Chapter 9 Outline

Chapter 9 Outline LO 9-1 Understand the potential effects of using reported product costs for decision making. REPORTED PRODUCT COSTS AND DECISION MAKING • Dropping a Product o Managers may consider dropping a product if the reported costs of producing it have risen more rapidly than the price charged for it, and the product line margins have fallen to unacceptable levels.  The decision will be based on the impact it has on reported product costs. o Product costs are used primarily for developing inventory balances and cost of goods sold amounts for financial reporting.  The basic approach to product costing involves assigning direct costs to products and allocating manufacturing overhead costs to products. o If managers rely on the cost accounting system to make the decision to keep or drop a product, the cost system provides potentially inaccurate unit costs.  Exhibit 9.1 shows the assignment of costs to two products using an allocation base of direct labor hours; management is considering dropping the C-27s; the cost savings appear to be $198,400. • The reported unit costs of C-20s will increase from $6,920 to $9,260, an increase of about 34 percent. • If the managers attempt to increase the price of the C-20s by an equivalent amount, the market is unlikely to accommodate it.  As a result, they face two equally unappealing choices: Remain in business and lose money, or shut down.  Exhibit 9.2 shows the assignment of costs assuming that the C-27 is dropped and only the remaining product (C-20) is produced; the cost estimate for the C-20s increases from $207, 600 to $277,800.  Exhibit 9.3 provides the total product estimates with (totaling $406,000) and without the C-27s (totaling $277,800); the cost savings are only $128,200 (= $406,000 – $277,800). o Once a predetermined overhead rate is calculated, it is applied as if all overhead costs were variable with respect to the allocation base, which is not true in most cases for two reasons: •  Some of the overhead items could be fixed, and reducing the number of units produced does not result in lower fixed costs. Examples of such fixed costs include cost of supervision, machine and plant depreciation, and miscellaneous items that do not vary with the allocation base.  Some of the overhead items could vary, but with cost drivers other than those traditionally chosen ones. The Death Spiral o If managers attempt to recover the costs with a smaller number of units, they are likely to meet resistance in the market, resulting in demand for even fewer units. With the smaller production, the reported product costs increase even more. o The death spiral is a process that begins by attempting to increase price to meet higher reported product costs, losing market, reporting still higher costs, and so on, until the firm is of business.   Death spiral may occur when the demand for a product falls for some reason or a major customer leaves. • The decline in demand will lead to higher reported costs. • If the firm attempts to recover the production costs from the remaining customers, they too will reduce or eliminate their demand. The death spiral can occur even in firms with increasing demand. • For example, a firm is likely to add capacity with increasing demand. This can be in the form of new plant and equipment. An increase in capacity is accompanied by an increase in fixed (overhead) costs without a similar increase in output, at least not immediately. o If the accounting system computes product costs based on relatively short-term demand estimates (for example, for the next year), it will include the costs of the excess capacity that exists for growth in the product costs.  Using reported product costs, managers will attempt to recover the excess capacity costs from current customers, who are unlikely to be willing to pay, assuming there are competitors without the excess capacity. • LO 9-2 In this case, the death spiral can lead companies to build new plants only to see them idle because of reduced demand. Explain how a two-stage product costing system works. TWO-STAGE COST ALLOCATION • The basic approach in product costing is to allocate costs in the cost pools to the individual cost objects, which are the products or services of interest. o We assign (or allocate) these costs to the individual cost objects by using appropriate cost allocation bases or cost drivers.  Exhibit 9.4 illustrates a cost flow diagram for a two-stage cost allocation system. • The first-stage cost objects are the overhead accounts, such as supplies, depreciation, and so on. • The two-stage approach allowed us to separate plant, or manufacturing, overhead into two or more cost pools based on the account in which the costs were recorded. • The allocation in the first stage, although simple, allowed us then to select multiple cost drivers—direct labor costs and machine-hours, for example—that were used to allocate costs to products. • An alternative view of the two-stage cost allocation process is as follows: Direct costs: Direct materials, Direct labor Indirect costs: Manufacturing overhead  Assigned to First stage allocation Cost pools Second stage allocation Cost objects: Products or services Another common choice for first-stage cost objects is to use production departments or product lines within the plant, as shown in Exhibit 9.5. • The allocation of overhead costs to departments is not as simple as it is when overhead accounts are used because the costs are not necessarily recorded at the department level. • Two-Stage Cost Allocation and the Choice of Cost Drivers o Complexity and special handling required during production may distort the product costs reported when the traditional costing method is used. The two-stage system, on the other hand, allows the firm to develop product costing systems that more closely align the allocation of costs with the use of resources.    