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Lecture

Ch 5 Activity Based Cost Systems.docx

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Business
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BU247
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Susan Lade

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BU247 Lecture 9-10
Chapter 5 Activity Based Cost Systems
Traditional Manufacturing Costing Systems
Systems that assign production costs to products important because product volume and mix
explain a large % of the costs that companies incur
If companies want to influence their costs, they must understand relationship between the volume
and mix of their products and the expenses they incur
Product costs provide the bridge between operating expenses and production output
Poorly designed product costing systems report inaccurate product costs companies may make
poor decisions on resource supply, product mix, pricing, order acceptance, & customer relationships
Product costing systems first assign direct labor/materials costs to products:
1) Calculate the cost per unit of each material (lb, kg, m2) used by a product, and the cost per hour of
each type of direct labor that processes the product
2) For each unit of product made, determine the quantity (lb, kg, m2) of each type of material used &
the quantity (# hrs) required by each type of labor
3) For each labor& material type, multiply the cost per unit/hour by the quantity used per product
4) Add all the materials and labor costs to obtain the total labor & materials cost of each product unit
With accurate records about labor time and material usage standards, and about the
standard/actual prices of each material & labor type, the product costs will be pretty accurate
Indirect expenses (shared, common costs): support the production of all products and not easily
traced to individual products in the simple way that direct materials/labor costs are
overhead allocation rate for department = Indirect cost for that department / volume of activity in
the department manufacturing companies assigned indirect costs (overhead) to production
departments in proportion to the direct labor hours worked in each department. Then, divide that
by a measure of the volume of activity in the department (ex: total direct labour/machine hours)
Under traditional costing systems, typical volume-based cost drivers include: Direct labor hours,
Machine hours, Direct labor dollars
Traditional costing system is adequate for companies with high-volume products with similar
production volumes and batch sizes, but can lead to cost distortion in an environment of high
product variety ABC has been developed to eliminate this distortion
Example
ice cream manufacturing plant at Madison Dairy
BU247 Lecture 9-10
originally produced vanilla and chocolate ice cream, with profit margins in excess of 15% of sales
introduced strawberry ice cream sold at 10% higher prices than vanilla/chocolate
introduced mocha-almond ice cream higher price premium
New strawberry and mocha flavors were profitable, but the high-volume vanilla and choco flavors
had just broken even overall profit margin was < 2% of sales. After subtracting plant
general/administrative expenses, the plant operated at a loss.
Madison’s monthly indirect expenses are comprised of:
increase in plant’s overhead costs allocated to products based on direct labor content
currently, the cost system’s current overhead rate was 240% of direct labour cost ($)
this standard cost system is adequate for the financial reporting role of inventory valuation but
was designed for when production operations were mostly manual, and total indirect costs were <
direct labour costs. now, production environment changed because of automation. Labour costs
fell and indirect expenses rose. cost system that was adequate before could not be giving
distorted signals about the relative profitability of the different products
many manufacturing companies use only drivers that vary directly with the volume of products
produced (direct labour dollars/hours, machine hours) for allocating production expenses to
products. but in an environment of high product variety, exclusive use of volume drivers to
allocate overhead costs lead to product cost distortion
first allocate the indirect and support expenses to production cost pools (see ch4)
once the traceable and allocated support expenses have been accumulated within each production
cost pool, the system allocates the pool’s costs to products on the basis of the volume cost driver for
that cost centre: direct labour, machine hours, unit produced, or materials quantity processed
example: chocolate and vanilla containers, each representing about 20% of plant’s output, would
have about 20% of the plant’s overhead applied to them
traditional cost systems, even those with multiple production cost centres, systematically/grossly
underestimate the cost of resources required for specialty, low-volume products overestimate
the resource cost of producing high-volume, standard products

