Chapter 7 - Lecture notes 7 PDF

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Chapter 7. Activity-Based Costing: A Tool to Aid Decision Making Activity-based costing (ABC): a costing method based on activities that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore fixed costs as well as variable costs – internal use THE TREATMENT OF COSTS UNDER THE ACTIVITY-BASED COSTING MODEL ABC differs from traditional cost accounting in several ways, In ABC 1. Non-manufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis. a. Traditional cost accounting -> only manufacturing costs are assigned to products (selling and administrative expenses are treated as period expenses and are not assigned to products) b. ABC -> products are assigned all of the overhead costs—non-manufacturing as well as manufacturing—that they can reasonably be estimated to have caused. In essence, we will be determining the entire cost of a product rather than just its manufacturing cost. 2. Some manufacturing costs may be excluded from product costs. a. Traditional cost accounting -> all manufacturing costs are assigned to products – even manufacturing costs that are not caused by the products  eg: The cost of unused capacity are assigned to products. If the budgeted level of activity declines, the overhead rate and unit product costs increase as the increasing costs of idle capacity are spread over a smaller base. b. ABC -> only if there is good reason to believe that the cost would be affected by decisions concerning the product  eg: Salary or the factory security guard’s wages are actually unaffected by product-related decisions and are therefore treated as period expenses instead of product costs under ABC.  Products are only charged for the costs of the capacity they use – not for the costs of the capacity they don't use. -> provides more stable unit product costs and is consistent with the goal of assigning to products only the costs of the resources that they use.  The cost of idle capacity are considered to be period costs that flow through to the income statement as an expense of the current period. – highlights the cost of idle capacity rather than burying it in inventory and cost of goods sold. 3. Numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measure of activity. a. One common thing between the plantwide and departmental approaches – they relied on allocation bases such as direct labour-hours and machine-hours to allocate overhead costs to products (19th & 20th centuries) b. ABC uses more cost pools and unique measures of activity to better understand the costs of managing and sustaining product diversity.  Traditional costing treats all manufacturing costs as product costs and all other costs as period costs. Activity-based costing recognizes both indirect manufacturing and indirect non-manufacturing costs as overhead and allocates overhead costs that change with levels of production activity as product costs and overhead costs that do not change with levels of production activity as period costs.

 Activity = any event that causes the consumption of overhead resources

 Activity cost pool: a “bucket” in which costs are accumulated that relate to a single activity measure in an ABC system  Activity measure: an allocation base in an ABC system; ideally, it is a measure of the amount of activity that drives the costs in an activity cost pool; also called a cost driver 2 most common types of activity measures are transaction drivers and duration drivers o Transaction driver: a simple count of the number of times an activity occurs (i.e., the number of bills sent out to customers) – more often used o Duration driver: a measure of the amount of time required to perform an activity (i.e., the time spent preparing individual bills for customers) -> more accurate but take more effort to record c. Five different levels of activity in ABC: 1. Unit-level activities: are performed each time a unit is produced. The costs of unit-level activities should be proportional to the number of units produced.  Eg: providing power to run processing equipment is a unit-level activity since power tends to be consumed in proportion to the number of units produced. 2. Batch-level activities: are performed each time a batch is handled or processed, regardless of how many units are in the batch.  Eg: tasks such as placing purchase orders, setting up equipment, and arranging for shipments to customers are batch-level activities. They are incurred once for each batch (or customer order).  The cost of setting up a machine for batch processing is the same regardless of whether the batch contains 100 or 10,000 items. 3. Product-level activities: relate to specific products and typically must be carried out regardless of how many batches are run or units of product are produced or sold.  Eg: designing a product, advertising a product, and maintaining a product manager and staff are all product-level activities. 4. Customer-level activities: activities that are carried out to support customers but that are not related to any specific product 5. Organization-sustaining activities: activities that are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made (i.e., cleaning, loans, or annual reports) 4. Overhead rates, or activity rates, may be based on the level of activity at capacity rather than on the budgeted level of activity. a. Traditional -> predetermined overhead rates are computed by dividing budgeted overhead costs by a measure of budgeted activity such as budgeted direct labour-hours – applying the costs of unused, or idle, capacity to products, and it results in unstable unit product costs  If budgeted activity falls, the overhead rate increases because the fixed components of overhead are spread over a smaller base, resulting in increased unit product costs. b. ABC -> products are charged for the costs of capacity they use, not for the costs of capacity they do not use – the costs of idle capacity are not charged to products.  This results in more stable unit costs and is consistent with the objective of assigning only those costs to products that are actually caused by the products. DESIGNING AN ACTIVITY-BASED COSTING SYSTEM Three essential characteristics of a successful ABC implementation: 1. Top managers must strongly support the implementation because their leadership is instrumental in properly motivating all employees to accept the need for change. 2. Top managers should ensure that ABC data are linked to how people are evaluated and rewarded. 3. A cross-functional team should be created to design and implement the ABC system.  The team should include representatives from each area that will use ABC data, such as marketing, production, engineering, and accounting departments. – they possess detailed knowledge of many parts of an organization’s operations that is crucial for designing an effective ABC system  Utilizing the knowledge of cross-functional managers reduces their resistance to change because they feel involved in the ABC implementation process. To illustrate the design and use of an ABC system, we use a company that makes two main product lines for luxury yachts—standard stanchions and custom compass housings.