The Port Arthur manufacturing facility of Joplin Industries makes two types of digital cameras. • The J25P is a simple, point-and-shoot digital camera with few features. It is often sold in large quantities to discount stores, convenience stores, and other outlets that rely on impulse purchases. • The J40X is a sophisticated, digital camera with many features that can use multiple lenses; it is sold mostly online and in camera stores. Exhibit 9.6 shows the data on the operations of the Port Arthur manufacturing facility for the third quarter by product line and in total. • The facility’s cost system is a traditional product costing system that allocates manufacturing overhead to products based on direct labor costs. • The overhead allocation rate at the Port Arthur facility is 90%. Exhibit 9.7 shows the unit product cost report. •  When the production managers they studied the cost report, they were surprised that the J40X was only about twice as costly to produce as the J25P. That seemed too low.  The production managers explained that the J40X requires much more complex equipment and special handling in Assembly.  In addition, the J40X requires much shorter production runs, requiring more setups. Company policies called for initial price guidelines for products to include a 30 percent markup over full cost. • The marketing managers complained that, although the J40X was selling very well even with prices quoted above the guidelines, the J25P was meeting very heavy price resistance and was being discounted well below the guidelines to sell. o Janis decided to experiment with a two-stage cost allocation system.  In the first stage, the overhead costs would be allocated to the two buildings (departments).  In the second stage, the overhead costs in each building would be allocated to products using different cost drivers. • Because of the use of production cells and the importance of equipment cost in the Assembly building, the cost accounting manager decided to use machine-hours to allocate overhead costs in Assembly. • The cost accounting manager decided that Packaging’s direct labor costs were still appropriate as an allocation base in the Packaging building.  See Exhibit 9.8 for the cost flow diagram that the cost accounting manager developed for the cost system.  Exhibit 9.9 shows the data on the operations of the Port Arthur manufacturing facility for the third quarter by product line and in total using the new two-stage cost allocation system. • The overhead allocation rate for the Assembly building is $45 per machine hour. • The overhead allocation rate for the Packing building is 60% of direct labor cost.  Based on the new costing approach, it appeared that the sophisticated, low-volume J40X model was about three times more costly to produce. o This example illustrates that one advantage of the two-stage system is that it allows the firm to develop product costing systems that more closely align the allocation of costs with the use of resources. LO 9-3 • Compare and contrast plantwide and departmental allocation methods. Plantwide Versus Department-Specific Rates o The plantwide allocation method is an allocation method that uses one cost pool for the entire plant; it uses one overhead allocation rate, or one set of rates, for all of a plant’s departments.  Although it is called plantwide allocation, this allocation concept can be used in both manufacturing and nonmanufacturing organizations. o Plantwide allocation is the single-stage approach first described in Chapter 6.  Accounting for overhead is simple. • All actual overhead costs are recorded in one cost pool in the Manufacturing Overhead Control account for the plant without regard to the department or activity that caused them. • A single overhead rate is used to apply overhead to products, crediting Applied Manufacturing Overhead.   For example, if overhead is applied using a predetermined rate per machine-hour, the amount of the credit to the Applied Manufacturing Overhead account and the amount of the debit to Work in Process for overhead costs equal the rate per machine-hour times the total number of machine-hours worked. Companies using a single plantwide rate generally use an allocation base related to the volume of output, such as direct labor-hours, machine-hours, units of output, or materials costs. • Example 1: A company estimated its annual overhead costs to be $240,000. The company uses the plantwide allocation method to assign overhead costs to its two products, AA and BB, using machine hours, budgeted to be 12,000 for the coming year. Then the single plantwide rate would be $20 (= $240,000 ÷ 12,000 machine hours). In March, 400 units of product AA were produced using 800 machine hours; 100 units of product BB were produced using 400 machine hours. The overhead allocation would be:  To AA: $20 per machine hour × 800 machine hours = $16,000 (or $16,000 ÷ 400 units = $40 per unit)  To BB: $20 per machine hour × 400 machine hours = $8,000 (or $8,000 ÷ 100 units = $80 per unit) The journal entry would be: Work-in-Process Inventory (AA) Work-in-Process Inventory (BB) Applied Manufacturing Overhead 16,000 8,000 24,000  Companies using a single plantwide rate generally use an allocation base related to the volume of output, such as direct labor hours, machine hours, units of output, or materials costs. o Using the department allocation method, a company has a separate cost pool for each department. The company establishes a separate overhead allocation rate for each department.  • The department allocation method is an allocation method that has a separate cost pool for each department, which has its own overhead allocation rate or set of rates. Choice of Cost Allocation Methods: A Cost-Benefit Decision o The choice of whether to use a plantwide rate or departmental rates depends on the products and the production process.  If the company manufactures products that are quite similar and that use the same set of resources, the plantwide rate is probably sufficient.  If multiple products use the manufacturing facilities in many different ways, departmental rates provide a better picture of the use of manufacturing resources by the different products. o Managers need to make a decision about plantwide versus departmental rates based on the costs and benefits of the information inherent in each system. LO 9-4  Selecting more complex allocation methods requires more time and skill to collect and process accounting information.  Such incremental costs of additional information must be justified by an increase in benefits from improved decisions. Explain how activity-based costing and a two-stage product system are related. ACTIVITY-BASED COSTING • Activity-based costing (ABC) is a two-stage product costing method that first assigns costs to activities and then allocates them to products based on the each product’s consumption of activities. o An activity is any discrete task that an organization undertakes to make or deliver a product or service. o Activity-based costing can be used by any organization that wants a better understanding of the costs of the goods and services it provides, including manufacturing, service, and even nonprofit organizations. (See Business Application box “Activity-Based Costing in a Not-for-Profit.”) • Developing Activity-Based Costs o Activity-based costing involves the following four steps:  Identify the activities that consume resources and assign costs to them.  Identify the cost driver(s) associated with each activity. A cost driver is any factor that causes, or “drives,” an activity’s costs.  Compute a cost rate per cost driver unit or transaction. Each activity could have multiple cost drivers.  Assign costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product. o Identifying Activities that Use Resources  Often the most interesting and challenging part of the exercise is identifying activities that use resources because doing so requires understanding all the activities required to make a product. • When managers step back and analyze the processes (activities) they follow to produce a good or service, they often uncover many nonvalue-added steps that they can eliminate o Choosing Cost Drivers  Exhibit 9.10 provides several examples of the types of cost drivers that most companies use. •  Most of the cost drivers are related either to the volume of production or to the complexity of the production or marketing process. The best cost driver is one that is causally related to the cost being allocated. • With an ABC system, the selection of an allocation base, or cost driver, is often easier because we can use a measure of the activity volume  Cost drivers are selected based on three criteria: • Causal relation. Ideally, choose a cost driver that causes the cost. This is the best cost drive available. • Benefits received. Choose a cost driver to assign costs in proportion to benefits received. • Reasonableness or fairness. When the first two criteria fail, assign costs on the basis of fairness or reasonableness. o Computing a Cost Rate per Cost Driver  For any indirect cost, a predetermined rate can be computed as follows: Predetermined rate =  Estimated indirect cost Estimated volume of allocation base For activity-based costing, the first stage consists of activities. Each activity has an associated cost pool and requires a cost driver rate using the formula above. o Assigning Costs to Products  The final step in the activity-based costing system is to assign the activity costs to products. • We do this just as we have done for the other product costing systems we have considered. We multiply the cost driver rates by the number of units of the cost driver in each product. • Exhibit 9.11 illustrates the four steps of developing activity-based costs graphically.  Identify the activities.  Identify the cost driver(s) associated with each activity.  Compute a cost rate per cost driver unit or transaction.  Assign costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product. COST HIERARCHIES • A cost hierarchy classifies cost drivers by general dimensions or levels of activity o A cost hierarchy represents a classification of cost drivers into general levels of activity, volume, batch, product, etc.  Four possible levels of cost hierarchy are: • Volume-related • Batch-related • Product-related • Facility-related o An activity-based costing system can have fewer than four levels in the hierarchy or it can have more than four.  