Activity-Based Costing: A Tool to Aid Decision Making

Chapter 7

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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ActivityBased Costing (ABC)

ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity, and therefore, affect fixed as well as variable costs.
ABC is a good supplement to our traditional cost system

I agree!

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Learning Objective 1
Understand activitybased costing and how it differs from a traditional costing system.

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How Costs are Treated Under ActivityBased Costing

ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways. ways. Manufacturing costs Nonmanufacturing costs

Traditional product costing

ABC product costing

ABC assigns both types of costs to products.

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How Costs are Treated Under ActivityBased Costing

ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways. ways. Manufacturing costs
Mo st, not but all

Nonmanufacturing costs Some ABC product costing

Traditional product costing

ABC does not assign all manufacturing costs to products.

All

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How Costs are Treated Under ActivityBased Costing

ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways. ways. Level of complexity
ActivityBased ActivityBased Costing Costing Departmental Departmental Overhead Overhead Rates Rates Plantwide Plantwide Overhead Overhead Rate Rate

Number of cost pools ABC uses more cost pools.

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How Costs are Treated Under ActivityBased Costing

ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways. ways.

Each Each ABC ABC cost cost pool has has its own own unique unique measure measure of of activity. activity. Traditional Traditional cost systems usually usually rely rely cost systems on volume measures measures such such as as direct direct labor labor on volume hours hours and/or and/or machine machine hours hours to to allocate allocate all all overhead overhead costs costs to to products. products.
ABC uses more cost pools.

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How Costs are Treated Under ActivityBased Costing

Activity
An event that causes the consumption of overhead resources. A cost bucket in which costs related to a single activity measure are accumulated.

Activity Cost Pool $$ $ $ $ $

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How Costs are Treated Under ActivityBased Costing

Activity Measure An allocation base in an activity-based costing system. The term cost driver is also used to refer to an activity measure.

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How Costs are Treated Under ActivityBased Costing

Two common types of activity measures: Transaction driver
Simple count of the number of times an activity occurs.

Duration driver
A measure of the amount of time needed for an activity.

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How Costs are Treated Under ActivityBased Costing

ABC defines five levels of activity that largely do not relate to the volume of units produced.

Traditional Traditional cost cost systems systems usually usually rely rely on on volume volume measures measures such such as as direct direct labor labor hours hours and/or and/or machine machine hours hours to to allocate allocate all all overhead overhead costs costs to to products. products.

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How Costs are Treated Under ActivityBased Costing

Unit-Level Activity Batch-Level Activity

Manufacturing companies typically combine their activities into five classifications.

Product-Level Activity Customer-Level Activity

Organizationsustaining Activity

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Characteristics of Successful ABC Implementations

Strong Strong top top management support

Link to evaluations and and rewards

Cross-functional involvement involvement

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Baxter Battery An ABC Example

Baxter Battery Company Income Statement Year Ended December 31, 2012 Sales Cost of goods sold Direct materials Direct labor Manufacturing overhead Gross margin Selling and administrative expenses Shipping expenses Marketing expenses General administrative expenses Net operating income loss $ 50,000,000 $ 15,000,000 12,000,000 14,000,000

41,000,000 9,000,000

3,000,000 2,000,000 6,000,000

11,000,000 $ (2,000,000)

Manufacturing Manufacturing overhead overhead is is allocated allocated to to products products using using a a single single plantwide plantwide overhead overhead rate rate based based on on machine machine hours. hours.

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Define Activities, Activity Cost Pools, and Activity Measures

At Baxter Battery, the ABC team selected the following activity cost pools and activity measures:

Activity Cost Pools at Baxter Battery

Activity Cost Pool Customer orders Design changes Order size Customer relations Other Activity Measure Number of customer orders Number of design changes Machine-hours Number of active customers Not applicable

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Define Activities, Activity Cost Pools, and Activity Measures

Customer Customer Orders Orders - assigned assigned all all costs costs of of resources resources that that are are consumed consumed by by taking taking and and processing processing customer customer orders. orders. Design Design Changes Changes - assigned assigned all all costs costs of of resources resources consumed consumed by by customer customer requested requested design design changes. changes. Order Order Size Size - assigned assigned all all costs costs of of resources resources consumed consumed as as a a consequence consequence of of the the number number of of units units produced. produced. Customer Customer Relations Relations assigned assigned all all costs costs associated associated with with maintaining maintaining relations relations with with customers. customers. Other Other assigned assigned all all organization-sustaining organization-sustaining costs costs and and unused unused capacity capacity costs costs

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Learning Objective 2
Assign costs to cost pools using a first-stage allocation.

