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Chapter 07 - Lecture Notes
7-11
(3). SureStart consumed 480,000
machine-hours and LongLife
consumed 320,000 machine-
hours.
b. The overhead cost assignments to
SureStart and LongLife are as shown.
Notice:
(1). The total overhead costs
assigned to SureStart and
LongLife are $4,928,000 and
$7,832,000, respectively.
c. The total overhead costs assigned to
products ($12,760,000) plus the total
overhead costs not assigned to
products ($9,240,000) equal the total
overhead cost of $22,000,000 from
earlier slides.
2. Assigning overhead to customers
a. The data needed to assign overhead
costs to one of Baxter’s customers—
Acme Auto Parts is as shown.
b. The total overhead cost assigned to
Acme Auto Parts ($12,916) is
calculated as shown.
Learning Objective 5: Use activity-based costing to
compute product and customer margins.
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Chapter 07 - Lecture Notes
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vi. Step 5: prepare management reports
1. Product margin calculations
a. The first step in computing product
margins is to gather each product’s
sales and direct cost data which are
assumed to be as shown.
b. The second step is to incorporate the
previously computed activity-based
cost assignments pertaining to each
product.
c. The third step is to compute product
margins ($8,372,000 for SureStarts
and a loss of $1,132,000 for
LongLifes) by deducting each
product’s direct and indirect costs from
its sales.
d. The product margins can be
reconciled with the company’s net
operating income as shown.
2. Customer margin calculation
a. The first step in computing Acme Auto
Parts’ customer margin is to gather its
sales and direct cost data which are
assumed to be as shown.
b. The second step is to incorporate
Acme Auto’s previously computed
activity-based cost assignments.
c. The third step is to compute Acme
Auto’s customer margin ($384) by
deducting all its direct and indirect
costs from its sales.
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Chapter 07 - Lecture Notes
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IV. Comparison of traditional and ABC product costs
A. Product margins computed using the traditional
cost system
i. The first step is to gather each product’s sales
and direct cost data as shown.
ii. The second step is to compute the plantwide
overhead rate. Notice:
1. The numerator is the $14,000,000 of
manufacturing overhead shown earlier on
the company’s income statement.
2. The denominator is the 800,000 machine
hours used for the order size activity from
the ABC system.
3. The plantwide overhead rate is $17.50 per
machine-hour.
iii. The third step is to allocate manufacturing
overhead to each product. Notice:
1. 480,000 machine-hours were worked on
SureStarts, so $8,400,000 (480,000 hours ×
$17.50) of manufacturing overhead is
assigned to this product. LongLifes are
assigning the remaining $5,600,000
(320,000 × $17.50) of manufacturing
overhead.
iv. The fourth step is to compute the product
margins—$6,900,000 for SureStarts and
$2,100,000 for LongLifes.
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Chapter 07 - Lecture Notes
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1. Notice selling and administrative expenses
are not allocated to products because they
are assumed to be period expenses.
2. The overall net loss of $2,000,000 reconciles
with the income statement shown earlier.
B. The differences between ABC and traditional
product costs
i. The changes in product margins caused by
switching from the traditional cost system to
the activity-based costing system are as shown.
Notice:
1. The traditional cost system overcosts the
SureStarts and consequently reports an
artificially low product margin for this
product.
2. Conversely, the traditional cost system
undercosts the LongLifes and consequently
reports an artificially high product margin
for this product.
ii. There are three reasons why the reported
product margins for the two costing systems
differ from one another.
1. The traditional cost system allocates all
manufacturing overhead to products. The
ABC system only assigns manufacturing
overhead costs consumed by products to
those products. More specifically:
a. The ABC system does not assign the
manufacturing overhead costs
consumed by the customer relations
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Chapter 07 - Lecture Notes
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activity to products because these costs
are caused by customers, not specific
products.
b. The ABC system does not assign the
manufacturing overhead costs included
in the “other” activity to products
because these organization-sustaining
and unused capacity costs are not
caused by products.
