activity based costing · 5. assign costs to a ... activity-based costing system. after studying...

Activity Based Costing:A Tool to Aid Decision Making

Chapter

8

8-2

© McGraw-Hill Ryerson Limited., 2001

LEARNING OBJECTIVES

1. Explain the major differences between activity-based costing and a traditional costingsystem.

2. Distinguish between unit-level, product-level,customer-level and organization-sustainingactivities.

3. Assign costs to cost pools using a first-stageallocation.

4. Compute activity rates for cost pools andexplain how they can be used to targetprocess improvements.

After studying this chapter, you should be able to:

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LEARNING OBJECTIVES

5. Assign costs to a cost object using a second-stage allocation.

6. Prepare a report showing activity-basedcosting product margins from an activity view.

7. Prepare an action analysis report usingactivity-based costing data and interpret thereport.

8. Use the simplified approach to computeactivity-based costs and margins.

9. (Appendix 8A) Record the flow of costs in anactivity-based costing system.

After studying this chapter, you should be able to:

8-4


Activity Based Costing (ABC)

The objective ofactivity-basedcosting is tounderstand

overhead and theprofitability ofproducts andcustomers.

ABC is agood supplementto our traditional

cost systemI agree!

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Overhead rates maybe based on activity

at capacity.

Overhead rates maybe based on activity

at capacity.

Activity Based Costing (ABC)

Activity-Based CostingActivity-Based Costing

Both manufacturingand nonmanufacturing

costs may be assigned toproducts.

Both manufacturingand nonmanufacturing

costs may be assigned toproducts.

Some manufacturingcosts may be excluded

from productcosts.

Some manufacturingcosts may be excluded

from productcosts.

There are a numberof cost pools each of

which is allocatedusing a unique

measure of activity.

There are a numberof cost pools each of

which is allocatedusing a unique

measure of activity.

Allocation bases oftendiffer from

traditional costingsystems.

Allocation bases oftendiffer from

traditional costingsystems.

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How Costs are Treated UnderActivity-Based Costing

Level o

f Com

plexit

y

Level o

f Com

plexit

y

O verhead Allocation

Plantwide Overhead

Rate

Plantwide Overhead

Rate

DepartmentalOverhead

Rates

DepartmentalOverhead

Rates

Activity BasedCosting

Activity BasedCosting

8-7


Plantwide Overhead Rate

Companies tend to use direct labourdirect labour as the overhead allocation base.

8-8


A two stage process isnecessary because costs

are allocated to departmentsand then to products.

A two stage process isnecessary because costs

are allocated to departmentsand then to products.

Finishing Department

Shipping Department

Painting Department

Departmental Overhead Rates

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Department1

Department2

Department3Cost poolsCost pools

IndirectLabourIndirectLabour

IndirectMaterialsIndirect

MaterialsOther

OverheadOther

OverheadStage One:Stage One:Costs assignedCosts assignedto poolsto pools


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Department1

Department2


Stage One:Stage One:Costs assignedCosts assignedto poolsto pools

Products Products

Stage Two:Stage Two:Costs appliedCosts appliedto productsto products




MaterialsOther

OverheadOther

Overhead

8-11


Department1

Department2


Stage One:Stage One:Costs assignedCosts assignedto poolsto pools

Products Products

Stage Two:Stage Two:Costs appliedCosts appliedto productsto products

Direct Labour Hours

MachineHours

RawMaterials

Cost

Departmental Allocation Bases




MaterialsOther

OverheadOther

Overhead

8-12


Designing an ABC System

Cost Objects(e.g., productsand customers)

Cost Objects(e.g., productsand customers)

ActivitiesActivities Consumptionof Resources

Consumptionof Resources

CostCost

8-13


Designing an ABC System

Steps for Implementing ABCSteps for Implementing ABC! Identify and define activities and activity pools.

"Where possible, trace costs to activities and costobjects.

#Assign costs to activity cost pools.

$Calculate activity rates.

%Assign costs to cost objects.

&Prepare management reports.

8-14


Identifying Activity to Include

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-LevelActivity

Batch-Level Activity

Product-LevelActivity

Customer-LevelActivityOrganization-

sustainingActivity

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Identifying Activity to Include

Activity Cost PoolActivity Cost Poolis a “bucket” inwhich costs are

accumulated thatrelate to a single

activity in the ABCsystem.

$

$

$ $

$$

8-16


The Mechanics of ABC

At Classic Brass, the ultimate cost objects are:!Products,

"Customer orders, and

#Customers.

