503 ABC Module Fa14

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ACTIVITY BASED COSTING PRODUCT PROFITABILITY MODULE (Mills) Objective 1. Explain the role of activity-based systems To create value and to satisfy customer needs for quality, reasonable price, and timely delivery, managers must work with suppliers and customers view the organization as a collection of value-adding activities use resources for value-adding activities reduce or eliminate nonvalue-adding activities know the total cost of creating value for a customer The full product cost includes not only the costs of direct materials and direct labor, but also the costs of all production and nonproduction activities required to satisfy the customer. Activity-based systems are information systems that provide quantitative information about activities in an organization. Objective 2. Define Activity-Based Management (ABM) and discuss its relationship with the supply chain and value chain. Activity-Based Management (ABM) is an approach to management that includes: Identifying all major operating activities Determining what resources are consumed by each activity Categorizing the activities as either adding value to a product or service or not adding value ABM provides financial and operational performance information at the activity level that: Is helpful for making decisions about business segments 1

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Transcript of 503 ABC Module Fa14

Activity Based Costing -- Lecture Outline

ACTIVITY BASED COSTING

PRODUCT PROFITABILITY MODULE

(Mills)

Objective 1. Explain the role of activity-based systems

To create value and to satisfy customer needs for quality, reasonable price, and timely delivery, managers must

work with suppliers and customers

view the organization as a collection of value-adding activities

use resources for value-adding activities

reduce or eliminate nonvalue-adding activities

know the total cost of creating value for a customerThe full product cost includes not only the costs of direct materials and direct labor, but also the costs of all production and nonproduction activities required to satisfy the customer.

Activity-based systems are information systems that provide quantitative information about activities in an organization.

Objective 2. Define Activity-Based Management (ABM) and discuss its relationship with the supply chain and value chain.

Activity-Based Management (ABM) is an approach to management that includes:

Identifying all major operating activities

Determining what resources are consumed by each activity

Categorizing the activities as either adding value to a product or service or not adding value

ABM provides financial and operational performance information at the activity level that:

Is helpful for making decisions about business segments

Helps managers eliminate waste and inefficiencies and redirect resources to activities that add value to the product or service

Supply Chain is an interdependent collection or organizations that supplies materials, products, or services to a customer. A supply chain includes suppliers and suppliers suppliers as well as customers and customers customers.

A value chain is a related sequence of value-creating activities within an organization.

Helps managers better understand the interdependencies of those activities

A companys value chain is part of its supply chain

When organizations work cooperatively with others in their supply chain or larger value chain, new processes can be introduced or existing processes redesigned to reduce the total cost of products or services.

Objective 3. Distinguish between Value-Adding and Nonvalue-adding Activities

A value-adding activity is an activity that adds value to a product or service from the customers perspective (e.g., assembling, painting or installing brakes on a car).

A nonvalue-adding activity is an activity that adds cost to a product or service but does not increase its market value (e.g., moving or storing materials).

By identify nonvalue-adding activities, organizations can reduce costs and redirect resources to value-adding activities.

ADDITIONAL NOTES

Cost systems estimate cost of objects, Why?

To determine profits

To price products/services

Direct cost assignment

Direct materials cost = materials cost X quantity of material consumed to make one unit of product

Direct labor cost = labor cost per hour X quantity of hours consumed to make one unit of product

Traditionally, direct materials and direct labor have been used to assign indirect production costs (manufacturing overhead) to products cost. Why?

Represent the majority of product's cost

Usage and consumption must be controlled

Are fairly easy to measure

Traditional indirect cost assignment: Step 1. Calculate the rate

Identify indirect resource costs (ex: manufacturing overhead costs)

Identify cost driver (ex: direct labor hours, direct labor $, machine hours)

Calculate the cost driver rate (Resource costs divided by cost driver amount) (ex: total manufacturing overhead costs / total direct labor hours = manufacturing overhead rate per hour)

Traditional indirect cost assignment: Step 2. Assign cost to cost object

Multiply cost driver rate for each resource by the quantity consumed by product or service

Traditional indirect cost assignment: Step 3. Calculate total cost

Sum indirect resource costs and add this to sum of direct costs. Divide by number of units of cost object to obtain unit cost (Ex: Direct materials + Direct labor + Manufacturing overhead = Total costs

Unit cost = total cost / total units

Companies should use ABC when they have one or more of the following:

More than one product line

Different products use different resources or activities

Different products use different amounts of same resources or activities

Problems if marketing is unable to price the homes to be competitive

Standard products are overpriced so competition can sell for less than us. Thus, the competition is stealing sales of standard products away from us.

