Activity-Based Costing (ABC) PDF

8-1 Activity–Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect “fixed” as well as variable costs. McGraw-Hill Education (Asia) McGraw-Hill/Irwin ABC is a good supplement to our trad...

8-1 Activity–Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect “fixed” as well as variable costs. McGraw-Hill Education (Asia) McGraw-Hill/Irwin ABC is a good supplement to our traditional cost system Garrison, Noreen, Brewer, Cheng & Yuen I agree! Slide 1 ABC is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” as well as variable costs. It is ordinarily used as a supplement to, rather than as a replacement for, the company’s usual costing system. 1 8-2 How Costs are Treated Under Activity–Based Costing ABC differs from traditional cost accounting in three ways. Manufacturing costs Nonmanufacturing costs Traditional product costing ABC product costing  ABC assigns both types of costs to products. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 2 ABC differs from traditional cost accounting in three ways. The first is that nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis. For example, ABC systems can assign sales commissions, shipping costs, and warranty repair costs to specific products. 2 8-3 How Costs are Treated Under Activity–Based Costing ABC differs from traditional cost accounting in three ways. Some Nonmanufacturing costs All Manufacturing costs Traditional product costing ABC product costing  ABC does not assign all manufacturing costs to products. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 3 The second major difference between ABC and traditional cost accounting is that some manufacturing costs may be excluded from product costs. This is because ABC only assigns a cost to a product if decisions concerning that product will cause changes in the cost. ABC excludes two types of costs from product costs: 1.Organization-sustaining costs (which will be formally defined later); and 2.The costs of unused or idle capacity. 3 8-4 How Costs are Treated Under Activity–Based Costing ABC differs from traditional cost accounting in three ways. Each ABC cost pool has its own unique measure of activity. Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products.  ABC uses more cost pools. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 4 Each ABC cost pool has its own unique measure of activity. On the contrary, traditional cost systems usually rely on direct labor hours and/or machine hours to allocate all overhead costs to products. Direct labor and machine hours work correctly when changes in the quantity of the base are correlated with changes in the overhead costs being assigned using the base. Relying exclusively on these bases to assign overhead costs to products has come under increased scrutiny since, on an economy-wide basis, direct labor and overhead costs have been moving in opposite directions and the variety of products produced by companies has increased. 4 8-5 How Costs are Treated Under Activity–Based Costing Activity An event that causes the consumption of overhead resources. Activity Cost Pool A “cost bucket” in which costs related to a single activity measure are accumulated. $$ $ $ $ $ McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 5 Part I. An activity is any event that causes the consumption of overhead resources. Part II. An activity cost pool is a “bucket” in which costs are accumulated that relate to a single activity measure in an ABC system. 5 8-6 How Costs are Treated Under Activity–Based Costing The term cost driver is also used to refer to an activity measure. Activity Measure An allocation base in an activity-based costing system. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 6 An activity measure is an allocation base in an activity-based costing system. The term cost driver is also used to refer to an activity measure. The two most common types of activity measures are shown on the next slide. 6 8-7 How Costs are Treated Under Activity–Based Costing Two common types of activity measures: Transaction driver Duration driver Simple count of the number of times an activity occurs. A measure of the amount of time needed for an activity. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 7 Two types of activity measures include: 1.Transaction drivers – simple counts of the number of times that an activity occurs such as the number of bills sent out to customers. 2.Duration drivers — measures of the amount of time needed to perform an activity such as the time spent preparing individual bills for customers. 7 8-8 How Costs are Treated Under Activity–Based Costing ABC defines five levels of activity that largely do not relate to the volume of units produced. Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 8 Traditional cost systems rely exclusively on allocation bases that are driven by the volume of production. ABC defines five levels of activity that largely do not relate to the volume of units produced. 