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chap008doc - Chapter 2

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    Chapter 8

    Lecture Notes

    Chapter theme: This chapter introduces students to

    activity-based costing (ABC) which is a tool that has 1 been embraced by a wide variety of service,

    manufacturing, and non-profit organizations.

    I. Activity-based costing: key definition

    A. 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

     2 ―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.

II. How costs are treated under activity-based costing

    A. ABC differs from traditional cost accounting in three

    ways:

    Learning Objective 1: Understand activity-based

    costing and how it differs from a traditional costing 3

    system.

    i. Nonmanufacturing as well as manufacturing

    costs may be assigned to products, but only on

    a cause-and-effect basis.

     4 1. For example, ABC systems can assign sales

    commissions, shipping costs, and warranty

    repair costs to specific products.

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    ii. Some manufacturing costs may be excluded

    from product costs.

    1. This is because ABC only assigns a cost to a

    product if decisions concerning that product

    will cause changes in the cost. 5 2. ABC excludes two types of costs from

    product costs:

    a. Organization-sustaining costs (which

    will be formally defined later)

    b. The costs of unused or idle capacity.

Helpful Hint: Emphasize that ABC systems that are

    used to support internal decision making do not need to

    conform to GAAP. Therefore, while GAAP requires

    treating selling and administrative expenses as period

    expenses and it requires assigning all manufacturing

    costs to products, ABC systems can assign selling and

    administrative expenses to products and they can

    exclude manufacturing costs from product costs where

    appropriate.

    iii. Numerous overhead cost pools are used, each

    of which is allocated to products and other cost

    objects using its own unique measure of

    activity.

    1. ABC cost pools are created to correspond to

    the activities performed in an organization 6

    that cause the consumption of overhead

    resources. Therefore, the total number of

    ABC cost pools will definitely exceed one

    (as in the plantwide approach) and it is

    likely to exceed the number of departments

    within a company (as in the departmental

     129

    approach) since more than one activity is

     6 often performed within each department.

    2. 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.

    a. 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

     7 using the base.

    b. 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.

    B. Key definitions/concepts

i. An activity is any event that causes the

    consumption of overhead resources.

    ii. An activity cost pool is a ―bucket‖ in which 8

    costs are accumulated that relate to a single

    activity measure in an ABC system.

    iii. 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 9

    measure. The two most common types of

    activity measures are:

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    1. Transaction drivers are simple counts of

    the number of times an activity occurs such

    as the number of bills sent out to customers.

    2. Duration drivers measure the amount of 10

    time required to perform an activity such as

    the time spent preparing individual bills for

    customers.

Helpful Hint: Introduce the cost-benefit concept by

    explaining that transaction drivers are more prevalent

    in practice than duration drivers because the data is

    much easier to obtain. The additional accuracy

    provided by duration drivers often times does not pass

    the cost-benefit test.

    iv. Traditional cost systems rely exclusively on

    allocation bases that are driven by the volume

    of production. ABC defines five levels of 11

    activity that largely do not relate to the

    volume of units produced.

    1. Unit-level activities are performed each

    time a unit is produced.

    a. 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, 12

    regardless of how many units are in the

    batch.

    a. 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

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    of how many batches are run or units are

    produced or sold.

    a. 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.

    a. For example, sales calls and catalog

     12 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.

    a. For example, heating a factory and

    cleaning executive offices are

    organization-sustaining activities.

    III. Designing an activity-based costing (ABC) system

    A. Characteristics of a successful ABC implementation:

    i. There should be strong top management

    support. 13

    1. Without leadership from top management,

    some managers may not be motivated to

    embrace the need to change.

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ii. Top managers should ensure that ABC data are

    linked to how people are evaluated and

    rewarded.

    1. 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.

     13 iii. A cross-functional team should be created to

    design and implement the ABC system.

    1. Cross-functional employees possess intimate

    knowledge of operations that is necessary

    for designing an effective ABC system.