The important factor is whether the cost drivers for the activities reflect the cost incurred by the activity. (See Business Application box “The ABC Cost Hierarchy—Maintenance Costs for an Airline.”) o Exhibit 9.11 illustrates a cost hierarchy. o Exhibit 9.12 provides example of costs and cost drivers associated with each of the four levels. LO 9-5 Compute product costs using activity-based costing. ACTIVITY-BASED COSTING ILLUSTRATED In this section, the reported product costs under activity-based costing are computed in a comprehensive example. • Step 1: Identify the Activities o A cost accountant interviewed the production manager to determine the major activities used in the manufacturing process. • Step 2: Identify the Cost Drivers o The cost accountant interviewed production supervisors, who in turn discussed with line employees, to determine the cost drivers and the expected volume of each driver.  • The information is presented in Exhibit 9.13. Step 3: Compute the Cost Driver Rates o Once the overhead costs incurred in the facility were determined, the cost accountant calculated the cost driver rates by dividing overhead cost by the estimated volume for each activity identified in Step 1.  • Exhibit 9.14 shows the calculation. Step 4: Assign Costs Using Activity-Based Costing o Based on these interviews, the cost accountant develops a cost flow diagram, which includes the first-stage assignment of costs to activity pools and the second-stage allocation of activity costs to products noting the cost drivers for each activity.  Exhibit 9.15 shows the cost flow diagram that assigns overhead costs to activity pools in the first stage and allocates activity costs to products in the second stage. o For each product, the direct costs (direct materials and direct labor) are the same regardless of the costing methods used. The difference is in the assignment of overhead costs.  There are two ways to calculate unit cost for each product. • The total cost of production for each product is calculated first. Then the total cost is divided by the number of units produced to arrive at the unit cost.  • LO 9-6 • This approach is shown in Exhibit 9.16. The cost driver rate per unit of product for each of the cost drivers can be calculated first, which then is multiplied by the volume of activity consumption per unit of product. The resulting sum across the cost drivers will also determine the unit cost. Compare activity-based product costing to traditional department product costing methods. Unit Costs Compared o As summarized in Exhibit 9.17, both the plantwide rate and the department rate systems assumed that overhead was incurred proportionally with the volume of output. The activity-based costing system recognized that overhead was related to activity usage, not necessarily to the volume of output. o Important points about activity-based costing:  Different cost allocation methods result in different estimates of how much it costs to make a product.  Activity-based costing provides more detailed measures of costs than do plantwide or department allocation methods.  Production also benefits because activity-based costing provides better information about how much each activity costs. It helps identify cost drivers that previously were unknown.  Activity-based costing provides more information about product costs but requires more record keeping.  Installing activity-based costing requires teamwork between accounting, production, marketing, management, and other non-accounting personnel. LO 9-7 Demonstrate the flow of costs through accounts using activity-based costing. COST FLOW THROUGH ACCOUNTS • Exhibit 9.18 shows the flow of costs through accounts using activity-based costing. The overhead accounts (both incurred and applied) are grouped by activities. CHOICE OF ACTIVITY BASES IN MODERN PRODUCTION SETTINGS • Early industries were labor intensive, and much of the overhead cost was related to the support of labor. At that time, it made sense to allocate overhead to products based on the amount of labor component in the products. • Nowadays, labor is still a major product cost in many companies, especially service organizations such as consulting, law, and public accounting firms. In those cases, overhead is often allocated to products (jobs) on the basis of the amount of labor in the product. o When the labor component drops in the products and overhead cost increases, companies that continue to allocate overhead to products based on direct labor are experiencing substantial overhead rate increases.  Even small errors in cost allocation can be magnified many times.  It also sends the wrong signal that direct labor is more expensive than it really is and drives managers to reduce the already slim labor content of products. o The magnitude of the overhead rate based on direct labor is of less concern when all resources are used proportionally.  • In modern manufacturing settings, proportionality between machine hours and direct labor hours is much less so. Complexity as a Resource-Consuming Activity o Costs are a function of both volume and complexity.  When overhead is applied based on the volume of output, high-volume products are allocated relatively more overhead than are low-volume products. High-volume products “subsidize” lowvolume products in this case. o Volume-based allocation methods hide the cost effects of keeping a large number of low-volume products. This has led many companies to continue producing or selling products without realizing how costly they are. (See Business Application box “Evidence on the Benefits of Activity-Based Costing.”) LO 9-8 Apply activity-based costing to marketing and administrative services. ACTIVITY-BASED COSTING IN ADMINISTRATION • Activity-based costing can be applied to administrative activities. The principles and methods are the same as those discussed earlier. o Activity-based costing in administration involves these steps:  Identify the activities that consume resources.  