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11 th  Edition Chapter 8
Activity-Based Costing:  A Tool to Aid Decision Making Chapter Eight
Activity Based Costing (ABC) <ul><li>ABC is designed to provide managers with cost information for strategic and other dec...
How Costs are Treated Under Activity – Based Costing “ Best practice” ABC differs from traditional costing in five ways. M...
How Costs are Treated Under Activity – Based Costing <ul><li>ABC does not assign all manufacturing costs to products. </li...
How Costs are Treated Under Activity – Based Costing Plantwide  Overhead Rate Departmental Overhead Rates Activity – Based...
How Costs are Treated Under Activity – Based Costing “ Best practice” ABC differs from traditional costing in five ways. <...
How Costs are Treated Under Activity – Based Costing “ Best practice” ABC differs from traditional costing in five ways. <...
How Costs are Treated Under Activity – Based Costing <ul><li>Problems: </li></ul><ul><li>In many processes, overhead is in...
How Costs are Treated Under Activity – Based Costing “ Best practice” ABC differs from traditional costing in five ways. <...
How Costs are Treated Under Activity – Based Costing “ Best practice” ABC differs from traditional costing in five ways. T...
Characteristics of Successful ABC Implementations Strong top management support Cross-functional involvement Link to evalu...
Designing an ABC System Cost Objects (e.g., products and customers) Activities Consumption of Resources Cost
Designing an ABC System <ul><li>Steps for Implementing ABC </li></ul><ul><li>Identify and define activities and activity c...
 Identify and Define Activities and Activity Cost Pools Manufacturing companies typically combine their activities into f...
 Identify and Define Activities and Activity Cost Pools Activities  should only be combined within a level if they are hi...
 Identify and Define Activities and Activity Cost Pools <ul><li>An  Activity Cost Pool  is a “bucket” in which costs are ...
 Identify and Define Activities and Activity Cost Pools Two types of activity measures: Simple count of the number of tim...
 Identify and Define Activities and Activity Cost Pools <ul><li>At Classic Brass, the ABC team, selected the following ac...
 Identify and Define Activities and Activity Cost Pools <ul><li>Customer Orders  - assigned all costs of resources that a...
 When Possible, Directly Trace Overhead Costs to Activities and Cost Objects
 Assign Costs to Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity ...
 Assign Costs to Activity Cost Pools Indirect factory wages  $500,000 Percent consumed by customer orders  25% $125,000
 Assign Costs to Activity Cost Pools Factory equipment depreciation  $300,000 Percent consumed by customer orders  20% $ ...
 Assign Costs to Activity Cost Pools
 Calculate Activity Rates <ul><li>The ABC team determines that Classic Brass will have these total activities for each ac...
 Calculate Activity Rates
Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Cost Objects: Products...
Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Cost Objects: Products, Customer Orde...
Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Cost Objects: Products, Customer Orde...
 Assigning Costs to Cost Objects <ul><li>Let’s take a look at how our system works for just one customer – Windward Yacht...
 Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.
 Prepare Management Reports
 Prepare Management Reports Customer Profitability Analysis
Product Margins Traditional  Cost Accounting System 400 units x 0.5 MH/unit x $50/MH = $10,000 Predetermined manufacturing...
Differences Between ABC and Traditional Product Costs <ul><li>Product margins are different for four reasons: </li></ul><u...
Differences Between ABC and Traditional Product Costs When batch-level and product-level costs are present, ABC will usual...
Targeting Process Improvement Activity-based management is used in conjunction with ABC to identify areas that would benef...
Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because . . . <ul><li>E...
ABC Limitations Substantial resources required to implement and maintain. Resistance to unfamiliar numbers and reports. De...
Appendix 8A: ABC Action Analysis <ul><li>Conventional ABC analysis does not identify potentially relevant costs. An  actio...
Appendix 8A: ABC Action Analysis Constructing an action analysis report begins with the first-stage allocation process.  I...
Appendix 8A: ABC Action Analysis $125,000  ÷ 1,000 orders = $125 per order Other entries in the table are computed similar...
Appendix 8A: ABC Action Analysis $125 per order  × 2 orders = $250 Other entries in the table are computed similarly.
Appendix 8A: ABC Action Analysis $125 per order  × 1 orders = $125 Other entries in the table are computed similarly.
Appendix 8A: ABC Action Analysis <ul><li>Next, label each cost using an ease of adjustment code: </li></ul><ul><li>Green c...
Appendix 8A: ABC Action Analysis
End of Chapter 8
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Managerial Accounting by G. Norren Chap008

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Managerial Accounting by G. Norren Chap008

  1. 1. 11 th Edition Chapter 8
  2. 2. Activity-Based Costing: A Tool to Aid Decision Making Chapter Eight
  3. 3. Activity Based Costing (ABC) <ul><li>ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect fixed as well as variable costs. </li></ul>ABC is a good supplement to our traditional cost system I agree!
