Chapter 11 – Criticisms of Absorption Cost Systems: Inaccurate Product Costs ACTG 6310.

Chapter 11 – Criticisms of Absorption Cost Systems: Inaccurate Product Costs

ACTG 6310

© The McGraw-Hill Companies, Inc., 2003McGraw-Hill/Irwin

Traditional Costing Systems

Direct materials and direct labor costs are traced to products and services; indirect costs are allocated by some method to products/services.

Products are often undercosted or overcosted under this system.

Product-cost cross subsidization results

Trends - more costs are directly assigned, multiple indirect cost pools occur which also assign marketing and administrative costs to products


Plantwide Overhead Rate

Companies tended to use direct labordirect labor as asthe overhead allocation base. There was a

belief that direct labor and overhead costs were highly correlated.


Activity Based Costing (ABC)

ABC is designed to ABC is designed to provide managers provide managers

with cost with cost information for information for

strategic and other strategic and other decisions that decisions that

potentially affect potentially affect capacity and capacity and

therefore “fixed” therefore “fixed” costs.costs.

ABC is agood supplement to our traditional

cost systemI agree!


How Costs are Treated Under Activity-Based Costing

Level of C

omplexity

Level of C

omplexity

Overhead Allocation

Plantwide Plantwide OverheadOverhead

RateRate

Plantwide Plantwide OverheadOverhead

RateRate

DepartmentalDepartmentalOverheadOverhead

RatesRates

DepartmentalDepartmentalOverheadOverhead

RatesRates

Activity BasedActivity BasedCostingCosting



Overhead rates areOverhead rates arebased on activitiesbased on activities

Overhead rates areOverhead rates arebased on activitiesbased on activities

Activity Based Costing (ABC)

Both manufacturingBoth manufacturingand nonmanufacturingand nonmanufacturing

costs may be costs may be assigned toassigned toproducts.products.

Both manufacturingBoth manufacturingand nonmanufacturingand nonmanufacturing

costs may be costs may be assigned toassigned toproducts.products.

Some manufacturingSome manufacturingcosts may be excludedcosts may be excluded

from productfrom productcosts.costs.

Some manufacturingSome manufacturingcosts may be excludedcosts may be excluded

from productfrom productcosts.costs.

A numberA numberof cost pools each of cost pools each

allocated to a productallocated to a productor cost object.or cost object.

A numberA numberof cost pools each of cost pools each

allocated to a productallocated to a productor cost object.or cost object.

Allocation bases oftenAllocation bases oftendiffer fromdiffer from

traditional costingtraditional costingsystems.systems.

Allocation bases oftenAllocation bases oftendiffer fromdiffer from

traditional costingtraditional costingsystems.systems.


Cost of Idle Capacity

Traditional Cost Traditional Cost AccountingAccounting

The predetermined The predetermined overhead rate is based overhead rate is based on budgeted activity. on budgeted activity.

This results in applying This results in applying overhead costs of overhead costs of unused, or idle, unused, or idle,

capacity.capacity.

Traditional Cost Traditional Cost AccountingAccounting

The predetermined The predetermined overhead rate is based overhead rate is based on budgeted activity. on budgeted activity.

This results in applying This results in applying overhead costs of overhead costs of unused, or idle, unused, or idle,

capacity.capacity.


Products are charged for Products are charged for the costs of capacity the costs of capacity they use – not for the they use – not for the costs of capacity they costs of capacity they

don’t use.don’t use.


Products are charged for Products are charged for the costs of capacity the costs of capacity they use – not for the they use – not for the costs of capacity they costs of capacity they

don’t use.don’t use.


Designing of an ABC System

Steps for Implementing ABCSteps for Implementing ABC Identify and define activities and activity Identify and define activities and activity

cost pools.cost pools. Trace costs to activities and cost objects.Trace costs to activities and cost objects. Assign costs to activity cost pools.Assign costs to activity cost pools. Calculate activity rates.Calculate activity rates. Assign costs to cost objects.Assign costs to cost objects. Prepare management reports.Prepare management reports.


Identify and Define Activities and Activity Cost Pools

A part of the productionA part of the productionprocess for which managementprocess for which management

wants a separate reporting of thewants a separate reporting of thecosts of the activity involved.costs of the activity involved.

