BU8101 Accounting: A User Perspective

Lecture 9
ACTIVITY-BASED COSTING (ABC)
COST-VOLUME-PROFIT ANALYSIS (CVP)

Compulsory Reading:
WHB Chapter 17 & 20
Other Reference:
Financial & Managerial Accounting
Wild and Chiappetta
Chapters 17, 18
9-1
Lecture date: 18 March, 2013
Lecture Outline
I. ACTIVITY-BASED COSTING (ABC)
a. Traditional Plant-wide, Single Overhead Rate
b. ABC Multiple Overhead Rates
c. Comparison between Traditional Costing vs. ABC

II. COST-VOLUME-PROFIT ANALYSIS (CVP)
a. Costs and Cost Behaviors
b. Contribution Margin Income Statement
c. Break-even Analysis
d. Business Applications of CVP

9-2
Manufacturing Manufacturing
Overhead
(estimate)
Job No. 1 Job No. 1
Job No. 2 Job No. 2
Job No. 3 Job No. 3
Charge direct
costs to each job
Charge direct
material and
direct labor
costs to each job
as work is
performed
Direct Materials Direct Materials
(actual)
Direct Labor Direct Labor
(actual)
I. Activity-Based Costing (ABC)
Apply overhead
to each job using
a predetermined
Apply overhead
to each job using
a predetermined
rate (POHR)
RECAP: Manufacturing Cost Flow
9-3
Traditional Costing System
9-4
Traditional cost systems were created when manufacturing
processes were labor intensive.
A single, company-wide overhead rate based on direct labor hours
may be used to allocate overhead costs to products in these labor-
intensive processes.
Today, manufacturing processes are highly automated and direct
labor costs have become less significant.
Is it still appropriate to use direct labor hours to allocate overhead
costs?

Traditional Costing System
Overhead Cost
Indirect
Costs
Cost
Allocation
Base
Single Plant-Wide
Overhead Rate
Cost
Objects
Product 1 Product 2
Product 3
9-5
Traditional Costing System
Advantages
Information is readily
available
Easy to implement
Often sufficient to meet
external financial
reporting needs
Disadvantages
Overhead costs may
not bear any
relationship with direct
labor hours
All products may not
use overhead costs in
the same proportion
9-6
How to improve OH allocation?
Traditional
Costing
Traditional vs. ABC Method
9-7
ABC Costing
ActivityBased Costing
In the ABC method, we recognize that many activities
within a department drive overhead costs.
9-8
Activity
An event that causes the
consumption of overhead
resources.
A cost bucket in which
costs related to a single
activity measure are
accumulated.
Activities and Cost Pools
Activity
Cost
Pool
9-9
Repair and Maintenance of
Equipment
$100,000
POHR
=

Multiple Overhead
Categories
Multiple POHR
9-10
Cost Pools Cost Drivers
Materials purchasing Number of purchase orders
Materials handling Number of materials
requisitions
Personnel processing Number of employees hired
or laid off
Equipment depreciation Number of products
produced or hours of use
Quality inspection Number of units inspected
Indirect labor for Number of setups required
equipment setups
Engineering costs for Number of modifications
product modifications
Cost Driver: activity that leads to the incurrence of costs
Cost Pools and Cost Drivers
9-11
Overhead Actual
Rate Activity

Rate =
Estimated overhead costs in activity cost pool
Estimated number of activity units
ABC: 5-step Computation
9-12
1. Identify activities that consume resources.
2. Assign costs to a cost pool for each activity.
3. Identify cost drivers / cost allocation base
associated with each activity.
4. Compute overhead rate for each cost pool:


