activity-based costing. over- and undercosting overcosting – a product consumes a low level of...

Activity-Based Costing

Undercosting and Overcosting

• Consider the costing of a bill for four friends who go for dinner. • Each diner orders separate entrees, desserts, and drinks. • Bill details are as follows:

Entrée Dessert Drinks Total Emma $11 $0 $4 $15 J ames 20 8 14 42 J essica 15 4 8 27 Matthew 14 4 6 24 Total $60 $16 $32 $108

Average $15 $4 $8 $27

Over- and Undercosting

• Overcosting – a product consumes a low level of resources (costs) but is allocated high costs per unit

• Undercosting – a product consumes a high level of resources (costs) but is allocated low costs per unit

Direct versus Indirect Costs

Traditional Costing

All production costs All production costs except direct materials except direct materials

and direct labor are and direct labor are lumped together in one lumped together in one

overhead cost pool.overhead cost pool.

Traditional Costing

All production costs All production costs except direct materials except direct materials

and direct labor are and direct labor are lumped together in one lumped together in one

overhead cost pool.overhead cost pool.

Activity-Based Costing

An effort is made to An effort is made to account for as many account for as many costs as possible as costs as possible as

direct costs of direct costs of production.production.

Activity-Based Costing

An effort is made to An effort is made to account for as many account for as many costs as possible as costs as possible as

direct costs of direct costs of production.production.

IndirectIndirectCostsCosts

ActivityAn event that causes the consumption of overhead

resources.

Activity Cost Pool

A “cost bucket” in which costs related to a particular activity

measure are accumulated.

$

$

$ $

$$

How Costs are Treated UnderActivity–Based Costing

Activity MeasureActivity Measure

An allocation basein an activity-based

costing system.

An allocation basein an activity-based

costing system.

How Costs are Treated UnderActivity–Based Costing

The term cost driver is also used to refer to an

activity measure.

The term cost driver is also used to refer to an

activity measure.

Homogeneous Activity Cost Pools

A homogeneous cost pool is a grouping of overhead costs in which each cost component is consumed in roughly the same proportion by each product line.

A homogeneous cost poolA homogeneous cost pooluses a single cost driver.uses a single cost driver.

Simple countof the number oftimes an activity

occurs.

Transactiondriver

A measureof the amountof time neededfor an activity.

Durationdriver

Two common types of activity measures:

How Costs are Treated UnderActivity–Based Costing

Traditional Product-Costing System

• Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.

• The following information is obtained from company records:

• Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.

• The following information is obtained from company records:

Mode I Mode II Mode IIIProduction: Units 10,000 20,000 4,000 Runs 1 of 10,000 4 of 5,000 10 of 400

Traditional Product-Costing System

Additional information includes:

Mode I Mode II Mode IIIDirect materials 50.00$ 90.00$ 20.00$ Direct labor (hr/board) 3 4 2 Setup time (hr/run) 10 10 10 Machine time (hr/board) 1 1.25 2

Manufacturing overhead is determined as follows

Traditional Product-Costing System

Budgeted manufacturing overhead Budgeted manufacturing overhead $3,894,000 $3,894,000 Budgeted direct-labor hours 118,000Budgeted direct-labor hours 118,000 = $33 per hour= $33 per hour

Traditional Product-Costing System

With these product costs, Aerotech established target selling prices (Cost × 125%).

209.00 x 1.25

Traditional Product-Costing System

Aerotech wishes to see what target selling prices would be suggested when using activity-based

costing.

Aerotech wishes to see what target selling prices would be suggested when using activity-based

costing.

Let’s see how ABC works.Let’s see how ABC works.

Activity Based Costing System (ABC)

ABC systems follow a two-stage

procedure to assign overhead costs to

products.

Assigningoverhead to products is

a

difficult process. I agree!

Activity Based Costing System (ABC)

ABC systems follow a two-stage

procedure to assign overhead costs to

products.

Let’s beginby identifying

our major activities.

Stage OneIdentify significant

activities and assign overheadcosts to each activity in

proportion to resources used.

Stage OneIdentify significant

activities and assign overheadcosts to each activity in

proportion to resources used.

Activity Based Costing System (ABC)

ABC systems follow a two-stage

procedure to assign overhead costs to

products.

Overhead assigned to activities are called

“activity cost pools.”

Stage TwoIdentify cost drivers

appropriate to each activityand allocate overhead to

the products.

Stage TwoIdentify cost drivers

appropriate to each activityand allocate overhead to

the products.

Overhead CostsOverhead Costs

Total budgeted cost = $3,894,000Total budgeted cost = $3,894,000

ActivityActivityCostCostPoolsPools

MachineryMachinerycost poolcost pool

$1,212,600$1,212,600

SetupSetupcost poolcost pool$3,000$3,000

EngineeringEngineeringcost poolcost pool$700,000$700,000

FacilityFacilitycost poolcost pool$507,400$507,400

UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel

Identificationof ActivityCost Pools

Identificationof ActivityCost Pools

ActivityActivitymust bemust bedone ondone oneach uniteach unit

producedproduced..

ActivityActivityperformedperformed

on eachon eachbatchbatch

produced.produced.

Activities needed to supportActivities needed to supportan entire product linean entire product line Activities that support theActivities that support the

organization as a whole.organization as a whole.

