chapter 5 activity based cost systems

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Activity-Based Cost Systems

CHAPTER

5


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Product costing systems start by assigning direct labor and directmaterials costs to products.

For both materials and labor, cost accountants or industrial engineers

perform the following computations:1. Calculate the cost per unit (pound, kilogram, or suare meter! ofeach material usedby a product and the cost per hour of each typeof direct labor that processes the product.

2. For each unit of product made, determine the quantity (numberof pounds, kilograms, or suare meters! of each type o material

usedand the quantity !number o hours! reuired for each type oflabor"

".For each labor and material type, multiply the cost per unit (orhour! by the quantities usedper product, as shown by the followingeuations:

Materials cost/unit = Quantity of materials/unit of output

Cost per materials unitLabor cost/unit = Quantity of labor hours/unit of output

Cost per labor hour

#. $dd up all of the indi%idual materials and labor costs to obtain thetotal labor and materials cost of each product unit.

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&'he main focus of our attention in this chapter is on theassignment of indirect e#penses to products.&ndirect e)penses include:the costs of operating machines,scheduling,

uality control,purchasing,maintenance,super%ision, andgeneral factory support (including building depreciation,

insurance, utilities, and housekeeping!.&ndirect e)penses are also called shared or common costssince they support the production of all products and they arenot easily traced to indi%idual products in the simple way thatdirect materials and direct labor costs are.


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&Companies producing a more %aried and comple#mi# o products ha%e hi$her costs than companiesproducing only a narrow range of products.&Comple), di%erse product lines reuire moresupport !overhead% costs than simple, narrowproduct lines.&*ach different %ariation (model, style, color, etc.!

may reuire a %ariety of special acti%ities:1. +eparate engineering drawings, specifications,and testing.

2. +eparate production capability (production lines,machinery, workers with different skills.!

". +pecial materials, along with in%entories andmaterial control systems.

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&adison 'airy (ce cream

E#ample

Consider one ice cream manufacturing plant at adison-airy. 'he plant originally produced ust two products,vanilla and chocolate ice cream, and enoyed profitmargins in e)cess of 1/0 of sales. +e%eral years ago, the

plant manager had seen opportunities to e)pand thebusiness by e)tending the product line into new fla%orsthat earned premium selling prices. adison hadintroduced stra)berry ice cream, which reuired thesame basic production

technology but could be sold at prices that were 10higher than %anilla and chocolate. ast year, thecompany introduced mocha-almond ice cream, which itsold at an even hi$her price.

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E#ample

3ith the increase in product %arietycame an increase in the plant*soverhead costs. 'hese costs wereallocated to products based on theirdirect labor content. Currently, therate was +,. o direct labor dollars.

4esults of one month weredisappointing

(5e)t slide!.

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E#ample

'he manager of adison -airy wondered why shecould not assign indirect e)pense costs to products in

the same way that standard cost systems assign

materials and labor costs to products. 'hat is, why

couldn9t she obtain the cost o usin$ each unit o

overhead or indirect resource, and the quantity o

each indirect resource usedby each product the

plant produced='hus, Time-'riven Activity Based Costin$

>>


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'ime-ri%en $cti%ity ?ased Costing ('-$?C!

Time-driven activity based costin$ !T'ABC%

requires estimatin$ t)o parameters/

1.'he first parameter is the capacity cost rate or

each type o indirectresource"

The capacity cost rate or a resource iscomputed by dividin$ its cost by the

practical capacity it supplies"

E"$ Salary per month divided by numbero hours )or0ed per month"


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'ime-ri%en $cti%ity ?ased Costing ('-$?C!

2. 'he second parameter is an estimation o ho)much o each resource*s capacity is usedby the

acti%ities performed to produce the %arious

products and ser%ices.

& 3ith estimates of these two parameters for eachresource and product, the cost assignment is

performed as follows:

Cost o usin$ resource i by productj1

Capacity cost rate o resource i 23uantity ocapacity o resource i used by productj


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*@$P*

'ake an indirect production employee who speciali;es in

changing o%er machines from one product to the other.

'he employee9s total compensationis 4,6 per month.'he employee has about 7+ hours a%ailable to perform

changeo%ers each month.

The setup employee*s capacity cost rate is 4, per

hour !4,6 per month87+ hours per month%"

Considernow a product that is produced 9 times during

the month with the setup time for each production run

taking 7"5 hours"'he product uses ,"5 hours of thisindirect production employee9s time and would be

assigned 476 o cost !4,8hour 2 ,"5 hours%this month

for use of this indirect employee9s time.


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Calculating 4esource CapacityCost 4ates

(ndirect :abor

$ssume adison Co. had 7 productionemployees who did both the actual)or0 of producing the ice cream as wellas all of the production support )or0.'he standard cost accounting systemtreated the employees as ;direct labor1>

Calculating 4esource Time @sa$eper Product

(ndirect :abor Time

'he anager summari;ed the demand forindirect labor by each product with the followingtime euation:

(ndirect labor time8product 1 !, hours

product chan$eover time% 2 umber oproduction runs >

Dor e#ample if the anilla fla%or had 7production runs in a month, its total usage of

indirect labor time would be:anilla indirect labor time 1 !, =% 27 > 17> hours


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(ndirect :abor Time

'he total demands for indirect labor are summari;ed below:


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&achinery Time

achines were either producin$ products or being set up toproduce the ne)t batch of products.