The greater the number of sheets used to fill out production orders and the greater the amount of time devoted to filling out such orders, the greater the cost. As in most companies, that the company’s traditional cost accounting system adequately measured the direct material and direct labour costs of products since these costs are directly traced to products. => Therefore, the ABC system would be concerned solely with manufacturing overhead and selling and administrative costs. Five basic steps to implement the ABC: 1. Identify and define activities, activity cost pools, and activity measures a. The greater the number of activities tracked in the ABC system, the more accurate the costs are likely to be.  So the original lengthy list of activities is usually reduced to a smaller number by combining similar activities. Eg: material handling contains receive RM and load to storeroom  When combining activities in an ABC system, activities should be grouped together at the appropriate level. Batch-level activities should not be combined with unit-level activities, or product-level activities with batch-level activities, and so on. In general, it is best to combine only those activities that are highly correlated with each other within a level. Eg: the number of customer orders received is likely to be highly correlated with the number of completed customer orders shipped, so these two batch-level activities (receiving and shipping orders)

  The Customer Orders cost pool is assigned all costs of resources that are consumed by taking and processing customer orders, including costs of processing paperwork and any costs involved in setting up machines for specific orders. The activity measure for this cost pool is simply the number of customer orders received. This is a batch-level activity, since each order generates work that occurs regardless of whether the order is for l unit or 1,000 units.  The Product Design cost pool is assigned all costs of resources consumed in designing products. The activity measure for this cost pool is the number of products designed. This is a product-level activity, since the amount of design work on a new product does not depend on the number of units ultimately ordered or batches ultimately run.  The Order Size cost pool is assigned all costs of resources consumed as a consequence of the number of units produced, including the costs of miscellaneous factory supplies, power to run machines, and some equipment depreciation. This is a unit-level activity, since each unit requires some of these resources. The activity measure for this cost pool is machine-hours.  The Customer Relations cost pool is assigned all costs associated with maintaining relations with customers, including the costs of sales calls and the costs of entertaining customers. The activity measure

for this cost pool is the number of customers the company has on its active customer list. The Customer Relations cost pool represents a customer-level activity.  The Other cost pool is assigned all overhead costs that are not associated with customer orders, product design, production units, or customer relations. These costs mainly consist of organization-sustaining costs and the costs of unused, idle capacity. Recall that these types of costs should not be assigned to products since they represent resources that are not consumed by products. 2. Assign overhead costs to activity cost pools Assigning costs to cost objects under ABC is a Two-stage process: 1. Manufacturing and non-manufacturing overhead is allocated to the activity cost pools. 2. The costs for the activities are allocated to the various cost objects.

First-stage allocations are usually based on the results of interviewa with emplyees who have first-hand knowladhe

of the activity. The result of interviews displayed below Once the % distribution have been estabilished, it is easy to allocate costs to the activity cost pools. Each cost is allocated across the activity pools by multiplying it by the %.

3. Calculate activity rates Two things: 1. Direct materials, direct labour, and shipping costs are included because they are all direct costs of the cost objects and must be considered when analyzing total costs related to products, customer orders and customers. These costs were not included in the first-stage allocations because that process deals with assigning overhead costs to activity cost pools. 2. The other category, which contains organization-sustaining costs and costs of idle capacity, is not allocated to products or customers.

SECONG-STAGE ALLOCATION OF OVERHEAD COSTS In the second-stage allocation, activity rates are used to apply overhead costs to products ad customers. 4. Assign overhead costs to cost objects using the activity rates and activity Measures

*Activity 会给你 a. With second-stage allocations complete the ABC design team was ready to turn its attention to creating reports that would help explain the company’s first-ever operating loss.

As shown below, when the Customer Relations and Other activity costs are added to the $952,000 of overhead costs assigned to products, the total is $1,810,000:

PRODUCT AND CUSTOMER MARGINS 5. Prepare management reports Product margin: the profit from a product; a function of the product’s sales and the direct and indirect costs that the product incurs  Therefore, to compute a product’s profit (i.e., product margin), the design team needed to gather each product’s sales and direct costs in addition to the overhead costs previously computed.

 Having gathered the above data, the design team created the product profitability report.  Note, the product profitability report purposely does not include the costs in the Customer Relations and Other activity cost pools  These costs, which total $858,000, are excluded from the report because they are not caused by the products. Customer Relations costs are caused by customers, not products. The Other costs are organization-sustaining costs that are not caused by any particular product or customer.

