Activity-Based Costing and Activity-Based Management
Learning Objective 1 <ul><li>Explain undercosting </li></ul><ul><li>and overcosting of </li></ul><ul><li>products and services. </li></ul>
Undercosting and Overcosting Example Tariq, Nasir, and Hamid order separate items for lunch. Tariq’s order amounts to Rs 14 Nasir consumed 30 Hamid’s order is 16 Total Rs 60 What is the average cost per lunch?
Undercosting and Overcosting Example Rs 60 ÷ 3 = Rs 20 Tariq and Hamid are overcosted. Nasir is undercosted.
Learning Objective 2 <ul><li>Present three guidelines for </li></ul><ul><li>refining a costing system. </li></ul>
Existing Single Indirect- Cost Pool System Example Super Corporation manufactures a normal lens (NL) and a complex lens (CL). Super currently uses a single indirect-cost rate job costing system. Cost objects: 80,000 (NL) and 20,000 (CL).
Existing Single Indirect- Cost Pool System Example Normal Lenses (NL) Direct materials Rs 1,520,000 Direct mfg. labor 800,000 Total direct costs Rs 2,320,000 Direct cost per unit: Rs 2,320,000 ÷ 80,000 = Rs29
Existing Single Indirect- Cost Pool System Example Complex Lenses (CL) Direct materials Rs 920,000 Direct mfg. labor 260,000 Total direct costs Rs1,180,000 Direct cost per unit: Rs 1,180,000 ÷ 20,000 = Rs 59
Existing Single Indirect- Cost Pool System Example All Indirect Costs Rs 2,900,000 50,000 Direct Manufacturing Labor-Hours INDIRECT-COST POLL INDIRECT COST-ALLOCATION BASE Rs 58 per Direct Manufacturing Labor-Hour
Existing Single Indirect- Cost Pool System Example Indirect Costs Direct Costs COST OBJECT: NL AND CL LENSES DIRECT COSTS Direct Materials Direct Manufacturing Labor
Existing Single Indirect- Cost Pool System Example Super uses 36,000 direct manufacturing labor-hours to make NL and 14,000 direct manufacturing labor-hours to make CL. How much indirect costs are allocated to each product?
Existing Single Indirect- Cost Pool System Example NL: 36,000 × Rs 58 = Rs 2,088,000 CL: 14,000 × Rs 58 = Rs 812,000 What is the total cost of normal lenses? Direct costs Rs 2,320,000 + Allocated costs Rs 2,088,000 = Rs 4,408,000 What is the cost per unit? Rs 4,408,000 ÷ 80,000 = Rs 55.10
Existing Single Indirect- Cost Pool System Example What is the total cost of complex lenses? Direct costs Rs 1,180,000 + Allocated costs Rs 812,000 = Rs 1,992,000 What is the cost per unit? Rs 1,992,000 ÷ 20,000 = Rs 99.60
Existing Single Indirect- Cost Pool System Example Normal lenses sell for Rs 60 each and complex lenses for Rs 142 each. Normal Complex Revenue Rs 60.00 Rs 142.00 Cost 55.10 99.60 Income Rs 4.90 Rs 42.40 Margin 8.2% 29.9%
Refining a Costing System Direct-cost tracing Indirect-cost pools Cost-allocation basis
Refining a Costing System 1. Design of Products and Process The Design Department designs the molds and defines processes needed (details of the manufacturing operations).
Refining a Costing System 2. Manufacturing Operations Lenses are molded, finished, cleaned, and inspected. 3. Shipping and Distribution Finished lenses are packed and sent to the various customers.
Learning Objective 3 <ul><li>Distinguish between the </li></ul><ul><li>traditional and the </li></ul><ul><li>activity-based costing </li></ul><ul><li>approaches to designing </li></ul><ul><li>a costing system. </li></ul>
Activity-Based Costing System Fundamental Cost Objects Activities Costs of Activities Assignment to Other Cost Objects <ul><li>Cost of: </li></ul><ul><li>Product </li></ul><ul><li>Service </li></ul><ul><li>Customer </li></ul>
Activity-Based Costing System A cross-functional team at Super Corporation identified key activities: Design products and processes. Set up molding machine. Operate machines to manufacture lenses. Maintain and clean the molds.
Activity-Based Costing System Set up batches of finished lenses for shipment. Distribute lenses to customers. Administer and manage all processes.
Activity-Based Costing System No. of Setup Hours Lenses NL Lenses CL Lenses Other Cost Allocation Base Product Cost Objects No. of Shipments Parts- Square feet Setup Design Shipping Activity Indirect Cost Pool
Activity-Based Costing System NL CL Quantity produced 80,000 20,000 No. produced/batch 250 50 Number of batches 320 400 Setup time per batch 2 hours 5 hours Total setup-hours 640 2,000 Total setup costs are Rs 409,200.
