Learning Objectives. PRODUCT COSTING SYSTEMS Traditional Product Costing Systems Activity-Based Costing Systems

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1 PRODUCT COSTING SYSTEMS Traditional Product Costing Systems Activity-Based Costing Systems Learning Objectives Learn the mechanics of product costing systems Understand cost distortions in traditional costing systems Learn the strategic benefits of activity-based costing systems Rajiv D. Banker, Revised February Traditional Product Costing Systems Link Costs and Products Activity-Based Costing Systems Link Overhead Costs and Products COSTS POOLS Direct Materials PRODUCTS Product 1 RESOURCES Are Consumed By ACTIVITIES To Make and Sell PRODUCTS Activity 1 Product 1 TOTAL COSTS Direct Labor Product 2 OVERHEAD COSTS Activity 2 Product 2 Overhead Costs Product N Activity M Product N 3 4 Traditional Product Costing Systems Associate direct materials and direct labor costs directly with products Allocate all other costs (overhead costs) to products using a convenient basis such as direct labor hours All products are allocated overhead costs at the same average rate Overhead Cost Allocation Procedure Estimate total overhead costs for the period Estimate total direct labor hours (DLH), or another convenient basis, for the same period Divide total costs by total DLH to obtain overhead rate Apply overhead costs to individual jobs by multiplying each job s DLH by the overhead rate 5 6 1

2 The Zanthon Company (a): Existing Costing System Overhead Rate Pop Quiz Total manufacturing overhead costs = $15,000,000 Total direct labor hours = [ 2 + 4] = 200,000 Manufacturing overhead cost rate = $15,000,000 / 200,000 = $75 per direct labor hour 7 8 What is the amount by which total manufacturing overhead costs will go up if the total direct labor hours are 2 instead of 200,000? What is the average wage rate for direct labor at Zanthon Company? Direct Labor Wage Rate It includes both wages and fringe benefits paid to workers It is $25 per direct labor hour at the Zanthon Company (=$50/2 for basic and $100/4 for custom) Distinguish the $25 rate of actual compensation from the notional $75 rate to allocate overhead 9 10 Existing Costing System Product Cost Estimates The Zanthon Company (b) Basic Custom Direct materials $100 $150 Direct labor Manufacturing overhead Unit cost $300 $550 Selling price $350 $650 Unit profit $ 50 $100 Automobile Lamp Division

3 Consulting Group s Classifications Green Lamps Cost < External Bid Red Lamps Cost > External Bid plus 10% Manufacturing Complexity Long curvaceous lamps Molds with moving parts Multi-colored lamps Different melting temperatures Yellow Lamps Call us back More complex lamps consume more activity resources (setups, supervision, inspection, maintenance, tools) Pop Quiz Over- or Under-costing? Are complex lamps likely to be over-costed or under-costed by a traditional costing system? stem? What lamps are likely to be in the red category? Cost Distortions More complex lamps were undercosted, and appeared to cost less than outside bids Less complex lamps were overcosted, and appeared to cost more than outside bids The overcosted lamps were much more likely to be in the red category Let s Share the Bill Equally!

4 Product Complexity Small batch sizes Long set-up times Unique components Special inspection and tests Extensive material handling Special vendors Traditional Systems Distort Product and Customer Costs High Customer Complexity Low Traditional i Cost + Estimate Minus True Cost Overcosted Undercosted _ 19 Low Product Complexity High 20 Customer Complexity Customized products Short lead times Unpredictable orders Extensive technical support Extensive post-sales support Special tests and requirements Activity-Based Costing Systems are based on cost drivers that link activities performed to products and allocate activity costs directly to products using these cost drivers Analyze Details of Expenditure on Indirect Activities Activity Cost Pools Activity- Based Costing Activities Activity Costs Process customer orders Place purchase orders $2,000,000 Schedule production Move materials St Set up machines 2,500, Quality control 2,500,000 Maintain product information Perform engineering changes Maintain machines 2,300,000 Expedite orders Other overhead 5,700,000 TOTAL $15,000, Resource Drivers Activity Drivers Linking Resources and Activities to Products, Services and Customers Resource Activities Products/ Services/ Customers Purchase Order Overhead Costs Quality Control Maintain Machines Orders Inspections Maintenance Hours $/Order $/Inspection $/Maintenance Hour Setup Machines Setup Hours $/Setup Hour 24 4

