11 CH 05

Activity-Based Costing and Activity-Based Management Chapter 5
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
5-1
Learning Objective 1
Explain undercosting and overcosting of products and services.
5-2
Undercosting and Overcosting Example

Jose, Roberta, and Nancy order separate items for lunch. Joses order amounts to $14 Roberta consumed 30 Nancys order is 16 Total $60 What is the average cost per lunch?
5-3
Undercosting and Overcosting Example

$60 3 = $20
Jose and Nancy are overcosted.
Roberta is undercosted.
5-4
Present three guidelines for refining a costing system.
5-5
Existing Single IndirectCost Pool System Example

Kole Corporation manufactures a normal lens (NL) and a complex lens (CL). Kole currently uses a single indirect-cost rate job costing system. Cost objects: 80,000 (NL) and 20,000 (CL).
5-6

Normal Lenses (NL) Direct materials $1,520,000 Direct mfg. labor 800,000 Total direct costs $2,320,000 Direct cost per unit: $2,320,000 80,000 = $29
5-7

Complex Lenses (CL) Direct materials $ 920,000 Direct mfg. labor 260,000 Total direct costs $1,180,000 Direct cost per unit: $1,180,000 20,000 = $59
5-8

INDIRECT-COST POLL
All Indirect Costs $2,900,000
INDIRECT COST-ALLOCATION BASE
50,000 Direct Manufacturing Labor-Hours
$58 per Direct Manufacturing Labor-Hour
5-9

COST OBJECT: NL AND CL LENSES Indirect Costs Direct Costs
DIRECT COSTS
Direct Materials
Direct Manufacturing Labor

5 - 10

Kole uses 36,000 direct manufacturing labor-hours to make NL and 14,000 direct manufacturing labor-hours to make CL. How much indirect costs are allocated to each product?
5 - 11

NL: 36,000 $58 = $2,088,000 CL: 14,000 $58 = $812,000 What is the total cost of normal lenses? Direct costs $2,320,000 + Allocated costs $2,088,000 = $4,408,000 What is the cost per unit? $4,408,000 80,000 = $55.10
5 - 12

What is the total cost of complex lenses? Direct costs $1,180,000 + Allocated costs $812,000 = $1,992,000 What is the cost per unit? $1,992,000 20,000 = $99.60
5 - 13

Normal lenses sell for $60 each and complex lenses for $142 each. Normal Complex Revenue $60.00 $142.00 Cost 55.10 99.60 Income $ 4.90 $ 42.40 Margin 8.2% 29.9%
5 - 14
Refining a Costing System

Direct-cost tracing Indirect-cost pools Cost-allocation basis
5 - 15

1. Design of Products and Process The Design Department designs the molds and defines processes needed (details of the manufacturing operations).
5 - 16

2. Manufacturing Operations Lenses are molded, finished, cleaned, and inspected. 3. Shipping and Distribution Finished lenses are packed and sent to the various customers.
5 - 17
Distinguish between the traditional and the activity-based costing approaches to designing a costing system.
5 - 18
Activity-Based Costing System

Fundamental Cost Objects
Activities
Assignment to Other Cost Objects

Cost of: Product Service Customer
Costs of Activities
5 - 19

A cross-functional team at Kole Corporation identified key activities: Design products and processes.
Set up molding machine. Operate machines to manufacture lenses.
Maintain and clean the molds.

5 - 20

Set up batches of finished lenses for shipment. Distribute lenses to customers.
Administer and manage all processes.
5 - 21

Activity Indirect Cost Pool Design Setup Shipping
Cost Allocation Base
PartsSquare feet
No. of Setup Hours
No. of Shipments
Product Cost Objects
Lenses NL
Lenses CL
Lenses Other
5 - 22

NL CL Quantity produced 80,000 20,000 No. produced/batch 250 50 Number of batches 320 400 Setup time per batch 2 hours 5 hours Total setup-hours 640 2,000 Total setup costs are $409,200.
5 - 23

What is the setup cost per setup-hour? $409,200 2,640 hours = $155 What is the setup cost per direct manufacturing labor-hour? $409,200 50,000 = $8.184
5 - 24

Allocation using direct labor-hours: NL: $8.184 36,000 = $294,624 CL: $8.184 14,000 = $114,576 Total $409,200 Allocation using setup-hours: NL: $155 640 = $ 99,200 CL: $155 2,000 = $310,000 Total $409,200
5 - 25
Describe a four-part cost hierarchy.
5 - 26
Cost Hierarchies
A cost hierarchy is a categorization of costs into different cost pools. Cost drivers bases (cost-allocation bases) Degrees of difficulty in determining cause-and-effect relationships
5 - 27
Cost Hierarchies
ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: 1. Output unit-level costs
2. 3. 4. Batch-level costs Product-sustaining costs Facility-sustaining costs
5 - 28
Output Unit-Level Costs

These are resources sacrificed on activities performed on each individual unit of product or service. Energy Machine depreciation
Repairs
5 - 29
Batch-Level Costs
These are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. Setup-hours Procurement costs
5 - 30
Product-Sustaining Costs
These are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services. Design costs
Engineering costs
5 - 31
Facility-Sustaining Costs
These are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. General administration
rent
building security
5 - 32
Cost products or services using activity-based costing.
5 - 33
Implementing Activity-Based Costing

Step 1 Identify cost objects. Step 2 Identify the direct costs of the products. Direct material Direct labor Mold cleaning and maintenance
5 - 34
NL CL

