hello and welcome to our presentation for chapter 7 on activity based costing which is titled um a tool to Aid decision-making so we're going to get into uh what activity based costing is and essentially just go over how it's a method for accounting to assign cost to products or Services based on activities and resources that go into producing them so unlike traditional costing methods that we've done all already they all that allocate overhead cost evenly across products and services um activity based costing identifies um some specific activities such as production runs machine setups quality inspections Etc and sign and then assigns those costs to the products based on how much each activity they consume so this uh type of costing system is really heavily based on the overhead cost and how that's allocated to the various products and how uh in costing them so we'll get into the details of this chapter um now okay so we have five learning objectives in this chapter um we're going to not cover the appendices so these are the five that are coming out of the main chapter so first we want to explain the activity based costing model and how it differs from traditional costing methods uh we want to assign cost to cost pools using the first stage allocation and then we're going to do the second stage allocation and then we'll um use activity based cost to compute product and customer margins and then we're going to compare the traditional method with the activity based costing method to see how um each type of system affects the overall cost of your products okay so what is activity based costing so it's a system Divi designed to provide managers with cost information for strategic and other other decisions um that potentially affect capacity so therefore they affect both fixed and variable overhead costs so the uh overall use of this system um of course it gives managers that information they need to make decisions but it's very like I said very heavily focused on how overhead costs are are treated and then uh also activity based costing is not going to be the only costing system that a company has they'll use ABC for internal decisions and internal reports but it wouldn't be available to external stakeholders so that's why companies will have to have two costing systems because when they're costing their products based on ABC they'll sometimes in include um costs that normally aren't included in product costs or they'll exclude product costs that are normally included in product cost so it's going to have a slightly different um outcome compared to um the traditional or absorption costing system that's used for um other Financial Accounting reports okay so as previously mentioned activity based costing is designed for internal decision- making so that differs from the traditional cost accounting approach that we've seen so far uh they're they treat non- manufacturing costs uh differently so sometimes they will include those costs in uh the product cost but only if there's a cause and effect basis on them uh and then on the other side of the coin some manufacturing costs may be excluded from product costs so activity based costing is a costing method that assigns over head and indirect cost to related products and services as we've done in the uh traditional method as well but this accounting method recognizes the relationship between cost overhead activities and Manufacturing product uh products assigning indirect cost to products uh less arbitrarily than traditional costing methods normally do so there has to be a a cause and effect relationship there uh the third point is that numerous overhead cost pools are used and uh with their unique measures of activity and overhead rates or activity rates as we will get to know them as may be based on a level of activity at capacity rather than on the budgeted level of of activity so traditional costing methods typically allocate overhead costs based on a single cost driver such as uh direct labor hours and we've seen machine hours as well so this can lead to inaccurate cost allocations um and that's why activity based costing was uh invented uh especially in businesses where there's diverse products and services that um consume overhead resources in different ways so these systems um unlike the traditional methods identify the specific activities that drive overhead costs and assign those costs to products based on their Assumption of those activities um so this is more accurate when it's um comes to calculating the true cost of producing each product or service so rather than using one overhead rate that will allocate costs that don't have a cause and effect relationship with those products the activity based costing is focused on those that actually are using the resources those activities that are using the resources uh to produce that product so um non-manufacturing costs and activity based costing again like we mentioned activity based costing determines the entire cost of the product not just its manufacturing cost so selling and and Min costs are allocated to the product if they're directly relate to the uh to it so that's the cause and effect side of things and then activity based costing assigns all overhead costs manufacturing and non-manufacturing um if it's applicable that can be reasonably traced to uh directly to the product so some examples of non-manufacturing costs that might be included are design and development costs um so things like product design prototyping engineering changes and testing so why why include these these costs are directly related to specific products or product lines so activity based costing can accurately assign these costs based on their complexity and resources uh marketing and sales costs can be also um included so things like advertising campaigns sales promotion trade shows website development Etc uh then also distribution and Logistics cost so things like shipping warehousing order fulfillment and delivery can also be included and then finally some customer service costs can also be included like handling customer inquiries processing returns providing technical support and things like that okay so