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Assign Overhead Costs to Activity Cost Pools

Overhead Costs at Baxter Battery (Manufacturing and Nonmanufacturing) Production Department Indirect factory wages $ 6,000,000 Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 $ General Administrative Department Administrative wages and salaries 4,000,000 Office equipment depreciation 900,000 Administrative building lease 1,100,000 Marketing Department Marketing wages and salaries 1,500,000 Selling expenses 500,000 Total overhead costs $

14,000,000

6,000,000

2,000,000 22,000,000

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Assign Overhead Costs to Activity Cost Pools

Overhead Costs at Baxter Battery (Manufacturing and Nonmanufacturing) Production Department Indirect factory wages $ 6,000,000 Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 $ 14,000,000 General Administrative Department Administrative wages and salaries 4,000,000 Office equipment depreciation 900,000 Administrative building lease 1,100,000 6,000,000 Marketing Department Direct materials, direct labor, and shipping Marketing wages and salaries 1,500,000 are excluded Selling expenses 500,000 2,000,000 because Baxter Batterys existing cost system can directly Total overhead costs $ 22,000,000

trace these costs to products or customer orders.

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Assign Overhead Costs to Activity Cost Pools

At Baxter Battery the following distribution of resource consumption across activity cost pools is determined.
Activity Cost Pools Customer Design Orders Changes Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses 30% 20% 0% 0% 30% 30% 0% 30% 20% 30% 10% 10% 0% 10% 10% 0% 10% 0% Order Size 20% 60% 60% 0% 10% 0% 0% 0% 0% Customer Relations 10% 0% 0% 0% 30% 20% 0% 50% 70% Other 10% 10% 30% 100% 20% 40% 100% 10% 10%

Total 100% 100% 100% 100% 100% 100% 100% 100% 100%

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Assign Overhead Costs to Activity Cost Pools

Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total

Overhead Costs at Baxter Battery (Manufacturing and Nonmanufacturing)

Production Department Indirect factory wages $ 6,000,000 Factory equipment depreciation 3,500,000 Activity Cost Pools Factory utilities 2,500,000 Customer Design Customer Factory building lease Relations 2,000,000 Orders changes Order Size Other $ General Administrative Department Administrative wages and salaries 4,000,000 $ 1,800,000 Office equipment depreciation 900,000 Administrative building lease 1,100,000 Marketing Department Marketing wages and salaries 1,500,000 Selling expenses 500,000 Total overhead costs $

14,000,000 Total

6,000,000

2,000,000 22,000,000

Indirect $6,000,000 Indirect factory factory wages wages $6,000,000 Percent 30% Percent consumed consumed by by customer customer orders orders 30% $1,800,000 $1,800,000

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Assign Overhead Costs to Activity Cost Pools

Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total

Overhead Costs at Baxter Battery (Manufacturing and Nonmanufacturing)

Production Department Indirect factory wages $ 6,000,000 Factory equipment depreciation 3,500,000 Activity Cost Pools Factory utilities 2,500,000 Customer Design Customer Factory building lease Relations 2,000,000 Orders changes Order Size Other $ General Administrative Department Administrative wages and salaries 4,000,000 $ 1,800,000 Office equipment depreciation 900,000 700,000 Administrative building lease 1,100,000 Marketing Department Marketing wages and salaries 1,500,000 Selling expenses 500,000 Total overhead costs $

14,000,000 Total

6,000,000

2,000,000 22,000,000

Factory $3,500,000 Factory equipment equipment depreciation depreciation $3,500,000 Percent 20% Percent consumed consumed by by customer customer orders orders 20% $ $ 700,000 700,000

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Assign Overhead Costs to Activity Cost Pools

Customer Orders Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total $ Activity Cost Pools Design changes Order Size 1,800,000 $ 350,000 250,000 400,000 90,000 150,000 3,040,000 $ 1,200,000 $ 2,100,000 1,500,000 400,000 5,200,000 $ Customer Relations 600,000 $ 1,200,000 180,000 750,000 350,000 3,080,000 $ Other 600,000 $ 350,000 750,000 2,000,000 800,000 360,000 1,100,000 150,000 50,000 6,160,000 $ Total 6,000,000 3,500,000 2,500,000 2,000,000 4,000,000 900,000 1,100,000 1,500,000 500,000 22,000,000

1,800,000 $ 700,000 1,200,000 270,000 450,000 100,000 4,520,000 $

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Learning Objective 3
Compute activity rates for cost pools.