5. Assign costs to products:
Example: Traditional Costing vs. ABC
Pear Company manufactures a product in regular and
deluxe models. Overhead is assigned on the basis of
direct labor hours. Budgeted overhead for the current
year is $2,000,000. Other information:
Deluxe Regular
Model Model
Direct Material 150 $ 112 $
Direct Labor Cost 16 8
Direct Labor Time 1.6 hours 0.8 hours
Expected Volume (units) 5,000 40,000
Lets determine the unit cost of each model using
traditional costing methods.
9-13
1 : 8
Direct
Labor Hours
Deluxe Model 5,000 units @ 1.6 hours 8,000
Regular Model 40,000 units @ 0.8 hours 32,000
Total Direct Labor Hours (DLH) 40,000
Overhead Estimated overhead costs
Rate Estimated activity base
=
$2,000,000
40,000 DLH
=
$50 per DLH
Traditional Costing
=
9-14
Deluxe Regular
Model Model
Direct Material 150 $ 112 $
Direct Labor 16 8
Manufacturing Overhead
$50 per hour 1.6 hours 80
$50 per hour 0.8 hours 40
Total Unit Cost 246 $ 160 $
ABC will have different
overhead per unit.
Traditional Costing
9-15
Activity-Based Costing
Pear Company plans to adopt activity-based costing. Using
the following activity center data, determine the unit cost of
the two products using activity-based costing.
Overhead
Activity Cost for Cost Units of Activity
Cost Pool Activity Driver Deluxe Regular
Purchasing 84,000 $ Orders 400 800
Scrap Rework 216,000 Orders 300 600
Testing 450,000 Tests 4,000 11,000
Machine Related 1,250,000 Hours 20,000 30,000
Total Overhead 2,000,000 $
Step 1
Identify
Activities
Step 2
Assign cost to
Cost Pools
Step 3
Identify
Cost Driver
9-16
Overhead Units
Activity Cost Cost for of
Cost Pool Driver Activity Activity Rate
Purchasing Orders 84,000 $ 1,200 $ 70 per order
Scrap Rework Orders 216,000 900 $240 per order
Testing Tests 450,000 15,000 $ 30 per test
Machine Related Hours 1,250,000 50,000 $ 25 per hour
Total Overhead 2,000,000 $
Rate = Overhead Cost for Activity Units of Activity
Step 4
Compute
POHR
Activity-Based Costing
9-17
400 deluxe + 800 regular = 1,200
Deluxe Model Regular Model
Actual Cost Actual Cost
Activity Units of Allocated Units of Allocated
Cost Pool Rate Activity to Product Activity to Product
Purchasing $ 70/order 400 28,000 $ 800 56,000 $
Scrap Rework $240/order 300 ? 600 ?
Testing $ 30/test 4,000 ? 11,000 ?
Machine Related $ 25/hour 20,000 ? 30,000 ?
Total Overhead ? ?
Cost Allocated to Product = Rate (POHR) x Actual Units of Activity
Step 5
Allocate cost
to product
Activity-Based Costing
9-18
Deluxe Model Regular Model
Actual Cost Actual Cost
Activity Units of Allocated Units of Allocated
Cost Pool Rate Activity to Product Activity to Product
Purchasing $ 70/order 400 28,000 $ 800 56,000 $
Scrap Rework $240/order 300 72,000 600 144,000
Testing $ 30/test 4,000 120,000 11,000 330,000
Machine Related $ 25/hour 20,000 500,000 30,000 750,000
Total Overhead 720,000 $ 1,280,000 $
Cost Allocated to Product = Rate (POHR) Actual Units of Activity
Total overhead = $720,000 + $1,280,000 = $2,000,000
Recall that $2,000,000 was the original amount of overhead
assigned to the products using traditional costing.
9-19
Overhead Costs Assigned to Products:
Deluxe Model $720,000 5,000 units = $144 per unit
Regular Model $1,280,000 40,000 units = $32 per unit
Deluxe Regular
Model Model
Direct Materials 150 $ 112 $
Direct Labor 16 8
Manufacturing Overhead 144 32
Total Unit Cost 310 $ 152 $
Overhead Costs Assigned to Products:
Deluxe Model $720,000 5,000 units = $144 per unit
Regular Model $1,280,000 40,000 units = $32 per unit
Deluxe Regular
Model Model
Direct Materials 150 $ 112 $
Direct Labor 16 8
Manufacturing Overhead 144 32
Total Unit Cost 310 $ 152 $
Activity-Based Costing
9-20
This result is not uncommon when ABC is used.
Many companies have found that low-volume, specialized products
have greater overhead costs than previously realized.
Traditional Costing ABC
Deluxe Regular Deluxe Regular
Model Model Model Model
Direct materials 150 $ 112 $ 150 $ 112 $
Direct labor 16 8 16 8
Overhead 80 40 144 32
Total cost 246 $ 160 $ 310 $ 152 $
Traditional Costing vs. ABC
9-21
Cost
Distortions
Activity Levels
Activity Cost Consumption Consumption
Cost Pool Driver Deluxe Ratio Regular Ratio
Purchasing Orders 400 33% 800 67%
Scrap Rework Orders 300 33% 600 67%
Testing Tests 4,000 27% 11,000 73%
Machine Related Hours 20,000 40% 30,000 60%
ABC Consumption Ratios
Proportion of each activity consumed by a product.
Physical Units
Deluxe Regular
5,000 40,000
1 : 8
11% 89%