  4. 4. How Costs are Treated Under Activity – Based Costing “ Best practice” ABC differs from traditional costing in five ways. Manufacturing costs Nonmanufacturing costs  ABC assigns both types of costs to products. Traditional product costing ABC product costing
  5. 5. How Costs are Treated Under Activity – Based Costing <ul><li>ABC does not assign all manufacturing costs to products. </li></ul>Manufacturing costs Nonmanufacturing costs “ Best practice” ABC differs from traditional costing in five ways. Traditional product costing ABC product costing All Most, but not all Some
  6. 6. How Costs are Treated Under Activity – Based Costing Plantwide Overhead Rate Departmental Overhead Rates Activity – Based Costing Number of cost pools Level of complexity “ Best practice” ABC differs from traditional costing in five ways. <ul><li>ABC uses more cost pools. </li></ul>
  7. 7. How Costs are Treated Under Activity – Based Costing “ Best practice” ABC differs from traditional costing in five ways. <ul><li>ABC uses more allocation bases. </li></ul>Traditional Costing Number of Allocation Bases ABC Bases usually rely solely on volume measures. Volume measures plus other bases.
  8. 8. How Costs are Treated Under Activity – Based Costing “ Best practice” ABC differs from traditional costing in five ways. <ul><li>ABC uses more allocation bases. </li></ul>The most commonly used allocation base in traditional costing is direct labor hours. Direct labor hours work well when overhead increases as direct labor hours increase.
  9. 9. How Costs are Treated Under Activity – Based Costing <ul><li>Problems: </li></ul><ul><li>In many processes, overhead is increasing while direct labor is decreasing. </li></ul><ul><li>Variety and complexity of products is increasing. </li></ul>The most commonly used allocation base in traditional costing is direct labor hours. “ Best practice” ABC differs from traditional costing in five ways. <ul><li>ABC uses more allocation bases. </li></ul>
  10. 10. How Costs are Treated Under Activity – Based Costing “ Best practice” ABC differs from traditional costing in five ways. <ul><li>ABC uses more allocation bases. </li></ul>All overhead costs are not related to volume measures like direct labor hours. ABC uses volume as well as other allocation bases not related to the volume of production.
  11. 11. How Costs are Treated Under Activity – Based Costing “ Best practice” ABC differs from traditional costing in five ways. Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses. <ul><li>ABC bases level of activity on capacity. </li></ul>
  12. 12. Characteristics of Successful ABC Implementations Strong top management support Cross-functional involvement Link to evaluations and rewards
  13. 13. Designing an ABC System Cost Objects (e.g., products and customers) Activities Consumption of Resources Cost
  14. 14. Designing an ABC System <ul><li>Steps for Implementing ABC </li></ul><ul><li>Identify and define activities and activity cost pools. </li></ul><ul><li>Trace costs to activities and cost objects. </li></ul><ul><li>Assign costs to activity cost pools. </li></ul><ul><li>Calculate activity rates. </li></ul><ul><li>Assign costs to cost objects. </li></ul><ul><li>Prepare management reports. </li></ul>
  15. 15.  Identify and Define Activities and Activity Cost Pools Manufacturing companies typically combine their activities into five classifications. Unit-Level Activity Batch-Level Activity Product-Level Activity Customer-Level Activity Organization- sustaining Activity
  16. 16.  Identify and Define Activities and Activity Cost Pools Activities should only be combined within a level if they are highly correlated. When combining activities, they should be grouped together only at the appropriate level.
  17. 17.  Identify and Define Activities and Activity Cost Pools <ul><li>An Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system. </li></ul>$ $ $ $ $ $
  18. 18.  Identify and Define Activities and Activity Cost Pools Two types of activity measures: Simple count of the number of times an activity occurs. Transaction driver A measure of the amount of time needed for an activity. Duration driver
  19. 19.  Identify and Define Activities and Activity Cost Pools <ul><li>At Classic Brass, the ABC team, selected the following activity cost pools and activity measures: </li></ul>
  20. 20.  Identify and Define Activities and Activity Cost Pools <ul><li>Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. </li></ul><ul><li>Product Designs - assigned all costs of resources consumed by designing products. </li></ul><ul><li>Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. </li></ul><ul><li>Customer Relations – assigned all costs associated with maintaining relations with customers. </li></ul><ul><li>Other – assigned all overhead costs that are not associated with the other cost pools. </li></ul>
  21. 21.  When Possible, Directly Trace Overhead Costs to Activities and Cost Objects
  22. 22.  Assign Costs to 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.
  23. 23.  Assign Costs to Activity Cost Pools Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000
  24. 24.  Assign Costs to Activity Cost Pools Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000
  25. 25.  Assign Costs to Activity Cost Pools
  26. 26.  Calculate Activity Rates <ul><li>The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . . </li></ul><ul><ul><li>1,000 customer orders, </li></ul></ul><ul><ul><li>200 new designs, </li></ul></ul><ul><ul><li>20,000 machine-hours, </li></ul></ul><ul><ul><li>100 customer relations activities. </li></ul></ul>Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.