Identify the cost driver associated with each activity.  Compute a cost rate per cost driver for each unit or transaction.  Assign costs to the marketing or administration activity by multiplying the cost driver rate by the volume of cost driver units consumed for that activity. o Instead of computing the cost of a product, accountants compute the cost of performing an administrative service.  Time-related factors (and therefore cost drivers) are common for an administrative function or a service business. • Exhibit 9.19 shows other common cost drivers in a typical purchasing department. WHO USES ABC? • Exhibit 9.20 lists some of the organizations that have been cited as using ABC for at least some of their operations. • There are three problems with identifying users of ABC: o ABC means different things to different observers. o ABC can be applied in parts of an organization but not everywhere. o While firms may publicly announce the adoption of ABC, they are less likely to announce its discontinuance. • All organizations are interested in getting better cost information for decision making. TIME-DRIVEN ACTIVITY-BASED COSTING • A modified version of ABC that addresses the costs of maintaining an ABC system has been developed. o This modified approach to ABC is called time-driven activity-based costing (TDABC). o The development of a TDABC system is illustrated by showing how it has been implemented in the Receiving Department at the Port Arthur Facility of Joplin Industries. • Developing Time-Driven Activity-Based Costs o With TDABC, the manager only needs to determine:  The cost of the resources supplied to a department  The time it takes to complete the various activities of the department. • This approach avoids the need to conduct surveys or interviews of multiple managers and employees. This means that it is not as costly to maintain as the unmodified ABC system. o The Costs of Resources Supplied  The number of people in the department are identified as are the activities that they perform.  The costs of the resources supplied to this department, cost of the department manager, and the costs of the technology and facilities are totaled. o The Time Required for Each Activity  The manager is asked to estimate how much time each activity takes for a single transaction. o Calculating the Costs of the Activities  We start by calculating a cost driver rate. Cost driver rate = Total cost of department ÷ Minutes available  For each activity, the activity costs are determined by multiplying the cost driver rate by the time required for the activity.  The total cost of activity for the department is determined by adding together the individual activity costs. •  The difference between the actual departmental cost and the total cost of activity for the department is due to idle time and represents the excess capacity in the department. How can these calculations help the cost accountant and other managers? • The reported costs can be used when considering the demands placed on Receiving by the characteristics of different products.  • • For example, if some products are produced in small quantities, they might still require the same number of shipments as those products with larger volumes. These costs can help managers make better decisions about whether they should keep or drop these products by giving better information about support costs. Extensions of TDABC o TDABC is all based on a single measure for each activity: time. We can modify this somewhat without adding all of the complications of a regular ABC system. o Cost Drivers other than Time  Although TDABC is based primarily on time estimates for different activities, we can easily extend this to accommodate a particular case. • For example, when Receiving stores the material, it stores it in the warehouse, which is a part of the resources included in Receiving. We can think of an additional activity (storage, for example). The cost of storage might be more related to the space required instead of time. It is a simple extension of the model to compute the cost per square foot and apply it to materials that stored in the warehouse. • We would also recompute the time-based cost driver rate to account for the lower remaining costs in Receiving after splitting out the warehouse cost. o Time Equations   The TDABC system that we have developed so far assumes all orders that go through any one of the activities take the same amount of time. We can extend the TDABC system to allow for differences among orders by using what are called time equations. • Time equations allow managers to adjust the times for orders with different characteristics. • Time equations can also be written if there is a maximum size of an order that can be inspected or transported to the warehouse. TDABC provides an alternative to an unmodified ABC system that might be too costly to maintain given the benefits the ABC system provides. • Most likely, a combination of the two systems might be used depending on the size of the department and the need for improved cost information.