management accounting lecture 9

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McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Management Accounting Lecture 9 (Chapter 3)

Systems Design: Activity Based Costing


Activity Based Costing

n  Shortcomings of Simple Job Order Costing

n  What is Activity Based Costing?

n  How is it Superior?

n  How is it Applied?

n  Journal Entries


Shortcomings of Simple Job Order Costing

n  Plant-wide allocation of costs may be a reasonable methodology for single product facilities

n  Increasingly, companies produce a multitude of products out of the same plant

n  These different products tend to consume different amounts of overhead

n  Additionally overhead is increasing as a proportion of overall cost and consequently its allocation becomes more meaningful

n  In these circumstances, a simple plant wide allocation is not granular enough to capture good product cost information


Computing Overhead Cost per Unit

Activity and Activity MeasuresExpected Activity

Activity Rate

Labor related (DLHs) 100,000 × 1.60$ = 160,000$ Machine related (MHs) 300,000 × 2.10 = 630,000 Machine setups (setups) 3,000 × 400.00 = 1,200,000 Production orders (orders) 800 × 2,625.00 = 2,100,000 Parts administration (part types) 400 × 500.00 = 200,000 General factory (MHs) 300,000 × 2.00 = 600,000 Total overhead cost assigned 4,890,000$ Number of units produced 50,000 Overhead cost per unit 97.80$

Amount

DVD Units


Computing Overhead Cost per Unit

Activity and Activity MeasuresExpected Activity

Activity Rate

Labor related (DLHs) 400,000 × 1.60$ = 640,000$ Machine related (MHs) 700,000 × 2.10 = 1,470,000 Machine setups (setups) 1,000 × 400.00 = 400,000 Production orders (orders) 400 × 2,625.00 = 1,050,000 Parts administration (part types) 300 × 500.00 = 150,000 General factory (MHs) 700,000 × 2.00 = 1,400,000 Total overhead cost assigned 5,110,000$ Number of units produced 200,000 Overhead cost per unit 25.55$

Amount

CD Units


Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . .

. . . . while the unit cost of a DVD unit increased from $150 to $207.80.

Comparing the Two Approaches

DVD Unit CD Unit DVD Unit CD UnitDirect material 90.00$ 50.00$ 90.00$ 50.00$ Direct labor 20.00 20.00 20.00 20.00 Manufacturing overhead 97.80 25.55 40.00 40.00 Unit product cost 207.80$ 95.55$ 150.00$ 110.00$

Activity-Based Costing Direct-Labor Costing

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The ABC system assigns $14.45 less overhead than the traditional

system to each CD player.





The ABC system assigns $57.80 more overhead than the traditional

system to each DVD player.




When a company implements activity-based costing, overhead cost often shifts from high-volume to low-

volume products with a higher unit product cost resulting for the low-volume products.

Low-volume product

Shifting of Overhead Cost




High-volume product


The traditional system assigns the same amount of all overhead costs to each CD or DVD player

($40 per unit).



DVD Units CD UnitsNumber of units produced per year 50,000 200,000 Number of production orders issued per year 800 400 Number of units processed per production order 62.5 500

1. Compute the number of units processed per production order for each product.

Production Orders Activity Cost Pool (a batch-level cost pool)

The ABC system assigns different amounts of Production Order-related overhead costs to each product.

This fact can be illustrated in a two-step process.



2. Compute production order cost per unit for each product.

DVD Units CD UnitsCost to issue a production order 2,625$ 2,625$ Average number of units processed per production order 62.5 500 Production order cost per unit 42.00$ 5.25$

Notice, the costs are being shifted from the high volume CD players to the low volume DVD players.

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Activity-Based Management Focuses on managing activities to eliminate

waste and reduce delays and defects.

Targeting Process Improvements

An ABC system can help identify areas where the company can benefit from improving its current processes.


The first step in any improvement program is deciding what to improve.

Targeting Process Improvements

The Theory of Constraints approach targets the

highest impact improvement opportunities.

Activity rates can be used to target areas where costs seem excessively high.

Benchmarking can be used to compare activity cost information with world-class standards of performance

achieved by other organizations.


Benefits of Activity-Based Costing

ABC improves the accuracy of product costing by: n  Increasing the number of cost pools used to accumulate

overhead costs. n  Using activity cost pools that are more homogeneous than

departmental cost pools. n  Assigning overhead costs using activity measures that

cause those costs, rather than relying solely on direct labor hours.

Activity-based costing also highlights activities that could benefit most from process

improvement efforts, such as Six Sigma. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Costs of implementing an ABC system may outweigh

the benefits. However, the benefits are more likely to be worth the costs when:

1. Products differ substantially in volume, batch size, and in activities required.

2. Conditions have changed substantially since the existing cost system was established.

3. Overhead costs are high and increasing and no one seems to understand why.

4. Management does not trust the existing cost system and it ignores data from it when making decisions.

Limitations Activity-Based Costing


The cost in each activity pool is strictly proportional to its activity measure. When this assumption is violated, the accuracy of ABC

data can be called into question.

Activity-Based Costing Critical Assumption

For example, managers should be particularly alert to product costs that contain allocated

facility-level costs.


Modifying the ABC Model

The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: 1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs.

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Cost Flows in an ABC System

The flow of costs through Raw Materials, Work in Process, and other accounts is the same under activity

based costing. The only difference in

activity based costing is that more than one

predetermined overhead rate is used to apply costs to products.


Review

n  Shortcomings of Simple Job Order Costing

n  What is Activity Based Costing?

n  When should it be Applied?

n  How is it Superior?

n  Journal Entries


Tutorial

n  Review of last week’s and this weeks chapters.

n  Prologue, Chapter 1, 13, 14, 2, 3.

management accounting lecture 9

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