Chapter 5

Activity-Based Costing

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Traditional, Volume-Based Product-Costing System

Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records:
Mode I Production: Units Runs 10,000 1 run of 10,000 units Mode II 20,000 4 runs of 5,000 units Mode III 4,000 10 runs of 400 units

Traditional, Volume-Based Product-Costing System

Direct materials Direct labor Manufacturing overhead Total $ Mode I 50.00 60.00 99.00 209.00 Mode II $ 90.00 80.00 132.00 $ 302.00 Mode III $ 20.00 40.00 66.00 $ 126.00

Additional information includes:

Direct materials Direct labor (hr/board) Setup time (hr/run) Machine time (hr/board) $ Mode I 50.00 3 10 1 Mode II $ 90.00 4 10 1.25 Mode III $ 20.00 2 10 2

Manufacturing overhead is determined as follows

Traditional, Volume-Based Product-Costing System

Units produced Direct labor (hr/unit) Total hours Total hours required Mode I 10,000 3 30,000 Mode II 20,000 4 80,000 118,000 Mode III 4,000 2 8,000

Budgeted manufacturing overhead Budgeted direct-labor hours

Mode I Direct labor (hr/unit) Overhead rate per hour Overhead per unit $ $

$3,894,000 118,000
Mode II 3 33 99 $ $

= $33 per hour

Mode III 4 33 132 $ $ 2 33 66

Traditional, Volume-Based Product-Costing System

With these product costs, Aerotech established target selling prices (Cost 125%).
Direct materials Direct labor Manufacturing overhead Total $ Mode I Mode II Mode III 50.00 $ 90.00 $ 20.00 60.00 80.00 40.00 99.00 132.00 66.00 209.00 $ 302.00 $ 126.00

Cost per unit Target selling price

Mode I 209.00 261.25

Mode II $ 302.00 377.50

Mode III $ 126.00 157.50

209.00 x 1.25

Learning Objective 2

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Activity Based Costing System

(ABC)
ABC systems follow a twostage procedure to assign overhead costs to products.
Assigning overhead to products is a difficult process.

I agree!

Activity Based Costing System

(ABC)
ABC systems follow a two-stage procedure to assign overhead costs to products.
Lets begin by identifying our major activities.

Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.

Activity Based Costing System

(ABC)
ABC systems follow a two-stage procedure to assign overhead costs to products.
Overhead assigned to activities are called activity cost pools.

Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products.

Learning Objective 3

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Overhead Costs
Total budgeted cost = $3,894,000
Activity must be done on each unit produced.

Activity Cost Pools

Identification of Activity Cost Pools

Unit Level
Machinery cost pool $1,212,600
Activity performed on each batch produced.

Batch Level
Setup cost pool $3,000

ProductSustaining Level
Engineering cost pool $700,000

Facility Level
Facility cost pool $507,400

Activities needed to support an entire product line

Activity required in order for the production process to occur.

Unit Level Machinery cost pool $1,212,600

Batch Level Setup cost pool $3,000 Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000

ProductSustaining Level Engineering cost pool $700,000

Facility Level Facility cost pool $507,400

Learning Objective 4

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

STAGE ONE
Various overhead costs related to machinery

Maintenance Depreciation Computer Support

Lubrication Electricity Calibration

Activity cost pool

Machinery Cost Pool

Total budgeted cost = $1,212,600

STAGE TWO
Calculate the pool rate
Budgeted Machinery Costs = $1,212,600 Budgeted Machine Hours 43,000 = $28.20/hour

Cost Assignment

Mode I: $28.20 per hr. 1 hr. per unit $28.20 per unit

Mode II: $28.20 per hr. 1.25 hr. per unit $35.25 per unit

Mode III: $28.20 per hr. 2 hr. per unit $56.40 per unit

STAGE ONE
Calculation of total setup cost
Total budgeted setup cost $20 per hour 10 hr. per setup $200 cost per setup 15 production runs $ 3,000 Total

Activity cost pool

Setup Cost Pool

Total budgeted cost = $3,000

STAGE TWO
Calculate the pool rate
Budgeted Setup Costs Planned Production Runs = $3,000 15 runs = $200 per run

Cost Assignment

Mode I: (1 Run) $200 per run 10,000 units per run = $.02 per unit

Mode II: (4 Runs) $200 per run 5,000 units per run = $.04 per unit

Mode III: (10 Runs) $200 per run 400 units per run = $.50 per unit

STAGE ONE
Various overhead costs related to engineering
Engineering salaries Engineering supplies Engineering software Depreciation

Activity cost pool

Engineering Cost Pool

Total budgeted cost = $700,000

STAGE TWO
Allocate based on engineering transactions

Engineering Cost Pool

Total budgeted cost = $700,000

Cost Assignment

Mode I: 25% $700,000 10,000 units = $17.50 per unit

Mode II: 45% $700,000 20,000 units = $15.75 per unit

Mode III: 30% $700,000 4,000 units = $52.50 per unit

STAGE ONE
Various overhead costs related to general operations
Plant depr.
Plant mgmt. Plant maint.