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Calculate Activity Rates

The ABC team determines that Baxter Battery will have these total activities for each activity cost pool:
10,000 customer orders, 4,000 design changes, 800,000 machine-hours, 2,000 customers served.

Now Now the the team team can can compute compute the the individual individual activity activity rates rates by by dividing dividing the the total total cost cost for for each each activity activity by by the the total total activity activity levels. levels.

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Calculate Activity Rates

Computation of Activity Rates
Activity Cost Pools Customer orders Design changes Order size Customer relations Other Total (a) Total Cost $ 4,520,000 3,040,000 5,200,000 3,080,000 6,160,000 $ 22,000,000 (b) Total Activity 10,000 orders 4,000 changes 800,000 MHs 2,000 customers Not applicable (a) (b) Activity Rate $452 per order $760 per change $6.50 per MH $1,540 per customer Not applicable

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ActivityBased Costing at Baxter Battery

Direct Materials Direct Labor Shipping Costs Overhead Costs

Traced

Traced

Traced

Cost Objects: Products, Customer Orders, Customers

7-28

ActivityBased Costing at Baxter Battery

Direct Materials Direct Labor Shipping Costs Overhead Costs

First-Stage Allocation

Customer Orders

Design Changes

Order Size

Customer Relations

Other

Cost Objects: Products, Customer Orders, Customers

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ActivityBased Costing at Baxter Battery

Direct Materials Direct Labor Shipping Costs Overhead Costs

First-Stage Allocation

Customer Orders

Design Changes

Order Size

Customer Relations

Other

Second-Stage Allocations
$/Order $/Change $/MH $/Customer

Cost Objects: Products, Customer Orders, Customers

Unallocated

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Learning Objective 4
Assign costs to a cost object using a secondstage allocation.

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Assigning Overhead to Products

Baxter Battery Information
SureStart SureStart 1. 1. Requires Requires no no new new design design resources. resources. 2. 2. 800,000 800,000 batteries batteries ordered ordered with with 4,000 4,000 separate separate orders. orders. 3. 3. Each Each SureStart SureStart requires requires 36 36 minutes minutes of of machine machine time time for for a a total total of of 480,000 480,000 machine-hours. machine-hours. LongLife LongLife 1. 1. Requires Requires new new design design resources. resources. 2. 2. 400,000 400,000 batteries batteries ordered ordered with with 6,000 6,000 separate separate orders. orders. 3. 3. 4,000 4,000 custom custom designs designs prepared. prepared. 4. 4. Each Each LongLife LongLife requires requires 48 48 minutes minutes of of machine machine time time for for a a total total of of 320,000 320,000 machine-hours. machine-hours.

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Assigning Overhead to Products

Overhead Cost for the SureStart
Activity Cost Pools Customer orders Design changes Order size Total (a) Activity Rate $ 452.00 760.00 6.50 (b) Activity 4,000 480,000 $ (a) (b) ABC Cost 1,808,000 3,120,000 4,928,000

Overhead Cost for the LongLife

Activity Cost Pools Customer orders Design changes Order size Total (a) Activity Rate $ 452.00 760.00 6.50 (b) Activity 6,000 4,000 320,000 $ (a) (b) ABC Cost 2,712,000 3,040,000 2,080,000 7,832,000

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Assigning Overhead to Customers

Lets take a look at how Baxter Batterys system works for just one of the 2,000 customers Acme Auto Parts who placed a total of twelve orders. Note that the four orders for LongLifes required a design change.
Orders Orders 1. 1. Eight Eight orders orders for for 60 60 SureStarts SureStarts per per order. order. 2. 2. Four Four orders orders for for 50 50 LongLifes LongLifes per per order. order.