  27. 27.  Calculate Activity Rates
  28. 28. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers Traced Traced Traced
  29. 29. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Cost Objects: Products, Customer Orders, Customers Order Size Customer Orders Product Design Customer Relations Other Overhead Costs First-Stage Allocation
  30. 30. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Cost Objects: Products, Customer Orders, Customers Order Size Customer Orders Product Design Customer Relations Other Overhead Costs First-Stage Allocation Second-Stage Allocations $/MH $/Order $/Design $/Customer Unallocated
  31. 31.  Assigning Costs to Cost Objects <ul><li>Let’s take a look at how our system works for just one customer – Windward Yachts. </li></ul>Standard Stanchions (no design required) 1. 400 units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours. 3. Selling price is $34 each. 4. Direct materials total $2,110. 5. Direct labor totals $1,850. 6. Shipping costs total $180. Custom Compass Housing (requires new design) 1. One order during the year. 2. Each housing required 4 machine-hours. 3. Selling price is $650 each. 4. Direct materials total $13. 5. Direct labor totals $50. 6. Shipping costs total $25.
  32. 32.  Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.
  33. 33.  Prepare Management Reports
  34. 34.  Prepare Management Reports Customer Profitability Analysis
  35. 35. Product Margins Traditional Cost Accounting System 400 units x 0.5 MH/unit x $50/MH = $10,000 Predetermined manufacturing overhead rate $1,000,000 20,000 MH = $50/MH =
  36. 36. Differences Between ABC and Traditional Product Costs <ul><li>Product margins are different for four reasons: </li></ul><ul><li>Traditional costing assigns design costs to both products based on machine hours. ABC assigns product design costs to a product only if product design work is required. </li></ul><ul><li>Traditional costing assigns customer order costs, a batch- level cost, using a unit-level allocation base, machine hours. ABC assigns these batch-level costs using a batch-level activity measure. </li></ul><ul><li>Traditional costing assigns only manufacturing costs to products. ABC also assigns nonmanufacturing costs to products. </li></ul><ul><li>Traditional costing assigns all manufacturing costs to products. The ABC system does not assign organization- sustaining manufacturing costs to the products. </li></ul>
  37. 37. Differences Between ABC and Traditional Product Costs When batch-level and product-level costs are present, ABC will usually shift costs from high volume products, produced in large batches, to low volume products produced in small batches. This cost shifting will usually have its greatest impact on the per unit cost of the low volume products.
  38. 38. Targeting Process Improvement Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements. While the theory of constraints approach discussed in Chapter 1 is a powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on where to focus improvement efforts.
  39. 39. Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because . . . <ul><li>External reports are less detailed than internal reports. </li></ul><ul><li>It may be difficult to make changes to the company’s accounting system. </li></ul><ul><li>ABC does not conform to GAAP. </li></ul><ul><li>Auditors may be suspect of the subjective allocation process based on interviews with employees. </li></ul>
  40. 40. ABC Limitations Substantial resources required to implement and maintain. Resistance to unfamiliar numbers and reports. Desire to fully allocate all costs to products. Potential misinterpretation of unfamiliar numbers. Does not conform to GAAP. Two costing systems may be needed.
  41. 41. Appendix 8A: ABC Action Analysis <ul><li>Conventional ABC analysis does not identify potentially relevant costs. An action analysis report helps because it: </li></ul><ul><ul><li>Shows what costs have been assigned to a cost object. </li></ul></ul><ul><ul><li>Indicates how difficult it would be to adjust those costs in response to changes in the level of activity. </li></ul></ul>
  42. 42. Appendix 8A: ABC Action Analysis Constructing an action analysis report begins with the first-stage allocation process. In addition to computing an overall activity rate for each activity cost pool, an activity rate is computed for each type of overhead cost that is consumed supporting a given activity. Let’s revisit the stage-one allocations from the Classic Brass example that we discussed earlier.
  43. 43. Appendix 8A: ABC Action Analysis $125,000 ÷ 1,000 orders = $125 per order Other entries in the table are computed similarly.
  44. 44. Appendix 8A: ABC Action Analysis $125 per order × 2 orders = $250 Other entries in the table are computed similarly.
  45. 45. Appendix 8A: ABC Action Analysis $125 per order × 1 orders = $125 Other entries in the table are computed similarly.
  46. 46. Appendix 8A: ABC Action Analysis <ul><li>Next, label each cost using an ease of adjustment code: </li></ul><ul><li>Green costs adjust more or less automatically to changes in activity level without any action by managers. </li></ul><ul><li>Yellow costs can be adjusted to changes in activity level, but it would require management action to realize the change in cost. </li></ul><ul><li>Red costs can be adjusted to changes in activity level only with a great deal difficulty and with management intervention. </li></ul>
  47. 47. Appendix 8A: ABC Action Analysis
  48. 48. End of Chapter 8

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