Chapter 8 Notes

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Activity-Based Costing Cost Pools As we mentioned in Chapter 3, in a manufacturing situation, there are three components to cost: • • •

Direct Labor, Direct Materials, and Manufacturing Overhead.

As noted previously, it is relatively easy to allocate Direct Labor and Direct Materials to the products produced, but it is difficult to allocate Manufacturing Overhead costs. Because of this, we have Normal Costing and the allocation of Manufacturing Overhead using Predetermined Overhead Rates. In Chapter 3, we used a single, Predetermined Overhead Rate to allocate the Manufacturing Overhead costs to the products being produced. If all of the products are similar, this approach may produce a fairly accurate allocation of Manufacturing Overhead. On the other hand, if you have widely diversified product lines and production operations, then a Plant-Wide Application Rate may not be very accurate. You may find that some products are being under-costed and others are being over-costed. In this case, you might obtain more accuracy in the allocation of Manufacturing Overhead to the units that generated it by using more than one overhead cost pools. The number of cost pools to use always involves a cost-benefit analysis, because of the additional record keeping involved. Why should you care whether your products being over-costed or under-costed? Having more accurate cost information can lead to an improvement in your bidding process. If you base your customer bid prices on your costs, you could charge the wrong amounts. If you charge more than your competitors, then you will lose business. If you charge less than your competitors, you will get more business, but your profits will be less than you expected because you are not charging your customers enough. Having more accurate cost information could improve a firm’s product mix. Even if your prices are not based on your costs (e.g., set by the free market), you still may have problems. For example, you may not actively go after certain business because you don't think it is very profitable when that business actually is profitable. Similarly, you may go after other business that you believe is very profitable, when it is not profitable or less profitable than you believe. Another way that over-costing or under-costing can affect a business is in the decision whether to offer a product or discontinue a product. Having misinformation on the Please send comments and corrections to me at [email protected]

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profitability of a product may cause a product to be improperly discontinued (or retained when it should be discontinued). For example, a firm may incorrectly outsource the manufacture of a part or product because it wrongly believes that it is cheaper to purchase the part or product rather than manufacture it.

Department Allocations of Overhead A simple way to have multiple cost pools is to pool Manufacturing Overhead costs separately by production department. This is especially true if the departments are very different (e.g., one is labor intensive, and the other is automated). You calculate a separate Predetermined Overhead Rate for each department’s Manufacturing Overhead. When using Departmental Application Rates, it is possible to use different Cost Drivers for different departments.

Departmental Application Rate Example Ajax Inc. produces standard model trophies, as well as, custom designed trophies. Ajax’s plant has two production departments: (i) the Design Department and (ii) the Manufacturing Department. The standard model trophies are made in the Manufacturing Department without any Design Department services. Custom designed trophies are designed in the Design Department and then manufactured in the Manufacturing Department. The Design Department uses 10,000 Direct Labor Hours, and the Manufacturing Department uses 90,000 Direct Labor Hours. Ajax currently allocates its Manufacturing Overhead using one Plant-Wide Application Rate using Direct Labor Hours as the Cost Driver. The Manufacturing Overhead for the plant is as follows: Indirect Costs Rent Depreciation Supervisors Maintenance Total

Design $20,000 ---50,000 20,000 $90,000

Manufacturing Total $ 80,000 $100,000 200,000 200,000 50,000 100,000 80,000 100,000 $410,000 $500,000

Recently, Ajax bid on two different jobs. Job 1 involves a unique product design, and it requires 20 Direct Labor Hours of Design services and 20 Direct Labor Hours of Manufacturing services. Job 2 involves a standard model, and it involves no Design services. Job 2 only requires 20 Direct Labor Hours of Manufacturing services. Both jobs require $200 of Direct Materials, and the Direct Labor Cost is $5 per Direct Labor Hour. Ajax prices its products using a cost plus 20% profit margin method.

