Instructions - Avoid plagiarism, the work should be in your own words - All answered must be typed using Times New Roman (size 12, double-spaced) font. - Use APA style references - Q1- What process is used to assign costs in an ABC system? Provide numerical example. Q2- How is relevant quantitative and qualitative information used in special order decisions? Explain and analyze using numerical example. BATCH-LEVEL ACTIVITIES Batch-level activities are tasks or functions undertaken for a collection of goods or services that are processed as a group. Batch-level costs do not relate to the number of units in the batch, but instead to the number of batches processed. Batch-level activities are tasks or functions undertaken for a collection of goods or services that are processed as a group. Batch-level costs do not relate to the number of units in the batch, but instead to the number of batches processed. Sun Life might batch certain types of insurance claims together for more efficient processing, and it probably batches approved claims for payment. Thus, batch costs would increase as the number of batches increases. UNIT-LEVEL ACTIVITIES Unit-level activities are undertaken to produce individual units manufactured or services produced. Unit-level activities need to be performed for every unit of good or service, and therefore the cost should be proportional to the number of units produced. Unit-level costs for Sun Life would include the time of personnel to investigate and approve or deny individual claims. ASSIGNING COSTS USING AN ABC SYSTEM Q3 What process is used to assign costs in an ABC system? In an ABC system, the process of assigning costs is a two-stage process similar to other cost accounting methods we have studied: Overhead costs are gathered into cost pools in the first stage and then allocated to the cost objects, such as product line, batch, or units, in the second stage. ABC differs from traditional accounting methods in that overhead costs are assigned to a larger number of activity-based cost pools, and cost drivers are used as allocation bases. The following procedures are followed for the ABC method. 1. Identify the relevant cost object. 2. Identify activities. 3. Assign costs to activity-based cost pools. 4. For each ABC cost pool, choose a cost driver. 5. For each ABC cost pool, calculate an allocation rate. 6. For each ABC cost pool, allocate activity costs to the cost object. 1. IDENTIFY THE RELEVANT COST OBJECT Different managers have different purposes for implementing ABC systems. The design of the system begins with identification of one or more cost objects that are relevant to managers. For example, managers may wish to assign manufacturing costs to products when they adopt an ABC system. In this case, direct manufacturing costs are traced to products and manufacturing overhead costs are allocated using ABC. However, the cost object could be customers, customer orders, a product line, batches, or any other aspect of operations in which managers are interested. In this part of the chapter, we focus on assigning manufacturing costs first to batches and then to units of product. Later in the chapter, we will learn about assigning costs to other cost objects and about assigning other types of costs, such as costs of quality, to cost objects. CHAPTER REFERENCE Chapter 2 introduced cost objects and their relationship to cost behavior. Suppose the managers at Keener Doors and Windows want to improve their ability to measure the production costs of various types of windows. This information will help them identify potential improvements in the manufacturing process. In this case, the production costs of individual windows are the cost object. The accountant developing an ABC system would focus only on manufacturing activities and not on other activities such as marketing, distribution, or research and development. 2. IDENTIFY ACTIVITIES To identify the activities performed within the production process, the use of resources must be tracked and, in many cases, additional information gathered from employees. For example, accountants may ask production managers about the types of tasks and functions performed in each production area. At this time, an accountant would categorize activities into unit, batch, product, customer, facility, and organization levels. This task might seem simple, but considerable judgment is needed to identify and choose the best set of cost pools for an ABC system. The goal is to account for separate activities in a way that provides managers useful information for decision making. In general, accountants try to identify activities so that the costs within each cost pool are homogeneous. Homogeneous activitiesare related in a logical manner and consume similar resources. Sometimes the cost driver helps establish whether activities should be combined or separated. For Keener Doors and Windows, the accountant would identify all of the activities involved in window manufacturing, including handling and transporting the glass and framing materials, glass cutting, window framing, and preparation for distribution. The accountant must also decide whether to establish separate cost pools for each activity or whether to combine some activities into a single activity cost pool. An appropriate cost driver for glass cutting might be the number of windows produced, especially if each window requires a similar amount of equipment and employee time. In this case, the window-cutting activities are homogenous, the window-cutting tasks are all related in a logical manner, and they require similar amounts of time and equipment per window. If, in turn, each window