8 8-9 How Costs are Treated Under Activity–Based Costing Unit-Level Activity Batch-Level Activity Manufacturing companies typically combine their activities into five classifications. Product-Level Activity McGraw-Hill Education (Asia) McGraw-Hill/Irwin Organizationsustaining Activity Garrison, Noreen, Brewer, Cheng & Yuen Customer-Level Activity Slide 9 In an activity-based cost system, companies typically combine their activities into the following five classifications: 1. Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment would be a unit-level activity. 2. Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities. 3. Product-level activities relate to specific products and must be carried out regardless of how many batches are run or units are produced or sold. For example, designing or advertising a product would be product-level activities. 4. Customer-level activities relate to specific customers and are not tied to any specific product. For example, sales calls and catalog mailings would be customer-level activities. 5. Organization-sustaining activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are organization-sustaining activities. 9 8-10 Characteristics of Successful ABC Implementations Strong top management support Link to evaluations and rewards Cross-functional involvement McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 10 There should be strong top management support. Without leadership from top management, some managers may not be motivated to embrace the need to change. Top managers should ensure that ABC data are linked to how people are evaluated and rewarded. If employees continue to be evaluated and rewarded using traditional (non-ABC) cost data, they will quickly get the message that ABC is not important and they will abandon it. A cross-functional team should be created to design and implement the ABC system. Cross-functional employees possess intimate knowledge of operations that is necessary for designing an effective ABC system. Tapping the knowledge of cross-functional managers lessens their resistance to ABC because they feel included in the implementation process 10 8-11  Define Activities, Activity Cost Pools, and Activity Measures      Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Design Changes - assigned all costs of resources consumed by customer requested design changes. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations – assigned all costs associated with maintaining relations with customers. Other – assigned all organization-sustaining costs and unused capacity costs McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 11 At Baxter Battery, the definition for each of the activity cost pools is: • Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. • Design changes - assigned all costs of resources consumed by customer requested design changes. • Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. • Customer Relations – assigned all costs associated with maintaining relations with customers. • Other – assigned all organization-sustaining costs and unused capacity costs 11 8-12  Define Activities, Activity Cost Pools, and Activity Measures At Baxter Battery, the ABC team, selected the following activity cost pools and activity measures: McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 12 The first step in implementing ABC is to define activities, activity cost pools, and activity measures. The activities are often identified and defined by interviewing the employees that work in the respective overhead departments. The lengthy list of activities that emerges from this process is usually reduced to a handful by combining similar activities. Baxter Battery selected the following five activity cost pools and corresponding activity measures: Activity Cost Pool Activity Measure Customer orders Number of customer orders Design changes Number of design changes Order size Machine-hours Customer relations Number of active customers Other Not applicable 12 8-13  Assign Overhead Costs to Activity Cost Pools McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 13 The second step in implementing ABC is to assign overhead costs to activity cost pools. This is also called firststage allocation. Baxter Battery’s annual overhead costs (both manufacturing and nonmanufacturing) that it intends to assign to its activity cost pools are as shown. Notice that total costs for the Production Department ($14,000,000) equal the total manufacturing overhead costs shown in Baxter Battery’s income statement. In addition, the total costs for the General Administrative and Marketing Departments ($6,000,000 and $2,000,000, respectively) equal the general administrative and marketing expenses shown in Baxter Battery’s income statement. 13 8-14  Assign Overhead Costs to Activity Cost Pools Direct materials, direct labor, and shipping are excluded because Baxter Battery’s existing cost system can directly trace these costs to products or customer orders. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 14 Three costs included in Baxter Battery’s income statement—direct materials, direct labor, and shipping—are excluded from this slide because Baxter Battery’s existing cost system can directly trace these costs to products or customer orders. 14 8-15 RA0  Assign Overhead Costs to Activity Cost Pools At Baxter Battery the following distribution of resource consumption across activity cost pools is determined. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 15 Baxter Battery’s cross-functional interviews resulted in resource allocations as shown. Notice for example that the indirect factory workers allocated 30% of their time to the customer orders activity, 30% of their time to the design changes activity, 20% of their time to the order size activity, 10% of their time to customer relations, and 10% of their time to the “other” activity. Also note that 100% of the factory building lease is allocated to the “other” activity. Since Baxter Battery has a single production facility that it does not plan to contract or expand, the lease cost is an unavoidable organization-sustaining cost. 15 Slide 15 RA0 ‫الجدول معطى‬ Reham Alfahmi, 2023-10-20T14:49:23.537 8-16  Assign Overhead Costs to Activity Cost Pools Indirect factory wages $6,000,000 Percent consumed by customer orders 30% $1,800,000 McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 16 Once the percentage allocations have been determined, it is a simple matter to assign costs to activity cost pools. For example, the indirect factory wages assigned to the customer orders activity ($1,800,000) was computed by multiplying the total amount of indirect factory wages ($6,000,000) by the percentage of time that indirect factory workers spent on this activity (30%). 16 8-17  Assign Overhead Costs to Activity Cost Pools Factory equipment depreciation $3,500,000 Percent consumed by customer orders 20% $ 700,000 McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 17 As another example, the factory equipment depreciation assigned to the customer orders activity ($700,000) was computed by multiplying the total amount of factory equipment depreciation ($3,500,000) by the percentage of time that the factory equipment was used to support this activity (20%). 17 8-18  Assign Overhead Costs to Activity Cost Pools McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 18 The completed grid of first-stage allocations is shown on your screen. 18 8-19  Calculate Activity Rates The ABC team determines that Baxter Battery will have these total activities for each activity cost pool . . .     10,000 customer orders, 4,000 design changes, 800,000 machine-hours, 2,000 customers served. Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 19 The Baxter Battery ABC team determined that the company has the following activity for the four cost pools, 10,000 customer orders, 4,000 designs changes, 800,000 machine-hours, 2,000 customers served. This information enabled the team to compute ABC rates for each activity by dividing the total cost in each activity cost pool by the respective quantity of the activity measure. 19 8-20  Calculate Activity Rates McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 20 The activity rate for each cost pool is computed by dividing the total cost for an activity cost pool by the total activity for that pool. For example, the customer orders activity rate is $452 per order. Importantly, this is an average figure. Notice, the “other” cost pool does not have an activity rate. This is because these organization-sustaining costs will not be assigned to products or customers. 20 8-21 Activity–Based Costing at Baxter Battery Direct Materials Direct Labor Shipping Costs Traced Traced Traced Overhead Costs Cost Objects: Products, Customer Orders, Customers McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 21 Before proceeding, let’s get a visual perspective of the Baxter Battery ABC system. The direct materials, direct labor and shipping costs are directly traceable to products or customer orders. 21 8-22 Activity–Based Costing at Baxter Battery Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Customer Orders Design Changes Order Size Customer Relations Other Cost Objects: Products, Customer Orders, Customers McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 22 The first-stage allocation process assigned the remaining overhead costs to the five activity cost pools. 22 8-23 Activity–Based Costing at Baxter Battery Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Customer Orders Design Changes Order Size Customer Relations Other Second-Stage Allocations $/Order $/Change $/MH $/Customer Cost Objects: Products, Customer Orders, Customers McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Unallocated Slide 23 Then, activity measures were identified, activity levels were determined, and activity rates were computed for each activity as shown earlier. These rates will be used in the next step to assign overhead costs to cost objects. 