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Even though Ajax's costs are no different than its competitors, the customer, who received the Job 2 bid, asked Ajax to lower its bid stating that Ajax’s competitors charged lower prices for similar work. On the other hand, the customer, who received the Job 1 bid, did not hesitate to accept that bid. Plant-Wide Application Rate Ajax’s current Plant-Wide Application Rate is calculated as follows: $500,000 / 100,000 = $5 per Direct Labor Hour Using this application rate resulted in the following Manufacturing Overhead cost calculation for Jobs 1 and 2: Job 1: 40 hours x $5 per DLH = $200. Job 2: 20 hours x $5 per DLH = $100. Using these costs, Ajax bid the two jobs as follows:

Direct Materials Direct Labor Manufacturing Overhead Total Cost Profit Price Bid

Job 1 $200 $200 $200 $600 $120 $720

Job 2 $200 $100 $100 $400 $80 $480

Departmental Application Rates If Ajax were to use separate Departmental Application Rates, the following rates would be used: Design Department: Manufacturing Department:

$90,000/10,000 $410,000/90,000

= $9.00 per DLH = $4.55 per DLH

If Ajax had used Departmental Application Rates to calculate the Manufacturing Overhead costs of Jobs 1 and 2 the following costs would have resulted:

Design Department Manufacturing Department Total Overhead

Job 1 20 hours x $9 = $180 20 hours x $4.55 = $91 $271

Job 2 20 hours x $4.55 = $91 $91

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If Ajax had used these Manufacturing Overhead costs, the two jobs would have been priced as follows:

Direct Materials Direct Labor Manufacturing Overhead

Job 1 Job 2 $200.00 $200.00 $200.00 $100.00 $271.00 $91.00

Total Cost Profit Price Bid

$671.00 $391.00 $134.20 $78.20 $805.20 $469.20

Comparison As you can see, when compared to Departmental Application Rates, the use of a PlantWide Application Rate produces a lower bid for Job 1 and a higher bid for Job 2:

Plant-Wide Rate Departmental Rates Difference

Job 1 $720.00 $805.20 -$85.20

Job 2 $480.00 $469.20 $10.80

Assuming that Ajax’s competitor uses Departmental Application Rates, you can see why the competitor was able to offer a cheaper bid for Job 2. The reason why these differences exist can be seen by comparing the Plant-Wide Application Rate with the Departmental Application Rates: Plant-Wide Rate Design Department Rate Manufacturing Department Rate

$5.00 $9.00 $4.55

The Design services use a great deal of Manufacturing Overhead. When you use a Plant-Wide Application Rate, the Design overhead costs are spread over all of the units being produced. When Departmental Application Rates are used, then the Manufacturing Overhead associated with the Design services are borne by only those units that require Design services. This treatment results in the units accurately reflecting the Manufacturing Overhead costs incurred to produce them.

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Activity-Based Costing With Activity-Based Costing (ABC), you divide your Manufacturing Overhead into different cost pools based upon the different activities within the plant. These activities are not sub-divisions of a department. Activities can span more than one department. For example, CSULB’s College of Business is divided into five departments, Accounting, Finance, Marketing, Management and Information Systems, but the College could be divided into activities of such as lecturing, computer lab usage, copying, word processing, counseling, and office hours. These activities transcend multiple departments. In a manufacturing operation, you might have the following activities: • • • • • • • •

Perform Engineering Work; Plan Production; Purchase Materials; Receive and Handle Materials; Manage Production; Setup Machinery; Store Final Product; and Ship Final Product.

With ABC, you will calculate a Predetermined Application Rate for each activity, and apply it to your products, activity by activity, using appropriate Cost Drivers. A major disadvantage of ABC is that it requires more work to implement, maintain and use. The initial analysis of a firm’s activities and the costs associated with those activities is extensive, and this analysis must be updated in order to maintain the accuracy of the ABC system. Moreover, the record keeping necessary to use an ABC system is greater than other systems because of the increase in the number of Cost Drivers employed. Another problem that is commonly reported when implementing ABC is institutional resistance. While managers are familiar with applying Manufacturing Overhead based upon common drivers (e.g., Direct Labor Hours or Cost) because of its widespread use; these managers have no experience with ABC. Internal personnel may have trouble understanding or adapting to ABC. Similar problems may be experienced with outside personnel, who use your reported costs (e.g., regulatory bodies that approve rate hikes, or government bodies that are purchasing products at prices based on costs). Firms

