Managerial Accounting

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ACT500_Module04_PPT_Ch04.pptx

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Chapter 4

Activity-Based Costing

Product Costing Allocation Methods (slide 1 of 2)

Determining the cost of a product is termed product costing.

Allocation of Factory Overhead Costs

Product Costing Allocation Methods (slide 2 of 2)

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

The choice of allocation method is important to managers because the allocation affects the product cost.

Single Plantwide Factory Overhead Rate Method (slide 1 of 5)

Under the single plantwide factory overhead rate method, factory overhead costs are allocated to products using only one rate.

Assume that Ruiz Company, which manufactures snowmobiles and riding mowers in a single factory, has total budgeted factory overhead costs of $1,600,000 for the year and 20,000 total budgeted direct labor hours. The total budgeted direct labor hours are computed as follows:

Particulars	Snowmobiles	Riding Mowers	Total
Planned production for the year	1,000 units	1,000 units
Direct labor hours per unit	10 hours	10 hours
Budgeted direct labor hours	10,000 hours	10,000 hours	20,000 hours

Single Plantwide Factory Overhead Rate Method (slide 2 of 5)

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:

The budgeted allocation base is a measure of operating activity in the factory.

Common allocation bases would include direct labor hours, direct labor dollars, and machine hours.

Single Plantwide Factory Overhead Rate Method (slide 3 of 5)

Ruiz allocates factory overhead using budgeted direct labor hours as the plantwide allocation base.

Thus, Ruiz’s single plantwide factory overhead rate is computed as follows:

Single Plantwide Factory Overhead Rate Method (slide 4 of 5)

Ruiz uses the plantwide rate of $80 per direct labor hour to allocate factory overhead to snowmobiles and riding mowers, computed as follows:

Products	Single Plantwide Factory Overhead Rate	×	Direct Labor Hours per Unit	=	Factory Overhead Cost per Unit
Snowmobile	$80 per direct labor hour	×	10 direct labor hours	=	$800
Riding Mower	$80 per direct labor hour	×	10 direct labor hours	=	$800

Single Plantwide Factory Overhead Rate Method (slide 5 of 5)

Multiple Production Department Factory Overhead Rate Method (slide 1 of 3)

When production departments differ significantly in their manufacturing processes, factory overhead costs are normally incurred differently in each department.

In such cases, factory overhead costs may be more accurately allocated using multiple production department factory overhead rates.

Multiple Production Department Factory Overhead Rate Method (slide 2 of 3)

The multiple production department factory overhead rate method uses different rates for each production department to allocate factory overhead costs to products.

In contrast, the single plantwide rate method uses only one rate to allocate factory overhead costs.

Multiple Production Department Factory Overhead Rate Method (slide 3 of 3)

Assume that Ruiz Company uses the following two production departments in the manufacture of snowmobiles and riding mowers:

Fabrication Department, which cuts metal to the shape of the product.

Assembly Department, which manually assembles pieces into a final product.

The total budgeted factory overhead for Ruiz is $1,600,000 divided into the Fabrication and Assembly departments as follows:

Particulars	Budgeted Factory Overhead Costs ($)
Fabrication Department	1,030,000
Assembly Department	570,000
Total budgeted factory overhead costs	1,600,000

Department Overhead Rates and Allocation

Department	Snowmobile	Riding Mower
Fabrication Department	8 hours	2 hours
Assembly Department	2 hours	8 hours
Direct labor hours per unit	10 hours	10 hours

Distortion of Product Costs (slide 1 of 5)

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 single plantwide factory overhead rate distorts product cost of both the snowmobile and riding mower.

Particulars	Single Plantwide Method ($)	Multiple Production Department Method ($)	Difference ($)
Snowmobile	$800	$938	(138)
Riding Mower	800	662	138

Distortion of Product Costs (slide 2 of 5)

That is, the snowmobile is not allocated enough cost and, thus, is undercosted by $138.

In contrast, the riding mower is allocated too much cost and is overcosted by $138 ($800 – $662).

Distortion of Product Costs (slide 3 of 5)

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.

Using the single plantwide rate, it is assumed that all factory overhead is directly related to a single allocation base for the entire plant. However, this assumption is not realistic for Ruiz.

