ACCT230 Ch7 - Lecture notes 5 PDF

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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as pe distributed with a certain product or service or otherwise on a password-protected website for classroom use.Chapter 7:Activity-Based Costing and ManagementCornerstones ...

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Chapter 7: Activity-Based Costing and Management Cornerstones of Managerial Accounting, 4e © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Learning Objectives 1. 2. 3. 4.

Explain why functional (or volume)-based costing approaches may produce distorted costs. Explain how an activity-based costing system works for product costing. Describe activity-based customer costing and activity-based supplier costing. Explain how activity-based management can be used for cost reduction.

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Limitations of Functional-Based Cost Accounting Systems Plantwide and departmental rates based on direct labor hours, machine hours, or other volume-based measures have been used for decades to assign overhead costs to products and continue to be used successfully by many organizations. However, for many settings, this approach to costing is equivalent to an averaging approach and may produce distorted, or inaccurate, costs.

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Limitations of Functional-Based Cost Accounting Systems (continued)

Product cost distortions can be damaging, particularly for those firms whose business environment is characterized by :

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Limitations of Functional-Based Cost Accounting Systems (continued)

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The need for more accurate product costs has forced many companies to take a serious look at their costing procedures. ▶ Two major factors impair the ability of unitbased plant-wide and departmental rates to assign overhead costs accurately: 1. 2.

The proportion of nonunit-related overhead costs to total overhead costs is large. The degree of product diversity is great. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Nonunit-Related Overhead Costs

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The use of either plantwide rates or departmental rates assumes that a product’s consumption of overhead resources is related strictly to the units produced.

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For unit-level activities (or activities that are performed each time a unit is produced), this assumption makes sense. But if there are nonunit-level activities (or activities that are not performed each time a unit of product is produced), the costs associated with these nonunit-level activities are unlikely to vary (i.e., increase or decrease) with units produced.

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Categorizing Costs under ABC

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vity Drivers and the Consumption of Activities Nonunit-level activity drivers (i.e., batch, productsustaining, and facility-sustaining) are factors that measure the consumption of nonunit-level activities by products and other cost objects, whereas unit-level activity drivers measure the consumption of unitlevel activities. Activity drivers are factors that measure the consumption of activities by products and other cost objects and can be classified as either unit-level or nonunit-level.

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Distorted Product Costs Using only unit-based activity drivers to assign nonunit-related overhead costs can create distorted product costs.

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The severity of this distortion depends on what proportion of total overhead costs these nonunit-based costs represent.

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If nonunit- based overhead costs are only a small percentage of total overhead costs, then the distortion of product costs will be quite small.

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In such a case, using unit-based activity drivers to assign overhead costs is acceptable.

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Product Diversity The presence of product diversity is also necessary for product cost distortion to occur. Product diversity means that products consume overhead activities in systematically different proportions. This may occur for several reasons, including differences in: product size product complexity setup time size of batches

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Consumption Ratio Regardless of the nature of the product diversity, product cost will be distorted whenever the quantity of unit-based overhead that a product consumes does not vary in direct proportion to the quantity consumed of nonunit-based overhead. The proportion of each activity consumed by a product is defined as the consumption ratio and is calculated as: Amount of Activity Driver per Product Total Driver Quantity

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Cornerstone 7-1 Calculating Consumption Ratios

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Cornerstone 7-1 Calculating Consumption Ratios (continued)

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Cornerstone 7-2 Calculating Activity Rates

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Cornerstone 7-3 Calculating Activity-Based Unit Costs

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Cornerstone 7-3 Calculating Activity-Based Unit Costs (continued)

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mparison of Functional-Based and Activity-Based Product Costs

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A plantwide rate based on direct labor hours is calculated as follows:

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The activity-based cost assignment reflects the pattern of overhead consumption and is, therefore, the most accurate. Activity-based product costing reveals that functionalbased costing undercosts the low volume deluxe models and overcosts the high volume regular models.