23 8-24  Assigning Overhead to Products Baxter Battery Information SureStart 1. Requires no new design resources. 2. 800,000 batteries ordered with 4,000 separate orders. 3. Each SureStart requires 36 minutes of machine time for a total of 480,000 machine-hours. LongLife 1. Requires new design resources. 2. 400,000 batteries ordered with 6,000 separate orders. 3. 4,000 custom designs prepared. 4. Each LongLife requires 48 minutes of machine time for a total of 320,000 machine-hours. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 24 The data needed to assign overhead costs to Baxter Battery’s two products—SureStart and LongLife—are as shown. There were 4,000 separate customer orders placed for 800,000 SureStarts and 6,000 customer orders were placed for 400,000 LongLifes. All 4,000 design changes related to the LongLife batteries. The SureStart battery consumed 480,000 machine hours, and the LongLife consumed 320,000 machine-hours. 24 8-25  Assigning Overhead to Products McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 25 The overhead cost assignments to SureStarts and LongLifes are as shown. Notice that the total overhead costs assigned to SureStarts and LongLifes are $4,928,000 and $7,832,000, respectively, for a total of $12,760,000 assigned to the two products. The total overhead costs assigned to products ($12,760,000) plus the total overhead costs not assigned to products ($9,240,000) equal the total overhead cost of $22,000,000 from earlier slides. The overhead not assigned to products consists of customer relations ($3,080,000) and other ($6,160,000). 25 8-26 Assigning Overhead to Customers Let’s take a look at how Baxter Battery’s system works for just one of the 2,000 customers – Acme Auto Parts who placed a total of twelve orders. Note that the four orders for LongLifes required a design change. Orders 1. Eight orders for 60 SureStarts per order. 2. Four orders for 50 LongLifes per order. Machine-hours 1. The 480 SureStarts required 288 machine-hours. 2. The 200 LongLifes required 160 machine hours. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 26 Acme Auto Parts placed twelve orders. Eight orders were for 60 SureStarts each, and four orders were for 50 LongLifes each. The 480 SureStarts required 288 machine-hours, and 200 LongLifes required 160 machine-hours. 26 8-27 RA0 Assigning Overhead to Customers McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 27 The total overhead cost of $12,916 assigned to Acme Auto Parts is calculated as shown. 27 Slide 27 RA0 448= 160+288‫مجموع الساعات‬ Reham Alfahmi, 2023-10-20T15:04:06.597 8-28  Prepare Management Reports Product Margin Calculations The first step in computing product margins is to gather each product’s sales and direct cost data. Sales Direct costs Direct material Direct labor Shipping McGraw-Hill Education (Asia) McGraw-Hill/Irwin SureStarts $ 31,300,000 LongLifes $ 18,700,000 Total $ 50,000,000 9,000,000 7,000,000 2,000,000 6,000,000 5,000,000 1,000,000 15,000,000 12,000,000 3,000,000 Garrison, Noreen, Brewer, Cheng & Yuen Slide 28 One of the most common management reports prepared with ABC data is product profitability (product margin) reports. The first step in computing product margins is to gather each product’s sales and direct cost data which are assumed to be as shown. 28 8-29  Prepare Management Reports Product Margin Calculations The second step in computing product margins is to incorporate the previously computed activity-based cost assignments pertaining to each product. SureStarts Sales $ 31,300,000 Direct costs Direct material 9,000,000 Direct labor 7,000,000 Shipping 2,000,000 ABC cost assignments Customer orders 1,808,000 Design changes Order size 3,120,000 McGraw-Hill Education (Asia) McGraw-Hill/Irwin LongLifes $ 18,700,000 Total $ 50,000,000 6,000,000 5,000,000 1,000,000 15,000,000 12,000,000 3,000,000 2,712,000 3,040,000 2,080,000 4,520,000 3,040,000 5,200,000 Garrison, Noreen, Brewer, Cheng & Yuen Slide 29 The second step is to incorporate the previously computed activity-based cost assignments pertaining to each product. 29 8-30  Prepare Management Reports Product Margin Calculations The third step in computing product margins is to deduct each product’s direct and indirect costs from sales. Sales Costs Direct material Direct labor Shipping Customer orders Design changes Order size Total cost Product margin McGraw-Hill Education (Asia) McGraw-Hill/Irwin SureStarts $ 31,300,000 $ 9,000,000 7,000,000 2,000,000 1,808,000 LongLifes $ 18,700,000 $ 6,000,000 5,000,000 1,000,000 2,712,000 3,040,000 2,080,000 3,120,000 22,928,000 $ 8,372,000 Garrison, Noreen, Brewer, Cheng & Yuen 19,832,000 $ (1,132,000) Slide 30 The third step is to compute product margins ($8,372,000 for SureStarts and a loss of $1,132,000 for LongLifes) by deducting each product’s direct and indirect costs from its sales. 