Machine-hours Machine-hours 1. 1. The The 480 480 SureStarts SureStarts required required 288 288 machine-hours. machine-hours. 2. 2. The The 200 200 LongLifes LongLifes required required 160 160 machine machine hours. hours.

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Assigning Overhead to Customers

Overhead Cost for Acme Auto Parts
Activity Cost Pools Customer orders Design changes Order size Customer relations Total (a) Activity Rate $ 452.00 760.00 6.50 1,540.00 (b) Activity 12 4 448 1 (a) (b) ABC Cost $ 5,424 3,040 2,912 1,540 $ 12,916

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Learning Objective 5
Use activity-based costing to compute product and customer margins.

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Prepare Management Reports

Product Margin Calculations The first step in computing product margins is to gather each products sales and direct cost data.
Sales Direct costs Direct material Direct labor Shipping SureStarts $ 31,300,000 9,000,000 7,000,000 2,000,000 LongLifes $ 18,700,000 6,000,000 5,000,000 1,000,000 Total $ 50,000,000 15,000,000 12,000,000 3,000,000

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Prepare Management Reports

Product Margin Calculations The second step in computing product margins is to incorporate the previously computed activity-based cost assignments pertaining to each product.
Sales Direct costs Direct material Direct labor Shipping ABC cost assignments Customer orders Design changes Order size SureStarts $ 31,300,000 9,000,000 7,000,000 2,000,000 1,808,000 3,120,000 LongLifes $ 18,700,000 6,000,000 5,000,000 1,000,000 2,712,000 3,040,000 2,080,000 Total $ 50,000,000 15,000,000 12,000,000 3,000,000 4,520,000 3,040,000 5,200,000

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Prepare Management Reports

Product Margin Calculations The third step in computing product margins is to deduct each products direct and indirect costs from sales.
Sales Costs Direct material Direct labor Shipping Customer orders Design changes Order size Total cost Product margin SureStarts $ 31,300,000 $ 9,000,000 7,000,000 2,000,000 1,808,000 3,120,000 22,928,000 $ 8,372,000 LongLifes $ 18,700,000 $ 6,000,000 5,000,000 1,000,000 2,712,000 3,040,000 2,080,000 19,832,000 $ (1,132,000)

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Prepare Management Reports

Product Margin Calculations The product margins can be reconciled with the companys net operating income as follows:
Sales Total costs Product margins Less costs not assigned to products: Customer relations Other Total Net t operating income loss SureStarts $ 31,300,000 22,928,000 $ 8,372,000 LongLifes $ 18,700,000 19,832,000 $ (1,132,000) Total $ 50,000,000 42,760,000 $ 7,240,000

3,080,000 6,160,000 9,240,000 $ (2,000,000)

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Prepare Management Reports

Customer Margin Analysis The first step in computing Acme Auto Parts customer margin is to gather its sales and direct cost data.
Acme Auto Parts $ 29,200 7,500 6,700 1,700

Sales Direct costs Direct material Direct labor Shipping

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Prepare Management Reports

Customer Margin Analysis The second step is to incorporate Acme Auto Parts previously computed activity-based cost assignments.
Sales Direct costs Direct material Direct labor Shipping ABC cost assignments Customer orders Product design Order size Customer relations Acme Auto Parts $ 29,200 7,500 6,700 1,700 5,424 3,040 2,912 1,540

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Prepare Management Reports

Customer Margin Analysis The third step is to compute Acme Auto Parts customer margin of $384 by deducting all its direct and indirect costs from its sales.
Sales Direct costs Direct material Direct labor Shipping Customer orders Product design Order size Customer relations Customer margin Acme Auto Parts $ 29,200 $ 7,500 6,700 1,700 5,424 3,040 2,912 1,540

28,816 $ 384

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Product Margins Computed Using the Traditional Cost System

The first step in computing product margins is to gather each products sales and direct cost data.
Sales Direct costs Direct material Direct labor SureStarts $ 31,300,000 9,000,000 7,000,000 LongLifes $ 18,700,000 6,000,000 5,000,000 Total $ 50,000,000 15,000,000 12,000,000

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Product Margins Computed Using the Traditional Cost System

The second step in computing product margins is to compute the plantwide overhead rate.
Manufacturing Overhead Costs at Baxter Battery Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease Total manufacturing overhead $ 6,000,000 3,500,000 2,500,000 2,000,000 $ 14,000,000

