[ Music ] >> Now, we move on to lesson 2 for which our objectives are to understand how to apply ABC to a product costing scenario and also understand other considerations related to ABC systems. So in lesson 1 we talked about the design and implementation of an activity-based costing system. So, now let's see that in practice, as well as, as use it. This example we have C-Brook Enterprises they produce 4 models of its flavored health drink, so 4 different flavors. Managers in the past have used a simplified costing system in which all overhead was compiled in a single cost pool and then allocated to the different cost objects. But managers are now switching to an activity-based costing system. So, let's look at some numbers to see what that looks like. Recall that our first step is to identify the resources that the firm has. They looked over their accounting records in the past and they've estimated that following resources; support staff wages at $30,000, related benefits and insurance for that support staff at 12,000, information systems cost them $8000, equipment is 7000, maintenance is 3000 and utilities are 4000. I don't have the total in there, but that comes out to be $64,000. In step 2, the firm has gone through the process of identifying different activities and while this is a simplified example, we have a number of activities on this list. Managers have identified the following, processing production orders, scheduling production runs, preparing the manufacturing line for a new flavor, purchasing, preparing and releasing the materials, ensuring quality, and management and recordkeeping. All of these activities are necessary to create the 4 flavors that C-Brook produces. Step 3, is to group these activities into activities into activity pools, management has decided to group the activities according to activity cost or type. Recall that that is our hierarchy where we think of about unit level, batch level, and product level activities and costs. After much deliberation they have identified 4 different activity pools; running machines, that's at the unit level as running machines corresponds to production volume, and then 2 batch level activity pools. The first, is processing production runs and the second is setting up the production line and the equipment to produce each flavor. And finally at the product level, we just have a generic activity pool referred to as managing products. Now, to further create these activity pools, we take our resources and ultimately allocate those resources to the different pools we've identified. On the left-hand side, you have the different resources, again, our total is $64,000 broken down into staff wages, benefits and insurance, etcetera. Horizontally, we have the different production or activity pools, process production runs, setting up equipment, managing products, and running machines. Ultimately, our goal is to take these resources and put them into corresponding activity pools. Now, after a very large and very significant information collection phase, we found that the support staff has said that approximately 40% of their time goes towards processing production runs, 40% of their time goes towards setting up equipment and 20% of their time goes towards managing products. None of their time goes towards running machines. So, we've accounted for 100% of the resource and how it's allocated across the different pools, 40 plus 40 plus 20 is 100%. So, 40% of the 30,000 will belong in that first pool, processing production runs; 40% will belong in the pool for setting up equipment; and 20% of the 30,000 will be in the pool for managing products. Now, with respect of benefits and insurance because those are related to wages, we have the same breakdown, 40, 40, 20, and then 0 in running machines. Again, this comes from a variety of information collection processes where managers talk to the support staff and to better understand the types of activities that they engage in and while not every individual that's part of the support staff has this exact breakdown this is on average what the support staff looks like in terms of their allocation to the different activity pools. Information systems looks a bit differently, based on the information collected there, we know that 30% of the pool, of the resource belongs in the process production run pool and 70% belongs in the managing products pool there's nothing from this resource in the setting up equipment or the running of the machines themselves. Equipment based on information that we collected, 100% of that resource belongs in the run machine's activity pool. Nothing belongs in the first 3. Maintenance and utilities based on information we collected, we have the breakdowns there, 50/50 for maintenance and 10/10/10/70 for utilities. Again, to reiterate, each line item the entire 100% is split across the activity pools based on information collected from the people in charge of those resources and the identification of their activities that consume those resources. Now, we're going to turn these resources into dollar values according to each pool, so recall that it was 40/40/20 for the first 3 activity pools for support staff wages; 40% was in the process production activity pool. So, 40% of 30,000 is $12,000 and that belongs in that first pool. Another 40% belongs in the setting up equipment activity pool that's another $12,000 and 20% belongs in the manage products, 20% of that 30,000, $6000 dollars. So, we've accounted for 100% of the $30,000, 12,000 plus 12,000 plus 6000 is the entire 30,000. That's how we know we've allocated the entire resource to the appropriate activity pools. Benefits and insurance had the same split so it will end up being the same 12, or I'm sorry, 40%, 40%, and 20%; 40% of 12,000 is 4800, 40% of 12,000 is 4800, and 20% is half at 2400. Again, this total line the entire $12,000 resource that is represented by benefits and insurance. Information systems was split between processed production runs and managed products and for our last slide, that was 30% and 70% and so we've accounted for the entire 8000 and so on for the equipment all 100% was in the run machines pool and maintenance and utilities had their respective splits in which we've allocated to the various activity pools based on their percentage. So, in this first column we have all of the resources and they sum up to be $64,000. In the remaining columns we split those line items up into the various components represented in each activity pool, so this entire amount that's representing in the remaining columns, will sum up to the $64,000 because we have 100% of each line item accounted for across the 4 pools. That's how we know that we've accounted for all of the resources when the total of the columns on the right matches the total expense column on the left. Our totals for process production run, 21,100, setting up equipment is 17,200, managing products is 14,400, and 11,300 is the total for the run machines pool. The next step is to talk about our drivers basically computing those measures of activity that are going to allow us to allocate the costs from the activity pools to the cost objects themselves. So, once we have identified the activity pools and the drivers managers calculate a rate for each pool. Recall from the previous module that this is the predetermined overhead rate. In the numerator we have a dollar amount, an activity pool amount that would be total allocated to each activity pool and the denominator is the total volume of the driver and that is in whatever units, end units that we measure the activity in. This rate is then used to allocate costs from the activity pools to the cost objects themselves. So, recall that we has $64,000 in total resources, total expenses that we need to think about how to allocate. The activity pool amount from the 2 slides ago, the total for processing