30 8-31  Prepare Management Reports Product Margin Calculations The product margins can be reconciled with the company’s net operating income as follows: SureStarts $ 31,300,000 22,928,000 $ 8,372,000 Sales Total costs Product margins LongLifes $ 18,700,000 19,832,000 $ (1,132,000) Less costs not assigned to products: Customer relations Other Total Nett operating income loss McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Total $ 50,000,000 42,760,000 $ 7,240,000 3,080,000 6,160,000 9,240,000 $ (2,000,000) Slide 31 The product margins can be reconciled with the company’s net operating loss as shown. 31 8-32  Prepare Management Reports Customer Margin (Profitability) Analysis The first step in computing Acme Auto Parts’ customer margin is to gather its sales and direct cost data. Sales Direct costs Direct material Direct labor Shipping McGraw-Hill Education (Asia) McGraw-Hill/Irwin Acme Auto Parts $ 29,200 Garrison, Noreen, Brewer, Cheng & Yuen 7,500 6,700 1,700 Slide 32 The first step in computing Acme Auto Parts’ customer margin is to gather its sales and direct cost data which are assumed to be as shown. 32 8-33  Prepare Management Reports Customer Margin (Profitability) Analysis The second step is to incorporate Acme Auto Parts’ previously computed activity-based cost assignments. Sales Direct costs Direct material Direct labor Shipping ABC cost assignments Customer orders Product design Order size Customer relations McGraw-Hill Education (Asia) McGraw-Hill/Irwin Acme Auto Parts $ 29,200 Garrison, Noreen, Brewer, Cheng & Yuen 7,500 6,700 1,700 5,424 3,040 2,912 1,540 Slide 33 The second step is to incorporate Acme Auto Parts’ previously computed activity-based cost assignments. 33 8-34  Prepare Management Reports Customer Margin (Profitability) Analysis The third step is to compute Acme Auto Parts’ customer margin of $384 by deducting all its direct and indirect costs from its sales. Sales Direct costs Direct material Direct labor Shipping Customer orders Product design Order size Customer relations Customer margin McGraw-Hill Education (Asia) McGraw-Hill/Irwin Acme Auto Parts $ 29,200 $ 7,500 6,700 1,700 5,424 3,040 2,912 1,540 Garrison, Noreen, Brewer, Cheng & Yuen $ 28,816 384 Slide 34 The third step is to compute Acme Auto Parts’ customer margin of $384 by deducting all its direct and indirect costs from its sales. 34 8-35 Product Margins Computed Using the Traditional Cost System The first step in computing product margins is to gather each product’s sales and direct cost data. Sales Direct costs Direct material Direct labor McGraw-Hill Education (Asia) McGraw-Hill/Irwin SureStarts $ 31,300,000 LongLifes $ 18,700,000 Total $ 50,000,000 9,000,000 7,000,000 6,000,000 5,000,000 15,000,000 12,000,000 Garrison, Noreen, Brewer, Cheng & Yuen Slide 35 The first step is to gather each product’s sales and direct cost data as shown. 35 8-36 Product Margins Computed Using the Traditional Cost System The second step in computing product margins is to compute the plantwide overhead rate. Manufacturing Overhead Costs at Baxter Battery Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease Total manufacturing overhead Plantwide manufacturing overhead rate = 6,000,000 3,500,000 2,500,000 2,000,000 $ 14,000,000 $14,000,000 800,000 MH SureStarts (800,000 @ 0.60 hours) LongLifes (400,000 @ 0.80 hours) Total machine-hours McGraw-Hill Education (Asia) McGraw-Hill/Irwin $ = $17.50 per machine-hour Machine-hours 480,000 320,000 800,000 Garrison, Noreen, Brewer, Cheng & Yuen Slide 36 The second step is to compute the plantwide overhead rate. In our example, the numerator is the $14,000,000 of manufacturing overhead shown earlier, and the denominator is the 800,000 machine hours used for the order size activity from the ABC system. The plantwide overhead rate is $17.50 per machine-hour. 36 8-37 Product Margins Computed Using the Traditional Cost System The third step in computing product margins is allocate manufacturing overhead to each product. SureStarts LongLifes Total overhead allocated to products Machine Overhead Overhead Hours Rate Allocated 480,000 $ 17.50 $ 8,400,000 320,000 17.50 5,600,000 $ 14,000,000 480,000 hours × $17.50 per hour = $8,400,000 McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 37 The third step is to allocate manufacturing overhead to each product. For our example, 480,000 machine-hours were worked on SureStarts, so $8,400,000 (480,000 hours × $17.50) of manufacturing overhead is assigned to this product. LongLifes are assigned the remaining $5,600,000 (320,000 × $17.50) of manufacturing overhead. 