Unit-LevelUnit-LevelActivityActivity

Batch-Level Batch-Level ActivityActivity

Product-LevelProduct-LevelActivityActivity

Customer-LevelCustomer-LevelActivityActivityOrganization-Organization-

sustainingsustainingActivityActivity



At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

Activity Cost Pool Activity MeasureCustomer orders Number of customer ordersProduct design Number of product designsOrder size Machine-hoursCustomer relations Number of active customersOther Not applicable

Activity Cost Pools at Classic Brass



Activity Cost Activity Cost PoolPool is a “bucket” in which costs are accumulated that relate to a single activity measure

in the ABC system.

$

$

$ $

$$



Customer OrdersCustomer Orders - assigned all costs of resources - assigned all costs of resources that are consumed by taking and processing that are consumed by taking and processing customer orders.customer orders.Product DesignsProduct Designs - assigned all costs of resources - assigned all costs of resources consumed by designing products.consumed by designing products.Order SizeOrder Size - assigned all costs of resources - assigned all costs of resources consumed as a consequence of the number of units consumed as a consequence of the number of units produced.produced.Customer RelationsCustomer Relations – assigned all costs associated – assigned all costs associated with maintaining relations with customers.with maintaining relations with customers.OtherOther – assigned all overhead costs that are not – assigned all overhead costs that are not associated with the other cost pools.associated with the other cost pools.

Customer OrdersCustomer Orders - assigned all costs of resources - assigned all costs of resources that are consumed by taking and processing that are consumed by taking and processing customer orders.customer orders.Product DesignsProduct Designs - assigned all costs of resources - assigned all costs of resources consumed by designing products.consumed by designing products.Order SizeOrder Size - assigned all costs of resources - assigned all costs of resources consumed as a consequence of the number of units consumed as a consequence of the number of units produced.produced.Customer RelationsCustomer Relations – assigned all costs associated – assigned all costs associated with maintaining relations with customers.with maintaining relations with customers.OtherOther – assigned all overhead costs that are not – assigned all overhead costs that are not associated with the other cost pools.associated with the other cost pools.


Production DepartmentIndirect factory wages 500,000$ Factory equipment depreciation 300,000 Factory utilities 120,000 Factory building lease 80,000 1,000,000$

Shipping costs traced to customer orders 40,000 General Administrative Department

Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60,000 510,000

Marketing DepartmentMarketing wages and salaries 250,000 Selling expenses 50,000 300,000

Total overhead costs 1,850,000$

Overhead Costs at Classic Brass

(Manufacturing and NonManufacturing)

Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects


Assign Costs to Activity Cost Pools

Customer Orders

Product Design

Order Size

Customer Relations Other Total

Production DepartmentIndirect factory wages 25% 40% 20% 10% 5% 100%Factory equipment depreciation 20% 0% 60% 0% 20% 100%Factory utilities 0% 10% 50% 0% 40% 100%Factory building lease 0% 0% 0% 0% 100% 100%

Shipping costs **General Administrative Department

Administrative wages and salaries 15% 5% 10% 30% 40% 100%Office equipment depreciation 30% 0% 0% 25% 45% 100%Administrative building lease 0% 0% 0% 0% 100% 100%

Marketing DepartmentMarketing wages and salaries 20% 10% 0% 60% 10% 100%Selling expenses 10% 0% 0% 70% 20% 100%

Activity Cost Pools

At Classic Brass the following distribution of resource consumption across activity cost pools is determined.

**Not included because they are directly traced to customer orders.


Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ Factory equipment depreciationFactory utilitiesFactory building lease

General Administrative DepartmentAdministrative wages and salariesOffice equipment depreciationAdministrative building lease

Marketing DepartmentMarketing wages and salariesSelling expenses

Total

Activity Cost Pools

Indirect factory wages $500,000Indirect factory wages $500,000Percent consumed by customer orders 25%Percent consumed by customer orders 25%

$125,000$125,000

Indirect factory wages $500,000Indirect factory wages $500,000Percent consumed by customer orders 25%Percent consumed by customer orders 25%

$125,000$125,000







Overhead Costs at Classic Brass(Manufacturing and NonManufacturing)


Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ Factory equipment depreciation 60,000 Factory utilitiesFactory building lease

General Administrative DepartmentAdministrative wages and salariesOffice equipment depreciationAdministrative building lease

Marketing DepartmentMarketing wages and salariesSelling expenses

Total

Activity Cost Pools






Overhead Costs at Classic Brass(Manufacturing and NonManufacturing)

Factory equipment depreciation $300,000Factory equipment depreciation $300,000Percent consumed by customer orders 20%Percent consumed by customer orders 20%

$ 60,000$ 60,000

Factory equipment depreciation $300,000Factory equipment depreciation $300,000Percent consumed by customer orders 20%Percent consumed by customer orders 20%