Activity-Based Costing System What is the setup cost per setup-hour? Rs 409,200 ÷ 2,640 hours = Rs 155 What is the setup cost per direct manufacturing labor-hour? Rs 409,200 ÷ 50,000 = Rs 8.184
Activity-Based Costing System Allocation using direct labor-hours: NL: Rs 8.184 × 36,000 = Rs 294,624 CL: Rs8.184 × 14,000 = Rs114,576 Total Rs409,200 Allocation using setup-hours: NL: Rs155 × 640 = Rs 99,200 CL: Rs155 × 2,000 = Rs310,000 Total Rs409,200
Learning Objective 4 <ul><li>Describe a four-part </li></ul><ul><li>cost hierarchy. </li></ul>
Cost Hierarchies A cost hierarchy is a categorization of costs into different cost pools. Cost drivers bases (cost-allocation bases) Degrees of difficulty in determining cause-and-effect relationships
Cost Hierarchies ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: 1. Output unit-level costs 2. Batch-level costs 3. Product-sustaining costs 4. Facility-sustaining costs
Output Unit-Level Costs These are resources sacrificed on activities performed on each individual unit of product or service. Energy Machine depreciation Repairs
Batch-Level Costs These are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. Setup-hours Procurement costs
Product-Sustaining Costs These are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services. Design costs Engineering costs
Facility-Sustaining Costs These are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. General administration – rent – building security
Learning Objective 5 <ul><li>Cost products or services using </li></ul><ul><li>activity-based costing. </li></ul>
Implementing Activity-Based Costing Identify cost objects. NL CL Identify the direct costs of the products. Direct material Direct labor Mold cleaning and maintenance Step 1 Step 2
Implementing Activity-Based Costing Cleaning and maintenance costs of Rs360,000 are direct batch-level costs. Why? Because these costs consist of workers’ wages for cleaning molds after each batch of lenses is run.
Implementing Activity-Based Costing Select the cost-allocation bases to use for allocating indirect costs to the products. (1) (2) (3) Activity Cost Hierarchy Total Costs Design Product-sustaining Rs450,000 Setups Batch-level Rs409,200 Operations Unit-level Rs637,500 Step 3
Implementing Activity-Based Costing Identify the indirect costs associated with each cost-allocation base . Overhead costs incurred are assigned to activities, to the extent possible, on the basis of a cause-and-effect relationship. Step 4
Implementing Activity-Based Costing Compute the rate per unit. (1) (5) NL CL Total Setup-hours: 640 2,000 2,640 Step 5 Rs409,200 ÷ 2,640 = Rs155
Implementing Activity-Based Costing Compute the indirect costs allocated to the products. NL: Rs155 × 640 = Rs 99,200 CL: Rs155 × 2,000 = 310,000 Total Rs409,200 Step 6
Implementing Activity-Based Costing Compute the costs of the products. NL and CL would show three direct cost categories. Step 7 1. Direct materials 2. Direct manufacturing labor 3. Cleaning and maintenance
Implementing Activity-Based Costing NL and CL would show six indirect cost pools. 1. Design 2. Molding machine setups 3. Manufacturing operations 4. Shipment setup 5. Distribution 6. Administration
Learning Objective 6 <ul><li>Use activity-based </li></ul><ul><li>costing systems for </li></ul><ul><li>activity-based management. </li></ul>
Activity-Based Management ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits. Product pricing and mix decisions Cost reduction and process improvement decisions Design decisions
Product Pricing and Mix Decisions ABC gives management insight into the cost structures for making and selling diverse products. It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs.
Cost Reduction and Process Improvement Decisions Manufacturing and distribution personnel use ABC systems to focus on cost-reduction efforts. Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base.
Design Decisions Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can work with their customers to evaluate the costs and prices of alternative designs.
ABC and Department Indirect-Cost Rates Many companies have evolved their costing system from using a single cost pool to using separate indirect-cost rates for each department: Design Manufacturing Distribution
ABC and Department Indirect-Cost Rates Why? Because the cost drivers of resources in each department or sub department differ from the single, company-wide, cost-allocation base. ABC systems are a further refinement of department costing systems.
Learning Objective 8 <ul><li>Evaluate the costs and benefits </li></ul><ul><li>of implementing activity-based </li></ul><ul><li>costing systems. </li></ul>
Benefits of ABC Systems Significant amounts of indirect costs are allocated using only one or two cost pools. All or most costs are identified as output unit-level costs. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.
Benefits of ABC Systems Products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits. Complex products appear to be very profitable and simple products appear to be losing money.
Benefits of ABC Systems Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.
Limitations of ABC Systems The main limitations of ABC are the measurements necessary to implement the system. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.
Limitations of ABC Systems Activity-cost rates also need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand.
ABC In Service and Merchandising Companies The general approach to ABC in the service and merchandising areas is very similar to the approach in manufacturing. Costs are divided into homogeneous cost pools and classified as output unit-level, batch-level, product- or service-sustaining, and facility-sustaining costs.
ABC In Service and Merchandising Companies The cost pools correspond to key activities. Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool.
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