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- 2. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 2 Assigning Overhead Costs to Products Plantwide Overhead Rate A single overhead rate used throughout an entire factory. A simple method, but one that can distort unit product costs. Direct labor has often used as the allocation base for overhead.
- 3. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 3 Plantwide Overhead Rate Today, direct labor may no longer be a satisfactory base for allocation of overhead. Direct labor may no longer be highly correlated with overhead costs. No single allocation basis may be able to adequately reflect the demands that products place on overhead.
- 4. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 4 The allocation bases depend on the nature of the work performed in each department. In the machining department, overhead may be based on machine-hours, but in the assembly department overhead is based on labor- hours. Finishing Department Shipping Department Painting Department Departmental Overhead Rates Unfortunately, even departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs.
- 5. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 5 Activity-Based Costing (ABC) Cost Objects (e.g., products and customers) Activities Consumption of Resources Cost A number of allocation bases are used for assigning costs to products.
- 6. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 6 Activity-Based Costing (ABC) Activity Cost Pool a “cost bucket in which costs related to a particular activity are accumulated Each activity has its own activity rate that is used to apply overhead costs.
- 7. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 7 Designing an ABC System Steps for Implementing ABC Identify and define activities and activity pools and develop an activity dictionary. Trace or assign costs to activities and cost objects. Calculate activity rates. Assign costs to cost objects. Prepare necessary reports.
- 8. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 8 Hierarchy of Activities Level Activities Activity Measure Unit-level Processing units on machines Machine-hours Processing units by hand Direct labor-hours Consuming factory supplies Units produced Batch-level Processing purchase orders Purchase orders processed Processing production orders Production orders processed Setting up equipment Number of setups Handling materials Pounds of material handled Product-level Testing new products Hours of testing time Administering parts inventories Number of part types Designing products Hours of design time Facility-level General factory administration Direct labor-hours Plant building and grounds Direct labor-hours
- 9. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 9 Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Products Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool First-Stage Allocation Second-Stage Allocations $/DLH $/MH $/Setup $/Order Overhead Costs $/MH Unit-Level Activity Batch-Level Activity Facility-Level Activity
- 10. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 10 Using Activity-Based Costing Comtek Sound, Inc. makes two products, a radio with a built-in tape player and one with a built-in compact disc player. For the current year, Comtek has budgets sales of 50,000 CD units and 200,000 tape units. Both products require two direct labor-hours to complete. The company plans to work 500,000 hours to meet the budgeted production. All production is sold to auto manufacturers for installation in new cars and trucks. Direct materials cost $90 per unit for the CD unit and $50 for the Tape unit. Direct labor costs at $10 per hour are $20 for both the CD and Tape unit.
- 11. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 11 Direct Labor-Hours as a Base Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon labor-hours: Predetermined overhead rate $10,000,000 500,000 DLH = $20 per DLH = CD Unit Tape Unit Direct materials 90 $ 50 $ Direct labor 20 20 Manufacturing overhead 40 40 (2 DLH x $20/DLH) Unit product cost 150 $ 110 $
- 12. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 12 Computing Activity Rates The ABC project team at Comtek has developed the following basic information. Activity and Activity Measures Estimated Overhead Cost Total CD Tape Labor related (DLH) 800,000 $ 500,000 100,000 400,000 Machine related (MH) 2,100,000 1,000,000 300,000 700,000 Machine setups (setups) 1,600,000 4,000 3,000 1,000 Production orders (orders) 450,000 1,200 400 800 Product testing (tests) 1,700,000 20,000 16,000 4,000 Material receipts (receipts) 1,000,000 5,000 1,800 3,200 Parts administration (part types) 350,000 700 400 300 General factory (MH) 2,000,000 1,000,000 300,000 700,000 10,000,000 $ Expected Activity
- 13. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 13 Computing Activity Rates Using the basic information, we can calculate the following activity rates: Activity and Activity Measures Estimated Overhead Cost Total Expected Activity Labor related (DLH) 800,000 $ 500,000 1.60 $ per DLH Machine related (MH) 2,100,000 1,000,000 2.10 per MH Machine setups (setups) 1,600,000 4,000 400.00 per setup Production orders (orders) 450,000 1,200 375.00 per order Product testing (tests) 1,700,000 20,000 85.00 per test Material receipts (receipts) 1,000,000 5,000 200.00 per receipt Parts administration (part types) 350,000 700 500.00 per par type General factory (MH) 2,000,000 1,000,000 2.00 per MH 10,000,000 $ Activity Rate Using the new activity rates, let’s assign overhead to the two products based upon activity.