Cleaning and maintenance costs of $360,000 are direct batch-level costs. Why?
Because these costs consist of workers wages for cleaning molds after each batch of lenses is run.
5 - 35

Normal Lenses (NL) Cost Hierarchy Description Category Direct materials Unit-level $1,520,000 Direct mfg. labor Unit-level 800,000 Cleaning and maint. Batch-level 160,000 Total direct costs $2,480,000
5 - 36

Complex Lenses (CL) Cost Hierarchy Description Category Direct materials Unit-level $ 920,000 Direct mfg. labor Unit-level 260,000 Cleaning and maint. Batch-level 200,000 Total direct costs $1,380,000
5 - 37

Step 3
Select the cost-allocation bases to use for allocating indirect costs to the products. (1) (2) (3) Activity Cost Hierarchy Total Costs Design Product-sustaining $450,000 Setups Batch-level $409,200 Operations Unit-level $637,500
5 - 38

Step 4
Identify the indirect costs associated with each cost-allocation base. Overhead costs incurred are assigned to activities, to the extent possible, on the basis of a cause-and-effect relationship.
5 - 39

Step 5
Compute the rate per unit.

(1) (5) NL CL Total Setup-hours: 640 2,000 2,640 $409,200 2,640 = $155
5 - 40

Step 6
Compute the indirect costs allocated to the products. NL: $155 640 = $ 99,200 CL: $155 2,000 = 310,000 Total $409,200
5 - 41

Step 7
Compute the costs of the products.

NL and CL would show three direct cost categories. 1. Direct materials 2. Direct manufacturing labor
3.
Cleaning and maintenance

5 - 42

NL and CL would show six indirect cost pools.
1.
2.
Design
Molding machine setups
3.
4. 5.
Manufacturing operations
Shipment setup Distribution
6.
Administration
5 - 43
Use activity-based costing systems for activity-based management.
5 - 44
Activity-Based Management
ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits. Product pricing and mix decisions Cost reduction and process improvement decisions
Design decisions
5 - 45
Product Pricing and Mix Decisions

ABC gives management insight into the cost structures for making and selling diverse products. It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs.
5 - 46
Cost Reduction and Process Improvement Decisions

Manufacturing and distribution personnel use ABC systems to focus on cost-reduction efforts. Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base.
5 - 47
Design Decisions
Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can work with their customers to evaluate the costs and prices of alternative designs.
5 - 48
Compare activity-based costing systems and departmentcosting systems.
5 - 49
ABC and Department Indirect-Cost Rates

Many companies have evolved their costing system from using a single cost pool to using separate indirect-cost rates for each department:
Design Manufacturing Distribution
5 - 50
ABC and Department Indirect-Cost Rates

Why? Because the cost drivers of resources in each department or subdepartment differ from the single, company-wide, cost-allocation base. ABC systems are a further refinement of department costing systems.
5 - 51
Evaluate the costs and benefits of implementing activity-based costing systems.
5 - 52
Benefits of ABC Systems

Significant amounts of indirect costs are allocated using only one or two cost pools. All or most costs are identified as output unit-level costs. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.
5 - 53

Products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits. Complex products appear to be very profitable and simple products appear to be losing money.
5 - 54

Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.
5 - 55
Limitations of ABC Systems

The main limitations of ABC are the measurements necessary to implement the system. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.
5 - 56
Limitations of ABC Systems

Activity-cost rates also need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand.
5 - 57
ABC In Service and Merchandising Companies

The general approach to ABC in the service and merchandising areas is very similar to the approach in manufacturing. Costs are divided into homogeneous cost pools and classified as output unit-level, batch-level, product- or service-sustaining, and facility-sustaining costs.
5 - 58
ABC In Service and Merchandising Companies

The cost pools correspond to key activities. Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool.
5 - 59
End of Chapter 5
5 - 60

11 CH 05

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Activity-Based Costing and Activity-Based Management Chapter 5

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Explain undercosting and overcosting of products and services.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Undercosting and Overcosting Example

Undercosting and Overcosting Example

Jose and Nancy are overcosted.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Present three guidelines for refining a costing system.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Existing Single IndirectCost Pool System Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Existing Single IndirectCost Pool System Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Existing Single IndirectCost Pool System Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Existing Single IndirectCost Pool System Example

All Indirect Costs $2,900,000

INDIRECT COST-ALLOCATION BASE

50,000 Direct Manufacturing Labor-Hours

$58 per Direct Manufacturing Labor-Hour

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Existing Single IndirectCost Pool System Example

Direct Manufacturing Labor

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Existing Single IndirectCost Pool System Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Existing Single IndirectCost Pool System Example

Existing Single IndirectCost Pool System Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Existing Single IndirectCost Pool System Example

Refining a Costing System

Refining a Costing System

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Refining a Costing System

Activity-Based Costing System

Assignment to Other Cost Objects

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Activity-Based Costing System

Maintain and clean the molds.

Activity-Based Costing System

Administer and manage all processes.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Activity-Based Costing System

Cost Allocation Base

No. of Setup Hours

Product Cost Objects

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Activity-Based Costing System

Activity-Based Costing System

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Activity-Based Costing System

Describe a four-part cost hierarchy.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Output Unit-Level Costs

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Cost products or services using activity-based costing.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Implementing Activity-Based Costing

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Implementing Activity-Based Costing