costacctg13_sm_ch05 - CHAPTER 5 ACTIVITY­BASED COSTING AND...

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Unformatted text preview: CHAPTER 5 ACTIVITY­BASED COSTING AND ACTIVITY­BASED MANAGEMENT 5­1 Broad averaging (or “peanut­butter costing”) describes a costing approach that uses broad averages for assigning (or spreading, as in spreading peanut butter) the cost of resources uniformly to cost objects when the individual products or services, in fact, use those resources in non­uniform ways. Broad averaging, by ignoring the variat ion in the consumption o f resources by different cost objects, can lead to inaccurate and misleading cost data, which in turn can negatively impact the marketing and operating decisio ns made based on that informat ion. 5­2 Overcosting may result in co mpet itors entering a market and taking market share for products that a company erroneously believes are low­margin or even unprofitable. Undercosting may result in co mpanies selling products on which they are in fact losing mo ney, when they erroneously believe them to be profitable. 5­3 Costing system refinement means making changes to a simple cost ing system that reduces the use of broad averages for assigning the cost of resources to cost objects and provides better measurement of the costs of overhead resources used by different cost objects. Three guidelines for refinement are 1. Classify as many o f the total costs as direct costs as is econo mically feasible. 2. Expand the number of indirect cost pools until each o f these pools is more ho mogenous. 3. Use the cause­and­effect criterion, when possible, to ident ify the cost­allocat ion base for each indirect­cost pool. 5­4 An activit y­based approach refines a costing system by focusing on individual act ivit ies as the fundamental cost objects. It uses the cost of these activit ies as the basis for assigning costs to other cost objects such as products or services. 5­5 Four levels o f a cost hierarchy are (i) Output unit­level costs: costs of act ivit ies performed on each individual unit of a product or service. (ii) Batch­level costs: costs of activit ies related to a group of units of products or services rather than to each individual unit of product or service. (iii)Product­sustaining costs or service­sustaining costs: costs of activit ies undertaken to support individual products or services regardless of the number of unit s or batches in which the units are produced. (iv) Facilit y­sustaining costs: costs of act ivit ies that cannot be traced to individua l products or services but support the organizat ion as a who le. 5­6 It is important to classify costs into a cost hierarchy because costs in different cost pools relate to different cost­allocat ion bases and not all cost­allocat ion bases are unit­level. For example, an allo cation base like setup hours is a batch­level allocat ion base, and design hours is a product­sustaining base, both insensit ive to the number o f unit s in a batch or the number o f units o f product produced. If costs were not classified into a cost hierarchy, the alternat ive would be to consider all costs as unit­level costs, leading to misallocat ion of those costs that are not unit­level costs. 5­1 5­7 An ABC approach focuses on activit ies as the fundamental cost objects. The costs of these act ivit ies are built up to compute the costs of products, and services, and so on. Simple costing systems have one or a few indirect cost pools, irrespective of the heterogeneit y in the facilit y while ABC systems have mult iple indirect cost pools. An ABC approach attempts to use cost drivers as the allocat ion base for indirect costs, whereas a simple costing system generally does not. The ABC approach classifies as many indirect costs as direct costs as possible. A simple costing system has more indirect costs. 5­8 Four decisio ns for which ABC informat ion is useful are 1. pricing and product mix decisio ns, 2. cost reduction and process improvement decisio ns, 3. product design decisio ns, and 4. decisio ns for planning and managing activit ies. 5­9 No. Department indirect­cost rates are similar to activit y­cost rates if (1) a single activit y accounts for a sizable fraction o f the department’s costs, or (2) significant costs are incurred on different activit ies wit hin a depart ment but each activit y has the same cost­allocat ion base, or (3) significant costs are incurred on different activit ies wit h different cost­allo cation bases wit hin a department but different products use resources fro m the different activit y areas in the same proportions. 5­10 “Tell­tale” signs that indicate when ABC systems are likely to provide the most benefit s are as fo llows: 1. Significant amounts of indirect costs are allocated using only one or two cost pools. 2. All or most indirect costs are ident ified as output­unit­level costs (i.e., few indirect costs are described as batch­level, product­sustaining, or facilit y­sustaining costs). 