requires the same amount of time to frame, the accountant might conclude that the number of windows also drives the framing activity. In this case, both glass cutting and window framing have the same cost driver, and no benefit is likely to be gained by using separate cost pools for these two tasks. The accountant could combine the costs into one cost pool. Glass cutting and window framing are logically related, in that the glass is cut for a particular size frame and the activities take place sequentially, with glass cutting occurring first. In addition, the cost driver for both is number of windows produced because each window takes about the same amount of time and supplies to cut and frame. These activities could be considered homogeneous. Suppose different windows require different amounts of time and effort to cut. Each type of window would require the same amount of time to frame, but combining the activity costs in a single cost pool and using the same cost driver (number of windows processed) would not accurately reflect the cost of cutting resources. In this case, the two activities are not homogenous because they require different amounts of time and effort. Therefore, the accountant would probably separate glass cutting and window framing into two separate cost pools and choose time spent cutting as the cost driver for the cutting activity, and number of windows framed for framing activities. 3. ASSIGN COSTS TO ACTIVITY-BASED COST POOLS Costs related to each activity are identified and pooled. Some costs are directly traced to the cost pools. Indirect material costs are often traced directly to batch or unit cost pools, whereas costs such as property taxes, insurance, and lease or depreciation are directly traced to the facility. Similarly, costs such as depreciation on equipment used for only one product line are traced to a cost pool for that product line. Suppose the accountant for Keener Doors and Windows identifies glass cutting as a separate activity. The supplies used to cut glass, such as blades and oil for the glass-cutting equipment, are traced directly to the cost pool for this activity. Depreciation on the glass-cutting equipment is also traced directly to the glass-cutting activity. However, other overhead costs, such as the salary of a supervisor who oversees several different activities in the window department, need to be allocated to the cost pools for these activities. 4. FOR EACH ABC COST POOL, CHOOSE A COST DRIVER Ideally, activity costs are allocated to cost objects using a driver that explains changes in activity cost. Examples of cost drivers for various activities were listed in Exhibit 7.3. The terms cost driver andallocation base are sometimes used interchangeably. However, cost driver refers to some measure of activity that causes costs to fluctuate, whereas allocation base refers to the base used to allocate costs in an accounting system. Many allocation bases are not cost drivers. For example, in traditional costing systems square footage is often used as an allocation base for building-related costs such as property taxes and insurance, but no cause-and-effect relationship connects these costs with square footage in any specific work area or department. Therefore, the allocation base of square footage is not a cost driver. In contrast, the amount of time Keener employees spend cutting windows causes the cost of glass cutting to increase. Therefore, time spent cutting is a cost driver that can be used to allocate the cost pool for the glass cutting activity. Cost drivers are a special kind of allocation base. A cost driver is the best allocation base choice for an ABC cost pool. In other words, a cause-and-effect relationship should be evident between the allocation base and activity costs. Often, information about potential cost drivers is elicited from employees involved in the activities. They may suggest several potential drivers, and accountants must choose the most appropriate cost driver. CHAPTER REFERENCE See Chapter 2 for details about choosing and evaluating potential cost drivers. The accountant for Keener Doors and Windows needs to determine a cost driver for t window-framing costs. The best choice depends on the accountant's analysis of the variation in cost (increases and decreases). If windows are framed in batches by robotic equipment, the number of batches is a likely choice for a cost driver. If windows are framed individually, time spent framing and number of windows are potential cost drivers. If each window takes a different amount of time, then time spent framing is a more accurate cost driver. However, if roughly the same amount of time and supplies are used per window, number of windows may be nearly as accurate and easier to track. 5. FOR EACH ABC COST POOL, CALCULATE AN ALLOCATION RATE An allocation rate is calculated by dividing activity costs by some measure of volume for the cost driver. The choice of data for the activity costs and volume of the cost driver depend on the purpose of the ABC analysis. Sometimes managers are interested in measuring or analyzing past costs. In this case, the allocation rate is determined by dividing prior period cost by the prior period volume. Alternatively, managers may be interested in estimating future costs. In this case, estimated costs and estimated volumes could be used. The accountant for Keener Doors and Windows might calculate an estimated allocation rate for window framing costs as follows: Suppose that the estimated total cost for framing windows is $5,000 this month, and the estimated number of batches of windows framed is 100. The estimated allocation rate for window framing is then $50 per batch ($5,000 ÷ 100 batches). One of the potential benefits of ABC is that it can be used to measure the cost of an organization's capacity. Practical capacity is maximum capacity under typical operating conditions, assuming that some downtime is unavoidable for maintenance and holidays. If an estimated allocation rate is calculated using practical capacity in the denominator, then the allocation rate measures the cost of supplying the organization's production capacity. When this allocation rate is used to allocate costs, the ABC system will measure the cost of capacity used as well as the cost of unused capacity. 