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Activity-Based Costing

Activity-Based Costing. Lecture 5. Introduction. Activities generate transactions. Transactions generate costs . ABC traces costs to activities. Undercosting & Overcosting. U ndercosting :

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Activity-Based Costing

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  1. Activity-Based Costing Lecture 5

  2. Introduction • Activities generate transactions. • Transactions generate costs. • ABC traces costs to activities.

  3. Undercosting &Overcosting • Undercosting: A product consumes a relatively high level of resources but is reported to have a relatively low total cost. • Overcosting: A product consumes a relatively low level of resources but is reported to have a relatively high total cost.

  4. Undercosting &Overcosting • Irene, Roberta, and Nancy meet occasionally for lunch. • Each one orders separate items: • Irene’s order amounts to $14 Roberta consumed 30 Nancy’s order is 16 Total $60

  5. Assuming they divide the bill equally, what is the average cost per lunch? $60 ÷ 3 = $20 Actual Average Irene’s order amounts to $14 $20O Roberta consumed 30 $20U Nancy’s order is 16$20O Total $60 $60 Undercosting&Overcosting

  6. Traditional costing system vs ABC costing system

  7. Single Indirect Cost Pool • Cole Corporation manufactures two types of lenses: a normal lens (NL) and a complex lens (CL). • To cost products, Cole currently uses a single indirect-cost rate job costing system.

  8. Single Indirect Cost Pool • The cost objects are the total costs of manufacturing and distributing 80,000 units of normal lenses (NL) and 20,000 units of complex lenses (CL).

  9. Single Indirect Cost Pool • Normal Lenses (NL) • Direct materials $1,520,000 Direct mfg. labor $800,000 Total direct costs $2,320,000 • Direct cost per unit of NL: • $2,320,000 ÷ 80,000 = $29

  10. Single Indirect Cost Pool • Complex Lenses (CL) • Direct materials $ 920,000 Direct mfg. labor $260,000 Total direct costs $1,180,000 • Direct cost per unit of CL: • $1,180,000 ÷ 20,000 = $59

  11. Single Indirect Cost Pool • Indirect costs of $2,900,000 are grouped into a single overhead cost pool. • 50,000 of DL hours are used as the cost-allocation base. • What is the indirect cost rate? • $2,900,000 ÷ 50,000 = $58 per DL hr

  12. Single Indirect Cost Pool • Cole uses 36,000 DL hr.s to make NL and 14,000 DL hr.s to make CL. • How much indirect costs are allocated to each product? NL: 36,000 × $58 = $2,088,000 CL: 14,000 × $58 = $812,000

  13. Single Indirect Cost Pool • What is the total cost of NL? Direct costs $2,320,000 + Allocated costs $2,088,000 = $4,408,000 • What is the cost per unit? $4,408,000 ÷ 80,000 = $55.10

  14. Single Indirect Cost Pool • What is the total cost of CL? Direct costs $1,180,000 + Allocated costs $812,000 = $1,992,000 • What is the cost per unit? $1,992,000 ÷ 20,000 = $99.60

  15. Single Indirect Cost Pool • Normal lenses sell for $60 each and • complex lenses for $142 each. NormalComplex Revenue $60.00 $142.00 Cost 55.10 99.60 Income $ 4.90 $ 42.40 Margin 8.2% 29.9%

  16. Refining a Costing System • Let us say that our competitor is selling NL lenses for $55. • Maybe we are overcosting or undercosting our products? • How do we refine a simple costing system?

  17. Refining a Costing System • Guidelines for refining a costing system: • Direct-cost tracing – Classify as many of the total costs as direct costs as is economically feasible. • Indirect-cost pools – Expand the number of cost pools until each of these pools is homogeneous. • Cost-allocation basis – Identify the preferred cost-allocation base for each indirect-cost pool.

  18. Activity-Based Costing • ABC systems refine costing systems by focusing on activitiesas the fundamental cost object. • ABC: calculates the costs of activities and assigns costs to cost objects on the basisof the activities undertakento produce each product or service.

  19. Cost Hierarchies A cost hierarchy is a categorization of costs into different cost pools on the basis of the different types of cost drivers (cost-allocation bases) or different degrees of difficulty in determining cause-and-effect relationships.

  20. Output Unit-Level Costs... are resources sacrificed on activities performed on each individual unit of product or service. Energy Machine depreciation Repairs

  21. Batch-Level Costs... 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. Example: Setup hours Procurement costs

  22. Product-Sustaining... or service-sustaining, costs are resources sacrificed on activities undertaken to support individual products or services. Example: Design costs Engineering costs

  23. Facility-Sustaining Costs... are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. Example: General administration costs Rent Building security

  24. Cost Hierarchies ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: Output unit-level cost Batch level costs Product-sustaining costs Facility-sustaining costs

  25. Seven steps of implementing Activity-Based Costing

  26. 1. Identify cost objects • Step 1: Identify the chosen cost objects. • The cost object is to calculate • the total costsof designing, manufacturing, and distributing NL and CL.