3. Products make diverse demands on resources because o f differences in vo lume, process steps, batch size, or complexit y. 4. Products that a company is well suited to make and sell show small pro fits, whereas products that a company is less suited to produce and sell show large profits. 5. Operations staff has significant disagreements wit h the account ing staff about the costs of manufacturing and market ing products and services. 5­11 The main costs and limitat ions o f ABC are the measurements necessary to implement the systems. Even basic ABC systems require many calculat ions to determine costs of products and services. Activit y­cost rates often need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand. Somet imes the allocat ions necessary to calculate activit y costs often result in act ivit y­cost pools and quant ities of cost­allocat ion bases being measured with error. When measurement errors are large, activit y­cost informat ion can be misleading. 5­12 No, ABC systems apply equally well to service companies such as banks, railroads, hospitals, and account ing firms, as well merchandising co mpanies such as retailers and distributors. 5­13 No. An act ivit y­based approach should be adopted only if it s expected benefit s exceed it s expected costs. It is not always a wise invest ment. If the jobs, products or services are alike in the way they consume indirect costs of a company, then a simple costing system will suffice. 5­2 5­14 Increasing the number o f indirect­cost pools does NOT guarantee increased accuracy o f productor service costs. If the exist ing cost pool is already homogeneous, increasing the number of cost pools will not increase accuracy. If the existing cost pool is not homogeneous, accurac y will increase only if the increased cost pools themselves increase in ho mogeneit y vis­a­vis the single cost pool. 5­15 The controller faces a difficult challenge. The benefits o f a better accounting syste m show up in improved decisio ns by managers. It is important that the controller have the support of these managers when seeking increased investments in account ing systems. Statements by these managers showing how their decis io ns will be improved by a better accounting system are the controller’s best arguments when seeking increased funding. For example, the new syste m will result in more accurate product costs which will influence pricing and product mix decisio ns. The new system can also be used to reduce product costs which will lower selling prices. As a result, the customer will benefit from the new system. 5­16 (20 min.) Cost hierarchy. 1. a. Indirect manufacturing labor costs of $1,200,000 support direct manufacturing labor and are output unit­level costs. Direct manufacturing labor generally increases wit h output units, and so will the indirect costs to support it. b. Batch­level costs are costs of act ivit ies that are related to a group of units o f a product rather than each individual unit o f a product. Purchase order­related costs (including costs of receiving materials and paying suppliers) of $600,000 relate to a group of units of product and are batch­level costs. c. Cost of indirect materials o f $350,000 generally changes wit h labor hours or machine hours which are unit­level costs. Therefore, indirect material costs are output unit­ level costs. d. Setup costs of $700,000 are batch­level costs because they relate to a group of units of product produced after the machines are set up. e. Costs of designing processes, drawing process charts, and making engineering changes for individual products, $900,000, are product­sustaining because they relate to the costs of activit ies undertaken to support individual products regardless of the number of unit s or batches in which the product is produced. f. Machine­related overhead costs (depreciation and maintenance) of $1,200,000 are output unit­level costs because they change with the number of units produced. g. Plant management, plant rent, and insurance costs of $950,000 are facilit y­sustaining costs because the costs of these act ivit ies cannot be traced to individual products or services but support the organizat ion as a who le. 5­3 2. The co mplex boom box made in many batches will use significantly more batch­level overhead resources compared to the simple boom box that is made in a few batches. In addit ion, the co mplex boom box will use more product­sustaining overhead resources because it is complex. Because each boom box requires the same amount of machine­hours, both the simple and the co mplex boom box will be allocated the same amount of overhead costs per boom box if Teledor uses only machine­hours to allocate overhead costs to boom boxes. As a result, the complex boom box will be undercosted (it consumes a relat ively high level of resources but is reported to have a relat ively low cost) and the simple boom box will be overcosted (it consumes a relatively low level o f resources but is reported to have a relat ively high cost). 