6. FOR EACH ABC COST POOL, ALLOCATE ACTIVITY COSTS TO THE COST OBJECT Costs are allocated to the cost object based on the actual volume of activity for the cost driver. In the Keener example, the cost object is individual window units. The cost of an individual window includes the unit-level costs as well as allocated batch-level costs. For the window-framing activity, suppose 95 batches are processed during the month. Using the estimated batch-level allocation rate of $50 per batch, the total batch costs for the month are estimated as $4,750 (95 batches × $50 per batch). Assuming each batch includes 10 windows, the total number of windows produced during the month is 950 (95 batches × 10 windows per batch). Thus, the allocated framing cost per window would be $5 ($4,750 ÷ 950). The total cost of an individual window would be estimated as $5 for framing plus the per-unit cost of all other activities involved in producing the windows. ABC provides a more accurate picture of the flow of overhead resources than traditional costing methods. This accuracy is useful when organizations need to determine which products to emphasize or whether their pricing schemes adequately reflect resources used. The illustration that follows compares costs assigned using a traditional system and an ABC system. KEENER DOORS AND WINDOWS (PART 1) COMPARISON OF ABC AND TRADITIONAL JOB COSTING Keener Doors and Windows Company produces two types of wooden doors. Regular doors are high-volume and use standard parts and manufacturing processes. Premium doors are lower volume and are considered a customized, specialty item. Managers are considering the pricing policies for both doors because their major competitor recently lowered prices on regular doors. Premium doors have been selling well because they are priced lower than the competitor's specialty doors. The managers are concerned about the effects on profit margins if they reduce the price of regular doors to match the competition. Although they only consider variable costs in their pricing decisions, they would like to have more information about each product's use of overhead resources. The cost accountant, Valerie Bradley, suggested that Keener consider implementing an ABC system to better understand the costs for all of the manufacturing activities needed to produce the doors. She believes that the regular doors use fewer overhead resources because all of the regular doors go through routine processes, whereas the premium doors require special processes. Both doors are produced in batches of 100. However, each premium door is processed further to add custom features, such as special routing effects in the wood or special window treatments. Currently overhead is allocated based on direct labor hours, but machines perform much of the work. Valerie believes that labor hours do not reflect the two products' different use of plant overhead resources. An ABC team is assembled to analyze the manufacturing activities and costs for individual doors in both product lines. The team consists of Valerie, a product designer, and several employees from the manufacturing process. They want to compare costs under the current job costing system and a new ABC system. As they consider the task, they realize that ABC allocations typically ignore facility-related costs while job costing allocations include them. For purposes of comparison, they decide to ignore facility-sustaining costs in their calculations for job costing so that the results from both systems are comparable. From the general ledger, Valerie identifies overhead costs of $18,270,000 (not including any facility costs) that were assigned to regular and premium doors last period. PRODUCT COSTS USING JOB COSTING The team recreates the products' job costs using information from the accounting system. Each regular door requires $65 of direct materials and 2.5 hours of direct labor. Each premium door requires $100 of direct materials and 3 hours of direct labor. The job costing system allocates overhead using a factory-wide estimated allocation rate of $32.05 per direct labor hour based on a single cost pool for door production of $18,270,000 and direct labor hours of 570,000 for the year. The following schedule summarizes the cost of each type of door, assuming direct labor cost of $20 per hour: The team members notice that the overhead allocation for premium doors is $16.02, or 20% greater than for regular doors under the job costing system. However, the shop supervisor believes that premium doors use two to three times more resources than regular doors because of extra processing the premium doors receive on the most expensive equipment. PRODUCT COSTS USING ABC The managers want to know whether their current pricing policy reflects any differences in resources used by regular doors compared to premium doors. Therefore, the ABC team decides that the relevant cost objects are individual doors and the activities involved in production must be analyzed. When the team visits the production