2. The traditional cost system allocates all
manufacturing overhead costs using a
volume-related allocation base (machine-
hours). The ABC system uses volume-
related and non-volume related allocation
bases to assign manufacturing overhead to
products. More specifically:
a. The traditional cost system allocates
60% of all manufacturing overhead to
SureStarts and 40% to LongLifes.
b. The ABC system assigns 40% and
60% of customer orders activity cost
(a batch-level cost) to SureStarts and
LongLifes, respectively.
c. The ABC system assigns 0% and
100% of product design activity cost
(a product-level cost) to SureStarts and
LongLifes, respectively.
3. The traditional cost system disregards
selling and administrative expenses
because they are assumed to be period
expenses. The ABC system directly traces
shipping costs to products and includes
nonmanufacturing overhead costs caused by
products in the activity cost pools that are
assigned to products.
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Helpful Hint: A simple example can be used to
illustrate the impact of ABC systems on product costs
when batch-level costs are involved. Suppose two
products are each run in one batch a year and the cost
of setting up a batch is $100 for either product. Other
data follow:
A B Total
Units ......... 80 20
DLH/ unit.. x 1 x 1
Total DLHs 80 20 100
The two batches a year cost a total of $200 to set up. If
DLHs are used to allocate the setup costs, the overhead
rate would be $2 per DLH or $2 per unit for either
product A or product B. However, in an ABC system,
$100 will be allocated to product A and $100 to
product B. Consequently, the batch setup costs would
be $1.25 per unit for product A and $5.00 per unit for
product B. ABC systems tend to reduce the per-unit
costs of high-volume products and increase the per-unit
costs of low-volume products, but the impact is more
dramatic on the low-volume products.
Chapter 07 - Lecture Notes
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V. Targeting process improvements
A. Key definitions/concepts
i. Activity-based management is used in
conjunction with ABC to identify areas that
would benefit from process improvement. It
involves focusing on activities to eliminate
waste, decrease processing time, and reduce
defects.
ii. The activity rates computed in ABC can also
provide valuable clues concerning where there
is waste and the opportunity for improvement.
1. Benchmarking can be used to compare an
organization’s activity rates with standards
of performance that are external to the
organization.
VI. Activity-based costing and external reports
A. There are four reasons why most companies do not
use ABC for external reporting purposes.
i. External reports are less detailed than internal
reports in the sense that individual product
costs are not reported. External reports only
disclose cost of goods sold and ending
inventory. Therefore, if some products are
undercosted and others are overcosted, the
errors tend to cancel each other out when the
product costs are added together.
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ii. It is often very difficult to change a
company’s accounting system because it is
deeply embedded within complex computer
programs that have evolved over many years.
iii. An ABC system, such as the one described in
the chapter, does not conform to generally
accepted accounting principles (GAAP).
1. It excluded some organization-sustaining
manufacturing costs, some unused capacity
costs, and it included some
nonmanufacturing costs in its product cost
calculations. These cost system design
attributes do not comply with GAAP.
iv. Auditors are likely to be uncomfortable with
cost allocations that are based on interviews
with the company’s personnel. This type of
subjective data can be easily manipulated by
management.
VII. The limitations of activity-based costing
A. There are five limitations of ABC
i. Implementing an ABC system requires
substantial resources. The benefits of
increased cost accuracy may not outweigh the
implementation costs.
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ii. ABC systems produce numbers, such as
product margins, that are at odds with the
numbers produced by traditional cost systems.
Managers are not accustomed to managing
their operations using these numbers; hence,
ABC inevitably faces resistance. This
underscores the importance of having top
management support for and cross-functional
involvement with the ABC implementation.
iii. In practice, most managers insist on fully
allocating all costs to products. The ABC
system described in the main portion of this
chapter does not conform to this preference.
iv. ABC systems do not automatically identify the
relevant costs for particular decisions;
therefore, ABC data can be easily
misinterpreted and must be used with care
when making decisions. Costs assigned to
products, customers, and other cost objects are
only potentially relevant.
v. Most organizations use ABC as a supplement
to rather than a replacement for their
existing cost system. Maintaining two cost
systems is costlier than maintaining just one
system and it may cause confusion about which
set of numbers is to be relied on.
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