
Significant overhead costs allocated using oneor two cost pools
Most or all overhead is considered unit-level
Products that consume different amounts ofresources
Products that a firm should successfully makeand sell consistently show small profits
Operations staff disagreeing with accountingover manufacturing and marketing costs
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50ABC and Service / Merchandising
Firms
ABC implementation is widespread ina variety of applications outsidemanufacturing, including:
Health Care
BankingTelecommunications
Retailing
Transportation
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Activity-Based Management
A method of management that uses ABC asan integral part in critical decision-makingsituations, including:
Pricing and product-mix decisions
Cost reduction and process improvementdecisions
Design decisions
Planning and managing activities