Custom products are underpriced, so competition is unwilling to sell at our price. The competition knows they would not be able to cover their costs with the lower selling price and that would mean losses rather than profits.

Warning! Something is wrong with the accounting system!!!

Situations that create need for a new cost system:

Sales: Competition prices commodity products lower than us

Sales: Competition prices specialty products higher than us

Production: Wants to discontinue custom/specialty products

Accounting: Shows custom products to be more profitable than standard

Cause of problem is improperly assigning indirect costs to products

Solution? Activity Based Costing

A way to better assign costs to products, services or other cost objects leads to better decisions.

Traditional costing systems -- products consume capacity and capacity consumes resources. This justifies assigning overhead costs to products based on the capacity required to manufacture them. Sales forecasts establish production schedules. Production schedules determine the needed plant capacity (based on direct labor hours or machine hours). The overhead budget is set to meet the plant's capacity needs.

Activity-Based Costing systems -- products consume activities and activities consume resources. This explains the logic behind activity-based costing systems. With the help of computer systems the activities necessary to provide goods and services can be collected and recorded. Thus, unique product characteristics can be collected and assigned resource costs based on the activities used by them. These activities are used to budget overhead needs.

Cost Hierarchy

Unit Level -- performed each time a unit is produced. Direct variable costs (direct materials, direct labor, sales commissions)

Batch Level -- performed each time a batch is produced. Step costs (setups, materials handling, purchasing)

Product line Level -- direct fixed costs of a product line. Trace to product line and then allocate (advertising, architectural costs, product line supervision)

Facilities Level -- Indirect fixed costs of having facilities available. Traditional allocation (heating, building depreciation, insurance, property taxes)

ABC Income Statements show what activities really cost and which activities are used in various products or services

Strategic Uses for ABC

Add/drop product line

Product pricing

Outsourcing

Product redesign

Process redesign

Customer profitability analysis

ABC System challenges

Costs may exceed benefits

Too many cost pools and drivers

Lack of top management support

Review Questions 1. Define Activity- Based Management

2. How does ABM help managers?

3. Define the supply chain.

4. Define the value chain.

5. Explain the difference between a value-adding and a nonvalue-adding activity.

6. Explain the two steps of assigning indirect costs to a product or service.

7. What is the impact on net income if a product is overpriced? What is the impact on net income if a product is underpriced?

