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Chapter 11 – Criticisms of Absorption Cost Systems: Inaccurate Product Costs
ACTG 6310
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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
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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.
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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!
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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
Activity BasedActivity BasedCostingCosting
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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.
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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.
Activity BasedActivity BasedCostingCosting
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.
Activity BasedActivity BasedCostingCosting
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.
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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.
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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
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Identify and Define Activities and Activity Cost Pools
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
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Identify and Define Activities and Activity Cost Pools
Activity Cost Activity Cost PoolPool is a “bucket” in which costs are accumulated that relate to a single activity measure
in the ABC system.
$
$
$ $
$$
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Identify and Define Activities and Activity 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.
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.
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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
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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.
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Customer Orders
Product Design
Order Size
Customer Relations Other Total
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$125,000
Assign Costs to Activity Cost Pools
Production DepartmentIndirect factory wages 500,000$ 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)
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Customer Orders
Product Design
Order Size
Customer Relations Other Total
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
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)
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
Assign Costs to Activity Cost Pools
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Customer Orders
Product Design
Order Size
Customer Relations Other Total
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
Assign Costs to Activity Cost Pools
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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.
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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÷
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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
Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers
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Activity-Based Costing at Classic Brass
DirectMaterials
DirectMaterials
DirectLaborDirectLabor
ShippingCosts
ShippingCosts
Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers
Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers
OrderOrderSizeSize
OrderOrderSizeSize
CustomerCustomerOrdersOrders
CustomerCustomerOrdersOrders
ProductProductDesignDesignProductProductDesignDesign
CustomerCustomerRelationsRelationsCustomerCustomerRelationsRelations OtherOtherOtherOther
Overhead CostsOverhead Costs
First-Stage AllocationFirst-Stage Allocation
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Activity-Based Costing at Classic Brass
DirectMaterials
DirectMaterials
DirectLaborDirectLabor
ShippingCosts
ShippingCosts
Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers
Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers
OrderOrderSizeSize
OrderOrderSizeSize
CustomerCustomerOrdersOrders
CustomerCustomerOrdersOrders
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
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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 $25.
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Assigning Costs to Cost Objects
(a) (b) (a) (b)Activity Cost Pools Activity Rate Activity ABC CostCustomer orders 315$ 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.
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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)$
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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
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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
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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.
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When to use ABC
More than one product
Different complexities in products
Costs of products don’t make sense
Increased competition
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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
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Criticisms of ABC
More complex to useTime consuming to set upMore detailed accountingCost driver is often difficult to determine
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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
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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
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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.
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ABC at Service Firms
Banks
CPA firms
Advertising firms
U.S. Coast Guard
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Homework
P11-4 – Milan Pasta
P11-9 – Friendly Grocer
P11-14 – Wedig Diagnostics
DUE WEDNESDAY, FEBRUARY 18