$ 60,000$ 60,000



Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ 200,000$ 100,000$ 50,000$ 25,000$ 500,000$ Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000 Factory utilities - 12,000 60,000 - 48,000 120,000 Factory building lease - - - - 80,000 80,000

General Administrative DepartmentAdministrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000 Office equipment depreciation 15,000 - - 12,500 22,500 50,000 Administrative building lease - - - - 60,000 60,000

Marketing DepartmentMarketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000 Selling expenses 5,000 - - 35,000 10,000 50,000

Total 315,000$ 257,000$ 380,000$ 367,500$ 490,500$ 1,810,000$

Activity Cost Pools



Calculate Activity Rates

The ABC team determines that Classic Brass will have these total activities for each activity

cost pool . . . 1,000 customer orders1,000 customer orders 200 new designs200 new designs 20,000 machine-hours20,000 machine-hours 100 customer relations activities100 customer relations activities

Now the team can compute the individual Now the team can compute the individual activity rates by dividing the total cost for activity rates by dividing the total cost for

each activity by the total activity levels.each activity by the total activity levels.


Calculate Activity Rates

(a) (b) (a) (b)Activity Cost Pools Total Cost Total Activity Activity RateCustomer orders 315,000$ 1,000 orders $315 per orderProduct design 257,000 200 designs $1,285 per designOrder size 380,000 20,000 MHs $19 per MHCustomer relations 367,500 100 customer $3,675 per customerOther 490,500 Not applicable Not applicable

Computation of Activity Rates÷


TracedTracedTracedTraced TracedTracedTracedTraced TracedTracedTracedTraced

Activity-Based Costing at Classic Brass

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ShippingCosts

ShippingCosts Overhead CostsOverhead Costs

Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers




DirectMaterials

DirectMaterials


ShippingCosts

ShippingCosts



OrderOrderSizeSize

OrderOrderSizeSize

CustomerCustomerOrdersOrders


ProductProductDesignDesignProductProductDesignDesign

CustomerCustomerRelationsRelationsCustomerCustomerRelationsRelations OtherOtherOtherOther

Overhead CostsOverhead Costs

First-Stage AllocationFirst-Stage Allocation



DirectMaterials

DirectMaterials


ShippingCosts

ShippingCosts



OrderOrderSizeSize

OrderOrderSizeSize



ProductProductDesignDesignProductProductDesignDesign

CustomerCustomerRelationsRelationsCustomerCustomerRelationsRelations OtherOtherOtherOther

Overhead CostsOverhead Costs

First-Stage AllocationFirst-Stage Allocation

Second-Stage AllocationsSecond-Stage AllocationsSecond-Stage AllocationsSecond-Stage Allocations

$/MH$/MH$/MH$/MH $/Order$/Order$/Order$/Order $/Design$/Design$/Design$/Design $/Customer$/Customer$/Customer$/Customer

UnallocatedUnallocatedUnallocatedUnallocated


Assigning Costs to Cost Objects

Let’s take a look at how our system works for just one customer – Windward Yachts.

Standard Stanchions (no design required)1. 400 units ordered with 2 separate orders.1. 400 units ordered with 2 separate orders.2. Each stanchion required 0.5 machine-hours .2. Each stanchion required 0.5 machine-hours .3. Selling price is $34 each.3. Selling price is $34 each.4. Direct materials total $2,110.4. Direct materials total $2,110.5. Direct labor totals $1,850.5. Direct labor totals $1,850.6. Shipping costs total $180.6. Shipping costs total $180.

Custom Compass Housing (requires new design)1. One order during the year.1. One order during the year.2. Each housing required 4 machine-hours .2. Each housing required 4 machine-hours .3. Selling price is $650 each.3. Selling price is $650 each.4. Direct materials total $13.4. Direct materials total $13.5. Direct labor totals $50.5. Direct labor totals $50.6. Shipping costs total $25.6. Shipping costs total $25.


Assigning Costs to Cost Objects

(a) (b) (a) (b)Activity Cost Pools Activity Rate Activity ABC CostCustomer orders 315$ 2 630$ Product design 1,285 0 - Order size 19 200 3,800 Customer relations 3,675 N/A

Overhead Cost for the Standard Stanchions

(a) (b) (a) (b)Activity Cost Pools Activity Rate Activity ABC CostCustomer orders 315$ 1 315$ Product design 1,285 1 1,285 Order size 19 4 76 Customer relations 3,675 N/A

Overhead Cost for the Custom HousingThe customer-level The customer-level cost is assigned to cost is assigned to customers directly; customers directly; it is not assigned to it is not assigned to

products.products.