- 14. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 14 Computing Activity Rates Activity and Activity Measures Expected Activity Amount Expected Activity Amount Labor related (DLH) 100,000 160,000 $ 400,000 per DLH 640,000 $ Machine related (MH) 300,000 630,000 700,000 per MH 1,470,000 Machine setups (setups) 3,000 1,200,000 1,000 per setup 400,000 Production orders (orders) 400 150,000 800 per order 300,000 Product testing (tests) 16,000 1,360,000 4,000 per test 340,000 Material receipts (receipts) 1,800 360,000 3,200 per receipt 640,000 Parts administration (part types) 400 200,000 300 per par type 150,000 General factory (MH) 300,000 600,000 700,000 per MH 1,400,000 Total overhead cost assigned 4,660,000 $ 5,340,000 $ Number of units produced 50,000 200,000 Overhead cost per unit 93.20 $ 26.70 $ CD Units Tape Units ÷ ÷ ABC overhead rate per unit
- 15. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 15 Computing Activity Rates CD Units Tape Units CD Units Tape Units Direct material 90.00 $ 50.00 $ 90.00 $ 50.00 $ Direct labor 20.00 20.00 20.00 20.00 Manufacturing overhead 93.20 26.70 40.00 40.00 Unit product cost 203.20 $ 96.70 $ 150.00 $ 110.00 $ Activity-Based Costing Direct-Labor Costing Notice that the unit product cost of a tape unit decreased from $110 to $96.70 . . . . . . . . . . while the unit cost of a CD unit increased from $150 to $203.20.
- 16. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 16 Shifting of Overhead Cost CD Units Tape Units CD Units Tape Units Direct material 90.00 $ 50.00 $ 90.00 $ 50.00 $ Direct labor 20.00 20.00 20.00 20.00 Manufacturing overhead 93.20 26.70 40.00 40.00 Unit product cost 203.20 $ 96.70 $ 150.00 $ 110.00 $ Activity-Based Costing Direct-Labor Costing When a company implements activity-based costing, overhead cost often shifts from high-volume to low- volume products with a higher unit product cost resulting for the low-volume products. Low-volume product
- 17. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 17 Targeting Process Improvements Activity-Based Management involves focusing on activities to eliminate waste, decrease processing time, and reduce defects. Benchmarking is a systematic approach to identifying the activities with the greatest room for improvement. It is based on comparing the performance in an organization with the performance of other, similar organizations known for their outstanding performance.
- 18. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 18 Evaluation of Activity-Based Costing Benefits of ABC Improves the accuracy of product costs. Activity cost pools are more homogeneous than departmental cost pools. Allocates overhead on the basis of activities that cause overhead costs.
- 19. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 19 Evaluation of Activity-Based Costing Limitations of ABC Cost of implementation may exceed benefits. Products costs are not always relevant when making decisions. Benefits of ABC Improves the accuracy of product costs. Activity cost pools are more homogeneous than departmental cost pools. Allocates overhead on the basis of activities that cause overhead costs.
- 20. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 20 ABC and Service Industries Activity-based costing has been implemented in a wide variety of service industries including railroads, hospitals, banks, and data service companies.