Plantwide manufacturing overhead rate

$14,000,000 800,000 MH

= $17.50 per machine-hour

SureStarts (800,000 @ 0.60 hours) LongLifes (400,000 @ 0.80 hours) Total machine-hours

Machine-hours 480,000 320,000 800,000

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Product Margins Computed Using the Traditional Cost System

The third step in computing product margins is allocate manufacturing overhead to each product.
Machine Overhead Overhead Hours Rate Allocated 480,000 $ 17.50 $ 8,400,000 320,000 17.50 5,600,000 $ 14,000,000

SureStarts LongLifes Total overhead allocated to products

480,000 hours $17.50 per hour = $8,400,000

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Product Margins Computed Using the Traditional Cost System

The fourth step is to actually compute the product margins.
Sales Cost of goods sold Direct materials Direct labor Manufacturing overhead Product margin Selling and administrative Nett operating operating income loss SureStarts $ 31,300,000 $ 9,000,000 7,000,000 8,400,000 $ $ 24,400,000 6,900,000 LongLifes $ 18,700,000 6,000,000 5,000,000 5,600,000 $ 16,600,000 2,100,000 Total $ 15,000,000 12,000,000 14,000,000 50,000,000

41,000,000 9,000,000 11,000,000 (2,000,000)

Shipping expenses Marketing expenses General administrative expenses

3,000,000 2,000,000 6,000,000 $ 11,000,000

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Differences Between ABC and Traditional Product Costs

Product margins traditional Product margins ABC Change in reported margins SureStarts $ 6,900,000 8,372,000 $ 1,472,000 LongLifes $ 2,100,000 (1,132,000) $ (3,232,000)

The traditional cost system overcosts the SureStarts and reports a lower product margin for this product.

The traditional cost system undercosts the LongLifes and reports a higher product margin for this product.

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Differences Between ABC and Traditional Product Costs

There are three reasons why the reported product margins for the two costing systems differ from one another.

Traditional costing allocates all manufacturing overhead to products. ABC costing only assigns manufacturing overhead costs consumed by products to those products.

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Differences Between ABC and Traditional Product Costs

There are three reasons why the reported product margins for the two costing systems differ from one another. Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. ABC costing also uses non-volume related allocation bases.

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Differences Between ABC and Traditional Product Costs

There are three reasons why the reported product margins for the two costing systems differ from one another. Traditional costing disregards selling and administrative expenses because they are assumed to be period expenses. ABC costing directly traces shipping costs to products and includes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned to products.

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Targeting Process Improvement

Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements. While the theory of constraints approach discussed in Chapter 1 is a powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on where to focus improvement efforts. Benchmarking Benchmarking can can be be used used to to compare compare activity activity cost cost information information with with world-class world-class standards standards of of performance performance achieved achieved by by other other organizations. organizations.

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Activity-Based Costing and External Reporting

Most companies do not use ABC for external reporting because . . .
1. 1. External External reports reports are are less less detailed detailed than than internal internal reports. reports. 2. 2. It It may may be be difficult difficult to to make make changes changes to to the the companys companys accounting accounting system. system. 3. 3. ABC ABC does does not not conform conform to to GAAP. GAAP. 4. 4. Auditors Auditors may may be be suspect suspect of of the the subjective subjective allocation allocation process process based based on on interviews interviews with with employees. employees.

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ABC Limitations
Substantial resources required to implement and maintain. Desire to fully allocate all costs to products. Resistance to unfamiliar numbers and reports. Potential misinterpretation of unfamiliar numbers.

Does not conform to GAAP. Two costing systems may be needed.

ABC Action Analysis

Appendix 7A

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objective 6
(Appendix 7A) Prepare an action analysis report using activity-based costing data and interpret the report.

7-56

Appendix 7A: ABC Action Analysis

Conventional ABC analysis does not identify potentially relevant costs. An action analysis report helps because it: Shows what costs have been assigned to a cost object. Indicates how difficult it would be to adjust those costs in response to changes in the level of activity.

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Appendix 7A: ABC Action Analysis

Constructing an action analysis report begins with the first-stage allocation process. In addition to computing an overall activity rate for each activity cost pool, an activity rate is computed for each type of overhead cost that is consumed supporting a given activity. Lets revisit the stage-one allocations from the Baxter Battery Company example that we discussed earlier.