8. What situations can happen in a company that might indicate the need to create a new costing system?

9. Define Activity-Based Costing (ABC).

10. What are the three product or production related needs that make ABC a useful costing system for a company?

11. What is the difference between traditional costing systems and ABC systems?

12. List the four levels of a cost hierarchy. Define and give an example of a cost in each level.

13. List three strategic uses for ABC.

14. What are three challenges in implementing an ABC system?

Sample Multiple Choice Questions

1. Companies find it difficult to implement ABC when

a. Too many cost pools and drivers are chosen

b. Top management does not support the implementation

c. Costs of implementing and maintaining the system exceed the benefits

d. All of the above are difficulties

e. None of the above are difficulties

2. ABC can be used for which of the following strategic decisions

a. Product pricing

b. Outsourcing

c. Product redesign

d. Customer profitability analysis

e. All of the above

3. An example of a batch level cost in ABC is

a. Direct labor

b. Setups

c. Advertising

d. Building depreciation

e. Answers b. and c. above

4. Activity-Based costing systems demonstrate that

a. Products consume activities and activities consume resources

b. Products consume capacity and capacity consumes resources

c. Resources consume products

d. Capacity consumes products

e. None of the above is correct

Additional Information: Questions/Answers

1. Explain briefly how a traditional accounting system allocates costs to products.

Traditional accounting systems divides costs into two categories, direct and indirect costs, by their relationship to the products. Costs easily traceable to products are called direct costs. All other manufacturing costs are called indirect costs. Usually, only one or a few volume-based drivers like labor hours or machine hours are used to assign (allocate) the indirect costs to products. Using volume-based cost drivers, we calculate a Predetermined overhead rate (POR) for each driver to assign the overhead costs to products.

2. What are some fundamental differences between traditional volume-based systems and ABC systems?

Allocating overhead to product costs is much more detailed in ABC systems. The allocations relate to the actual unique activities of each product.

Because of the ability to trace product-related characteristics, nonmanufacturing costs are often included in the product cost for management purposes.

The cause/effect relationships are much clearer with ABC.

3. How do ABC systems work? ABC systems directly trace resources to activities and then activities to products and services. Resources are assets needed to perform activities. Activities represent the work done in providing a service or making a product.

4. What is a cost pool? Cost pools are groups of costs that have the same cost drivers, like purchase orders, direct labor hours, etc. By grouping costs by the drivers that cause them to change, we can assign all costs by their causes.

5. Define cost driver. What is its relationship to activity levels? The event, or transaction, that causes the resources to be used is a cost driver. As activities increase the cost drivers also increase. A machine setup is the activity using setup resources, man-hours, etc. The number of setups is this activity's cost driver. A cost driver is any factor that causes a change in the cost of an activity.

ILLUSTRATIONS OF ABC PROBLEMS WITH SOLUTIONS

Practice Problem 1. When is ABC useful? As a management accounting consultant, four prospective clients (companies) have approached you. For each of the four following situations, recommend for or against an activity-based costing system. Justify each recommendation.

a. The first company mass produces a single product (chalk for schools and artists). Each product is identical, so it should contain the same overhead resources and include the same overhead cost. For product costing, ABC is not needed. A simple allocation of overhead to each product, using product volume as the cost driver should be sufficient. For management accounting (supporting planning, operational monitoring, and performance evaluation), if different cost pools exist, each with unique cost drivers, ABC can provide useful information. But in this case, different cost pools will not exist.

b. The second company is a job shop (specialty printer of invitations, business cards, etc.) Because each "product" (job) is unique, it probably uses different resources than the next job. Many jobs will use the same resources, but in different quantities. When multiple products are made using the same facilities, and the products use different activities and resources, or the same resources but in different amounts, ABC can provide more accurate product costs. ABC also provides more relevant information for management accounting needs.

c. The third company makes many different variations of the same basic product (a "product family" such as an automobile or telephone manufacturer). All products within the product family use the same overhead resources in the same amount. ABC may not improve product-costing accuracy when compared with a traditional cost allocation system using a volume-based cost driver, such as direct labor or production volume. If all products use the same overhead resources, they should contain the same overhead cost.

ABC still can provide better management accounting information than a system using one volume-based overhead cost driver when the company has multiple departments, each responsible for its own budgeting and control and when each is separately evaluated. ABC also provides information about nonmanufacturing costs, which can aid management.

d. The fourth company (a milk producer) makes related products in large batch runs, and each product goes through different departments. Each department has unique overhead resources.

Because products are made indifferent departments, the resources they use probably are unique to the specific departments involved. In these situations, ABC can identify which resources and activities (and their costs) are traceable directly to individual product lines, like milk, butter, and ice cream. Thus, ABC can provide better product costs and management accounting information.

Practice Problem 2. Bozo, Roscoe, and Tina decided to spend a January weekend together skiing at Angel Fire. Required (using the table of information below):

A. Bozo suggests that the costs be shared equally based on number of people going on trip. Calculate cost that each person would pay.

