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Chapter 7 : Activity Based Costing System Introduction: Costing systems help management estimate costs and accurately charge customers. There are two types of Product Costing Systems o Job Costing System o Process Costing System The Nature of Product determine which system will be used. The following figure illustrate the process of estimating costs in both systems. Allocation Rate = $0.5 Per DLH Chapter 7 : Activity Based Costing System Q1: What is Activity-Based Costing? The following Figure illustrate the Traditional Overhead Cost Allocation System The following Figure illustrate the ABC Cost Allocation System Chapter 7 : Activity Based Costing System Q2: What Are Activities, and How Are They Identified? Activity: Type of task or function performed in an organization Activity Identification: * * * Track the use of resources Use the cost hierarchy Grouping homogeneous costs Cost Hierarchy * Organization-sustaining activities * Facility-sustaining activities * Customer-sustaining activities * Product-sustaining activities * Batch-level activities * Unit-level activities Q3: What Process Is Used to Assign Costs in an ABC System? ABC Procedures: 1. Identify the relevant cost object 2. Identify activities 3. Assign (trace and allocate) 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 Allocation Rate = Estimated Activity Cost Estimated Volume of Cost Driver 6. For each ABC cost pool, allocate activity costs to the cost object Allocation = Allocation Rate × Actual Volume of Activity Chapter 7 : Activity Based Costing System Alternative Allocation Rates ( Types of Rates) * Past cost rate: Use past costs and past volumes * Estimated rate: Use estimated costs and estimated volumes * Supply-based rate: Use estimated costs and practical capacity Selection of Cost Drivers * Cause-and-effect relationship between cost driver and activity costs * Judgment in choosing and evaluating potential cost drivers Exercises 1. BCH Corporation produces and sells two types of sofa pillows: plain and fancy. Currently, BCH uses a traditional costing system with direct labor hours as the allocation base. Actual hours for 20x3 were 20,000. In anticipation of developing an activity-based costing system, BCH has identified the following cost pools and activities associated with pillow production: Estimated Costs Actual Costs Activity Driver for 20x4 for 20x3 Material cutting Number of cuts $16,000 $13,665 Sewing machine setups Number of setups 27,000 24,800 Factory maintenance Number of direct labor hours 15,000 17,000 $58,000 $55,465 Direct costs for a plain sofa pillow are $1.25 for material and $2.00 for direct labor (15 minutes @ $8.00 per hour). Direct costs for a fancy sofa pillow are $1.50 for material and $4.00 for direct labor (30 minutes @ $8.00 per hour). In 20x4, BCH expects to make 8,000 Plan pillows and 10,000 fancy pillows. Those output levels will require 5 setups for Plan pillows and 10 setups for fancy pillows. For the material cutting activity, the number of cuts is estimated at 10,000 for each type of pillow. a. Calculate the cost per unit for each type of pillow under traditional costing b. Calculate the cost per unit for each type of pillow under ABC c. Under traditional costing, which type of pillow cross-subsidizes the other pillow? Explain. Fact Sheet : Direct Material Cost Direct Labor Cost DLH Units Produced Number of Setups Number of Cuts Plan $ 1.25 $ 2.00 15 minutes 8,000 5 10,000 Fancy $ 1.50 $ 4.00 30 minutes 10,000 10 10,000 Chapter 7 : Activity Based Costing System Solution: a. Calculate the cost per unit for each type of pillow under traditional costing Plain sofa $ 1.25 2.00 2.07 5.32 Direct Material Direct Labor Applied (allocated) overhead Allocation Rate = = Fancy sofa $ 1.50 4.00 4.15 9.65 = $8.29 Per DLH Direct labor hours for Plan pillows = 8,000 x 0.25 = 2,000 Direct labor hours for fancy pillows = 10,000 x 0.50 = 5,000 Total direct labor hours = 7,000 Applied Overhead = Allocation Rate × Actual Volume of Activity Plan = $8,29 × ¼ = $2.07 Fancy = $8,29 × ½ = $4.14 b. Calculate the cost per unit for each type of pillow under ABC Direct Material Direct Labor Applied (allocated) overhead Plain sofa $ 1.25 2.00 2.66 5.91 Allocation Rates: Estimated Estimated Allocation Volume of Cost Costs Rates Driver Material cutting $16,000 20,000 Cute $ 0.8 Per Cute Sewing machine setups 27,000 15 Setup $1,800 Per Setup Factory maintenance 15,000 7,000 DLH $2.14 Per DLH Activity Fancy sofa $ 1.50 4.00 3.67 9.17 Chapter 7 : Activity Based Costing System Applied Overhead: Activity Material cutting Sewing machine setups Factory maintenance Total Applied overhead ÷ Units Produced Plain Sofa $ 8,000 $ 0.8 × 10,000 9,000 $ 1,800 × 5 4,280 $ 2.14 × 2,000 $ 21,280 8,000 $2.66 Fancy Sofa $ 8,000 $ 0.8 × 10,000 18,000 $ 1,800 × 10 10,700 $ 2.14 × 5,000 $ 36,700 10,000 3.67 c. Under traditional costing, which type of pillow cross-subsidizes the other pillow? Explain. Under traditional costing, the plain pillows allocation ($5.32) was a little less than half of the allocation for fancy pillows ($9.65). The difference between the two is $4.33. Under ABC the difference was only $3.26 ($5.91 - $9.17). Therefore, fancy was cross-subsidizing plain, that is, plain was not assigned as much overhead cost as it should have been