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Customer Orders Total Activity 10,000 180 70 120 27 45 10 452 Activity Cost Pools Design Customer Changes Order Size Relations 4,000 800,000 1.50 2.62 1.88 0.50 6.50 2,000 300 600 90 375 175 1,540

Other N/A

Appendix 7A: ABC Action Analysis

Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total $ $ 450.00 87.50 62.50 100.00 22.50 37.50 760.00 $ $

Customer Orders Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total $

Activity Cost Pools Design changes Order Size 1,800,000 $ 350,000 250,000 400,000 90,000 150,000 3,040,000 $ 1,200,000 $ 2,100,000 1,500,000 400,000 5,200,000 $

Customer Relations 600,000 $ 1,200,000 180,000 750,000 350,000 3,080,000 $

Other 600,000 $ 350,000 750,000 2,000,000 800,000 360,000 1,100,000 150,000 50,000 6,160,000 $

Total 6,000,000 3,500,000 2,500,000 2,000,000 4,000,000 900,000 1,100,000 1,500,000 500,000 22,000,000

1,800,000 $ 700,000 1,200,000 270,000 450,000 100,000 4,520,000 $

$1,800,000 10,000 orders = $180 per order Other entries in the table are computed similarly.

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Action Analysis Cost Matrix for SureStart Batteries Activity Cost Pools Customer Orders Total activity for batteries Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total $ 4,000 720,000 $ 280,000 480,000 108,000 180,000 40,000 $ 1,808,000 $ Design Customer Changes Order Size Relations $ 480,000 720,000 1,260,000 900,000 240,000 $ 3,120,000 N/A $ 1,440,000 1,540,000 900,000 720,000 108,000 180,000 40,000 4,928,000 Total

$180 per order 4,000 orders = $720,000 Other entries in the table are computed similarly.

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Action Analysis Cost Matrix for LongLife Batteries Activity Cost Pools Customer Orders Total activity for battery housing Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total 6,000 Design Changes 4,000 Customer Order Size Relations 320,000 N/A $ 3,360,000 1,610,000 850,000 1,280,000 252,000 420,000 60,000 7,832,000 Total

$ 1,080,000 $ 1,800,000 $ 480,000 420,000 350,000 840,000 250,000 600,000 720,000 400,000 160,000 162,000 90,000 270,000 150,000 60,000 $ 2,712,000 $ 3,040,000 $ 2,080,000

$180 per order 6,000 orders = $1,080,000 Other entries in the table are computed similarly.

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Appendix 7A: ABC Action Analysis

Next, label each cost using an ease of adjustment code: Green costs adjust more or less automatically to changes in activity level without any action by managers. Yellow costs can be adjusted to changes in activity level, but it would require management action to realize the change in cost. Red costs can be adjusted to changes in activity level only with a great deal of difficulty and with management intervention.

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Appendix 7A: ABC Action Analysis

Action Analysis of LongLife Batteries Sales Green costs Direct materials Shipping costs Green margin Yellow costs Direct labor Indirect factory wages Factory utilities Administrative wages and salaries Office equipment depreciation Marketing wages and salaries Selling expenses Yellow margin Red costs Factory equipment depreciation Factory building lease Administrative building lease Red margin $ 6,000,000 1,000,000 $ 5,000,000 3,360,000 850,000 1,280,000 252,000 420,000 60,000 $ 1,610,000 $ $ 18,700,000

7,000,000 11,700,000

11,222,000 478,000

1,610,000 (1,132,000)

Using a Modified Form of Activity-Based Costing to Determine Product Costs for External Reports
Appendix 7B

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

7-64

Learning Objective 7
(Appendix 7B) Use activity-based costing techniques to compute unit product costs for external reports.

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Appendix 7B
A A modified modified form form of of activity-based activity-based costing costing can can be be used used to develop product product costs for for external external financial financial reports. reports.

ABC ABC product product costs: costs:

Include Include organization-sustaining organization-sustaining costs costs and and unused unused capacity capacity costs. costs. Exclude Exclude nonmanufacturing nonmanufacturing costs costs even even if if they they are are caused caused by by the the products. products.

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Appendix 7B
Simmons Industries provides the following information for the company as a whole and for its only two productsdeluxe and standard hedge trimmers.