B. Tina doesn't like the idea because she plans to stay in the room rather than ski. She suggests that each group of costs be allocated to each person based on the cost drivers listed above. The information above lists his estimates of the cost driver allocations to each person. Calculate the cost that each person would pay.

C. Calculate the total cost that was allocated in Part A and in Part B. Is there a difference? Explain.PracticeProblem 3. The following information is provided for the Astro Antennae Corp, which manufactures two products, low-gain and high gain antennae.

Required:A. Use the Traditional cost allocation

1. Calculate the predetermined overhead rate based on direct labor hours.

2. Calculate the product cost per unit for each product line.

B. Activity-based cost allocation

1. Calculate the predetermined overhead rate for each cost pool.

2. Calculate the product cost per unit for each product line.

Practice Problem 4. Roscoe Corp is considering the use of Activity=Based Costing to determine unit product cost. Overhead cost information follows:

Required: A. Traditional cost allocation Assuming that the company is currently applying overhead based on direct labor hours1. Calculate the predetermined overhead rate based on direct labor hours. 2. Calculate the product cost per unit for each product line. B. Activity-based cost allocation1. Calculate the predetermined overhead rate for each cost pool.

2. Calculate the product cost per unit for each product line.

SolutionsSolutions to Practice Problem 2

A. Total estimated costs divided by total number of people = $1,475 / 3 people = $491.67 per person

Note: This is an example of combining costs of three activities into one cost pool ($1,475) with one cost driver (or activity base; e.g. number of people). This illustrates the traditional approach to applying overhead to manufactured products.

B. Calculate the cost that each person would pay.

Note: We are using Activity-based costing here. We realize that each individual is consuming certain activities at different rates. It is not fair to charge Tina for skiing if she chooses to stay in the cabin and eat half of the food. Likewise, the guys shouldn't have to pay for food they didn't eat.

So step 1 is to calculate the rate for each cost pool. Three pools means three rates.

Step 2. Is to apply the rate to each person based on the amount of the activity consumed.

Step 3. Is it add the costs together for each person to get the total cost assigned to the person.

This problem illustrates the creation of three cost pools and three cost drivers, which lead to more accurate cost assignment to individuals based on their level of activity consumption.

C. Calculate the total cost that was allocated in Part A and in Part B. is there a difference? Explain.

In either case, we are assigning a total cost of $1,475 to the three individuals. Using activity-based costing means that you are simply slicing the pie differently, but the pie is still the same size. When we look at this in a business context, you will see that ABC does not immediately improve profits. The total overhead is still assigned to the products. The difference is in the amount assigned to each product line. Over time, profits will increase if we assume that you will make better pricing decisions using more accurate cost information.

Questions and Solution to Problem 3

A. Use the Traditional cost allocation

1. Calculate the predetermined overhead rate based on direct labor hours.

Total Budgeted Factory Overhead Costs / total estimated direct labor hours = $120,000 / (1,000 dlh for Lo-Gain + 2,000 dlh for Hi-Gain) = $40 per direct labor hour

Note: When you are getting the total direct labor hours, you have to combine the direct labor hours related to all products for the year. Hence, we added 1,000 + 2,000 to get a total of 3,000 direct labor hours worked for the year.

2. Calculate the product cost per unit for each product line.

Note that we are using the traditional approach to assigning overhead. We have one cost pool ($120,000) with one cost driver (3,000 direct labor hours).

B. Activity-based cost allocation

1. Calculate the predetermined overhead rate for each cost pool.

3. Calculate the product cost per unit for each product line.

Note: The combined total product costs using the traditional approach ($140,000 for lo-gain + $240,000 for hi-gain) is the same as the combined total product costs using ABC ($175,000 for lo-gain + $205,000 for hi-gain). So, net income or profit will be the same for the company as a whole. The same cost of goods sold amount will be subtracted from revenue, either way. However, the unit costs are different. Since ABC is more accurate, it will provide better information for pricing and bidding decisions.