    2. Tapping the knowledge of cross-functional

    managers lessens their resistance to ABC

    because they feel included in the

    implementation process

    B. The five steps for implementing ABC

i. Baxter Batterybackground information

    1. The company makes two types of

    automobile batteriesSureStart (a 14

    standard battery) and LongLife (a deluxe,

    higher quality battery).

    2. The company has reported its first loss ever

    of $2,000,000 as shown on the income

    statement.

     133

ii. Step 1: 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 15

    a handful by combining similar activities.)

    1. Baxter Battery selected the five activity cost

    pools and corresponding activity measures

    as shown.

    a. The definition for each of the activity

     16 cost pools is as shown.

Learning Objective 2: Assign costs to cost pools using a

     17 first-stage allocation.

iii. Step 2: assign overhead costs to activity cost

    pools (this is also called first-stage allocation)

    1. Baxter’s’ annual overhead costs (both

    manufacturing and nonmanufacturing) that it

    intends to assign to its activity cost pools are

    as shown. Notice:

    a. The total costs for the Production

     18 Department ($14,000,000) equal the

    total manufacturing overhead costs

    shown in the income statement.

    b. The total costs for the General

    Administrative and Marketing

    Departments ($8,000,000) equal the

    marketing and general administrative

    expenses shown in Baxter’s income

    statement.

     134

    c. Three costs included in Baxter’s

    income statementdirect materials,

    direct labor, and shippingare

     19 excluded from this slide because

    Baxter’s existing cost system can

    directly trace these costs to products or

    customer orders.

    2. Baxter’s cross-functional interviews resulted

    in resource allocations as shown. Notice for

    example:

    a. 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,

     20 10% of their time to customer

     relations, and 10% of their time to the

    ―other‖ activity.

    b. The lease costs are allocated entirely to

    the ―other‖ activity. Since Baxter has a

    single facility that it does not plan to

    contract or expand, the lease costs are

    treated as organization-sustaining costs.

    3. Once the percentage allocations have been

    determined, it is a simple matter to assign

    costs to activity cost pools.

    a. For example, the indirect factory

    wages assigned to the customer orders

    activity ($1,800,000) was computed by 21

    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%).

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    b. 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 22

    depreciation ($3,500,000) by the

    percentage of time that the factory

    equipment was used to support this

    activity (20%).

    c. The complete grid of first-stage

    allocations would be as shown. 23

    Learning Objective 3: Compute activity rates for cost

     24 pools.

    iv. Step 3: calculate activity rates

    1. The Baxter Battery ABC team determined

    activity levels for each activity as shown.

    This information enabled the team to

    compute ABC rates for each activity by 25

    dividing the total cost in each activity cost

    pool by the respective quantity of the

    activity measure.

    a. The activity rate for each cost pool is

    as shown. For example, the customer

    orders activity cost pool has an activity

    rate of $452 per order. Importantly,

    this is an average figure.

    b. Notice, the ―other‖ cost pool does not 26

    have an activity rate. This is because

    these organization-sustaining costs

    will not be assigned to products or

    customers.

     136

    2. Before proceeding, let us get a visual

    perspective of the Baxter Battery ABC

    system.

     27 a. The direct materials, direct labor and

    shipping costs are directly traceable

    to products or customer orders.

    b. The first-stage allocation process

    assigned the remaining overhead costs 28

    to five activity cost pools.

    c. Then, activity measures were

    identified, activity levels were

    determined, and activity rates were

     29 computed for each activity. These rates

    will be used in the next step to assign

    overhead costs to cost objects.

v. Step 4: assign overhead costs to cost objects

    (this is also called second stage allocation)

Learning Objective 4: Assign costs to a cost object

     30 using a second-stage allocation.

    1. Assigning overhead to products

    a. The data needed to assign overhead

    costs to Baxter Battery’s two

    productsSureStart and LongLife

    are as shown. Notice:

    (1). 4,000 customer orders were

    placed for SureStart and 6,000 31

    customer orders were placed for

    LongLife.

    (2). All 4,000 product designs

    related to LongLife

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