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may find that it is easier to use a more traditional technique for applying Manufacturing Overhead rather than educating these managers as to the need for ABC. An advantage of ABC is that it that the detailed cost calculations and analysis provide businesses with important information regarding how costs are incurred. This information provides insight into how costs can be controlled. For example, an analysis of activities might identify the fact that your firm spends a great deal of money on Material Handling, which uses the number of parts as its Cost Driver. With this information, you may discover that you can reduce your Material Handling Costs by reengineering your product to have less parts. Making management decisions based upon ABC data is called Activity-Based Management (also called Activity Based Cost Management). Direct Labor Costs may also be incorporated into the ABC system by including production activities (e.g., assembly and finishing) within the list of activities. When Direct Labor and Manufacturing Overhead Costs are combined they are referred to as Conversion Costs. The thought is that these costs “convert” Direct Materials into the finished product. ABC can also be used to determine the allocation of non-manufacturing costs (e.g., selling, general and administrative expenses). This is not GAAP, however, and such financial information is for internal use only.

ABC Example Lutz, Inc. produces three products: Quality, Superior, and Superb. The Lutz cost accounting system applied Conversion Costs using a Plant-Wide Application Rate using Direct Labor Hours as the Cost Driver. Lutz is thinking of employing an ABC system for Conversion Costs. Lutz concluded that its plant had six activities with the following Cost Drivers and costs budgeted for the upcoming year: Activity Area Material Handling Production Scheduling Setups Machinery Cost & Maintenance Finishing Packaging & Shipping Total

Budgeted Costs $ 258,400 114,000 160,000 3,510,000 1,092,000 190,000 $5,324,400

Cost Driver Number of parts Number of prod. orders Number of prod. setups Machine hours Direct Labor Hours Number of orders shipped

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The following information summarizes Lutz’ projections of the Cost Drivers listed above down by product type. Cost Driver Units to be produced Number of parts per unit Production orders Production setups Machine hours per unit Direct Labor Hours per unit Orders shipped

Quality 10,000 30 300 100 7 2 1,000

Superior 5,000 50 70 50 7 5 2,000

Superb 800 120 200 50 15 12 800

It is estimated that there will be 54,600 Direct Labor Hours in the upcoming year. Calculation of Application Rates Using this information, you can calculate the Predetermined Application Rates for each activity: Activity Calculation $258,400 / [(30 x10,000)+(50 x 5,000)+(120 x 800)] Material Handling Prod. Scheduling $114,000 / [300 + 70 + 200] Setups Machinery Finishing Packng & Shipng

Application Rate 40¢ / part $200 / prod order

$160,000 / [100 + 50 + 50]

$800 / prod setup $3,510,000 / [(7 x 10,000) + (7 x 5,000) + 15(800)] $30 / mach hour $1,092,000 / [(2 x 10,000)+(5 x 5,000) + (12 x 800)] $20 / DLH $190,000 / [1,000+2,000+800] $50 per order shpd

The more traditional, Plant-Wide Application Rate for Conversion Costs using Direct Labor Hours as the Cost Driver would be calculated as follows: Estimated Overhead Estimated DLHs

=

$5,324,400 54,600

=

$97.52 (rounded)

Application of Conversion Costs Let us calculate the budgeted Conversion Cost for the budgeted production described above. Because activities can represent batch costs (costs incurred in the production of products in groups) and product costs (cost incurred at the product line level) as opposed to unit-level costs, it is best to calculate the total Conversion Cost for the entire product line and then divide that total by the budgeted production level in order to get a Conversion Cost per unit.