Deluxe model consumes more
overhead resoures and should be
allocated more overhead costs!
9-22
Advantages and Disadvantages of ABC
Advantages
More accurate
overhead cost allocation
More effective overhead
cost control
Many uses: service
firms, customer
profitability studies (eg,
marketing/distribution/
customer service costs)
Disadvantages
Costs to implement and
maintain
Complexity may hamper
support for
implementation
9-23
II. Cost-Volume-Profit Analysis (CVP)
Understanding Costs
Fixed Costs
Variable Costs
Semivariable /
Mixed Costs
Cost behavior
Relationship between cost and activity level (eg, output).
How a cost behaves or changes as the amount of output changes
within the relevant range.

9-24
Total fixed costs
remain constant as
activity increases.
Number of Local Calls
M
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B
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B
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Cost per call
declines as
activity increases.
Number of Local Calls
M
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B
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T
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Fixed Costs
Total FC FC per unit
9-25
Variable Costs
Total variable
costs increase as
activity increases.
Minutes Talked
C
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p
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M
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Minutes Talked
Cost per Minute
is constant as
activity increases.
T
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L
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D
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Total VC VC per unit
9-26
Variable Costs Fixed costs
Per Unit
Remains the same even when
activity level changes.
Changes as activity level
changes.
Total
Changes as activity level
changes.
Remains the same over wide
ranges of activity.
Variable Cost vs. Fixed Cost
9-27
Quick Check
Which of the following statements about cost
behavior are true?
a. Fixed costs per unit vary with the level of activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the relevant
range.
d. Total variable costs are constant within the relevant
range.
9-28
Semivariable Costs (Mixed Costs)
Mixed costs contain a fixed portion that is
incurred even when facility is unused, and a
variable portion that increases with usage.

Example: monthly electric utility charge
Fixed service fee
Variable charge per
kilowatt hour used
9-29
Variable
Utility Charge
Activity (Kilowatt Hours)
T
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U
t
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C
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Fixed Monthly
Utility Charge
Slope is
variable cost
per unit
of activity.
Semivariable Costs (Mixed Costs)
9-30
Separating Semivariable Cost

Accounting records typically show only the total cost and the
associated amount of activity of a semivariable (mixed) cost
item.

Separate mixed costs into their fixed and variable components
for cost estimation purposes. E.g. Budgeting, CVP analysis.

Methods:
High-low
Scattergraph method
Method of least squares (regression analysis)
Managerial judgments
9-31
Total Cost
=
Total Fixed Cost
+
Total Variable Cost
Total Cost
= Total Fixed Cost + Variable Rate x Output
Separating Semivariable Cost
The Cost Formula
9-32

The High-Low Method
Matrix, Inc. recorded the following production activity and
maintenance costs for two months:








Using these two levels of activity, compute:
1. the variable cost per unit.
2. the total fixed cost.
3. total cost formula.
Units Cost
High activity level 9,000 9,700 $
Low activity level 5,000 6,100
Change / Difference 4,000 3,600 $
9-33
Units Cost
High activity level 9,000 9,700 $
Low activity level 5,000 6,100
Change 4,000 3,600 $
1. Unit variable cost = = = $0.90 per unit
2. Fixed cost = Total cost Total variable cost
Using High activity level
Fixed cost = $9,700 ($0.90 per unit 9,000 units)
Fixed cost = $9,700 $8,100 = $1,600
3. Total cost = $1,600 + $.90 per unit
in cost
in units
$3,600
4,000
The High-Low Method
9-34
Used primarily for
external reporting
Used primarily for
internal decision making
Both formats report the same Operating Income!
Different Income Statement Formats
9-35
Total Unit
Sales Revenue 100,000 $ 50 $
Less: Variable costs 60,000 30
Contribution margin 40,000 $ 20 $
Less: Fixed costs 30,000
Operating income 10,000 $
The contribution margin format emphasizes cost behavior.
Contribution margin covers fixed costs
and provides for income.
Contribution Margin (CM) = Sales Variable Costs
The Contribution Margin Format
9-36
Contribution Margin Ratio (CMR) =
Contribution Margin
Sales
Contribution Margin Ratio (CMR) =
Contribution Margin
Sales
The Contribution Margin Format
Now that youve learnt Cost Behaviors and CM format income
statement, lets start making some decisions..
9-37
CVP for Decision Making
Cost-volume-profit (CVP) analysis is used to
answer questions such as:

How will income be affected if I increase selling
prices or reduce costs? (cost)
What will happen to profitability if I expand
capacity? (volume)
How much must I sell to earn my desired income?
(profit)
How will income be affected if I reduce selling
prices to increase sales volume?



9-38
CVP: Computing Break-Even Point
The break-even point (expressed in units of
product or dollars of sales) is the unique
sales level at which a company neither
earns a profit nor incurs a loss.
9-39
Volume in Units
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Break-even
Point
Profit
Loss
Break-Even Point
A Graphical Representation
9-40
Total Revenue
Total Cost
How Many Units Must We Sell to Break-Even?
Break-even
point in units
Fixed costs
Contribution margin per unit
Unit sales price - unit variable cost Unit sales price - unit variable cost
($50 $30 = $20 in previous example)
=
9-41
The break-even formula may also be
expressed in sales dollars.
Unit contribution margin
Unit sales price
How Much Sales Dollars to Break-Even?
Break-even
point in dollars
Fixed costs
Contribution margin ratio
=
9-42
ABC Co. sells product XYZ at $5.00 per unit. If
fixed costs are $200,000 and variable costs are
$3.00 per unit, how many units must be sold to
break even?
a. 100,000 units
b. 40,000 units
c. 200,000 units
d. 66,667 units
Computing Break-Even Sales Units
9-43
Use the contribution margin ratio formula to
determine the amount of sales revenue ABC must
have to break even. All information remains
unchanged: fixed costs are $200,000; unit sales
price is $5.00; and unit variable cost is $3.00.
a. $200,000
b. $300,000
c. $400,000
d. $500,000
Computing Break-Even Sales Dollars
9-44
Computing Sales Needed to Achieve
Target Operating Income
Break-even formulas may be adjusted to Break-even formulas may be adjusted to
show the sales volume needed to earn
any amount of operating income.
Break-even
Units =
Fixed costs + Target income
Contribution margin per unit
Fixed costs + Target income
Contribution margin ratio
9-45
Break-even
Sales Dollars =
ABC Co. sells product XYZ at $5.00 per unit. If fixed
costs are $200,000 and variable costs are $3.00 per
unit, how many units must be sold to earn
operating income of $40,000?
a. 100,000 units
b. 120,000 units
c. 80,000 units
d. 200,000 units
Computing Sales Needed to Achieve
Target Operating Income
9-46
Related Concept: Margin of Safety
Margin of safety is the amount by which sales may
decline before reaching break-even sales:


The dollar amount by which Sales can decrease before
the company incurs a loss.

