CHAPTER 11 SYSTEMS DESIGN: ACTIVITY-BASED COSTING AND MANAGEMENT I. Questions The three levels available are: Level 1, in which a company uses a plantwide overhead rate; Level 2, in which a company uses departmental overhead rates; and Level 3, in which a company uses activity-based costing. New approaches to costing are needed because events of the last few decades have made drastic changes in many organizations. Automation has greatly decreased the amount of direct labor required to manufacture products; product diversity has increased in that companies are manufacturing a wider range of products and these products differ substantially in volume, lot size, and complexity of design; and total overhead cost has increased to the point in some companies that a correlation no longer exists between it and direct labor. The departmental approach to assigning overhead cost to products relies solely on volume as an assignment base. Where diversity exists between products (that is, where products differ in terms of number of units produced, lot size, or complexity of production), volume alone is not adequate for overhead costing. Overhead costing based on volume will systematically overcost high-volume products and undercost low-volume products. Process value analysis (PVA) is a systematic approach to gaining an understanding of the steps associated with a product or service. It identifies all resource-consuming activities involved in the production process and labels these activities as being either value-added or non-value-added. Thus, it is the beginning point in designing an activity-based costing system since management must know what activities are involved with each product before activity centers can be designated and cost drivers established. Also, PVA helps management to eliminate any non-value-added activities and thereby streamline operations and minimize costs. The four general levels of activities are: 1. Unit-level activities, which are performed each time a unit is produced. 2. Batch-level activities, which are performed each time a batch of goods is handled or processed. 3. Product-level activities, which are performed as needed to support specific products. 4. Facility-level activities, which simply sustain a facility’s general manufacturing process. First, activity-based costing increases the number of cost pools used to accumulate overhead costs. Second, it changes the base used to assign overhead costs to products. And third, it changes a manager’s perception of many overhead costs in that costs that were formerly thought to be indirect (such as depreciation or machine setup) are identified with specific activities and thereby are recognized as being traceable to individual products. The two chief limitations are: First, the portion of overhead costs that relate to facility-level activities are still usually allocated to products on some arbitrary basis, such as machine-hours or direct labor-hours. Critics of activity-based costing argue that facility-level activities account for the bulk of all overhead costs in some companies. Second, high measurement costs are involved in operating an activity-based costing system. That is, the system requires the tracking of large amounts of detail and the completion of many separate computations in order to determine the cost of a unit or product. Yes, activity-based costing can be used in service organizations. It has been successfully implemented, for example, in railroads, hospitals, banks and data service companies. A resource driver is a measure of the quality of resources consumed by an activity. An activity driver is a measure of frequency and intensity of demands placed on activities by cost objects. Two-stage allocation is a procedure that first assigns a firm’s resource costs, namely factory overhead cost, to cost pools, and then to cost objects. Two major advantages of ABM are: a. ABM measures the effectiveness of the key business processes and activities, and identifies how they can be improved to reduce costs and improve the customer value. b. ABM improves the management focus by allocating resources to key value-added activities, key customers, key products, and continuous improvement methods to maintain the firm’s competitive advantage. II. True or False True False False True True True False True III. Exercises Exercise 1 Activity Activity Classification Examples of Traceable Costs Examples of Cost Drivers Materials are moved from the receiving dock to product flow lines by a material-handling crew Batch-level Labor cost; depreciation of equipment; space cost Number of receipts; pounds handled Direct labor workers assemble various products Unit-level Direct labor cost; indirect labor cost; labor benefits Direct labor-hours Ongoing training is provided to all employees in the company Facility-level* Space cost; training costs; administration costs Hours of training time; number trained A product is designed by a specialized design team Product-level Space cost; supplies used; depreciation of design equipment Hours of design time; number of engineering change orders Equipment setups are performed on a regular basis Batch-level Labor cost; supplies used; depreciation of equipment Number of setups; hours or setup time Numerical control (NC) machines are used to cut and shape materials Unit-level Power; supplies used; maintenance; depreciation Machine-hours; number of units * Personnel administration and training costs might be traceable in part to the facility-level and in part to other activity centers at the unit-level, product-level, and batch-level. Exercise 2 plantwide overhead rate volume two stage, stage, stage Process value analysis Unit-level Batch-level Product-level Facility-level high-volume, low-volume, low-volume activity centers IV. Problems Problem 1 Cost Systems Pool Rate Cost Driver Consumption Cost Assignment Traditional cost system 350% P10,000 P35,000 ABC system Labor 10% P10,000 P 1,000 Machining P25/hour 800 hours 20,000 Setup P10/hour 100 hours 1,000 Production order P100/order 12 orders 1,200 Material handling P20/requisition 5 requisitions 100 Parts administration P40/part 18 parts 720 P24,020 Problem 2 Requirement 1 Total overhead = P200,000 + P32,000 + P100,000 + P120,000 = P452,000 Overhead rate = P452,000 / 50,000 direct labor hours = P9.04 per direct labor hour Overhead assigned to proposed job = P9.04 x 1,000 direct labor hours = P9,040 Total cost of proposed job: Direct materials P 6,000 Direct labor 10,000 Overhead applied 9,040 Total cost P25,040 Company’s bid = Full manufacturing cost x 120% = P25,040 x 120% = P30,048 Requirement 2 Maintenance : P200,000 / 20,000 = P10 per machine hour Materials handling: P32,000 / 1,600 = P20 per move Setups: P100,000 / 2,500 = P40 per setup Inspection: P120,000 / 4,000 = P30 per inspection Overhead assigned to proposed job: Maintenance (P10 x 500) P5,000 Material handling (P20 x 12) 240 Setups (P40 x 2) 80 Inspection (P30 x 10) 300 Total overhead assigned to job P5,620 Total cost of proposed project: Direct materials P 6,000 Direct labor 10,000 Overhead applied 5,620 Total cost P21,620 Company’s bid = Full manufacturing cost x 120% = P21,620 x 120% = P25,944 The bid price of P25,944 was determined as follows: Direct materials P6,000 Direct labor 10,000 Overhead assigned: Maintenance (P10 x 500) P5,000 Material handling (P20 x 12) 240 Setups (P40 x 2) 80 Inspections (P30 x 10) 300 Total overhead assigned to job 5,620 Total cost P21,620 Markup 120% Bid price P25,944 V. Multiple Choice Questions A B D D D A C C B B A A A C B D D D A D B B C C D B A C A C Chapter 11 Systems Design: Activity-Based Costing and Management Systems Design: Activity-Based Costing and Management Chapter 11 11-5 11-6 MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual 11-1