Chapter 4: Activity Based Costing (ABC) Product Costing Product Costing System - method of assigning manufacturing costs to units

produced Product Costs 1. Direct material 2. Direct labor 3. Overhead Assigning overhead costs to units produced Unit level product costing Normal costing - Overhead costs are charged to jobs using a Predetermined (budgeted) overhead rate. Unit level product costing - uses a single cost driver to assign overhead costs, on either a plantwide or departmental level Companies calculate an overhead rate by: 1. budget total overhead costs for year or normal operating cycle 2. determine a cost driver - a measurable activity that all products have in common and is correlated with overhead costs 3. budget the cost driver for the same period of time Predetermined (Budgeted) overhead rate = budgeted total overhead/budgeted total cost driver Overhead costs charged to a job = actual amount of the cost driver used by product X budgeted overhead rate

Activity Based Costing ABC was developed in the 1980s. Unit based cost drivers were causing distortions due to product diversity and complexity and direct labor being replaced with automated processes. Key concept underlying ABC: Activities consume the resources of the firm. Products, services, customers, processes, suppliers, etc. consume activities. Steps for Implementing ABC To implement ABC, a company must: 1. Identify the activities necessary to manufacture a product, provide a service, maintain customers, etc.. 2. Determine the budgeted cost of each activity. 3. Determine the cost driver (activity driver) for each activity. 4. Determine an activity rate. 5. Charge products, services, customers, etc. costs based on their consumption of the activity driver for each activity. Manufacturing Example: Cascade Corporation manufactures two products, Product #347 and Product #658. Product #347 has been a standard in the industry for many years. Cascade plans on selling 65,000 units of Product #347 at a price of $145. Product #658 is a recent addition to Cascades product line. Cascade plans to sell 40,000 units at a price of $300. Product #347 requires $80 in direct material and $21 in direct labor per unit. Product #658 requires $140 in direct material and $56 in direct labor per unit. Currently Cascade allocates overhead to products based on direct labor cost. Overhead is budgeted to be $5,472,400 and direct labor costs are budgeted to be $3,605,000. 1. Calculate the Predetermined overhead rate.

2. Calculate the products cost per unit using the plantwide overhead rate:

3.

Calculate the products gross margin per unit with the plantwide overhead rate.

Based on the products gross margins, the sales manager wants to expand the market for Product #658. The controller decides to set up an ABC system to see if the allocated overhead costs are accurate before trying to expanding the market for Product #658. The controller determines that the following activities are used to manufacture the product:
Activity Budgeted Cost Cost Driver Budgeted cost driver Activity rate

Material Procurement Machine Setup

$382,500 $400,000 $45,900 $1,184,000 $3,460,000

Parts

3,825,000 250,000 15,300 2,960,000 865,000

Number of setups Pounds of waste

Hazardous waste disposal Machine Insertion of Part Manual Insertion of Part

Number of parts

Number of parts

1. Determine activity rates.

Activities required per unit of product: Product #347

Parts Machine Insertions of parts Manual Insertions of parts Machine Setups Hazardous waste

Product #658 55 35 20 3 0.35

25 24 1 2 .02 lb.

2. Calculate the products cost per unit using ABC:

3. Calculate the products gross margin per unit using ABC:

Chapter 11: Value Chain Analysis Exploiting Internal Linkages Engineering redesigns Product #658 in order to save costs. In the new design, the number of parts per unit are reduced to 40. Five parts eliminated required machine insertion and 10 required manual insertion. All the machine insertion and manual insertion costs are variable. The material procurement costs consist of $344,250 fixed costs and variable costs are $.01 per part. The fixed costs include 8 purchasing clerks earning $25,000 per year. Each clerk can process 500,000 parts per year. 1. Calculate the total annual cost savings from the new design, assuming they continue to sell 40,000 units per year.

Supplier Costing Purchasing managers are typically rewarded based on the purchase price they are able to negotiate (material price variance). However, important characteristics of suppliers such as quality and reliability of the product and delivery performance are not captured in the purchase price. Companies can use ABC to determine how much issues such poor product quality or supplier unreliability are costing them and thus, calculate the total cost of a supplier. Example XYZ Company has 2 suppliers, Murray Inc. and Plata Inc., for 2 component parts, Part A1 and Part B2, used in the manufacture of tools. You are given the following information: Murray Part A1 Unit purchase price Units purchased Failed units $20 80,000 1,600 Murray Part B2 $52 40,000 380 40 Plata Part A1 $24 10,000 10 0 Plata Part B2 $56 10,000 10 0

Late shipments 60

The cost of repairing 2,000 failed units is expected to be $800,000. The cost of the 100 late shipments is expected to be $200,000. 1. Calculate activity rates for repairs and late shipments.

2.

Calculate the total unit purchasing cost for each component for each supplier

Customer Profitability Example: Jackson Company, a warehouse distributor of construction material, has two major customers, Accent Construction and Barton Construction. Sales Revenue and Cost of Goods Sold is given below: Accent Construction Sales $500,000 Cost of Goods Sold $300,000 Gross Margin $200,000 Barton Construction $700,000 $450,000 $250,000

Jackson Companys selling and administrative costs total $400,000 and consist of the costs to enter an order, to pick an order from the warehouse, to deliver the order and general administration. Jackson Companys budgeted activity costs and drivers are below: Activity Cost Driver Activity Cost Cost driver per activity Entering order Number of orders $45,000 500 entered Picking an order $120,000 Number of items picked 20,000 Delivering order $85,000 Number of deliveries 850 made Performing Order Value $150,000 $1,500,000 general administration

1.

Calculate activity rates.

Activities uses by Accent and Barton are as follows: Accent Number of orders 150 Number of items 7,000 Number of deliveries 150 Order value $500,000

Barton 250 9,000 400 $700,000

2. Allocate activity costs to Accent and Barton:

3. Determine Customer Profitability Analysis:

4.

Analyse results:

Homework 1. Bell Inc. is considering redesigning one of its products. You are given the following information. a. The current design requires 100 machine setups per year. The new design would only require 80 machine setups per year. Fixed machine setup costs consist of employee wages. Two employees, earning $50,000 per year, are required for every 50 setups. Variable machine setup costs are $100 per setup. b. The current design requires 50,000 component parts be purchased per year. The new design would decrease the component parts to 40,000 per year. Fixed purchasing costs are a step fixed cost. $5,000 in fixed costs are incurred for every 10,000 component parts purchased (i.e., if 10,000 components are purchased total fixed costs are $5,000; if 20,000 components are purchased, total fixed costs are $10,000; etc.). Variable purchasing costs are $2 per component purchased. c. The inspection costs depend upon the number of component parts in a product. All inspection costs are fixed and are a step fixed cost. $2,000 in fixed costs are incurred for every 5,000 component parts inspected. Calculate the total annual cost savings from the new design.