Thus, using a single plantwide rate distorted the product costs of snowmobiles and riding mowers.

Distortion of Product Costs (slide 4 of 5)

Distortion of Product Costs (slide 5 of 5)

Condition one exists for Ruiz because the factory overhead rate for the Fabrication Department is $103 per direct labor hour, whereas the rate for the Assembly Department is only $57 per direct labor hour.

Condition two also exists for Ruiz because the snowmobile consumes 8 direct labor hours in the Fabrication Department, whereas the riding mower consumes only 2 direct labor hours.

Thus, the ratios of allocation base usage for the Fabrication and Assembly departments are computed as follows:

Activity-Based Costing Method (slide 1 of 2)

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.

Activity-Based Costing Method (slide 2 of 2)

Under activity-based costing, factory overhead costs are initially budgeted for activities, sometimes called activity cost pools, such as machine usage, inspections, moving, production setups, and engineering activities.

In contrast, when multiple production department factory overhead rates are used, factory overhead costs are first accounted for in production departments.

Activity Rates

Budgeted activity costs are assigned to products using factory overhead rates for each activity.

These rates are called activity rates.

The term activity base, rather than allocation base, is used because the base is related to an activity.

Activity Rates and Allocation (slide 1 of 2)

Assume that snowmobiles are a new product for Ruiz Company, and engineers are still making minor design changes. Ruiz has produced riding mowers for many years. Activity-base usage for the two products is as follows:

Particulars	Snowmobile	Riding Mower
Estimated units of total production	1,000 units	1,000 units
Estimated setups	100 setups	20 setups
Quality control inspections	100 inspections (10%)	4 inspections (0.4%)
Estimated engineering change orders	12 change orders	4 change orders

Activity Rates and Allocation (slide 2 of 2)

The number of direct labor hours used by each product is 10,000 hours, computed as follows:

Particulars	Direct Labor Hours per Unit	Number of Units of Production	Total Direct Labor Hours
Snowmobile Fabrication Department	8 hours	1,000	8,000
Snowmobile Assembly Department	2 hours	1,000	2,000
Total			10,000
Riding Mower Fabrication Department	2 hours	1,000	2,000
Riding Mower Assembly Department	8 hours	1,000	8,000
Total			10,000

Allocating Costs

Overhead costs of each activity rate are allocated to a product using the following formula:

The estimated total factory overhead for a product is the sum of the product’s individual activity allocations.

The factory overhead cost per unit is determined by the following formula:

Dangers of Product Cost Distortion—Ruiz Company

Activity-Based Costing for Selling and Administrative Expenses (slide 1 of 5)

Generally accepted accounting principles (G A A P) require that selling and administrative expenses be reported as period expenses on the income statement.

However, selling and administrative expenses may be allocated to products for managerial decision making.

One method of allocating selling and administrative expenses to the products is based on sales volume.

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.

Activity-Based Costing for Selling and Administrative Expenses (slide 2 of 5)

Assume that Abacus Company has two products, Ipso and Facto. Both products have the same total sales volume. However, Ipso and Facto consume selling and administrative activities differently.

Activity-Based Costing for Selling and Administrative Expenses (slide 3 of 5)

If Abacus’s selling and administrative expenses are allocated on the basis of sales volume, then the same amount of expense would be allocated to Ipso and Facto.

This is because Ipso and Facto have the same sales volume.

However, such an allocation would be misleading.

The activity-based costing method can be used to allocate the selling and administrative activities to Ipso and Facto.

This is because activity-based costing allocates selling and administrative expenses based on how each product consumes activities.

Activity-Based Costing for Selling and Administrative Expenses (slide 4 of 5)

Assume that Abacus’s field warranty service activity has a budgeted cost of $150,000. Additionally, assume that 100 warranty claims are estimated for the period. Using warranty claims as an activity base, the warranty claim activity rate is computed as follows:

Activity-Based Costing for Selling and Administrative Expenses (slide 5 of 5)

Assuming that Ipso had 10 warranty claims and Facto had 90 warranty claims, the field service activity expenses would be allocated as follows:

Activity-Based Costing in Service Businesses (slide 1 of 6)

In service companies, the use of single and multiple department overhead rate methods may lead to distortions to those of manufacturing firms. Thus, many service companies use activity-based costing for determining the cost of services.