'he time euation to estimate machine usage was:

&achine time per product 1 Product run time Product

chan$eover time1 !Product volume !$allons% 2 Run time8$allon% !Product chan$eover time 2 umber o runs%

Dor e#ample, if anilla had 1 production runs producing


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Calculatin$ Product Cost and Proitability

ee had now de%eloped all of the inormationFcapacity

cost ratesor each resource and capacity demands on

resources by each product8that she needed to calculate

accurate product costs.

+he summari;ed the production data for the four products

from the recent month as shown below:


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ee ne)t entered the production data into the two time euations for

indirect production labor time and machine time to obtain the

resource demand for the four products, as shown below:


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ee calculated the costs for each product by multiplying

the resource usage times in Preceding table by eachresource9s capacity cost rate, shown in the last column.

+he summari;ed the results in the product profit and loss

statements shown below:


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ee was initially surprised by the resultsreported. +he saw that the products

pre%iously thought to be the mostprofitable, (strawberry and mocha-

almond), were actually the least profitableand in fact had enormous losses as a

percentage of sales. Con%ersely, %anillaand chocolate, pre%iously thought to be

breake%en, were actually profitable withprofit margins greater than 10 of sales.


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4easons for the re%ersals in profit rankings.

1.anilla and chocolate were produced in long production runs,so their use of indirect labor and machine setup time weresmall compared to actual production %olumes.

2. ochaalmond, had small production runsB its use of indirectlabor and machine setup time e#ceededthe uantity of directlabor and machine run time for the product.

".-espite mochaalmond ha%ing a unit price that was morethan 1/0 higher than %anilla or chocolate, its price failed, by alarge amount, to pay for the cost of its use of indirect labor andmachine setup time.

n general, the ne) costin$ approach clearly revealed thatthe revenues rom sales o the specialty stra)berry andmocha-almond lavors ailed to cover all o the e#pensesassociated )ith their production"


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& &ana$ers may use insi$hts rom activity-based cost

analysis to improve operations such as by

7"reducin$ setup times or

+"reducin$ the times required to do purchasin$ and

schedulin$ or production orders"

& &ana$ers may also use their ne) insi$hts to Gustiy/

7"price increases or unproitable products

+"impose minimum order sies and9"ma0e decisions on the desired product mi#"


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E#ercise 5-7?


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E#ercise 5-7?

5-7? Dalifa) ?rass Company manufactures pumps and %al%es and usesa timedri%en acti%itybased cost ('-$?C! system. ast year, Dalifa) recorded the following data for assigningmanufacturing o%erhead costs to its products:

Dalifa) also de%eloped the following information on re%enues and costs other thanmanufacturing o%erhead:

'otal re%enues A,

'otal direct labor cost A12,

'otal direct materials cost A>,

+E$ e)penses A1,

Required(a! Gsing the company9s '-$?C system, how much manufacturing o%erhead cost will beassigned to pumps= Dow much will be assigned to %al%es=

(b! 3hat is the company9s net income= ($ssume the company sells the entire amount of theproducts it produces.!


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E#ercise 5-+


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E#ercise 5-+

C$5 Company sells multiple products and uses a timedri%en $?C system.

'he company9s products must be wrapped indi%idually before shipping. 'hepackaging and shipping department employs 2/ people. *ach person works

22 days per month on a%erage. *mployees in this department work an eight

hour shift that includes a total of > minutes for breaks and a meal. 'he full

compensation, including fringe benefits, for each packaging and shipping

employee is A",/7/ per month.

Required

!a! Gsing the principles discussed in this chapter and timedri%en $?C, what

is the rate per hour for each packaging and shipping employee at C$5=

(b! Hn a%erage, it takes one packaging and shipping employee 16 minutes to

prepare a package and label, independent of the number or types of items in

the shipment, plus > minutes per item to bubble wrap and pack it in thecarton. Gsing C$59s timedri%en $?C system, what is the packaging and

shipping cost assigned to Hrder $I"2, which consisted of 12 items=


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E#ercise 5- +5


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E#ercise 5- +5

Earber Company uses a traditional acti%itybased costingsystem to assign A6, of committed resource costs forcustomer ser%ice on the basis of the following informationgathered from inter%iews with customer ser%ice personnel:

Required

!a% Compute the activity cost driver rates usin$ this system"


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E#ercise 5- +5

Required

(b! +uppose instead that Earber uses timedri%en $?C to

assign the A6, of committed resource costs to the

three acti%ities. Compute the timedri%en acti%ity cost

dri%er rates, assuming 1, hours of useful work and

the unit time estimates that follow:


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E#ercise 5- +5

(c! +uppose that the uantities of acti%ities this period are


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E#ercise 5- +5

(d! +uppose that in the ne)t time period, theuantities of acti%ities change to


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chapter 5 activity based cost systems

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