In this course, you will learn how to use accounting to facilitate and align decisions made by owners, managers, and employees. You will learn how accountants create, organize, interpret, and communicate information that improves internal processes, and allows organizations to identify and leverage opportunities to create value within the supply chain and with customers. Upon successful completion of this course, you will be able to: • Understand what managerial accounting is and why it is important. • Describe fundamental concepts of managerial accounting. • Apply the financial perspective of accounting for costs. • Identify problems associated with relying on financial accounting information for internal decision making. • Organize cost information according to the decision-making needs of the organization. • Apply activity-based costing (ABC) and recognize the influence of setting and decision characteristics on the relevance of ABC systems. • Address common "what-if" questions using cost-volume-profit (CVP) analysis. • Apply CVP analysis in a variety of scenarios. This course is part of the iMBA offered by the University of Illinois, a flexible, fully-accredited online MBA at an incredibly competitive price. For more information, please see the Resource page in this course and onlinemba.illinois.edu.
Learning Objectives and Steps Through an Example
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From the course by University of Illinois at Urbana-Champaign
Managerial Accounting: Cost Behaviors, Systems, and Analysis
310 ratings
University of Illinois at Urbana-Champaign
310 ratings
Course 1 of 7 in the Specialization Value Chain Management
From the lesson
Costing Systems II - Activity-Based Costing
Activity-based costing systems adopt a more refined view of the organization, and can increase the accuracy of cost information. In this module, we introduce the fundamentals of activity-based costing systems, identify related advantages and disadvantages, and demonstrate how such systems are implemented using an in-depth example.
Meet the Instructors
Gary Hecht, Ph.D.Associate Professor of Accountancy
Department of Accountancy, College of Business
[ 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.
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