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Product Diversity and Product Costing Accuracy For unit-level overhead rates to fail, products must consume the non-unit-level activities in proportions significantly different than the unit-level activities. The key message of the relationship analysis is that in a diverse product environment, activity-based costing promises greater accuracy. Given the importance of making decisions based on accurate facts, a detailed look at activity-based costing is certainly merited.

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Product Diversity and Product Costing Accuracy

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Activity-Based Product Costing Functional-based overhead costing involves two major stages: Overhead costs are assigned to an organizational unit (plant or department). Overhead costs are then assigned to cost objects.

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Activity-Based Product Costing (continued)

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Identifying Activities and Their Attributes

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An activity is action taken or work performed by equipment or people for other people. ▶ Identifying activities usually is accomplished by interviewing managers or representatives of functional work areas (departments).

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Questions for Identifying Activities and Their Attributes A set of key questions is asked in which answers provide much of the data needed for an ABC system. Here are some examples: How many employees are in your department? (Activities consume labor.) What do they do (please describe)? (Activities are people doing things for other people.) Do customers outside your department use any equipment? (Activities also can be equipment working for other people. In other words, the equipment provides the service for someone by itself). What resources are used by each activity (equipment, materials, energy)? (Activities consume resources in addition to labor.) What are the outputs of each activity? (Helps to identify activity drivers.)

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Activity Dictionary Interview-derived data are used to prepare an Activity dictionary, which lists the activities in an organization along with some critical activity attributes (financial and nonfinancial information items that describe individual activities). Examples include: types of resources consumed amount (percentage) of time spent on an activity by workers cost objects that consume the activity output (reason for performing the activity) measure of the activity output (activity driver) activity name

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Activity Dictionary Example for a Credit Card Department

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Assigning Costs to Activities activities are identified and described, the next task is to determine how much it costs to perform each activity.

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This determination requires identification of the resources being consumed by each activity.

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The cost of labor, energy, materials, and capital is found in the general ledger, but the money spent on each activity is not revealed.

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Thus, a work distribution matrix is developed which identifies the amount of labor consumed by each activity and is derived from the interview process (or a written survey). Here is an example:

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Resource Drivers Both direct tracing and driver tracing are used to assign resource costs to activities. If the resource is shared by several activities (as is the case of the clerical resource), then the assignment is driver tracing, and the drivers are called resource drivers, which are factors that measure the consumption of resources by activities. Once resource drivers are identified, then the costs of the resource can be assigned to the activity.

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Cornerstone 7-4

Assigning Resource Costs to Activities By Using Direct Tracing and Resource Drivers

Information: Refer to the work distribution matrix for Hemingway Bank’s credit card department below. Assume that each clerk is paid a salary of $30,000 ($150,000 total clerical costs for five clerks).

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Assigning Costs to Products Activity costs are assigned to products by multiplying a predetermined activity rate by the usage of the activity, as measured by activity drivers. To calculate an activity rate, the practical capacity of each activity must be determined. To assign costs, the amount of each activity consumed by each product must also be known.

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ctivity-Based Customer Costing and Activity-Based Supplier Costing ABC systems originally became popular for their ability to improve product-costing accuracy by tracing activity costs to the products that consume the activities.

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However, since the beginning of the 21st century, the use of ABC has expanded into areas upstream (i.e., before the production section of the value chain—research and development, prototyping, etc.) and downstream (i.e., after the production section of the value chain— marketing, distribution, customer service, etc.) from production.

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Specifically, ABC often is used to more accurately determine the upstream costs of suppliers and the downstream costs of customers.

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Knowing the costs of suppliers and customers can be vital information for improving a company’s profitability. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Cumulative Customer Profitability A high-tech producer of semiconductors, implemented ABC customer costing and discovered that 10 percent of its customers were responsible for about 90 percent of its profits. It also discovered it was actually losing money on about 50 percent of its customers. It worked to convert its unprofitable customers into profitable ones and invited those who would not provide a fair return to take their business elsewhere. As a consequence, company sales decreased, but its profit tripled. The following slide depicts this interesting yet common relationship between customers and their contribution to company profitability.

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The Whale Curve of Cumulative Customer Profitability

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