Unit 5 ACTIVITY-BASED COSTING Study Objectives Recognize the difference between traditional costing...

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Unit 5 ACTIVITY-BASED COSTING Study Objectives Recognize the difference between traditional costing and activity based costing. Identify the steps in the development of an activity-based costing system. Classify resource consuming activities.

Transcript of Unit 5 ACTIVITY-BASED COSTING Study Objectives Recognize the difference between traditional costing...

Page 1: Unit 5 ACTIVITY-BASED COSTING Study Objectives  Recognize the difference between traditional costing and activity based costing.  Identify the steps.

Unit 5

ACTIVITY-BASED COSTING

Study Objectives

Recognize the difference between traditional costing and activity based costing.

Identify the steps in the development of an activity-based costing system.

Classify resource consuming activities.

Page 2: Unit 5 ACTIVITY-BASED COSTING Study Objectives  Recognize the difference between traditional costing and activity based costing.  Identify the steps.

Study Objectives: Continued

Distinguish cost drivers in activity based costing systems.

Explain the benefits and limitations of ABC.

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ACTIVITY-BASED COSTING VERSUS TRADITIONAL COSTING

Study Objective 1

Traditional Costing Systems

Allocates overhead using a single predetermined rate.

Job order costing: direct labor cost is assumed to be the relevant activity base.Process costing: machine hours is the relevant activity base.

Assumption was satisfactory when direct labor was a major portion of total manufacturing costs.

Wide acceptance of a high correlation between direct labor and overhead costs.

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Traditional Costing Systems:Continued

Direct labor is still often the appropriate basis for assigning overhead costs when:

Direct labor constitutes a significant part of total product cost

and

High correlation exists between direct labor and changes in overhead costs.

Overhead Direct Labor Products

Costs Hours/Dollars

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Need for a New Approach

Tremendous change in manufacturing and service industries.

Decrease in amount of direct labor usage.

Significant increase in total overhead costs.

May be inappropriate to use plant-wide predetermined overhead rates based on direct labor or machine hours when a lack of correlation exists.

Complex manufacturing processes may require multiple allocation bases; this approach is called Activity-Based Costing (ABC).

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Activity-Based Costing (ABC)

An overhead cost allocation system that allocates overhead to multiple activity cost pools

and Assigns the activity cost pools to products or

services by means of cost drivers that represent the activities used.

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Activity-Based Costing (ABC)Terms

Activity: any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service.

Activity Cost Pool: a distinct type of activity.For example: ordering materials or setting up machines.

Cost Drivers: any factors or activities that have a direct cause-effect relationship with the

resources consumed.

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The Logic Behind ABC

Products consume activities,

and activities consume resources.

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Activity-Based Costing (ABC) – Continued

ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity cost pools.

Stage 2: The overhead costs allocated to the cost pools is assigned to products using cost drivers.

The more complex a product’s manufacturing operation, the more activities and cost drivers likely to be present.

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Activities and Related Cost Drivers

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ABC System Design – Lift Jack Company

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Traditional Costing vs ABC

ABC does not replace an existing job order/process cost system.

ABC does segregate overhead into various cost pools to provide more accurate cost information.

ABC, thus, supplements – it does not replace – the traditional cost system.

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Traditional Costing vs ABCAn IllustrationStudy Objectives 2, 3, & 4

Atlas Company produces two automotive antitheft devices: The Boot: a high volume item with sales totaling 25,000 per year The Club: a low volume item with sales totaling 5,000 per

year

Each product requires 1 hour of direct labor Total annual direct labor hours (DLH) 30,000 (25,000 + 5000) Direct labor cost $12 per unit for each product

Expected annual manufacturing overhead costs $900,000

Direct materials cost: The Boot - $40 per unit The Club - $30 per unit

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Unit Costs Under Traditional Costing

Products

Manufacturing Costs The Boot The ClubDirect Materials $40 $30Direct Labor 12 12Overhead 30* 30*Total unit cost $82 $72

* Predetermined overhead rate: $900,000/30,000 DLH = $30 per DLH Overhead = predetermined overhead rate times direct labor hours

($30 X 1 hr. = $30)

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Unit Costs Under ABC:Step 1: Identify and Classify Activities and

Allocate Overhead to Cost PoolsStudy Objective 3

Activity Cost Pools Estimated OverheadSetting up machines $300,000Machining 500,000 Inspecting 100,000 Total $900,000

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Unit Costs Under ABC:Step 2: Identify Cost Drivers

Study Objective 4

Expected Use of Cost Drivers

Activity Cost Pools Cost Drivers Per ActivitySetting up machines Number of setups 1,500 Machining Machine hours 50,000

Inspecting Number of Inspections 2,000

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Unit Costs Under ABC:Step 3: Compute Overhead Rates

Formula for Computing Activity-Based Overhead Rate:

