Chapter 4 - Lecture 3 Lecture 3 Activity Based Costing How do you split a bill in a restaurant How do you split a bill in a restaurant Entree Emma

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Unformatted text preview: Lecture # 3 Lecture # 3 Activity Based Costing How do you split a bill in a restaurant? How do you split a bill in a restaurant? Entree Emma James Jessica Matthew Total Average 11 20 15 14 60 15 Dessert 0 8 4 4 16 4 Drinks 4 14 8 6 32 8 Total 15 42 27 24 108 27 Need for a New Approach Need for a New Approach Tremendous change in manufacturing and service industries. Decrease in amount of direct labour usage. Significant increase in total overhead costs. Often inappropriate to use plant­wide pre­determined overhead rates based on direct labour or machine hours when a lack of correlation exists. Complex manufacturing processes may require multiple allocation bases; this approach is called Activity­Based Costing (ABC). Activities and Related Cost Drivers Activities and Related Cost Drivers 6 steps to trace activity costs to 6 steps to trace activity costs to products 1. 2. 3. 4. 5. 1. Identify the activities that generates indirect product costs Estimate the direct cost of the activities (DL, DM) Select a cost driver (CD) for each activity Estimate the cost driver use by all products Calculate the cost driver application rate = activity cost/ estimated usage of CD by all products Apply activity costs to each product When not to use volume­based product When not to use volume­based product costing system? If you have a large proportion of non­unit­level activities (batch, product, or facility level) a unit­ level cost driver like DL, or machine hours, will not be able to assign the costs to the non­unit level activities. If you have product diversity, where the proportions of activities consumed by products are different, no single cost driver will accurately assign the resulting overhead costs. Activity­Based Costing (ABC) Activity­Based 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. Activity­Based Costing (ABC) Activity­Based 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. Activity Based Costing Activity Based Costing ABC: a two stage procedure used to assign overhead costs to products or services produced. In the first stage, significant activities are identified, and overhead costs are assigned to activity cost pools in accordance with the way resources are consumed by the activities. In the second stage, the overhead costs are allocated from each activity cost pool to each product line in proportion to the amount of the cost driver consumed by the product line. Traditional Costing vs. ABC Traditional Costing vs. ABC Atlas Company produces two automotive anti­theft devices: An Illustration Each product requires 1 hour of direct labour 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 Total annual direct labour hours (DLH) 30,000 (25,000 + 5000) Direct labour cost $12 per unit for each product Expected annual manufacturing overhead costs $900,000 Direct materials cost: The Boot ­ $40 per unit Products Manufacturing Costs The Boot The Club Direct Materials $40 $30 Direct Labour 12 12 Overhead 30* 30* Total unit cost $82 $72 Unit Costs under Traditional Unit Costs under Traditional Costing * Predetermined overhead rate: $900,000/30,000 DLH = $30 per DLH Overhead = predetermined overhead rate times direct labour hours ($30 X 1 hr. = $30) Step 1: Identify and Classify Activities and Allocate Overhead to Cost Pools Unit Costs under ABC: Unit Costs under ABC: Activity Cost Pools Estimated Overhead Setting up machines $300,000 500,000 100,000 $900,000 Machining Inspecting Total Unit Costs under ABC: Unit Costs under ABC: Step 2: Identify Cost Drivers Expected Use of Cost Drivers Activity Cost Pools Cost Drivers Per Activity Setting up machines Number of setups 1,500 Machining Machine hours 50,000 Inspecting Number of Inspections 2,000 Step 3: Calculate Overhead Rates Formula for Calculating Activity­Based Overhead Rate: Estimated Overhead Per Activity ­ Based = Expected Use of Cost Drivers Per Activity Overhead Rate Unit Costs under ABC: Unit Costs under ABC: Activity Cost Pools Setting up machines Machining Inspecting Total Estimated Overhead Expected Use of Cost Drivers per Activity Activity­Based Overhead Rates $200 per setup $10 per mach. hour $50 per inspection $300,000 1,500 setups $500,000 50,000 machine hrs. $100,000 2,000 inspections $900,000 Part 1: Expected Use of Cost Driver Per Product Expected Use Expected Use Pools Cost Driver Step 4: Assign Overhead Costs to Products of Cost Drivers