3. Using the cost hierarchy to calculate activit y­based costs can help Teledor to ident ify both the costs of individual act ivit ies and the cost of act ivit ies demanded by individual products. Teledor can use this informat ion to manage its business in several ways: a. Pricing and product mix decisio ns. Knowing the resources needed to manufacture and sell different types o f boom boxes can help Teledor to price the different boom boxes and also ident ify which boom boxes are more profitable. It can then emphasize its more profitable products. b. Teledor can use informat ion about the costs of different activit ies to improve processes and reduce costs of the different activit ies. Teledor could have a target of reducing costs of act ivit ies (setups, order processing, etc.) by, say, 3% and constant ly seek to eliminate activit ies and costs (such as engineering changes) that its customers perceive as not adding value. c. Teledor management can ident ify and evaluate new designs to improve performance by analyzing how product and process designs affect activit ies and costs. d. Teledor can use it s ABC systems and cost hierarchy informat ion to plan and manage activit ies. What activit ies should be performed in the period and at what cost? 5­17 (25 min.) ABC, cost hierarchy, service. 1. Output unit­level costs a. Direct­labor costs, $243,000 b. Equipment­related costs (rent, maintenance, energy, and so on), $400,000 These costs are output unit­level costs because they are incurred on each unit of materials tested, that is, for every hour of testing. Batch­level costs c. Setup costs, $385,000 These costs are batch­level costs because they are incurred each time a batch of materials is set up for either HT or ST, regardless o f the number of hours for which the tests are subsequent ly run. Service­sustaining costs d. Costs of designing tests, $252,000. These costs are service­sustaining costs because they are incurred to design the HT and ST tests, regardless o f the number of batches tested or the number of hours of test time. 5­4 2. Heat Testing (HT) Total (1) Direct labor costs (given) Equipment­r elated costs $5 per hour * ´ 50,000 hours $5 per hour * ´ 30,000 hours Setup costs † $22 per setup­hour ´ 13,500 setup­hours † $22 per setup­hour ´ 4,000 setup­hours Costs of designing tests $60 per hour ** ´ 2,800 hours $60 per hour ** ´ 1,400 hours Total costs $183,000 250,000 Per Hour (2) = (1) ¸ 50,000 $ 3.66 5.00 150,000 297,000 5.94 88,000 168,000 $898,000 3.36 $17.96 84,000 $382,000 2.80 $12.73 2.93 5.00 Stress Testing (ST) Total (3) $ 60,000 Per Hour (4) = (3) ¸ 30,000 $ 2.00 *$400,000 ¸ (50,000 + 30,000) hours = $5 per test­hour † $385,000 ¸ (13,500 + 4,000) setup hours = $22 per setup­hour **$252,000 ¸ (2,800 + 1,400) hours = $60 per hour At a cost per test­hour of $16, the simple costing system undercosts heat testing ($17.96) and overcosts stress testing ($12.73). The reason is that heat testing uses direct labor, setup, and design resources per hour more intensively than stress testing. Heat tests are more complex, take lo nger to set up, and are more difficult to design. The simple costing system assumes that testing costs per hour are the same for heat testing and stress testing. 3. The ABC system better captures the resources needed for heat testing and stress testing because it ident ifies all the various act ivit ies undertaken when performing the tests and recognizes the levels o f the cost hierarchy at which costs vary. Hence, the ABC system generates more accurate product costs. Plymouth’s management can use the informat ion from the ABC system to make better pricing and product mix decisio ns. For example, it might decide to increase the prices charged for the more costly heat testing and consider reducing prices on the less costly stress testing. Plymouth should watch if co mpet itors are underbidding Plymouth in stress testing, and causing it to lose business. Plymouth can also use ABC informat ion to reduce costs by eliminat ing processes and act ivit ies that do not add value, ident ifying and evaluat ing new methods to do testing that reduce the act ivit ies needed to do the tests, reducing the costs of do ing various activit ies, and planning and managing act ivit ies. 5­5 5­18 (15 min.) Alternative allocation bases for a professional services firm. 1. Direct Professional Time Rate per Number Hour of Hours Total (2) (3) (4) = (2) ´ (3) Support Services Rate (5) Amount Billed to Total Client (6) = (4) ´ (5) (7) = (4) + (6) Client (1) SEATTLE DOMINION Wo lfson Brown Anderson TOKYO ENTERPRISES Wo lfson Brown Anderson $500 120 80 15 3 22 $7,500 360 1,760 30% 30 30 $2,250 108 528 $ 9,750 468 2,288 $12,506 $500 120 80 2 8 30 $1,000 960 2,400 30% 30 30 $300 288 720 $1,300 1,248 3,120 $5,668 2. Direct Professional Time Support Services Amount Rate Number Rate per Billed to per of Hours Total Hour Total Client Hour (2) (3) (5) (4) = (2) ´ (3) (6) = (3) ´ (5) (7) = (4) + (6) Client (1) SEATTLE DOMINION Wo lfson Brown Anderson TOKYO ENTERPRISES Wo lfson Brown Anderson $500 120 80 15 3 22 $7,500 360 1,760 $50 50 50 $ 750 150 1,100 $ 8,250 510 2,860 $11,620 $500 120 80 2 8 30 $1,000 960 2,400 $50 50 50 $ 100 400 1,500 $1,100 1,360 3,900 $6,360 Seattle Do minio n Tokyo Enterprises Requirement 1 $12,506 5,668 $18,174 Requirement 2 $11,620 6,360 $17,980 Both clients use 40 hours of professio nal labor time. However, Seattle Dominio n uses a higher proportion o f Wo lfson’s t ime (15 hours), which is more costly. This attracts the highest support­ services charge when allocated on the basis of direct professio nal labor costs. 