In addition to customer costs and margins, many firms today are using activity-based costing to calculate supplier costs and margins. Just like customers, suppliers can impact costs accumulated within the firm. Eg ：the cost of a purchased component should include the price paid to the supplier plus any related costs of reliability, quality, late delivery of components, etc. When selecting longer-term suppliers, all of these potential costs are relevant.

COMPARISON OF TRADITIONAL AND ACTIVITY-BASED COSTING PRODUCT COSTS 1. the team reviewed the product margins reported by the traditional costing system. 2.they looked at the differences between the traditional and ABC product margins. The ABC team used a two-step process to compare its traditional and ABC products costs. Product margins computed using the traditional costing system Classic Brass’s traditional costing system assigns only manufacturing costs to products—this includes direct materials, direct labour, and manufacturing overhead. Selling and administrative costs are not assigned to products.

 these margins were calculated in three steps  1. the sales and direct materials and direct labour cost data are the same numbers used by the ABC team to prepare Exhibit 7–12. =》the traditional costing system and the ABC system treat these three pieces of revenue and cost data identically.  2. the traditional costing system uses a plantwide overhead rate to assign manufacturing overhead costs to products.

This rate is used to calculate manufacturing overhead  3. the operating loss of $1,250 shown in Exhibit agrees with the loss reported in the income statement in Exhibit 7–2. Although the “total pie” remains constant across the traditional and ABC systems, what differs is how the pie is divided between the two product lines.  The traditional product margin calculations suggest that standard stanchions are generating a product margin of $615,750 and the custom compass housings a product margin of $258,000.  However, these product margins differ from the ABC product margins reported in Exhibit 7–12. Indeed, the traditional costing system is sending misleading signals to Classic Brass’s managers about each product’s profitability. We explain why in the next section. The differences between activity-based costs and traditional product costs The changes in product margins caused by switching from the traditional costing system too the ABC system are shown below:

Three reasons of the differences: 1) The traditional costing system allocates all manufacturing costs to products regardless of whether they consumed those costs. The ABC system does not assign manufacturing overhead costs to products for either Customer Relations activities or Other activities because they are not caused by any particular product. From an ABC point of view, assigning these costs to products is inherently arbitrary and counterproductive. 2) The traditional costing system allocates all manufacturing overhead costs using machine-hours, a volume-related allocation base that may or may not reflect what actually causes these costs.  The ABC system uses unique activity measures (most of which are not volume-related) to allocate the cost of each activity cost pool selected on the basis of management’s assessment of the driver of overhead costs for that activity. 3) The ABC system assigns non-manufacturing overhead costs such as shipping to products on a cause-and-effect basis. The traditional costing system excludes. Targeting process improvements Activity-based management (ABM):a management approach that is used in conjunction with ABC to improves processes and reduces costs  Firstly, they have to decide what to improve  ABC provides an approach-> The activity rates computed in ABC can provide valuable clues concerning where there is waste and scope for improvement in an organization. Benchmarking is another way to utilize the information in activity rates: a systematic approach to identifying the activities with the greatest room for improvement  It is based on comparing the performance of some aspect of an organization’s operations (e.g., quality control) with the performance of other, similar organizations known for their outstanding performance. If a particular part of the organization performs well below the external or internal benchmark, managers will likely target that area for improvement.  External benchmarking= using outside organizations as the basis for comparison is known as external benchmarking.  Internal benchmarking: where one division’s operations (e.g., customer order processing) is compared to other divisions that are performing well on that activity. Activity-based costing and external reports

Although ABC generally provides more accurate product costs than traditional costing methods, it is infrequently used for external reports for a number of reasons. 1. External reports are less detailed than internal reports prepared for decision making. Eg ：individual product cost are not reported 2. Often very difficult to make changes in a company’s accounting system. 3. An ABC system such as the one described in this chapter does not conform to GAAP.  Product costs computed for external reports MUST include all of the manufacturing costs and only manufacturing costs; however, ABC system excludes some manufacturing costs and include some nonmanufacturing costs. – able to adjust the ABC data at the end, but requires more work 4. Auditors are likely to be uncomfortable with allocations based on interviews with the company’s personnel.

THE LIMITATIONS OF ACTIVITY-BASED COSTING  Substantial resources required to implement and maintain-> more costly to maintain– the benefits of increased accuracy may not outweigh these costs.  Resistance to unfamiliar numbers and reports  More costly to maintain than a traditional costing system  ABC data an easily be misinterpreted and must be used with care in making decisions. Costs assigned to products, customer, and other cost objectives are only potentially relevant. Before making decision, managers must identify which costs are really relevant for the decision at hand.  Does not conform to GAAP. Two costing systems may be needed (one for internal use and one for preparing external reports) comparing the performance of some aspect of an organization’s operations to that of outstanding external companies APPENDIX 7A: USING A MODIFIED FORM OF ACTIVITY-BASED COSTING TO DETERMINE PRODUCT COSTS FOR EXTERNAL REPORTS A modified form of ABC can be used to develop product costs for external financial reports.  For this purpose, product cost include all manufacturing overhead costs-including organization-sustaining...