37 8-38 Product Margins Computed Using the Traditional Cost System The fourth step is to actually compute the product margins. Sales Cost of goods sold Direct materials Direct labor Manufacturing overhead Product margin Selling and administrative Nett operating operating income loss SureStarts $ 31,300,000 $ 9,000,000 7,000,000 8,400,000 $ $ 24,400,000 6,900,000 6,000,000 5,000,000 5,600,000 Total $ $ 16,600,000 2,100,000 15,000,000 12,000,000 14,000,000 $ Shipping expenses Marketing expenses General administrative expenses McGraw-Hill Education (Asia) McGraw-Hill/Irwin LongLifes $ 18,700,000 50,000,000 41,000,000 9,000,000 11,000,000 (2,000,000) $ 3,000,000 2,000,000 6,000,000 $ 11,000,000 Garrison, Noreen, Brewer, Cheng & Yuen Slide 38 The fourth step is to compute the product margins—$6,900,000 for SureStarts and $2,100,000 for LongLifes. Notice selling and administrative expenses are not allocated to products because they are assumed to be period expenses. The overall net loss of $2,000,000 reconciles with the income statement shown earlier. 38 8-39 Differences Between ABC and Traditional Product Costs Product margins – traditional Product margins – ABC Change in reported margins The traditional cost system overcosts the SureStarts and reports a lower product margin for this product. McGraw-Hill Education (Asia) McGraw-Hill/Irwin SureStarts $ 6,900,000 8,372,000 $ 1,472,000 LongLifes $ 2,100,000 (1,132,000) $ (3,232,000) The traditional cost system undercosts the LongLifes and reports a higher product margin for this product. Garrison, Noreen, Brewer, Cheng & Yuen Slide 39 The changes in product margins caused by switching from the traditional cost system to the activity-based costing system are as shown. First, the traditional cost system overcosts the SureStarts, and consequently, reports an artificially low product margin for this product. Conversely, the traditional cost system undercosts the LongLifes, and consequently, reports an artificially high product margin for this product. 39 8-40 Differences Between ABC and Traditional Product Costs There are three reasons why the reported product margins for the two costing systems differ from one another. Traditional costing allocates all manufacturing overhead to products. ABC costing only assigns manufacturing overhead costs consumed by products to those products. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 40 There are three reasons why the reported product margins for the two costing systems differ from one another. The first reason is that the traditional cost system allocates all manufacturing overhead to products. The ABC system only assigns manufacturing overhead costs consumed by products to those products. More specifically, the ABC system does not assign the manufacturing overhead costs consumed by the customer relations activity to products because these costs are caused by customers, not specific products. The ABC system does not assign the manufacturing overhead costs included in the “other” activity to products because these organization-sustaining and unused capacity costs are not caused by products. 40 8-41 Differences Between ABC and Traditional Product Costs There are three reasons why the reported product margins for the two costing systems differ from one another.  Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. ABC costing also uses non-volume related allocation bases. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 41 The second reason why the reported product margins for the two costing systems differ from one another is that the traditional cost system allocates all manufacturing overhead costs using a volume-related allocation base (machine-hours). The ABC system uses volume-related and non-volume related allocation bases to assign manufacturing overhead to products. More specifically: The traditional cost system allocates 60% ($8,400,000 ÷ $14,000,000) of all manufacturing overhead to SureStart and 40% ($5,600,000 ÷ $14,000,000) to LongLifes. The ABC system assigns 40% ($1,808,000 ÷ $4,520,000) and 60% ($2,712,000 ÷ $4,520,000) of customer orders activity cost (a batch-level cost) to SureStarts and LongLifes, respectively. The ABC system assigns 0% and 100% of design change activity cost (a product-level cost) to SureStarts and LongLifes, respectively. 41 8-42 Differences Between ABC and Traditional Product Costs There are three reasons why the reported product margins for the two costing systems differ from one another.  Traditional costing disregards selling and administrative expenses because they are assumed to be period expenses. ABC costing directly traces shipping costs to products and includes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned to products. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 42 The third reason why the reported product margins for the two costing systems differ from one another is that the traditional cost system disregards selling and administrative expenses because they are assumed to be period expenses. The ABC system directly traces shipping costs to products and includes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned to products. 