Exh. 5-9

Property taxes
Insurance Security

Activity cost pool

Facility Cost Pool

Total budgeted cost = $507,400

STAGE TWO
Calculate the pool rate
Budgeted Facilities Cost = $507,400 Budgeted Direct-Labor Hours 118,000 = $4.30/hour

Exh. 5-9

Cost Assignment

Mode I: $4.30 per hr. 3 hr. per unit $12.90 per unit

Mode II: $4.30 per hr. 4 hr. per unit $17.20 per unit

Mode III: $4.30 per hr. 2 hr. per unit $8.60 per unit

Other Overhead Costs

Re c e ivin g an d In s pe c t ion Cos t P ool
Board Mode I Mode II Mode III Ove rh e ad $ 200,000 200,000 200,000 % 6% 24% 70% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 1.20 = 2.40 = 35.00

Mat e rial-Han dlin g Cos t P ool

Board Mode I Mode II Mode III Ove rh e ad $ 600,000 600,000 600,000 % 7% 30% 63% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 4.20 = 9.00 = 94.50

Qu alit y-As s u ran c e Cos t P ool

Board Mode I Mode II Mode III Ove rh e ad $ 421,000 421,000 421,000 % 20% 40% 40% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 8.42 = 8.42 = 42.10

P ac kagin g an d Sh ippin g Cos t P ool

Board Mode I Mode II Mode III Ove rh e ad $ 250,000 250,000 250,000 % 4% 30% 66% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 1.00 = 3.75 = 41.25

Other Overhead Costs

Re c e ivin g an d In s pe c t ion Cos t P ool
Board Mode I Mode II Mode III Ove rh e ad $ 200,000 200,000 200,000 % 6% 24% 70% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 1.20 = 2.40 = 35.00

Mat e rial-Han dlin g Cos t P ool

$14.82

Board Mode I Mode II Mode III

Ove rh e ad $ 600,000 600,000 600,000

% 7% 30% 63%

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 4.20 = 9.00 = 94.50

Qu alit y-As s u ran c e Cos t P ool

Board Mode I Mode II Mode III Ove rh e ad $ 421,000 421,000 421,000 % 20% 40% 40% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 8.42 = 8.42 = 42.10

P ac kagin g an d Sh ippin g Cos t P ool

Board Mode I Mode II Mode III Ove rh e ad $ 250,000 250,000 250,000 % 4% 30% 66% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 1.00 = 3.75 = 41.25

Product Cost from ABC

These are the new product costs when Aerotech uses ABC.
Mode I Direct materials $ 50.00 Direct labor 60.00 Machinery 28.20 Setup 0.02 Engineering 17.50 Facilities 12.90 Other 14.82 Total $ 183.44 Mode II $ 90.00 80.00 35.25 0.04 15.75 17.20 23.57 $ 261.81 Mode III $ 20.00 40.00 56.40 0.50 52.50 8.60 212.85 $ 390.85

Learning Objective 5

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Distorted Product Costs

Both original and ABC target selling prices are based on (Cost 125%).
Tradition al cos tin g ABC cos tin g Origin al targe t s e llin g price ABC targe t s e llin g price Mode I $ 209.00 183.44 261.25 229.30 Mode II $ 302.00 261.81 377.50 327.26 Mode III $ 126.00 390.85 157.50 488.56

The selling price of Mode I and II are reduced and the selling price for Mode III is increased.
[$209.00 1.25] [$183.44 1.25]

Distorted Product Costs

Can you identify any problems Aerotech is likely to face as a result of this distortion?
Mode I Tradition al cos tin g $ 209.00 ABC cos tin g 183.44 Cos t dis tortion pe r u n it 25.56 Un its produ ce d 10,000 Total cos t dis tortion 255,600 Mode II $ 302.00 261.81 40.19 20,000 803,800 Mode III $ 126.00 390.85 (264.85) 4,000 (1,059,400)

Traditional costing understates the cost of complex, low volume products.

Two Key Points

A large proportion of nonunit-level activities A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately. Product diversity When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs.

Learning Objective 6

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost Drivers
A characteristic of an event or activity that results in the incurrence of costs.

Cost Drivers
A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .
Degree of Correlation

Cost Drivers
A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .
Degree of Correlation Cost of Measurement

Cost Drivers
A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .
Degree of Correlation Cost of Measurement Behavioral Effects

Learning Objective 7

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Interviewing and Paper Trails

The information for ABC systems initially comes from interviews with employees in the support departments and a review of each departments records.

Storyboarding
A procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities.
Step 1 Step 2 Step 3 Step 4 These are the steps we follow to build a memory board.

Direct versus Indirect Costs

Volume-Based Costing Activity-Based Costing All production costs An effort is made to except direct account for as many materials and direct costs as possible as labor are lumped direct costs of together in one production. overhead cost pool.
Indirect Costs

Indicators of Need for ABC

Direct labor is a small percentage of total costs Product-line profit margins are hard to explain

Sales are increasing, but profits are declining.

Line managers do not believe the product costs reports

Some products that have reported high profit margins are not sold by competitors

Marketing does not use costs reports for pricing decisions

Exh. 5-13

Optimal Product-Costing System

Cost
High Total Cost

Cost of inferior decisions resulting from inaccurate information. Low Low Optimal system

Design, implementation and maintenance costs

Information System High Accuracy

Learning Objective 8

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

ABC in the Service Industry

Objectives

End of Chapter 5
This is my kind of cost pool!