5 Four Basic Steps in an Activity-Based Costing System 1. Trace all costs to activity cost pools 2. Determine cost drivers for all activities to capture how costs are driven by activity levels and measure the differences in the consumption of activity resources 3. Determine activity cost driver rates 4. Allocate costs to products based on activity cost driver rates multiplied by the activity level 25 (1) Trace All Overhead Costs to Activity Cost Pools The Zanthon Company Total Overhead Costs : $15,000,000 Purchase Orders Quality Control $2,000,000 $2,500,000 Production Setups Machine Maintenance $2,500,000 $2,300,000 Other Overhead $5,700, (2) Determine Cost Drivers for All Activities Purchase Orders Number of Orders The Zanthon Company (c) Quality Control Number of Inspections 5,000 Production Setups Machine Maintenance Number of Setups Machine Hours 2,500 46,000 Other Overhead Direct Labor Hours ,000 Selecting the Activity Cost Driver Setup hours measure the amount of resources required for the setup activity more accurately than the number of setups If setups required for all products are alike then the simpler measure, number of setups, is adequate 28 The Zanthon Company Cost Driver Demanded Activity Cost Driver Cost Total Basic Custom Purchase orders Number of orders $2,000,000 6,400 3,600 Quality control Number of inspection 2,500, ,000 3,200 1,800 Production setups Number of setups 2,500,000 2,500 1, Machine-related Machine hours 2,300,000 46,000 32,000 14,000 Other overhead Direct labor hours 5,700, , ,000 40,000 $15,000,000 (3) Activity Cost Driver Rates Activity Purchase Orders Quality Control Production Setups The Zanthon Company (c) Machine Maintenance Other Overhead Rate per Unit of Cost Driver $2,000,000 $200 $2,500,000 $500 5,000 $2,500,000 $1,000 2,500 $2,300,000 $50 46,000 $5,700,000 $ ,

6 Aggregation of Activities The purchase order activity cost pool includes costs of all activities that are initiated because a purchase order needs to be placed: Identify suppliers Check each supplier s price and availability Select a supplier Negotiate price and delivery terms Place the order Follow up with supplier Check materials when delivered Return rejected materials and follow up Store materials 31 Activity Requirement Analysis The Zanthon Company (d) Activity Purchase Orders Quality Control Production Setups Machine Maintenance Other Overhead Basic Custom 6, , , , , , , ,000 40, (4) Allocate Costs Using Activity Rates The Zanthon Company (e) Pop Quiz Activity Basic Custom Purchase Orders $200 x 0.08 = $ 16 $200 x 0.36 = $ 72 Quality Control $500 x 0.04 = 20 $500 x 0.18 = 90 Production Setups $1,000 x 0.02 = 20 $1,000 x 0.09 = 90 Machine-Related $50 x 0.4 = 20 $50 x 1.4 = 70 Other Overhead $28.5 x 2 = 57 $28.5 x 4 = 114 Overhead Allocated $133 $436 Observe: $133 x + $436 x = $15,000, Why is the amount of overhead charged to the custom product much higher than that under the old product costing system? Old New Basic $150 $133 Custom Comparison of Resources Required The Zanthon Company (f) Activity Basic Custom Ratio Purchase Orders :4.5 Quality Control :4.5 Production Setups :4.5 Machine Maintenance :3.5 Direct Labor Hours 2 4 1:

7 What If All Overhead Costs Were Allocated Based on Machine Hours? MH is in the ratio 1:3.5 instead of 1:2 for DLH If all overhead costs are allocated based on MH then the overhead rate is $326 per MH (=$15,000,000 / 46,000 MH) The basic product will be charged $130 per unit (=$ ) and the custom product $456 per unit (=$ ) When Is Traditional Product Costing Adequate? Amount of overhead costs is very small All products consume different activity resources in the same proportion A surrogate basis measure is available that approximates the differences in the relative intensity of consumption for all products ABC Profitability Analysis The Zanthon Company (g) The custom model is not as profitable as the company thinks. Basic Custom Direct Material $ 100 $ 150 Direct Labor Manufacturing Overhead Unit Costs $ 283 $ 686 Selling Price per Unit $ 350 $ 650 Gross Margin per Unit $ 67 ($ 36) Recommendation to Marketing Staff for Profitability Improvement The Zanthon Company (h) Push the more profitable products (increase commissions on the basic model relative to the custom model) Raise the price of the loss making product Drop the loss making product 39 The Zanthon Company 40 (h) Recommendation to Production Staff for Profitability Improvement The Zanthon Company (h) Reduce Demand for Activities Re-engineer the complex product to decrease its high demand for activity resources Increase Efficiency of Activities Re-engineer the activity processes to decrease the cost driver rate for performing the activities Costs Do Not Disappear! When unprofitable products identified based on activity cost analysis are dropped, their costs do not disappear automatically Managers have to make deliberate decisions to eliminate or redeploy the newly slack activity resource capacity when the products are dropped The Zanthon Company 41 (h) 42 7

8 Take-Home Message Traditional cost systems may distort product costs in a systematic manner Activity-based cost management systems provide information to control costs, budget for resources and evaluate product and customer profitability 43 8