production runs was 21,100. The driver that the managers have identified is the number of production runs. So, in the next accounting period the managers will estimate how many production runs can be run and that's estimated to be 105 production runs. The 21,100 is our numerator, the total activity pool amount. The driver volume is our denominator, 21,000 divided by 105 yields a rate of $200.95 per production run. What this means is that if flavor A was set for a production run we would allocate $200.95 to flavor A, matter of fact whatever flavor is setup for a production run we would allocate $200.95 to that flavor for that particular production run. Similar calculations can be made for the other activity pools. For setting up equipment we had a total pool of $17,200. Management has decided that the driver that is used to measure the activity of setting up equipment is the number of hours that individuals spend setting up the equipment. We've figured out that we usually have or have 688 hours available and so 17,000 divided by the 688 is equal to $25 per setup hour. So, every hour that is spent setting up for a particular flavor is allocated $25 to that flavor. Similar situation for managing products; the total pool amount there was 14,400. We figured out that we have 4 product lines, product A, product B, C, and D so 14,400 divided by the 4 that's $3600 per product line and then finally running machines. Running machines amounted to $11,300 worth of resources. We've identified machine hours as the best driver. We've counted up and said 9000 hours is a good measure of the volume that we have of machine hours for the accounting period, dividing that 11,300 by the 9000 hours is $1.26 per hour. So, every machine hour that's used gets allocated a $1.26 from the run machines activity pool. [ Pause ] So, in terms of thinking about what we do with this information now that we have the driver we would measure what level of activity is consumed by each of our products. So, take for instance production run, we just calculated a driver rate of $200.95 and let's imagine that over the next accounting period we either estimate or actually use 60 production runs for flavor A. Well, that would mean that flavor A gets allocated $200.95 for each of those 60 production runs which totals $12,057. This would be cost allocation for A. We would have similar calculations based on the estimate or actual use of the production runs for each of the other flavors; flavor B, C and D. That way we understand how much cost is allocated to each of those cost objects, in this case the different flavor product lines. So, now let's talk about assigning costs to different products, actually using the system and let's look at the firm as a whole. So, on our left we have the different line items that would comprise in income statement so to speak and vertically we have the different columns for flavor A, flavor B, flavor C, and D and then the total for all the flavors together. So, sales are provided to us, this is how much revenue each flavor has generated or we expect to generate in the future. Flavor A is 85,000, flavor B is 50,000, and so on; totaling $153,800 in revenue or sales for the firm as a whole. We've talked in the past about activity-based costing systems not addressing material and labor too much. The reason being we already have that information from a regular system about materials and labor, those costs we understand quite regularly. So, we provided this information for each of the flavors in terms of direct materials and direct labor. Where the action is in activity-based costing systems is what is traditionally viewed as overhead and so you can see line items here for each of our activity pools that would not be included in direct materials and direct labor. Again, we had the 4 pools; process production runs, setting up equipment, managing products, and running machines. And as we calculated on the previous slide, we assume that flavor A had 60 production runs charged with $200.95 for each production run, so the amount of costs assigned to flavor A for processing production runs is the $12,057. We would have similar calculations based on the production runs that were used for flavor B, C, and D and so after collecting the actual information or estimating even if this is a budget we would have inputs for each of the additional flavors for that processing production. And then of course, we'd have a total for the firm as a whole. We would use the same rate, same calculation as we did for process production for the other activity pools but their specific rates; setting up equipment, managing products, and running machines would use the driver times the actual or estimated usage by flavor A and we would have the same information apply for products B, C, and D yielding totals for each of those activity pools. Now, all of our materials, labor, and the processed production, setup equipment, manage products, and running machines costs yield our total expenses for the firm. And they our total expenses for each product are subtracted from the product specific revenues to yield the operating income; our totals over on the right. So, what jumps out at us from this information? Well, the first thing is that product A or flavor A yields us our highest operating income and depending on the level of sales and other financial ratios, we might deem that to be the most profitable. Second in line in terms of operating income is flavor B that generated or we estimate that it will generate the second highest operating income. Flavor C and flavor D on the other hand are our losers for this accounting period and this is very, this will highlight something very important to the firm in the sense that which is our most profitable product based on operating income? A and B versus C and D not really pulling their weight and this can facilitate decisions that yield everything from enhancing the operations related to flavor C and D or potentially anticipating dropping those flavors in the future if they continue to lose money Another thing that jumps out from us is how specific this information is by product. So, let's assume that we go back to a traditional system and think about when a situation where we would use a single cost pool and include all overhead in that single cost pool, so that means that all these costs in these items would be in a single pool and allocated to products using a single driver. Now, in a manufacturing industry it's very common to use a unit level driver and the only unit level driver that we have here is running machines. So, if you look at how running machines are allocated, it's pretty proportional to the level of sales for each of the products. If we were to collapse all of the overhead costs and allocate them to flavors A, B, C, and D based on the running of the machines that unit level activity and costs, then we would see a very different picture here, as a matter of fact, because it's proportional to the level of sales we might see that some flavor C and flavor D under our traditional costing system would show profits and flavor A and B would show less profits than they actually do under an activity-based costing system. This is a very different picture then when we get via A,BC, and this case could potentially lead to very misleading decisions, so this is an example where the in depth information, the detail underlying in activity-based costing system provides us with a more accurate view of the firm, the cost that it incurs, and the profitability of each product. So, not all examples are like this, it's not always the case that some products are over costed and other products are under costed and ABC uncovers that but this exemplified a situation where this information becomes very valuable to managers and facilitates and influences the decisions related to future product profitability.