5­6 3. Assume that the Wo lfson Group uses a cause­and­effect criterion when choosing the allocat ion base for support services. You could use several pieces o f evidence to determine whether professio nal labor costs or hours is the dr iver of support­service costs: a. Interviews with personnel. For example, staff in the major cost categories in support services could be interviewed to determine whether Wo lfson requires more support per hour than, say, Anderson. The professio nal labor costs allocat ion base implies that an hour of Wo lfso n’s t ime requires 6.25 ($500 ÷ $80) times more support­service dollars than does an hour of Anderson’s time. b. Analysis of tasks undertaken for selected clients. For example, if co mputer­related costs are a sizable part of support costs, you could determine if there was a systemat ic relat ionship between the percentage invo lvement of professio nals wit h high billing rates on cases and the computer resources consumed for those cases. 5­19 (20 min.) Plantwide, department and ABC indirect cost rates. 1. Actual plant­wide variable MOH rate based on machine hours, $308,600 ¸ 4,000 $77.15 per machine hour United Motors Holden Motors Leland Vehicle Total Variable manufacturing overhead, allocated based on machine hours ($77.15 ´ 120; $77.15 ´ 2,800; $77.15 ´ 1,080) 2. Department Design Production Engineering Variable MOH in 2007 $39,000 29,600 240,000 Total Driver Units 390 370 4,000 $9,258 $216,020 $83,322 $308,600 Rate $100 $ 80 $ 60 United Motors per CAD­design hour per engineering hour per machine hour Holden Motors Leland Vehicle Total Design­related overhead, allocated on CAD­design hours (110 ´ $100; 200 ´ $100; 80 ´ $100) Production­related overhead, allocated on engineering hours (70 ´ $80; 60 ´ $80; 240 ´ $80) Engineering­related overhead, allocated on machine hours (120 ´ $60; 2,800 ´ $60; 1,080 ´ $60) Total $11,000 $ 20,000 $ 8,000 $ 39,000 5,600 4,800 19,200 29,600 7,200 168,000 64,800 240,000 $23,800 $192,800 $92,000 $308,600 5­7 3. United Motors a. Department rates (Requirement 2) b. Plantwide rate (Requirement 1) Ratio of (a) ÷ (b) $23,800 $ 9,258 2.57 Holden Motors $192,800 $216,020 0.89 Leland Vehicle $92,000 $83,322 1.10 The variable manufacturing overhead allocated to United Motors increases by 157% under the department rates, the overhead allocated to Holden decreases by about 11% and the overhead allocated to Leland increases by about 10%. The three contracts differ sizably in the way they use the resources of the three departments. The percentage of total driver units in each department used by the co mpanies is: Cost Department Driver Design CAD­design hours Engineering Engineering hours Production Machine hours United Motors 28% 19 3 Holden Motors 51% 16 70 Leland Vehicle 21% 65 27 The United Motors contract uses only 3% of total machines hours in 2004, yet uses 28% of CAD design­hours and 19% of engineering hours. The result is that the plantwide rate, based on machine hours, will great ly underest imate the cost of resources used on the United Motors contract. This explains the 157% increase in indirect costs assigned to the United Motors contract when department rates are used. In contrast, the Ho lden Motors contract uses less of design (51%) and engineering (16%) than o f machine­hours (70%). Hence, the use of department rates will report lower indirect costs for Holden Motors than does a plantwide rate. Holden Motors was probably co mplaining under the use of the simple system because it s contract was being overcosted relat ive to its consumpt ion o f MOH resources. United, on the other hand was having its contract undercosted and underpr iced by the simple system. Assuming that AP is an efficient and co mpetit ive supplier, if the new department­based rates are used to price contracts, United will be unhappy. AP should explain to United how the calculat ion was done, and po int out United’s high use of design and engineering resources relat ive to production machine hours. Discuss ways of reducing the consumpt ion o f those resources, if possible, and show willingness to partner with them to do so. If the price rise is go ing to be steep, perhaps offer to phase in the new prices. 4. Other than for pricing, AP can also use the informat ion fro m the department­based system to examine and streamline its own operations so that there is maximum value­added fr...
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