Prepare Management Reports

Standard StanchionsSales 13,600$ Cost: Direct materials 2,110$ Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570

Product margin 5,030$

Standard StanchionsSales 13,600$ Cost: Direct materials 2,110$ Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570

Product margin 5,030$

Custom Compass HousingSales 650$ Cost: Direct materials 13$ Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285 Order size 76 1,764

Product margin (1,114)$

Custom Compass HousingSales 650$ Cost: Direct materials 13$ Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285 Order size 76 1,764

Product margin (1,114)$


Windward YachtsProduct margins: Standard stanchion 5,030$ Custom compass housing (1,114) Total product margin 3,916 Less: Customer relations 3,675 Customer margin 241$

Prepare Management Reports

Customer Profitability AnalysisCustomer Profitability Analysis


Product Margins

Standard Stanchions

Compass Housing

Sales 13,600$ 650$ Costs

Direct materials (2,110) (13) Direct labor (1,850) (50) Manufacturing overhead (10,000) (200)

Product margin (360)$ 387$

Traditional Traditional Cost Accounting SystemCost Accounting System

Predetermined manufacturingoverhead rate

$1,000,000 20,000 MH

= $50/MH=

400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000


Difference Between ABC and Traditional Product Costs

Batch-level or product-Batch-level or product-level costs will level costs will ordinarily shift ordinarily shift

overhead costs from overhead costs from high-volume high-volume

products produced products produced in large batches to in large batches to

low-volume products low-volume products produced in small produced in small

batches. batches.

Batch-level or product-Batch-level or product-level costs will level costs will ordinarily shift ordinarily shift

overhead costs from overhead costs from high-volume high-volume

products produced products produced in large batches to in large batches to

low-volume products low-volume products produced in small produced in small

batches. batches.

Under ABC both Under ABC both manufacturing and manufacturing and nonmanufacturing nonmanufacturing

costs may be costs may be assigned to products. assigned to products.

Organization-Organization-sustaining costs and sustaining costs and

the costs of idle the costs of idle capacity are not capacity are not

assigned to products.assigned to products.

Under ABC both Under ABC both manufacturing and manufacturing and nonmanufacturing nonmanufacturing

costs may be costs may be assigned to products. assigned to products.

Organization-Organization-sustaining costs and sustaining costs and

the costs of idle the costs of idle capacity are not capacity are not

assigned to products.assigned to products.


When to use ABC

More than one product

Different complexities in products

Costs of products don’t make sense

Increased competition


Benefits of ABC

Benefits More accurate product costing More costs can be assigned directly to products Focus switches to control over activities Better information for strategic planning and decision

making Product profitability statements can be prepared Provides a means to “value engineer” the cost

structure Operations managers often benefit the most


Criticisms of ABC

More complex to useTime consuming to set upMore detailed accountingCost driver is often difficult to determine


Cost Driver Analysis

Examples of new measures Storage – number of cartons stored Requisition handling – number of requisitions Materials handling – # of parts processed, weight

of parts Warehouse stock selection – carton lines Data entry - number of lines, number of invoices Desk top delivery - # of deliveries Freight out – distance traveled


Activity-Based Management

Aids for strategySatisfy customers Improve profits by improving processesProduct pricing/ product mix decisions can

be made easilyCost reduction hopefully will occur because

activities are easier to control than costs


Activity-Based Costing and External Reporting

Most companies do not use ABC for external reporting Most companies do not use ABC for external reporting because . . .because . . .

1.1. External reports are less detailed than internal External reports are less detailed than internal reports.reports.

2.2. It may be difficult to make changes to the It may be difficult to make changes to the company’s accounting system.company’s accounting system.

3.3. ABC does not conform to GAAP.ABC does not conform to GAAP.

4.4. Auditors may be suspect of the subjective Auditors may be suspect of the subjective allocation process based on interviews with allocation process based on interviews with employees.employees.


ABC at Service Firms

Banks

CPA firms

Advertising firms

U.S. Coast Guard


Homework

P11-4 – Milan Pasta

P11-9 – Friendly Grocer

P11-14 – Wedig Diagnostics

DUE WEDNESDAY, FEBRUARY 18

Chapter 11 – Criticisms of Absorption Cost Systems: Inaccurate Product Costs ACTG 6310.

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Transcript of Chapter 11 – Criticisms of Absorption Cost Systems: Inaccurate Product Costs ACTG 6310.