Margin of safety = Actual sales Break-even sales
9-47
Total Per Unit Percent
Sales (500 bikes) 250,000 $ 500 $ 100%
Less: variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 $ 40%
Less: fixed expenses 80,000
Operating income 20,000 $
Business Applications of CVP
Consider the following information developed by the
accountant at Speedo, a bicycle retailer:
9-48
Should Speedo spend $12,000 on advertising to
increase sales by 10 percent?
Total Per Unit Percent
Sales (500 bikes) 250,000 $ 500 $ 100%
Less: variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 $ 40%
Less: fixed expenses 80,000
Operating income 20,000 $
9-49
500 550
Bikes Bikes
Sales 250,000 $ 275,000 $
Less: variable expenses 150,000 165,000
Contribution margin 100,000 $ 110,000 $
Less: fixed expenses 80,000 92,000
Operating income 20,000 $ 18,000 $
550 $300
$80K + $12K
No!
Income has decreased.
550 $500
Should Speedo spend $12,000 on advertising to
increase sales by 10 percent?
9-50
500 625
Bikes Bikes
Sales 250,000 $ 281,250 $
Less: variable expenses 150,000 187,500
Contribution margin 100,000 $ 93,750 $
Less: fixed expenses 80,000 92,000
Operating income 20,000 $ 1,750 $
625 $300
$80K + $12K
No!
Income has decreased even more.
625 $450
Now, in combination with the advertising,
Speedo is considering a 10 percent price reduction that will
increase sales by 25 percent.
What is the effect on income ?
1.25 500
9-51
500 750
Bikes Bikes
Sales 250,000 $ 337,500 $
Less: variable expenses 150,000 243,750
Contribution margin 100,000 $ 93,750 $
Less: fixed expenses 80,000 42,000
Operating income 20,000 $ 51,750 $
Yes!
The combination of advertising, a price cut,
and change in compensation increases income.
750 ($300+25)
$80K+$12K-$50K
750 $450
Now, in combination with advertising and a 10% price cut,
Speedo will replace $50,000 in sales salaries with
a $25 per bike commission, increasing sales by 50 percent
above the original 500 bikes. What is the effect on income?
1.5 500
9-52
CVP
Multiple Products

Different products have different selling prices,

Sales mix is the relative combination in which
a companys different products are sold.
Different products have different selling prices,
costs, and contribution margins.
If Speedo sells bikes and roller blades, how
will we deal with break-even analysis?
9-53
Multiple Products
Break-even in Sales Dollars
The overall contribution margin ratio is:
= 48% (rounded)
Bikes Roller Blades Total
Sales 250,000 $ 100% 300,000 $ 100% 550,000 $ 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin 100,000 $ 40% 165,000 $ 55% 265,000 $ 48%
Fixed exp. 170,000
Net income 95,000 $
$265,000
$550,000
9-54
Weighted
CMR
=
Bikes Roller Blades Total
Sales 250,000 $ 100% 300,000 $ 100% 550,000 $ 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin 100,000 $ 40% 165,000 $ 55% 265,000 $ 48%
Fixed exp. 170,000
Operating income 95,000 $
Multiple Products
Break-even in Sales Dollars
9-55
= $354,167
(combined sales)
$170,000
.48
BE Sales
Dollars
=
Description
Breakeven
Sales
% of
Total
Individual
Sales
Bikes $354,167 45.0% $159,375
Roller Blades $354,167 55.0% $194,792
Total units $354,167
$250k/550k = 45% $300k/550k = 55%
Multiple Products
Break-even in Units
9-56
Bikes Roller Blades Total Units
Sales 250,000 $ 300,000 $ 550,000 $ 500
Var. exp. 150,000 135,000 285,000 300
CM 100,000 $ 165,000 $ 265,000 $ 800
Fixed exp. 170,000
Net income 95,000 $
CM / unit
$265,000
800
= = $331.25 (combined)
BE Sales
Units
= =
FC $170,000
$331.25
513.20 (combined)
Multiple Products
Break-even in Units
Description
Number of
Units
% of
Total
Bikes 500 62.5% (500 800)
Roller Blades 300 37.5% (300 800)
Total sold 800 100.0%
9-57
BE Sales (Units)
= 513.20 (combined)
Description
Breakeven
Units
% of
Total
Individual
Sales
Units
Bikes 513.20 62.5% 321
Roller Blades 513.20 37.5% 192
Total units 513
Check List
Do you have a good understanding of:
ABC
Activity-based costing (ABC) methodologies
Difference between traditional vs. ABC costing
CVP
Types of cost behaviour
Breakout mixed costs by using High-Low method
Break-even and CVP computations
Break-even computations for single product and
multiple products
END END
9-58