One overhead cost - shipping - can be traceddirectly to customer orders.

The company’s overhead costs are shown onthe next slide.

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Production DepartmentIndirect factory wages 500,000$ Factory equipment amortization 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 amortization 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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Activity-Based Costing at Classic Brass

DirectMaterials

DirectMaterials

DirectLabourDirectLabour

ShippingCosts

ShippingCosts Overhead CostsOverhead Costs

TracedTraced $/DLH$/DLH TracedTraced

Cost Objects:Products, Customer Orders, Customers


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DirectMaterials

DirectMaterials


ShippingCosts

ShippingCosts

OrderSize

OrderSize

CustomerOrders

CustomerOrders

ProductDesignProductDesign

CustomerRelationsCustomerRelations OtherOther

Overhead CostsOverhead Costs



First-Stage Allocation

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DirectMaterials

DirectMaterials


ShippingCosts

ShippingCosts



OrderSize

OrderSize

CustomerOrders

CustomerOrders

ProductDesignProductDesign

CustomerRelationsCustomerRelations OtherOther

Overhead CostsOverhead Costs

First-Stage Allocation

Second-Stage Allocations

$/MH$/MH $/Order$/Order $/Design$/Design $/Customer$/Customer

UnallocatedUnallocated

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Assigning 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 amortization 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 traced to customer order N/AGeneral Administrative Department

Administrative wages and salaries 15% 5% 10% 30% 40% 100%Office equipment amortization 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

Management at Classic Brass believes overhead should bedistributed as follows:

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Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ Factory equipment amortizationFactory utilitiesFactory building lease

General Administrative DepartmentAdministrative wages and salariesOffice equipment amortizationAdministrative building lease

Marketing DepartmentMarketing wages and salariesSelling expenses

Total

First-Stage Allocation to Activity Cost Pools


Indirect factory wages $500,000Percent consumed by customer orders 25%

$125,000

Indirect factory wages $500,000Percent consumed by customer orders 25%

$125,000

Using the total costs and percentage consumption ofoverhead, costs are assigned to activity pools.

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Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ Factory equipment amortization 60,000 Factory utilitiesFactory building lease



Total



Factory equipment amortization $300,000Percent consumed by customer orders 20%

$ 60,000

Factory equipment amortization $300,000Percent consumed by customer orders 20%

$ 60,000

Using the total costs and percentage consumption ofoverhead, costs are assigned to activity pools.

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Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ 200,000$ 100,000$ 50,000$ 25,000$ 500,000$ Factory equipment amortization 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 amortization 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$


Assigning Costs to Activity Cost PoolsUsing the total costs and percentage consumption of

overhead, costs are assigned to activity pools.

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Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ 200,000$ 100,000$ 50,000$ 25,000$ 500,000$ Factory equipment amortization 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 amortization 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$


Assigning Costs to Activity Cost PoolsUsing the total costs and percentage consumption of

overhead, costs are assigned to activity pools.

These costs shouldbe cross-added to get

the total

This number should thenequal the total of the

individual overhead itemto be allocated

8-26


Computation of Activity Rates

The ABC team has determined that ClassicBrass has the following total activities for each

activity cost pool . . .'1,000 customer orders,

'200 new designs,

'20,000 machine-hours

'100 customers.

Now the team can compute the individualNow the team can compute the individualactivity rates.activity rates.

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1,000 Orders

200 Designs

20,000

machine-hours

100 Customers Other

Production Department

Indirect factory wages 125$ Factory equipment amortizationFactory utilitiesFactory building lease

General Administrative DepartmentAdministrative w ages and salariesOffice equipment amortizationAdministrative building lease


Total

Activity Rates for each Activity Cost Pools


Customer Orders

Indirect factory wages 125,000$ Number of orders ÷ 1,000 Indirect factory wages/order 125$

8-28



1,000 Orders

200 Designs

20,000

machine-hours

100 Customers Other


Indirect factory wages 125$ 1,000$ 5$ 500$ N/AFactory equipment amortization 60 - 9 - Factory utilities - 60 3 - Factory building lease - - - -

General Administrative DepartmentAdministrative w ages and salarie 60 100 2 1,200 Office equipment amortization 15 - - 125 Administrative building lease - - - -

Marketing DepartmentMarketing wages and salaries 50 125 - 1,500 Selling expenses 5 - - 350

Total 315$ 1,285$ 19$ 3,675$

Activity Rates for each Activity Cost Pools

8-29


Assigning Costs to Cost Objects

Let’s take a look at how our system works for just onecustomer - Windward Yachts.