Total estimated manufacturing overhead Total estimated direct labor hours

$ 1,800,000 400,000

Direct materials cost per unit Direct labor cost per unit Direct labor hours per unit Units produced

Deluxe $ 38.00 $ 24.00 2.0 100,000

Standard $ 28.00 $ 12.00 1.0 200,000

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Appendix 7B
Assuming Assuming that that Simmons Simmons traditional traditional cost cost system system relies relies on on one one predetermined predetermined plantwide plantwide overhead overhead rate rate with with direct direct labor-hours labor-hours (DLHs) (DLHs) as as the the allocation allocation base, base, then then its its plantwide plantwide overhead overhead rate rate is is computed computed as as follows: follows:

Predetermined $1,800,000 = overhead rate 400,000 DLHs

= $4.50 per DLH

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Appendix 7B
Simmons traditional cost system would report unit product costs as follows:
Deluxe Standard $ 38.00 $ 28.00 24.00 12.00 9.00 4.50 $ 71.00 $ 44.50

Direct materials cost per unit Direct labor cost per unit Manufacturing overhead per unit Unit product cost

2.0 DLH $4.50 per DLH 1.0 DLH $4.50 per DLH

7-69

Appendix 7B
The ABC project team at Simmons has developed the following basic information.
Estimated Overhead Cost

Activity and Activity Measures

Direct labor support (DLHs) $ 900,000 Machine setups (setups) 600,000 Parts administration (part types) 300,000 Total manufacturing overhead $ 1,800,000

Expected Activity Deluxe Standard 200,000 200,000 400 100 200 100

Total 400,000 500 300

7-70

Appendix 7B
We can calculate the following activity rates:
Estimated Total Overhead Expected Cost Activity Activity Rate $ 900,000 400,000 = $ 2.25 per DLH 600,000 500 = $ 1,200 per setup 300,000 300 = $ 1,000 per part type $ 1,800,000

Activity and Activity Measures Direct labor support (DLHs) Machine setups (setups) Parts administration (part types) Total manufacturing overhead

Using the new activity rates, lets assign overhead to the two products based upon expected activity.

7-71

Appendix 7B

Deluxe Product

Expected Activity Activity and Activity Measures Activity Rate Amount Direct labor support (DLHs) 200,000 $ 2.25 = $ 450,000 Machine setups (setups) 400 $ 1,200 = 480,000 Parts administration (part types) 200 $ 1,000 = 200,000 Total overhead cost assigned $ 1,130,000

Standard Product
Expected Activity Activity and Activity Measures Activity Rate Direct labor support (DLHs) 200,000 $ 2.25 = $ Machine setups (setups) 100 $ 1,200 = Parts administration (part types) 100 $ 1,000 = Total overhead cost assigned $ Amount 450,000 120,000 100,000 670,000

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Appendix 7B
Activity-based Activity-based unit unit product product costs costs for for both both product product lines lines
Premium $ 38.00 24.00 11.30 $ 73.30 Standard $ 28.00 12.00 3.35 $ 43.35

Direct materials cost per unit Direct labor cost per unit Manufacturing overhead per unit Unit product cost

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Appendix 7B
Activity-based Activity-based unit unit product product costs costs for for both both product product lines lines
Premium $ 38.00 24.00 11.30 $ 73.30 Standard $ 28.00 12.00 3.35 $ 43.35

Direct materials cost per unit Direct labor cost per unit Manufacturing overhead per unit Unit product cost

$1,130,000 100,000 units $670,000 200,000 units

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Appendix 7B
Comparing the two approaches:
Activity-Based Costing Deluxe Standard Direct material $ 38.00 $ 28.00 Direct labor 24.00 12.00 Manufacturing overhead 11.30 3.35 Unit product cost $ 73.30 $ 43.35 Traditional Costing Deluxe Standard $ 38.00 $ 28.00 24.00 12.00 9.00 4.50 $ 71.00 $ 44.50

Note Note that that the the unit unit product product cost cost of of a a Standard Standard unit unit decreased decreased from from $44.50 $44.50 to to $43.35 $43.35 .. .. .. .. .. .. .. .. .. .. while while the the unit unit cost cost of of a a Deluxe Deluxe unit unit increased increased from from $71.00 $71.00 to to $73.30. $73.30.

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End of Chapter 7B