Estimated Overhead Per Activity Activity-Based

Expected Use of Cost Drivers Per Activity Overhead Rate

Expected Use Estimated of Cost Drivers Activity-Based

Activity Cost Pools Overhead Per Activity Overhead RatesSetting up machines $300,000 1,500 setups $200 per setup Machining 500,000 50,000 machine hrs. $ 10 per mach. hour Inspecting 100,000 2,000 inspections $ 50 per inspectionTotal $900,000

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Unit Costs Under ABC:Step 4: Assign Overhead Costs to ProductsPart 1: Expected Use of Cost Driver Per Product

Expected Use of Cost Drivers per Product

Expected UseActivity Cost of Cost Drivers Pools Cost Driver Per Activity The Boot The

ClubSetting up Number of machines setups 1,500 setups 500 1,000Machining Machine hours 50,000 hours 30,000 20,000Inspecting Number of

inspections 2,000 inspections 500 1,500

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Unit Costs Under ABC:Step 4: Assign Overhead Costs to Products

Part 2: Assign Cost Pools to Products

The Boot

Expected Use of Activity-BasedActivity Cost Drivers X Overhead = Cost Cost Pools per Product Rates AssignedSetting up machines 500 $200 $100,000Machining 30,000 10 300,000Inspecting 500 50 25,000Total costs assigned $425,000Units produced 25,000Overhead cost per unit $17

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Unit Costs Under ABC:Step 2: Assign Overhead Costs to Products

Part 2: Assign Cost Pools to Products

The Club

Expected Use of Activity-BasedActivity Cost Drivers X Overhead = Cost Cost Pools per Product Rates AssignedSetting up machines 1,000 $200 $200,000Machining 20,000 10 200,000Inspecting 1,500 50 75,000Total costs assigned $475,000Units produced 5,000Overhead cost per unit $95

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Comparison of Unit CostsTraditional vs ABC

The Boot The ClubTraditional Traditional

Manufacturing Costs Costing ABC Costing ABCDirect Materials $40 $40 $30 $30Direct Labor 12 12 12 12Overhead 30 17 30 95

Total Cost per Unit $82 $69 $72 $137

Overstated Understated $13 $65

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Activity-Based Costing:A Closer Look

Study Objective 5

More accurate product costing through: Use of more cost pools to assign overhead costsEnhanced control over overhead costsBetter management decisions

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Activity-Based Costing: A Closer Look

Limitations of ABC

Can be expensive to use Some arbitrary allocations continue

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Activity-Based Costing:A Closer Look

Use ABC When One or More of the Following Exist:

Products differ greatly in volume/manufacturing complexity

Products lines are Numerous Diverse Require different degrees of support services

Overhead costs are a significant portion of total costs

Significant change in manufacturing process or number of products

Managers ignore data from existing system and instead use “bootleg” costing data

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Let’s ReviewLet’s Review

Activity-based costing (ABC):

a. Can be used only in a process cost system

b. Focuses on units of production

c. Focuses on activities performed to produce a product

d. Uses only a single basis of allocation

Page 26: Unit 5 ACTIVITY-BASED COSTING Study Objectives  Recognize the difference between traditional costing and activity based costing.  Identify the steps.

Let’s ReviewLet’s Review

Activity-based costing (ABC):

a. Can be used only in a process cost system

b. Focuses on units of production

c. Focuses on activities performed to produce a product

d. Uses only a single basis of allocation

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Summary of Study Objectives

Recognize the difference between traditional and activity-based costing.

Traditional system allocates overhead to products using predetermined unit-based output rate.ABC allocates overhead to activity cost pools and assigns cost to products using cost drivers.

Identify the steps in the development of an activity-based costing system.

Step 1: Identify the major activities and allocate the overhead costs to cost pools.

Step 2: Identify the cost driver highly correlated to the cost pool.Step 3: Compute the overhead rate per cost driver.Step 4: Assign cost pools to products or services using the

overhead rates.

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Summary of Study Objectives Know how companies identify cost pools used in ABC.

Analyze each operation or process, document and time every task, action, or transaction.

Know how companies identify and use cost drivers in ABC.Cost drivers identified for assigning activity cost pools must: Accurately measure the consumption of the activity Have related data easily available.

Understand the benefits and limitations of ABCBenefits: Enhanced control over overhead costs Better management decisions

Limitations: Higher costs accompany multiple activity centers and cost

drivers Some costs must still be allocated arbitrarily

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Summary of Study Objectives

Differentiate between value-added and non-value-added activities.

Value-added activities increase the worth of a product or service.

Non-value-added activities add cost to, or increase the time spent on, a product or service without increasing its market

value.

Understand the value of using activity levels in ABCActivities may be classified as:

Unit-level Batch-level Product-level Facility-level

Failure to recognize this classification can resultin distorted product costing.

Page 30: Unit 5 ACTIVITY-BASED COSTING Study Objectives  Recognize the difference between traditional costing and activity based costing.  Identify the steps.

Summary of Study Objectives

Apply ABC to service industries.Same objective – improved costing of

services provided.

The general approach to costing is also the same: analyze operations identify activities accumulate overhead costs by activity

cost pools identify and use cost drivers to assign

cost to services