' Windward ordered two products - Stanchions andCustomer Compass Housings.

' The details are outlined on the following slide.

8-30



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 labour totals $50.6. Shipping costs total $25.

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 labour totals $50.5. Direct labour totals $50.6. Shipping costs total $25.6. Shipping costs total $25.

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 labour totals $1,850.6. Shipping costs total $180.

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 labour totals $1,850.5. Direct labour totals $1,850.6. Shipping costs total $180.6. Shipping costs total $180.

8-31


2 Orders No new design

200

machine hours N/A Total


Indirect factory wages 250$ Factory equipment amortizationFactory utilitiesFactory building lease



Total

Activity Cost Pools - Two Standard Stanchions


$125 per order × 2 orders = $250$125 per order × 2 orders = $250

Overhead cost of two orders for standard stanchions.Overhead cost of two orders for standard stanchions.

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2 Orders No new design

200

machine hours N/A Total


Indirect factory wages 250$ -$ 1,000$ -$ 1,250$ Factory equipment amortization 120 - 1,800 - 1,920 Factory utilities - - 600 - 600 Factory building lease - - - -

General Administrative DepartmentAdministrative wages and salaries 120 - 400 - 520 Office equipment amortization 30 - - - 30 Administrative building lease - - - -

Marketing DepartmentMarketing wages and salaries 100 - - - 100 Selling expenses 10 - - - 10

Total 630$ -$ 3,800$ -$ 4,430$

Activity Cost Pools - Two Standard Stanchions

Overhead cost of two orders for standard stanchions.Overhead cost of two orders for standard stanchions.

8-33


1 Order 1 new design

4 machine

hours N/A Total

Production DepartmentIndirect factory wages 125$ Factory equipment amortizationFactory utilitiesFactory building lease

General Administrative DepartmentAdministrative w ages and salariesOffice equipment amortizationAdministrative building lease


Total

Activity Cost Pools - One Custom Compass Housing

Assigning Costs to Cost ObjectsOverhead cost of one order for custom compass housing.Overhead cost of one order for custom compass housing.

$125 per order × 1 order = $125$125 per order × 1 order = $125

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1 Order 1 new design

4 machine

hours N/A Total

Production DepartmentIndirect factory wages 125$ 1,000$ 20$ -$ 1,145$ Factory equipment amortization 60 - 36 - 96 Factory utilities - 60 12 - 72 Factory building lease - - - -

General Administrative DepartmentAdministrative wages and salaries 60 100 8 - 168 Office equipment amortization 15 - - - 15 Administrative building lease - - - -

Marketing DepartmentMarketing wages and salaries 50 125 - - 175 Selling expenses 5 - - - 5

Total 315$ 1,285$ 76$ -$ 1,676$

Activity Cost Pools - One Custom Compass Housing

Overhead cost of one order for custom compass housing.Overhead cost of one order for custom compass housing.

8-35


Product MarginsStandard Stanchions

Sales 13,600$ Cost: Direct materials 2,110$ Direct labour 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 labour 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570


Custom Compass HousingSales 650$ Cost: Direct materials 13$ Direct labour 50 Shipping costs 25 Customer orders 315 Product design 1,285 Order size 76 1,764

Product margin (1,114)$



8-36






Product MarginsStandard Stanchions

Sales 13,600$ Cost: Direct materials 2,110$ Direct labour 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570


Standard StanchionsSales 13,600$ Cost: Direct materials 2,110$ Direct labour 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570


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$

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$

8-37


Product Margins

Standard Stanchions

Compass Housing

Sales 13,600$ 650$ Costs

Direct materials (2,110) (13) Direct labour (1,850) (50) Manufacturing overhead (10,000) (200)

Product margin (360)$ 387$

Traditional Cost Accounting System

Predetermined manufacturingoverhead rate

$1,000,000 20,000 MH

= $50/MH=

8-38


Product Margins

Standard Stanchions

Compass Housing





400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000

8-39


Product Margins

Standard Stanchions

Compass Housing





1 units x 4.0 MH/unit x $50/MH = $2001 units x 4.0 MH/unit x $50/MH = $200

8-40


Difference Between ABC andTraditional Product Costs

ABC will ordinarily shiftbatch-level andproduct-level

overhead costs fromhigh-volume

products produced inlarge batches to low-

volume productsproduced in small

batches.