42 8-43 Activity-based Costing and Customer Profitability Analysis • Analyze profitability of different customer groups e.g. retail customers vs corporate customers • Examine different activities by resource consumption and relevant cost drivers • Sum up the allocated costs in each activity based on customer group • Other factors to consider: • Growth potential • Customer loyalty and industry’s barrier of entry • Customer lifetime value McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 43 ABC is very useful for customer profitability analysis • Analyze profitability of different customer groups e.g. retail customers vs corporate customers • Examine different activities by resource consumption and relevant cost drivers • Sum up the allocated costs in each activity based on customer group • Other factors to be considered: • Growth potential • Customer loyalty and industry’s barrier of entry • Customer lifetime value 43 8-44 Activity-based Management: Targeting Process Improvement Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements. While the theory of constraints approach discussed in Chapter 1 is a powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on where to focus improvement efforts. Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 44 Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvement. It involves focusing on activities to eliminate waste, decrease processing time, and reduce defects. While the theory of constraints approach discussed in Chapter 1 is a powerful tool for targeting process improvement efforts, the activity rates computed in ABC can also provide valuable clues concerning where there is waste and the opportunity for improvement. Benchmarking can be used to compare an organization’s activity rates with standards of performance that are external to the organization. 44 8-45 Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because . . . 1. External reports are less detailed than internal reports. 2. It may be difficult to make changes to the company’s accounting system. 3. ABC does not conform to GAAP. 4. Auditors may be suspect of the subjective allocation process based on interviews with employees. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 45 There are four reasons why most companies do not use ABC for external reporting purposes. First, external reports are less detailed than internal reports in the sense that individual product costs are not reported. External reports only disclose cost of goods sold and ending inventory. Therefore, if some products are undercosted and others are overcosted, the errors tend to cancel each other out when the product costs are added together. Next, it is often very difficult to change a company’s accounting system because it is deeply embedded within complex computer programs that have evolved over many years. Third, an ABC system, such as the one described in the chapter, does not conform to generally accepted accounting principles (GAAP). It excluded some organization-sustaining manufacturing costs, some unused capacity costs, and it included some nonmanufacturing costs in its product cost calculations. These cost system design attributes do not comply with GAAP. Finally, auditors are likely to be uncomfortable with cost allocations that are based upon interviews with the company’s personnel. This type of subjective data can be easily manipulated by management. 45 8-46 ABC Limitations Substantial resources required to implement and maintain. Resistance to unfamiliar numbers and reports. Desire to fully allocate all costs to products. Potential misinterpretation of unfamiliar numbers. Does not conform to GAAP. Two costing systems may be needed. McGraw-Hill Education (Asia) McGraw-Hill/Irwin Garrison, Noreen, Brewer, Cheng & Yuen Slide 46 There are five limitations of activity-based costing. First, implementing an ABC system requires substantial resources. The benefits of increased cost accuracy may not outweigh the implementation costs. Next, ABC systems produce numbers, such as product margins, that are at odds with the numbers produced by traditional cost systems. Managers are not accustomed to managing their operations using these numbers; hence, ABC inevitably faces resistance. This underscores the importance of having top management support for and cross-functional involvement with the ABC implementation. Also, in practice, most managers insist on fully allocating all costs to products. The ABC system described in the main portion of this chapter does not conform to this preference. The next limitation is that ABC systems do not automatically identify the relevant costs for particular decisions; therefore, ABC data can be easily misinterpreted and must be used with care when making decisions. Costs assigned to products, customers, and other cost objects are only potentially relevant. Finally, most organizations use ABC as a supplement to rather a replacement for their existing cost system. Maintaining two cost systems is costlier than maintaining just one system and it may cause confusion about which set of numbers is to be relied on. 46