of Cost Drivers Per Activity per Product: The The Boot Club 500 1,000 20,000 Unit Costs under ABC: Unit Costs under ABC: Setting up Number of 1,500 setups machines setups Machining Machine hours 50,000 Hours 30,000 Inspecting Number of 2,000 Step 4: Assign Overhead Costs to Products Activity Cost Expected Use of Pools Cost Drivers per Product Setting up machines Machining Inspecting Total costs assigned Units produced: 25,000 Unit Costs under ABC: Unit Costs under ABC: Part 2: Assign Cost Pools to Products The Boot Activity­ Based Over­ head Rates 500 $200 Cost Assigned $100,000 300,000 25,000 $425,000 30,000 10 500 50 Step 4: Assign Overhead Costs to Products Activity Cost Expected Use of Pools Cost Drivers per Product Setting up machines Machining Inspecting Total costs assigned Units produced : 5,000 Unit Costs under ABC: Unit Costs under ABC: Part 2: Assign Cost Pools to Products The Club Activity­ Based Over­ head Rates 1,000 $200 Cost Assigned $200,000 200,000 75,000 $475,000 20,000 10 1,500 50 Comparison Of Unit Costs Comparison Of Unit Costs Traditional vs. ABC The Boot Manufacturin Traditional ABC g Costing Costing Costs The Club Traditional ABC Costing Costing $30 12 30 $72 $30 12 95 $137 Direct Materials Direct Labour $40 12 30 $82 $40 12 17 $69 Overhead Total Cost per Unit Overstated $13 Understated $65 Value­Added vs. Value­Added vs. Non­Value­Added Activities Activity Based Management (ABM): An extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision making A refinement of ABC used in ABM classifies activities as either value­added or non­value­added. Value­Added vs. Non­Value­Added Activities An activity that increases the worth of a product or service such as: Manufacturing Company Service Company engineering design performing surgery machining legal research services assembly delivering packages painting packaging Value­Added Activity Value­Added vs. Non­Value­Added Activities Non­Value­Added Activities An activity that adds cost to, or increases the time spent on, a product/service without increasing its market value such as: Manufacturing Company Service Company Repair of machines Taking appointments Storage of inventory Reception Moving of raw materials, Bookkeeping/billing assemblies, and finished goods Traveling Building maintenance Ordering supplies Unit costs: costs that vary proportionally with the number of units produced Classes of costs: Unit and Classes of costs: Unit and Batch DM, DL, machine hours These costs are proportional to short­run production decision Batch related costs are incurred each time a batch of goods is processed set­ups, material movements, purchase orders, inspection The demand for setup resources are independent of the number of units produced after completing the setup Classes of costs: Product and Classes of costs: Product and Facility Product related costs: incurred to enable individual products to be produced and sold Facility related costs: costs incurred to create productive capacity for all products the expenses of these activities can be traced to the individual products, but the resources consumed by the activities are independent of how many units or batches of the products are produced. (i.e. process engineering, product specifications, product enhancements i.e. factory administration, maintenance, heating and lighting Benefits of ABC Benefits of ABC Recognizes the different levels of indirect costs More beneficial for organizations with multiple products More beneficial for organizations that have products and services that used overhead activities in different ways More beneficial if there is a high proportion of overhead relative to direct costs Assists managers in finding opportunities to reduce costs and to make better product and pricing decisions Identifies how different activities relate to each other Forces the organization to understand its processes Problems with ABC Problems with ABC Usage of cost drivers may not be proportional to the activity costs Facility costs are allocated to products arbitrarily Costly to implement Implementation fails when… There is a lack of senior management support The project is delegated to consultants There is resistance to change To Do… To Do… Exercise No Office Hours on Thursdays, If you have a question send me an email to: [email protected] Office Hours are in AC1110 not in Dunton Tower. ...
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This note was uploaded on 12/15/2010 for the course ACCT 1005 taught by Professor Mr during the Spring '10 term at Carleton CA.

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