- 21. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 21 Cost Flows in an ABC System Sarvik Company uses activity-based costing. The company has five cost pools shown below. Activity Cost Pool Activity Measure Estimated Overhead Cost Expected Activity Machine related Machine-hours 175,000 $ 5,000 MHs Purchase orders Number of orders 63,000 700 orders Machine setups Number of setups 92,000 460 setups Product testing Number of tests 160,000 200 tests General factory Direct-labor hours 300,000 25,000 DLHs 790,000 $
- 22. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 22 Cost Flows in an ABC System At the beginning of the year, the company had inventory balance as follows. Raw materials $3,000 Work in process 4,000 Finished goods - 0 -
- 23. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 23 Cost Flows in an ABC System Transaction recorded by the company: a. Raw materials purchased on account, $915,000. b. Raw materials used in production, $900,000 ($810,000 direct and $90,000 indirect). c. Factor labor costs, $370,000 ($95,000 direct and $275,000 indirect). d. Depreciation of factory assets, $180,000. e. Miscellaneous manufacturing overhead costs, $230,000. f. Goods costing $1,650,000 manufactured.
- 24. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 24 Cost Flows in an ABC System Manufacturing overhead cost was applied to production. Actual activity during the year was as follows: 1. Machine related, 4,600 machine-hours. 2. Purchase orders, 800 orders. 3. Machine setups, 500 setups. 4. Product testing, 190 tests. 5. General factory, 23,000 direct-labor hours.
- 25. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 25 Cost Flows in an ABC System Description Debit Credit a. Raw Materials 915,000 Accounts Payable 915,000 b. Work in Process 810,000 Manufacturing Overhead 90,000 Raw materials 900,000 c. Work in Process 95,000 Manufacturing Overhead 275,000 Wages payable 370,000 The following journal entries would be used to record transactions (a) through (c).
- 26. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 26 Cost Flows in an ABC System Predetermined overhead rates are determined as follows: Activity Cost Pool Estimated Overhead Cost Total Expected Activity Activity Rate Machine related 175,000 $ 5,000 MHs 35 $ MHs Purchase orders 63,000 700 orders 90 $ orders Machine setups 92,000 460 setups 200 $ setups Product testing 160,000 200 tests 800 $ tests General factory 300,000 25,000 DLH 12 $ DLHs 790,000 $
- 27. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 27 Cost Flows in an ABC System Overhead is applied on the basis of actual activities during the year. Activity Cost Pool Activity Rate Actual Activity Applied Overhead Cost Machine related $35/MH 4,600 MHs 161,000 $ Purchase orders $90/order 800 orders 72,000 Machine setups $200/setup 500 setups 100,000 Product testing $800/test 190 tests 152,000 General factory $12/DLH 23,000 DLHs 276,000 Total Overhead Applied 761,000 $
- 28. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 28 Cost Flows in an ABC System The following journal entry is made to record applied overhead. Description Debit Credit Work in Process 761,000 Manufacturing Overhead 761,000
- 29. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 29 Cost Flows in an ABC System Description Debit Credit d. Manufacturing Overhead 180,000 Accumulated Depreciation 180,000 e. Manufacturing Overhead 230,000 Accounts Payable 230,000 f. Finished Goods 1,650,000 Work in Process 1,650,000 The following journal entries would be used to record transactions (d) through (f).
- 30. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 30 Bal. 20,000 Bal. 4,000 (b) 810,000 (c) 95,000 (f) 761,000 (g) 1, 650,000 Work in Process Bal. 14,000 Manufacturing Overhead (b) 90,000 (c) 275,000 (d) 180,000 (e) 230,000 (g) 761,000 Raw Materials Bal. 3,000 (a) 915,000 Bal. 18,000 (b) 900,000 Accumulated Depreciation (d) 180,000 Accounts Payable (a) 915,000 (e) 230,000 Wages Payable (c) 370,000 Finished Goods Bal. -0- (g) 1,650,000 Underapplied Overhead Costs
- 31. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 31 End of Chapter 3