Activity-Based Costing in Service Businesses (slide 2 of 6)

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

Dietary and laundry

Activity-Based Costing in Service Businesses (slide 3 of 6)

Assume that the budgeted costs for radiological testing are $960,000 and the total estimated activity-base usage is 3,000 images.

The activity rate per radiological image is computed as follows:

The activity rates for the other activities are determined in a similar manner.

Activity-Based Costing in Service Businesses (slide 4 of 6)

These activity rates along with the patient activity-base usage are used to allocate costs to patients as follows:

Activity-Based Costing in Service Businesses (slide 5 of 6)

Assume that Mia Wilson was a patient of the hospital. The hospital overhead services (activities) performed for Mia Wilson were as follows:

Based on the preceding services (activities), the Hopewell Hospital overhead costs allocated to Mia Wilson total $2,790, as computed in slide 62.

Particulars	Patient (Mia Wilson) Activity-Base Usage
Admission	1 admission
Radiological testing	2 images
Operating room	4 hours
Pathological testing	1 specimen
Dietary and laundry	7 days

Activity-Based Costing in Service Businesses (slide 6 of 6)

Analysis for Decision Making (slide 1 of 4)

Activity-based costing can be used to improve the cost of a product.

Consider Lee Corporation, that assembles LCD monitors.

The activity information is shown in slide 70.

All of the activity cost is related to labor.

Management is seeking to remove $3.00 of activity cost from the product in order to remain price competitive.

Analysis for Decision Making (slide 2 of 4)

Activity	Activity-Base Usage (hours per unit)	×	Activity Rate per Hour ($)	=	Activity Cost ($)
Assembly	0.80	×	14	=	11.20
Setup	0.30	×	20	=	6.00
Production control	0.15	×	32	=	4.80
Materials control	0.10	×	32	=	3.20
Moving	0.40	×	12	=	4.80
Testing	0.25	×	24	=	6.00
Activity cost per unit					$36.00

Analysis for Decision Making (slide 3 of 4)

The activity cost reduction can be accomplished by:

Improving operations so that the activity-base usage per unit is either reduced or eliminated.

Changing the classification of employees doing an activity and thereby decreasing the activity rate.

Assume the following:

The process was improved so that the setup activity required one-third less time to complete per unit.

The moving distance was cut in half.

Analysis for Decision Making (slide 4 of 4)

Activity	Activity-Base Usage (hours per unit)	×	Activity Rate per Hour ($)	=	Activity Cost ($)
Assembly	0.80	×	14	=	11.20
Setup	0.20	×	20	=	4.00
Production control	0.15	×	32	=	4.80
Materials control	0.10	×	32	=	3.20
Moving	0.20	×	12	=	2.40
Testing	0.25	×	24	=	6.00
Activity cost per unit					$36.00

Total Budgeted Factory Overhead

Single Plantwide Factory Overhead Rate

Total Budgeted Plantwide Allocation Base

$1,600,000

Single Plantwide Factory Overhead Rate

20,000 direct labor hours

= $80 per hou

Budgeted Department Factory

Production Department Facto

Overhead

Budgeted Department

ry Overhead Rate

Allocation Base

Direct Labor Hours for Snowmobiles8 hour

Ratio of Allocation Base Usage in the Fa

brication Department = 4:1

Direct Labor Hours for Riding Mowers2 ho

urs

Ratio of Allocation Base Usage in the

Assembl

Direct Labor Hours for Snowmobiles2 hour

y Department = 1:4

Direct Labor Hours for Riding Mowers8 ho

urs

Budgeted Activity Cost

Activity Rate =

Total Activity-Base Usage

Activity Overhead Allocated = Activity-B

ase Usage Activity Rate

Total Factory Overhead Cost

Factory Overhead Cost per Unit =

Total Units of Estimated Production

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

Ipso: 10 warranty claims $1,500 per w

arranty claim = $15,000

Facto: 90 warranty claims $1,500 per wa

rranty claim = $135,000

Budgeted Activity Cost

Activ

ity Rate =

Total Activity-Base Usage

Budgeted Radiological Testing Costs

Radiological Testing Activity Rate =

Total Estimated Images

$960,000

= $320 per image

3,000 images