area, they ask about the activities performed for each type of door. They learn that the first activity is delivery of materials to work stations. They identify a material handling cost pool for this activity. The next steps involve work done in batches, such as the initial cutting, sanding, and smoothing of doors. The team learns that two different activities are required: setting up machines for the next batch, and monitoring the machines as batches are processed. Some team members believe that these two activities could be combined into one cost pool allocated on the number of batches run. Valerie asks whether these activities differ between regular doors and premium doors. She learns that the setup for premium door batches is more complex and takes more time than for regular doors. The batches take the same amount of time, no matter what type of door is produced. Therefore the team identifies two activity pools, one for setup costs and one for batch monitoring costs because the activities in these pools are not homogeneous and cannot be allocated using a single cost driver. After the doors are cut and sanded, they are processed through routing machines. The team discovers that premium doors require more routing machine hours because the designs are more complex. An activity pool for machining is identified. The last activity is inspection. The inspectors explain that premium doors take longer to inspect because of their greater detail. The team identifies inspection as a cost pool. Now that the cost pools are identified, costs need to be traced or allocated to each pool. Valerie uses annual accounting records and information from employees about supplies used and the amount of time they spend performing different tasks. Material handling costs are easy to trace because workers perform only material handling duties, so their wages are traced directly to the cost pool. Equipment depreciation accounts are analyzed, and the cost of material handling equipment is separated. Workers estimate fuel costs and some supply costs, because detailed records are not kept for these expenses. Employees who set up and monitor batches estimate the amount of time spent in each activity. The employees performing the machining estimate the time and indirect materials used on each type of door, as do the inspectors. The team's next step is to select cost drivers. They decide to use number of parts as the cost driver for material handling because each part is handled separately. The setup for each batch varies with the complexity of the door design. Regular doors are processed using three simple designs. The machines automatically cut the doors to size and rout simple designs on the doors. Premium door setup requires more time because the door designs are more complex and usually include windows. The robotic machines cut holes for and insert windows. Setup for this process is more time intensive. The team decides to use setup time as the cost driver for this activity. Each batch requires about the same amount of monitoring, so the team selects number of batches as the cost driver for monitoring costs. Premium doors require more machine hours than regular doors because the routing designs are more complex, so machine hours are chosen as cost driver for machining costs. Each door requires a different amount of time to inspect, so the team selects inspection labor time as the cost driver for inspection. Before calculating the allocation rates, the team estimates the volume for each cost driver. They have complete records for machine hours and labor hours, but are not sure about information for number of parts, because that statistic is not tracked. The material handling employees estimate the number of parts they handled last year. Records are maintained for the number of batches, so that information is readily available. Employees are asked to estimate time spent in setup. The number of doors inspected is available, as is total time spent inspecting. However, time per regular versus premium door has not been tracked, so inspectors estimate these figures. Next, the team gathers information about the amount of each cost driver used by regular and premium doors last month as follows. Exhibit 7.4 summarizes the steps thus far, showing the activities, related cost drivers, overall costs, estimated volume for each cost driver, and estimated allocation rates. Machine setup time is 1/2 hour per batch for regular doors. At $100 per hour, the cost is $50 per batch. Because each batch consists of 100 doors, the cost per regular door is $0.50. Similarly, the cost per premium door is $1.00. EXHIBIT 7.4 Estimated Volumes and Costs Developed by the ABC Team at Keener Doors and Windows The total ABC overhead cost for each type of door is calculated as follows: USING ABC PRODUCT COST INFORMATION The team believes that the calculations under ABC costing confirm their intuition that the job costing system did not accurately reflect each product's use of resources. Under the job costing system, $80.13 in overhead was allocated to regular doors, and under ABC regular doors are allocated only $52.50. For the premium doors $96.15 in overhead cost was allocated by the job costing system compared to $133.00 under activity-based costing. These results suggest that the old system overstated the cost of regular doors and understated the cost of premium doors. The team believes that the ABC costs are more accurate because they better map the use of resources to each type of product. When the team presents its results to the company's managers, they decide that the regular door price can be reduced to match competitors' prices and the