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Activity Mat Hand

Quality ((30 x 10,000) x .40) $120,000

Superior (50 x 5,000) x $.40) $100,000

Superb ((120 x 800) x $.40) $38,400

Prod Sch Setups Machinery Finishing

60,000 (100 x $800) 80,000 ((7 x 10,000) x $30) 2,100,000 ((2 x 10,000) x $20) 400,000

14,000 (50 x $800) 40,000 ((7 x 5,000) x $30) 1,050,000 ((5 x 5,000) x $20) 500,000

40,000 (50 x $800) 40,000 ((15 x 800) x $30) 360,000 ((12 x 800) x $20) 192,000

Pck & Shp Ttl Conv. Conv./Unit

50,000 $2,810,000 ($2,810,000/ 10,000) $281.00

100,000 $1,804,000 ($1,804,000/ 5,000) $360.80

40,000 $710,400 ($710,400/ 800) $888.00

(300 x $200)

(1,000 x $50)

(70 x $200)

(2,000 x $50)

(200 x $200)

(800 x $50)

If you compare Conversion Cost applied to each unit using ABC versus the Plant-Wide Application Rate, you can see the results are different:

Plant-Wide ABC Difference

(2 x $97.52)

Quality $195.04 $281.00 -$85.96

Superior (5 x $97.52) $487.60 $360.80 $126.80

(12 x $97.52)

Superb $1,170.24 $888.00 $282.24

Assuming that ABC presents a more accurate Conversion Cost for each product, under the traditional, Plant-Wide Application Rate, the Quality units are under-costed and the Superior and Superb units are over-costed.

Real Life ABC Examples Laporte Industries, Ltd. Laporte Industries, Ltd., a British specialty chemicals and materials producer, implemented ABC in one of its Divisions in the 1990’s. The Division produced cleaning chemicals for use in businesses where hygiene is important. The Division’s sales force tended to focus on big-name customers, such as large food and drink producers, at the expense of smaller ones, such as farmers. The prices charged to the larger customers were higher than the prices charged to the smaller ones. The overhead allocation system previously employed made the sales to the larger customers appear more profitable than the sales to the smaller ones. After implementing ABC, the Division realized that it was focusing on the wrong customers. When overhead was accurately allocated using ABC, it turned out that the Operating Profit margins on the smaller customer sales were actually higher than those on sales to larger customers. Smaller customers did not generate many overhead costs. These smaller customers placed orders by telephone and required with little contact with the sales force. In

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contrast, big-name customers required: (i) constant contact with the sales force, (ii) 24hour technical support, (iii) loans of equipment at no charge, and (iv) other concessions. After implementing ABC, the awareness of actual costs led to a change in sales mixes and prices bid. The Division’s Operating Profits increased as a result of these changes. Mobil Oil Mobil’s implementation of ABC at its US Lubricants Division in the early 1990’s, highlighted thousands of unprofitable product lines and an inefficient relationship with its suppliers. As a result of this analysis, the Division reduced the number of its products from around 12,000 to 5,000 within eight years of adopting ABC, and cut the number of its suppliers from over 2,000 to around 500 in that same period. The Division’s after-tax profit increased from zero to $150 million within that same eight-year period. The Boeing Company Although Boeing does not use ABC as part of its accounting system, it has experimented with Activity Based Management (ABM). As noted above, ABM involves the use of ABC data in management decisions. In 2000, Boeing tested ABM in two operations at its Wichita plant. One of the operations studied was Boeing’s Phase I preassembly chemical bath operation. It found that: • • •

Boeing incorrectly calculated the in-house cost of that operation at $7 per part. As a result, Boeing outsourced that operation at a cost of $4 per part. Boeing found that it could actually conduct some of those outsourced operations in house at a cost of $3.50 per part. Boeing identified additional costs that were associated with the outsourced operation.

Boeing’s analysis of the activities that made up its Phase II structural bonding operation highlighted the fact that rework orders were an important Cost Driver for Manufacturing Overhead costs. An examination of the rework orders revealed that parts were being unnecessarily reworked. By introducing standardized quality criteria, Boeing was able to reduce the number of rework orders and thereby reduced its rework cost by 20%.

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