Financial & Managerial Accounting, 16e Chapter 18 PDF

Financial & Managerial Accounting, 16e Chapter 18: Activity-Based Costing Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be sca...

Financial & Managerial Accounting, 16e Chapter 18: Activity-Based Costing Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter Objectives By the end of this chapter, you should be able to: Obj. 1 Describe three methods used for allocating factory overhead costs to products. Obj. 2 Use a single plantwide factory overhead rate for product costing. Obj. 3 Use multiple production department factory overhead rates for product costing. Obj. 4 Use activity-based costing for product costing. Obj. 5 Use activity-based costing to allocate selling and administrative expenses to products. Obj. 6 Use activity-based costing in a service business. Obj. 7 Describe and illustrate the use of activity-based costing information in decision making. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Product Costing Allocation Methods (Learning Objective 1) Determining the cost of a product is termed product costing. Product costs consist of direct materials, direct labor, and factory overhead. The direct materials and direct labor are direct costs that can be traced to the product. However, factory overhead includes indirect costs that must be allocated to the product. The most common methods of allocating factory overhead using predetermined factory overhead rates are: Single plantwide factory overhead rate method Multiple production department factory overhead rate method Activity-based costing method Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 1 - Allocation of Factory Overhead Costs Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Knowledge Check Activity 1 Which of the following are considered product costs? a. Direct materials, direct labor, and supervisors’ salaries b. Direct labor, manufacturing overhead, and executive salaries c. Direct materials, direct labor, and factory overhead d. Direct materials, administrative overhead, and indirect labor Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Knowledge Check Activity 1: Answer Which of the following are considered product costs? Answer: c. Direct materials, direct labor, and factory overhead Product costs consist of direct materials, direct labor, and factory overhead. Any cost that occurs outside the manufacturing process is a period cost. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Single Plantwide Factory Overhead Rate Method (Learning Objective 2) Under the single plantwide factory overhead rate method, factory overhead costs are allocated to products using only one rate. The budgeted allocation base is a measure of operating activity in the factory. Common allocation bases include direct labor hours, direct labor dollars, and machine hours. The primary advantage of using the single plantwide factory overhead rate method is that it is simple and inexpensive to use. However, the single plantwide rate assumes that the factory overhead costs are consumed in the same way by all products. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Single Plantwide Factory Overhead Rate Method―Ruiz Company (1 of 2) Ruiz Company manufactures snowmobiles and riding mowers in a single factory: The total budgeted direct labor hours are computed as follows: Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Single Plantwide Factory Overhead Rate Method―Ruiz Company (2 of 2) Under the single plantwide factory overhead rate method, the $1,600,000 budgeted factory overhead is applied to all products by using one rate. This rate is computed as follows: Total Budgeted Factory Overhead Single Plantwide Factory Overhead Rate = Total Budgeted Plantwide Allocation Base Ruiz allocates factory overhead using budgeted direct labor hours as the plantwide allocation base; thus, Ruiz’s single plantwide factory overhead rate is $80 per direct labor hour, computed as follows: $1,600,000 Single Plantwide Factory Overhead Rate = 20,000 direct labor hours $80 per direct labor hour Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 2 - Single Plantwide Factory Overhead Rate Method―Ruiz Company Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Knowledge Check Activity 2 Which of these is the primary advantage of using a single plantwide factory overhead rate? a. It is the most accurate method. b. It is simple and inexpensive to use. c. It is the only method accepted by generally accepted accounting principles. d. It is the most common method to use. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Knowledge Check Activity 2: Answer Which of these is the primary advantage of using a single plantwide factory overhead rate? Answer: b. It is simple and inexpensive to use. The primary advantage of using the single plantwide overhead rate method is that it is simple and inexpensive to use. The other methods are more expensive, but relatively more accurate. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Multiple Production Department Factory Overhead Rate Method (Learning Objective 3) The multiple production department factory overhead rate method uses different rates for each production department to allocate factory overhead costs to products. Assume that Ruiz uses the following two production departments in the manufacture of snowmobiles and riding mowers: Fabrication Department and Assembly Department. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Exhibit 3 - Comparison of Single Plantwide Rate and Multiple Production Department Rate Methods Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Department Overhead Rates and Allocation―Ruiz Company (1 of 2) Each production department factory overhead rate is computed as follows: Budgeted Department Factory Overhead Production Department Factory Overhead Rate = Budgeted Department Allocation Base Ruiz Company uses direct labor hours as the allocation base for the Fabrication and Assembly departments. The Fabrication Department is budgeted for 8,000 direct labor hours while the Assembly Department is budgeted for 12,000 direct labor hours: $1,000,000 Fabrication Department Factory Overhead Rate = $125 per direct labor hour 8,000 direct labor hours $600,000 Assembly Department Factory Overhead Rate = $50 per direct labor hour 12,000 direct labor hours Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Department Overhead Rates and Allocation―Ruiz Company (2 of 2) Ten direct labor hours are required for the manufacture of each snowmobile and riding mower. These hours are consumed in the Fabrication and Assembly departments as follows: The factory overhead allocated to each snowmobile and riding mower is shown in Exhibit 4. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 4 - Allocating Factory Overhead to Products―Ruiz Company Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 5 - Multiple Production Department Rate Method―Ruiz Company Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Distortion of Product Costs―Ruiz Company The differences in Ruiz Company’s factory overhead for each snowmobile and riding mower using the single plantwide and the multiple production department factory overhead rate methods are as follows: The preceding cost distortions are caused by averaging the differences between the high factory overhead costs in the Fabrication Department and the low factory overhead costs in the Assembly Department. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Distortion of Product Costs The following conditions indicate that a single plantwide factory overhead rate may cause product cost distortions: Condition 1: Differences in production department factory overhead rates. Some departments have high rates, whereas others have low rates. Condition 2: Differences among products in the ratios of allocation base usage within a department and across departments. Some products have a high ratio of allocation base usage within departments, whereas other products have a low ratio of allocation base usage within the same departments. Because both conditions exist for Ruiz, the product costs from using the single plantwide factory overhead rate are distorted. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 6 - Conditions for Product Cost Distortion―Ruiz Company Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Discussion Activity 1 Using a factory overhead allocation method such as the single plantwide factory overhead rate can cause product cost distortions. However, this method is less complicated and inexpensive to maintain. In groups of three to four students, discuss when and why a company would consider using a more complicated method. Are there some products within a company’s product line where using the simpler method would be “accurate enough”? Think of companies that may use a simpler or more complicated method. Share your thoughts with the class. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Discussion Activity 1: Debrief While the single plantwide factory overhead rate can cause product cost distortions, it may still be a choice for some companies if the cost of a more expensive system is prohibitive. Just knowing that the method may be inaccurate could allow some management decision making on adjustments of product prices. However, systems are continuously improving, easier to learn, and cheaper, such as the use of bar codes for pricing and inventory control using technology. Thus, in the long run, it may be more effective for a company to avoid using the single plantwide factory overhead rate method. What do you think? Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Activity-Based Costing Method (Learning Objective 4) The activity-based costing (ABC) method provides an alternative approach for allocating factory overhead that uses multiple factory overhead rates based on different activities. Activities are the types of work, or actions, involved in a manufacturing or service process. Factory overhead costs are initially budgeted for activities, sometimes called activity cost pools, such as machine usage, inspections, moving, production setups, and engineering activities. Exhibit 7 illustrates how activity-based costing differs from the multiple production department method. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 7 - Multiple Production Department Factory Overhead Rate Method vs. Activity-Based Costing―Ruiz Company Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Activity-Based Costing―Ruiz Company Fabrication and assembly are now identified as activities rather than departments. The setup, quality-control inspections, and engineering change functions that were previously allocated to the Fabrication and Assembly departments are now classified as separate activities. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Activity Rates―Ruiz Company Activity rates are computed as follows: Budgeted Activity Cost Activity Rate = Total Activity-Base Usage The term activity base, rather than allocation base, is used because the base is related to an activity. Activity-base usage for the two products are as follows: Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 8 - Activity Bases―Ruiz Company and Exhibit 9 - Activity Rates―Ruiz Company Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Direct Labor Hours―Ruiz Company The number of direct labor hours used by each product is 10,000 hours, computed as follows: Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Allocating Costs Overhead costs of each activity are allocated to a product by multiplying the product’s activity-base usage by the activity rate, as follows: Activity Overhead Allocated = Activity-Base Usage × Activity Rate The estimated total factory overhead cost for a product is the sum of the product’s individual activity allocations. The factory overhead cost per unit is computed by dividing the product’s total factory overhead cost by the total units of estimated production, as follows: Total Factory Overhead Cost Factory Overhead Cost per Unit = Total Units of Estimated Production These computations for Ruiz’s snowmobile and riding mower are shown in Exhibit 10. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 10 - Activity-Based Product Cost Calculations―Ruiz Company Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 11 - Activity Bases―Ruiz Company Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 12 - Overhead Cost Allocation Methods―Ruiz Company Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Knowledge Check Activity 3 Which of the following would not be considered a manufacturing activity cost pool in activity-based costing? a. Number of inspections b. Hours of machine usage c. Number of machine setups d. Number of employees in the department Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Knowledge Check Activity 3: Answer Which of the following would not be considered a manufacturing activity cost pool in activity-based costing? Answer: d. Number of employees in the department Factory overhead costs are initially budgeted for activities, sometimes called activity cost pools. Examples in manufacturing could be machine usage, inspections, moving, production setups, and engineering activities. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Activity-Based Costing for Selling and Administrative Expenses (Learning Objective 5) Selling and administrative expenses may be allocated to products for managerial decision making, such as analyzing product profitability. One method of allocating selling and administrative expenses to the products is based on sales volumes. However, products may consume activities in ways that are unrelated to their sales volumes. When this occurs, activity-based costing may be a more accurate method of allocation. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 13 - Selling and Administrative Activity Product Differences―Abacus Company Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Activity-Based Costing for Selling and Administrative Expenses Example―Abacus Company Abacus’s field warranty service activity has a budgeted cost of $150,000. Assume that 100 warranty claims are estimated for the period. Using warranty claims as an activity base, the warranty claim activity rate is $1,500, computed as follows: Budgeted Activity Cost Activity Rate = Total Activity-Base Usage Budgeted Warranty Claim Expenses Warranty Claim Activity Rate = Total Estimated Warranty Claims $150,000 =  $1,500 per warranty claim 100 claims Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Activity-Based Costing in Service Businesses (Learning Objective 6) Many service companies use activity-based costing for determining the cost of services. Assume that Hopewell Hospital uses activity-based costing to allocate hospital overhead to patients. Hopewell applies activity-based costing as follows: Step 1. Identifying activities. Step 2. Determining activity rates for each activity. Step 3. Allocating overhead costs to patients based upon activity-base usage. Hopewell has identified the following activities: admission, radiological testing, operating room, pathological testing, and dietary and laundry. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Exhibit 14 - Activity-Based Costing Method―Hopewell Hospital Based on the budgeted costs for each activity and related estimated activity-base usage, the following activity rates were developed: Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Activity-Based Costing Method―Hopewell Hospital Assume the following data for radiological testing: The activity rate of $320 per radiological image is computed as follows: Budgeted Activity Cost Activity Rate = Total Activity-Base Usage Budgeted Radiological Testing Costs Radiological Testing Activity Rate = Total Estimated Images $960,000 =  $320 per image 3,000 images These activity rates along with the patient activity-base usage are used to allocate costs to patients as follows: Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Exhibit 15 - Hopewell Hospital Overhead Costs Allocated to Mia Wilson Based on the preceding services (activities), the Hopewell Hospital overhead costs allocated to Mia Wilson total $2,790, as computed here: Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 16 - Customer Profitability Report―Hopewell Hospital Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Discussion Activity 2 Many service companies use activity-based costing for allocating the cost of services. The chapter discussed the use of activity- based costing for a hospital. In groups of three to four students, think of other service companies that may use activity-based costing, and determine what types of activities they may use to allocate their overhead cost. Make a list of service companies you discussed along with the activities. Share your group’s work with the class. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Discussion Activity 2: Debrief Students will think of various service companies in their examples. For instance, attorneys’ offices could allocate overhead costs based on the number of hours taken for a case, or the number of pages used in their court documents, essentially anything that considers volume and can be measured. Animal hospitals may have similar activities and activity- base usages as the hospital example. Service businesses will tend to have a lot of costs that are not easily traced, such as materials that would be in a manufacturing entity. Thus, using activity-based costing for allocation of service costs is important. What service businesses did your class think of? Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Analysis for Decision Making: Using ABC Product Information to Reduce Costs―Lee Corporation (Learning Objective 7) Activity-based costing (ABC) can be used to improve the cost of a product. For example, Lee Corporation assembles LCD monitors. The following activity information is available for its 40-inch monitor: Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Using ABC Product Cost Information to Reduce Costs―Lee Corporation (1 of 2) Management is seeking to remove $3.00 of activity cost from the product in order to remain price competitive. The activity cost reduction can be accomplished in two basic ways: 1. Improve operations so that the activity-base usage per unit is either reduced or eliminated. 2. Change the classification of employees doing an activity and thereby decrease the activity rate. Higher-classified employees are more expensive but more skilled than lower-classified employees. Assume the process was improved so the setup activity required one-third less time to complete per unit and the moving distance was cut in half. Would these improvements be sufficient to remove $3.00 of activity cost from the product? Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Using ABC Product Cost Information to Reduce Costs―Lee Corporation (2 of 2) The shaded areas show the improvements. Setup was reduced from 0.3 hour to 0.2 hour. The moving distance was cut from 0.4 hour to 0.2 hour. These changes reduced the activity cost of each monitor from $36.00 to $31.60, or $4.40, thus exceeding the $3.00 target. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Summary Now that the lesson has ended, you should have learned how to: Describe three methods used for allocating factory overhead costs to products. Use a single plantwide factory overhead rate for product costing. Use multiple production department factory overhead rates for product costing. Use activity-based costing for product costing. Use activity-based costing to allocate selling and administrative expenses to products. Use activity-based costing in a service business. Describe and illustrate the use of activity-based costing information in decision making. Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.