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Description
BU247 Lecture 9-10 Chapter 5 – Activity Based Cost Systems Traditional Manufacturing Costing Systems  Systems that assign production costs to products  important because product volume and mix explain a large % of the costs that companies incur  If companies want to influence their costs, they must understand relationship between the volume and mix of their products and the expenses they incur  Product costs provide the bridge between operating expenses and production output   Poorly designed product costing systems report inaccurate product costs  companies may make poor decisions on resource supply, product mix, pricing, order acceptance, & customer relationships  Product costing systems first assign direct labor/mate2ials costs to products: 1) Calculate the cost per unit of each material (lb, kg, m ) used by a product, and the cost per hour of each type of direct labor that processes the product 2) For each unit of product made, determine the quantity (lb, kg, m ) of each type of material used & the quantity (# hrs) required by each type of labor 3) For each labor& material type, multiply the cost per unit/hour by the quantity used per product 4) Add all the materials and labor costs to obtain the total labor & materials cost of each product unit  With accurate records about labor time and material usage standards, and about the standard/actual prices of each material & labor type, the product costs will be pretty accurate  Indirect expenses (shared, common costs): support the production of all products and not easily traced to individual products in the simple way that direct materials/labor costs are  overhead allocation rate for department = Indirect cost for that department / volume of activity in the department  manufacturing companies assigned indirect costs (overhead) to production departments in proportion to the direct labor hours worked in each department. Then, divide that by a measure of the volume of activity in the department (ex: total direct labour/machine hours)  Under traditional costing systems, typical volume-based cost drivers include: Direct labor hours, Machine hours, Direct labor dollars  Traditional costing system is adequate for companies with high-volume products with similar production volumes and batch sizes, but can lead to cost distortion in an environment of high product variety  ABC has been developed to eliminate this distortion Example  ice cream manufacturing plant at Madison Dairy BU247 Lecture 9-10  originally produced vanilla and chocolate ice cream, with profit margins in excess of 15% of sales  introduced strawberry ice cream  sold at 10% higher prices than vanilla/chocolate  introduced mocha-almond ice cream  higher price premium  New strawberry and mocha flavors were profitable, but the high-volume vanilla and choco flavors had just broken even  overall profit margin was < 2% of sales. After subtracting plant general/administrative expenses, the plant operated at a loss.  Madison’s monthly indirect expenses are comprised of:  increase in plant’s overhead costs  allocated to products based on direct labor content  currently, the cost system’s current overhead rate was 240% of direct labour cost ($)  this standard cost system is adequate for the financial reporting role of inventory valuation  but was designed for when production operations were mostly manual, and total indirect costs were < direct labour costs.  now, production environment changed because of automation. Labour costs fell and indirect expenses rose.  cost system that was adequate before could not be giving distorted signals about the relative profitability of the different products  many manufacturing companies use only drivers that vary directly with the volume of products produced (direct labour dollars/hours, machine hours) for allocating production expenses to products.  but in an environment of high product variety, exclusive use of volume drivers to allocate overhead costs lead to product cost distortion  first allocate the indirect and support expenses to production cost pools (see ch4)  once the traceable and allocated support expenses have been accumulated within each production cost pool, the system allocates the pool’s costs to products on the basis of the volume cost driver for that cost centre: direct labour, machine hours, unit produced, or materials quantity processed  example: chocolate and vanilla containers, each representing about 20% of plant’s output, would have about 20% of the plant’s overhead applied to them  traditional cost systems, even those with multiple production cost centres, systematically/grossly underestimate the cost of resources required for specialty, low-volume products  overestimate the resource cost of producing high-volume, standard products BU247 Lecture 9-10 Activity-Based Costing (ABC)  time-driven ABC (TD ABC): new cost system required estimating 2 parameters 1) cost rate for each type of indirect resource A) Identify all costs incurred to supply the resource (machine, indirect worker, space, etc.). B) Identify the capacity (hours of work by the machine/worker, or space provided by the warehouse/truck) supplied by that resource. C) The resource’s cost rate is calculated by dividing its cost by the capacity it supplies  usually expressed as a cost per hour or cost per minute. For warehouses, cost per square foot. 2) Estimate of how much each resource’s capacity (time/space) is used by the activities performed to produce the various products and services (and customers)  with estimates of those 2 parameters for each resource & product, the cost assignment can be done similarly to that performed for direct materials and labor costs  if it takes 4 hours to order materials, schedule, and prepare for a production run; and if it takes 9 hours per product to maintain raw materials and finished goods inventory; and if it takes 3 workers to perform each changeover between products, and if these are the changeover times: Then indirect labour time for vanilla for 10 production runs = (4 + (3*2)) x 10 + 0 = 109 hours  We can predict when standard costing systems will lead to high errors in estimating product costs. Cost systems that allocate overhead (indirect and support expenses) to products based on the direct labor hours (or any production volume measure) of each product proceed will lead to the over costing of high-volume products and undercoating of low-volume products when: 1) indirect and support expenses are high, especially when they’re > cost of allocation base (DL) BU247 Lecture 9-10 2) product diversity is high: the plant produces both high and low volume products, standard and custom products, complex & simple products Possible Actions as a Result of the More Accurate Costing  costs of activities to purchase materials, schedule production runs, set up, and maintain products  buried in the large overhead pool  hence, not visible for improvement opportunities  raise prices for unprofitable products to cover the higher per-unit production costs  impose a minimum order size so that the specialty products would be produced in larger production runs, thereby reducing the quantity of indirect resources they required  increase sales volumes of more profitable products  make decisions on desired product mix  try to reduce setup times so small batches of specialty products can be cheaper to produce  new, more accurate costing systems provide managers with insights to become more profitable Measuring Cost of Unused Resource Capacity  with TD ABC, the cost of unused capacity is not assigned to products, but it shouldn’t be ignored  usually, one can assign unused capacity after analyzing the decision that authorized the level of capacity supplied  if the capacity was acquired to meet anticipated demands from a particular customer / market segment, the costs of unused capacity due to lower-than-expected demands can be assigned to the person responsible for that customer/segment o such assignment is done on a lump-bum basis to the person  should not be driven down to the products actually produced during the period in the unit  managers often assign idle cost to a product line, department, or executive  lump-sum assignment of idle capacity costs provides feedback to 4grs.. on supply/demand decisions  the cost of unused capacity is not the cost of products actually produced. It’s a period cost caused by having more capacity than required for the volume/mix of products produced during the period.  If company isn’t careful about segregating the cost of unused capacity from product costs, it could be confused by having products report a loss that was caused by allocation of excess capacity costs, and not because of inefficient production or lack of adequate margins > production costs  Manager may raise prices to cover the apparently higher costs at just the wrong time, when there’s already idle capac
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