Overhead CostsOverhead Costs

Total budgeted cost = $3,894,000Total budgeted cost = $3,894,000

ActivityActivityCostCostPoolsPools

MachineryMachinerycost poolcost pool

$1,212,600$1,212,600

SetupSetupcost poolcost pool$3,000$3,000

EngineeringEngineeringcost poolcost pool$700,000$700,000

FacilityFacilitycost poolcost pool$507,400$507,400

MoreCostPools

UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel

Identificationof ActivityCost Pools

Identificationof ActivityCost Pools

Receiving/InspectionReceiving/Inspectioncost poolcost pool $200,000$200,000

Material-HandlingMaterial-Handlingcost pool cost pool $600,000$600,000

Quality-AssuranceQuality-Assurancecost pool cost pool $421,000$421,000

Packaging/ShippingPackaging/Shippingcost poolcost pool $250,000$250,000

MachineryMachinerycost poolcost pool

$1,212,600$1,212,600

SetupSetupcost poolcost pool$3,000$3,000

EngineeringEngineeringcost poolcost pool$700,000$700,000

FacilityFacilitycost poolcost pool$507,400$507,400

UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel

Various overheadVarious overheadcosts relatedcosts relatedto to machinerymachinery

Maintenance

Depreciation

Computer Support

Lubrication

Electricity

Calibration

Machinery Cost PoolMachinery Cost PoolTotal budgeted cost = $1,212,600

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

CalculateCalculatethe poolthe pool

raterate

Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hour$28.20/hour

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

=

=

Calculation ofCalculation oftotal total setup costsetup cost

Setup Cost PoolSetup Cost PoolTotal budgeted cost = $3,000

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

CalculateCalculatethe poolthe pool

raterate

Budgeted Setup Costs $3,000Planned Production Runs 15 runs $200 per run$200 per run

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

=

=

Various overheadVarious overheadcosts relatedcosts related

to to engineeringengineering

Engineering salaries

Engineering supplies

Engineering software

Depreciation

Engineering Cost PoolEngineering Cost PoolTotal budgeted cost = $700,000

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

Allocate basedAllocate basedon on engineeringengineering

transactionstransactions

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

Engineering Cost PoolEngineering Cost PoolTotal budgeted cost = $700,000

Various overheadVarious overheadcosts relatedcosts relatedto to generalgeneraloperationsoperations

Plant depr.

Plant mgmt.

Plant maint.

Property taxes

Insurance

Security

Facility Cost PoolFacility Cost PoolTotal budgeted cost = $507,400

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

CalculateCalculatethe poolthe pool

raterate

Budgeted Facilities Cost $507,400Budgeted Direct-Labor Hours 118,000 $4.30/hour$4.30/hour

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

=

=

Product Cost from ABCHere are the new product costs so far . . .

Additional ABC Information

Mode I Mode II Mode IIIReceiving Lots 18 72 210 Material Handling Moves 21 90 189 Quality/Inspections 40 80 80 Packaging/Shipments 8 60 132

Percentages for the above information are as follows:

Other Overhead Costs

Board Overhead × % ÷ Units = Cost/UnitMode I 200,000$ × 6% ÷ 10,000 = 1.20$ Mode II 200,000 × 24% ÷ 20,000 = 2.40 Mode III 200,000 × 70% ÷ 4,000 = 35.00

Receiving and Inspection Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 600,000$ × 7% ÷ 10,000 = 4.20$ Mode II 600,000 × 30% ÷ 20,000 = 9.00 Mode III 600,000 × 63% ÷ 4,000 = 94.50

Material-Handling Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 421,000$ × 20% ÷ 10,000 = 8.42$ Mode II 421,000 × 40% ÷ 20,000 = 8.42 Mode III 421,000 × 40% ÷ 4,000 = 42.10

Quality-Assurance Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 250,000$ × 4% ÷ 10,000 = 1.00$ Mode II 250,000 × 30% ÷ 20,000 = 3.75 Mode III 250,000 × 66% ÷ 4,000 = 41.25

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 250,000$ × 4% ÷ 10,000 = 1.00$ Mode II 250,000 × 30% ÷ 20,000 = 3.75 Mode III 250,000 × 66% ÷ 4,000 = 41.25

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 421,000$ × 20% ÷ 10,000 = 8.42$ Mode II 421,000 × 40% ÷ 20,000 = 8.42 Mode III 421,000 × 40% ÷ 4,000 = 42.10

Quality-Assurance Cost Pool

Other Overhead Costs

Board Overhead × % ÷ Units = Cost/UnitMode I 200,000$ × 6% ÷ 10,000 = 1.20$ Mode II 200,000 × 24% ÷ 20,000 = 2.40 Mode III 200,000 × 70% ÷ 4,000 = 35.00

Receiving and Inspection Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 600,000$ × 7% ÷ 10,000 = 4.20$ Mode II 600,000 × 30% ÷ 20,000 = 9.00 Mode III 600,000 × 63% ÷ 4,000 = 94.50

Material-Handling Cost Pool

$14.82$14.82

Product Cost from ABCThese are the new product costs when Aerotech uses

ABC.

Product DiversityBoth original and ABC target selling prices are based on

(Cost × 125%).

[$209.00 × 1.25] [$183.44 × 1.25]

The selling price of Mode I and II are reducedThe selling price of Mode I and II are reducedand the selling price for Mode III is increased.and the selling price for Mode III is increased.

Product DiversityCan you identify any problems Aerotech is likely to face

as a result of this distortion?

Traditional costing understates the costTraditional costing understates the costof complex, low volume products.of complex, low volume products.

Activity-Based Management

• A method of management that used ABC as an integral part in critical decision-making situations, including:– Pricing decisions– Cost reduction and process improvement

decisions– Planning and managing activities