Questions and Solutions to Practice Problem 4.Assuming that the company is currently applying overhead based on direct labor hours,

1. Calculate the predetermined overhead rate based on direct labor hours.Total Budgeted Factory Overhead Costs / total estimated direct labor hours = $150,000 / (6,000 dlh for Product A + 4,000 dlh for Product B) = $15 per direct labor hourNote: When you are getting the total direct labor hours, you have to combine the direct labor hours related to all products for the year. Hence, we added 6,000 + 4,000 to get a total of 10,000 direct labor hours worked for the year.

4. Calculate the product cost per unit for each product line.Note that we are using the traditional approach to assigning overhead. We have one cost pool ($150,000) with one cost driver (10,000 direct labor hours) representing all of the budgeted costs and budgeted hours to be work for the year. The number of hours is driven, in part, by capacity constraints. How many people can we really have working and what is the maximum number of hours they can work? How is this to be scheduled over production of several product lines?

B. Activity-based cost allocation1. Calculate the predetermined overhead rate for each cost pool.

2. Calculate the product cost per unit for each product line.

Note: The combined total product costs using the traditional approach ($290,000 for Product A + $460,000 for Product B) is the same as the combined total product costs using ABC ($242,500 for Product A + $507,500 for Product B). So, net income or profit will be the same for the company as a whole. The same cost of goods sold amount will be subtracted from revenue, either way. However, the unit costs are different. Since ABC is more accurate, it will provide better information for pricing and bidding decisions in the long run. Thus, profits should improve in the future.

InClass Practice Problem #1. Turbo Champs Corp is considering the use of Activity-Based Costing to determine unit product cost. Overhead cost information follows:

Required: A. Traditional cost allocation 1.Calculate the predetermined overhead rate based on direct labor hours. 2. Calculate the product cost per unit for each product line. B. Activity-based cost allocation1. Calculate the predetermined overhead rate for each cost pool.

2. Calculate the product cost per unit for each product line.InClass Practice Problem #2. Textile Mills Corp is considering the use of Activity-Based Costing to determine unit product cost. Overhead cost information follows:

Setup

$125,000

Maintenance

75,000Total

$200,000

Other information:

Product AProduct B

Direct Materials$140,000$360,000

Direct Labor$60,000$40,000

Number of units200200

Number of direct labor hours6,0004,000

Number of setups3070

Hours of maintenance1,2503,750

1) Assume that the predetermined overhead rate is $10 per direct labor hour. The product cost per unit for product A would be

a) $200

b) $300c) $1,010d) $1,300e) $1,500

2) If the company uses ABC, the rate per setup would be

a) $12.50 b) $625 c) $1,250d) $2,000e) None of above

3) Assume ABC is used to assign overhead to the product lines and the rates are $500 per setup and $40 per maintenance hour. The product cost per unit for product B would be

a) $3,250

b) $ 2,925c) 1,325d) $925 e) None of the above

4) Calculate the consumption ratios and place in the spaces provided:

QtyRatioQtyRatio

Number of direct labor hours6,0004,000

Number of setups3070

Hours of maintenance1,2503,750

Assume we are currently using direct labor hours to assign overhead traditionally. If we switch to ABC, will Product As product cost increase or decrease? Why?

5) Will net income change if we use ABC, assuming no inventories exist?

InClass Practice Problem #3. LMS Corp is considering the use of Activity-Based Costing to determine unit product cost. Overhead cost information follows:

Setup

$30,000

Maintenance

10,000Total

$40,000

Other information:

Product LProduct M

Direct Materials$50,000$24,000

Direct Labor$16,000$8,000

Number of units100100

Number of direct labor hours5,0003,000

Number of setups2040

Hours of maintenance300700

1.Assume that the predetermined overhead rate is $6 per direct labor hour. The product cost per unit for product L would be

a) $960

b) $660c) $320d) $300e) $1802.If the company uses ABC, the rate per setup would be

b) $3.75 b) $500 c) $750d) $1,500e) None of above

3.Assume ABC is used to assign overhead to the product lines and the rates are $400 per setup and $20 per maintenance hour. The product cost per unit for product M would be

b) $320

b) $ 480c) 620d) $660 e) None of the above

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