premium door price can be increased. Valerie reminds the managers that this ABC information contains some allocated fixed costs, such as salaries for supervisors and equipment depreciation, and that these costs probably will not change proportionately with changes in production volumes. Therefore, these ABC costs should only be used as a guide for pricing decisions. After any pricing changes are made, the managers need to monitor sales volumes to determine the effects of price changes on demand and determine whether profitability actually improves. STRATEGIC RISK MANAGEMENT Keener Doors and Windows (Part 1) PRODUCT COST INFORMATION BIAS. In Keener Doors and Windows (Part 1), the managers learned that their traditional costing system consistently assigned too much overhead cost to one product and too little cost to another product. Why did it matter whether overhead costs were assigned accurately? Inaccurate product cost information could encourage managers to make inappropriate decisions such as emphasizing less profitable products, dropping profitable products, outsourcing products that could be produced internally at lower cost, or accepting special orders that would generate negative marginal profit. ABC generally provides more accurate cost information than traditional costing, thus reducing the risk of some types of decision errors. However, ABC does not measure costs perfectly. For Keener, the ABC overhead cost per door included at least some fixed costs, such as employee salaries that do not vary proportionately with volume of activity. Thus, the ABC costs are likely to overstate relevant costs for many short-term decisions. ABC IN SERVICE ORGANIZATIONS Q3 What process is used to assign costs in an ABC system? ABC is used to assign costs not only to physical products, but also to services. Often, service organizations analyze cost performance by comparing their actual costs to budgeted costs each year. These types of comparisons do not provide information about cost per activity or service provided, which is needed to measure an organization's efficiency in providing services. To better understand the effects of activities on their costs, service organizations such as Sun Life Assurance of Canada may benefit from developing ABC systems. By analyzing activities, organizations may be able to improve efficiency or quality of service, and control or reduce costs. Service organizations follow the same process as manufacturing organizations for implementing an ABC system. Self-study problem 2 provides practice using ABC in a service setting. ACTIVITY-BASED MANAGEMENT Q5 What is activity-based management (ABM)? Activity-based management (ABM) is the process of using ABC information to evaluate the costs and benefits of production and internal support activities and to identify and implement opportunities for improvements in profitability, efficiency, and quality within an organization. ABM relies on accurate ABC information. Next we learn about four major uses of ABM: • • • • Managing customer profitability Managing product and process design Managing environmental costs Managing quality MANAGING CUSTOMER PROFITABILITY ABC can be used to identify characteristics that cause some customers to be more costly than others. Customer-sustaining activities include sales and technical support supplied to specific customers or groups of customers, costs of holding inventory for just-in-time deliveries, and costs of customizing orders. Exhibit 7.5 describes characteristics of customers having higher and lower costs. As the costs of serving specific customers are determined, managers can choose different strategies for different types of customers. For example, some customers need very little service, but are quite price sensitive. Although margins for these customers are low, these customers are profitable when service costs are also kept low. Customers with high service costs are also profitable when their net margins are high enough to account for the extra service costs. Alternatively, the company can price its extra services and let customers pick the services they are willing to pay for. The most valuable customers are those who order high-margin products, but have low service requirements. Managers can identify these customers using ABC information and then monitor their sales volumes. The organization can then compete for the best customers by offering discounts, special services, or other sales incentives when necessary. Customers requiring the most creative approaches are those who order low-margin products, but require costly services. Customer-ordering patterns can be analyzed and information shared with these customers to improve predictability of orders, reduce engineering and delivery changes, reduce demand for technical or sales support, and increase standardization of product and delivery requirements. In addition, pricing arrangements can be modified to increase margins and to introduce a pricing system for specialized services. MANAGING PRODUCT AND PROCESS DESIGN An advantage of ABC is its focus on activities. As an organization's activities are analyzed more closely, managers improve their understanding of how resources are used. In turn, this analysis enables managers to improve operations and profits. They can focus resources on value-added activities, which increase the worth of an organization's goods or services to customers. Conversely, they can reduce or eliminate non-value-added activities, which are worthless to customers and often waste resources. EXHIBIT 7.5 Characteristics of Customers with High and Low Service Costs
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