  27. 2. Identify direct costs • Step 2: Identify the direct costs of the product. • Cole identifies • direct materials costs and • direct manufacturing labor as direct costs. • Using Direct cost tracing new direct costs of • Mold cleaning and maintenance costs of $360,000 are also identified.

  28. 2. Identify direct costs • In the ABC costing system: • Cleaning and maintenance costs of $360,000 are direct batch-level-costs. • Because these costs consist of workers’wages for cleaning molds after each batchof lenses is run.

  29. 2. Identify direct costs • In the OLD costing system: • The existing cost system classifies mold cleaning and maintenance costs as part ofthe indirect costs. • and indirect costs were allocated to products using DL hr.s.

  30. 2. Identify direct costs Normal Lenses (NL) Description Cost Hierarchy Category Direct materials Unit-level $1,520,000 Direct mfg. labor Unit-level $800,000 Cleaning &Mainten. Batch-level $160,000 Total direct costs $2,480,000

  31. 2. Identify direct costs Complex Lenses (CL) Description Cost Hierarchy Category Direct materials Unit-level $920,000 Direct mfg.labor Unit-level $260,000 Cleaning &Mainten. Batch-level $200,000 Total direct costs $1,380,000

  32. 3. Select cost-allocation bases • Step 3: Select the cost-allocation bases to use in allocating indirect costs to the products.

  33. 3. Select cost-allocation bases • Six activities were identified as cost allocation basis. • Design • Molding machines setups • Manufacturing operations • Shipment set up • Distribution • Administration

  34. 4. Identify indirect costs • Step 4: 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. • Let use the activity of Molding machines setups as an example: • Total setup costs are $409,200.

  35. 5. Compute rate per unit Setup data for the normal lens and the complex lens: NL CL Quantity produced 80,000 20,000 No. produced per batch 250 50 Number of batch (80K/250) = 320 (20K/50) = 400 Setup time per batch 2 hours 5 hours Total setup hours 640 hr.s2,000 hr.s

  36. 5. Compute rate per unit • Step 5: Compute the rate per unit of each cost allocation base used to allocate indirect costs to the products. • Setup hours: NLCLTotal640 2,000 2,640 hr.s • $409,200 ÷ 2,640 hours = $155 per set up hour

  37. ABC vs Traditional • Total setup costs are $409,200. • Cost per setup hour using ABC $409,200 ÷ 2,640 (640+2,000) hr.s = $155 / set up hr.s • Cost per DL hour using Traditional costing $409,200 ÷ 50,000 (given) hours = $8.184 / DL hr.s

  38. 6. Compute indirect costs • Step 6: Compute the indirect costs allocated to the products. • Total cost of setup activity: • NL: $155 × 640 hr.s = $ 99,200 • CL: $155 × 2,000 hr.s = 310,000 • Total $409,200

  39. ABC vs Traditional • Cost allocation using DL hr.s: NL: $8.184 × 36,000 = $294,624 CL: $8.184 × 14,000 = $114,576 Total $409,200 • Cost allocation using setup-hours: NL: $155 × 640 = $ 99,200 CL: $155 × 2,000 = $310,000 Total $409,200

  40. ABC vs Traditional • Setup costs should be allocated on the basis of setup hours. • Because there is a strong cause-and-effect relationship between setup-related overhead costs and setup-hours.

  41. Steps 4, 5, and 6 will have to be repeated for each of the new allocation basis: • Design • Molding machines setups (the example) • Manufacturing operations • Shipment set up • Distribution • Administration

  42. 7. Compute productcosts • Step 7: Compute the costs of the products by adding all direct and indirect costs assigned to them. • NL and CL would show costs related to three direct cost categories. • Direct materials • Direct manufacturing labor • Cleaning and maintenance

  43. NL & CL Total Direct costs Description Cost Hierarchy Category Direct materials Unit-level $2,440,000 Direct mfg.labor Unit-level $1,060,000 Cleaning &Mainten. Batch-level $360,000 Total direct costs $3,860,000 7.Computeproductcosts

  44. 7. Compute productcosts • NL and CL would show costs related to six indirect cost pools. • Design • Molding machine setups • Manufacturing operations • Shipment setup • Distribution • Administration

  45. What is the total cost of NL? Direct costs $2,480,000 + Allocated costs $1,040,000 = $3,520,000 What is the cost per unit? $3,520,000 ÷ 80,000 = $44.00 What is the cost per unit in OLD system? $4,408,000 ÷ 80,000 = $55.10 O 7. Compute productcosts

  46. What is the total cost of CL? Direct costs $1,380,000 + Allocated costs $1,500,000 = $2,880,000 What is the cost per unit? $2,880,000 ÷ 20,000 = $144.00 What is the cost per unit in OLD system? $1,992,000 ÷ 20,000 = $99.60 U 7. Compute productcosts

  47. ABC costing will assign indirect and direct costs in a more accurate way to our products and we will be able to compete better against our competitors.

  48. Use ABC systems for activity-based management

  49. 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

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