8-41


Difference Between ABC andTraditional Product Costs

Under ABC bothmanufacturing andnonmanufacturing

costs may beassigned to products.

Organization-sustaining costs and

the costs of idlecapacity are not

assigned to products.

8-42


Ease of Adjustment Codes(Green, Yellow and Red Costs)

Costs that adjust automatically to changes in activity:' Direct materials.

' Shipping.

Costs that could be adjusted to changes in activity:' Direct labour.

' Factory utilities.

' Administrative wages and salaries.

' Office equipment amortization.

' Marketing wages and salaries.

' Selling expenses.

Costs that are difficult to adjust to changes in activity:' Factory equipment amortization.

' Factory building lease.

' Administrative building lease.

8-43


Custom Compass HousingSales 650$ Green costs:

Direct materials 13$ Shipping costs 25 38 Green margin 612

Yellow costs:Direct labour 50.00 Indirect factory wages 1,145.00 Factory utilities 72.00 Administrative wages 168.00 Office equip. amortization 15.00 Marketing wages 175.00 Selling expenses 5.00 1,630 Yellow margin (1,018)

Red costs:Factory equip. amortization 96 Factory building lease 0Admin. Building lease 0 96 Red margin (1,114)$

8-44


Simplified Approach to ABC

After the first-stage allocation is complete, computationof activity rates for each activity cost pool can be

simplified as follows:

Computation of the Activity Rates Customer

Orders Product Design Order Size

Customer Relations Other

Costs from first- stage allocation 315,000$ 257,000$ 380,000$ 367,500$ 490,500$ Total activity 1,000 200 20,000 100 N/ACost per unit of activity 315$ 1,285$ 19$ 3,675$

Computation of the Activity Rates Customer

Orders Product Design Order Size

Customer Relations Other

Costs from first- stage allocation 315,000$ 257,000$ 380,000$ 367,500$ 490,500$ Total activity 1,000 200 20,000 100 N/ACost per unit of activity 315$ 1,285$ 19$ 3,675$

÷ ÷ ÷ ÷

8-45



Standard Stanchions: Sales 13,600$ Costs: Direct materials 2,110$ Direct labour 1,850 Shipping costs 180 Customer orders (2) 630 Product design - Order size (200) 3,800 8,570 Product margin 5,030$

2 orders @ $315 per order2 orders @ $315 per order

8-46



Custom Compass Housing Sales 650$ Costs: Direct materials 13$ Direct labour 50 Shipping costs 25 Customer orders (1) 315 Product design 1,285 Order size 76 1,764 Product margin (1,114)$

1 design @ $1,285 per design1 design @ $1,285 per design

8-47



Customer margin for Windward Yachts is shown below:

Customer Profitability AnalysisProduct margins: Standard stanchion $ 5,030 Custom compass housing (1,114) Total product margins 3,916 Less: Customer relations (3,675) Customer margin 241

Cost Flows in an Activity-Based Costing System

Appendix

8A

8-49


Predetermined Overhead Rates

(Calculate the predetermined overheadrate for each activity centre based on thefollowing formula:

Predetermined overhead rate =

Estimated overhead cost associatedwith the activity centre

Expected activity level of the cost driver

8-50


JOURNAL ENTRIES

( Record purchase of raw materialsDr Raw Materials

Cr Accounts Payable

( Record transfer of raw material to work inprocess

Dr Work In Process (direct material)

Dr Manufacturing overhead (indirect material)

Cr Raw Materials

8-51


JOURNAL ENTRIES (con’t)

(Record labour costsDr Work In Process (direct labour)

Dr Manufacturing Overhead (indirect labour)

Cr Salaries and Wages Payable

(Record overhead costsDr Manufacturing Overhead

Cr Accumulated Amortization

Cr Property Taxes Payable

Cr Prepaid Insurance

Cr Accounts Payable

8-52



(Record applied overhead

Dr Work In Process

Cr Manufacturing Overhead

Applied overhead for each activity centre iscalculated by multiplying each of the individualpredetermined overhead rates by the actuallevel of cost driver activity incurred. Then, sumall these individual totals to determine the totalapplied overhead for the company.

8-53



(Record transfer to finished goods

Dr Finished Goods

Cr Work In Process

(Record sale of goods

Dr Accounts Receivable

Cr Sales

and

Dr Cost of Goods Sold

Cr Finished Goods

8-54


End of Chapter 8End of Chapter 8 I call thisI call thisquality quality

time!time!

activity based costing · 5. assign costs to a ... activity-based costing system. after studying...

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