again in a traditional costing system all manufacturing costs are assigned to products even manufacturing costs that are not caused by the products so this can cause the this uh issue with um inaccurate costing so ABC systems assign costs to products only if there's a good reason to believe that the costs would be affected by decisions concerning the product so that means there's some kind of cause and effect relationship um ABC products are only charged for the cost of capacity that they use so you're not getting these extra costs that aren't being caused by the product um so things like cost of idle capacity are a good example and they're treated as period cost so these arise when production resources are not fully utilized so some examples are depreciation on unused equipment salaries of idle workers uh utility cost of unused Factory space so those would not be included in the product costs um other costs might be excluded are costs with very minor impact so some of these might be technically traceable but it's not really worth the time to do so so they're so small that it um it really there's no benefit to that increased accuracy so um yeah so while these are these might be excluded from the product costs they still have to be included somewhere so you need to still track them in your overall cost management so they can be tracked and analyzed separately to understand their impact on profitability um in a different way so you can still make informed business decisions okay and this chart just shows the summary of what we've talked about so far in terms of how indirect costs are treated the top just shows the traditional absorption costing method and how the manufacturing and non-manufacturing costs are kept separate and then on the bottom it shows how the indirect cost for both manufacturing and in uh non-manufacturing costs can be applied to overhead for these products if there is a cause and effect relationship okay so overhead costs um cost pools the allocation of bases and activity based costing so they in activity based costing there are multiple cost pools that are used and they have a unique measure for each of these cost pools and this allows for better understanding of costs and managing them so the first thing we want to Define is what an activity is so it's U an event that causes the consumption of overhead resources so it can be any task action or process that consumes resources and is necessary for production to deliver uh the product or service um produce or deliver so these are the core components of activity based costing because they are are the basis for determining how costs should be allocated so some examples of activities are machine setups uh product design uh quality inspections packaging customer service um so instead of assigning cost based on Broad categories like overhead they use these individual activities um as their cost allocation method the next one is activity cost pool so it's a cost bucket in which costs related to a particular activity are accumulated so it's a collection of all those costs associated with a particular activity so it groups together the expenses related to performing a specific activity such as salaries equipment maintenance or supplies needed for activity so some uh a cost pool for something like a machine setups would include the labor equipment depreciation maintenance cost everything involved in setting up the machines for production so when you see the cost that's what the accumulated um amount is it's all all the cost related to that specific activity next we have activity measures so these are the cost drivers so it's um essentially the allocation base in an activity based costing system so these are the basis used to allocate the costs from an activity cost pool to the products or services so it reflects the factor that causes es or drives the cost of the activity to increase or decrease so the activity measure quantifies how much of an activity a product or service consumes it's also important to note that there are two types of trans um activity measures so there's transaction drivers and duration drivers so the transaction driver is a simple count of the number of times in activity occur and the duration driver is a measure of the amount of time needed for an activity so just to reiterate uh the transaction driver counts the number of times in activity happens so for example the number of production runs or customer orders processed uh then we have the duration driver which measures the amount of time spent on each activity so uh for example the hours required for a machine setup or the time required for inspections so the transaction driver is best used for activities that have fairly consistent time or resource requirements each time that they're performed whereas the duration drivers best for activities where the time requirement uh to complete each occurrence varies pretty significantly between one um occurrence and another so this type does provide better accuracy but it requires more detail tracking which can be problematic okay so overhead cost pulls again uh so activity based costing defines five levels of activities so these um largely don't relate to volume of products or units produced U whereas traditional cost systems usually rely on volume measures such as direct labor hours and machine hours to allocate their overhead costs um activity based costing doesn't necessarily have to use those okay so we'll talk more about the five levels of activities um in the next few slides but it's just important to note that the classification does help businesses better understand which activities are driving the costs and how much of the cost should be allocated to those activities okay so here's just a quick summary of what the um five levels of activity R so we have unit level batch level customer level organizational sustaining level and product level so we'll talk about each of those separately so the unit level activities are the ones that are performed for each individual unit that is produced so every time uh just think of direct cost that's probably the easiest way direct materials are a unit level cost because they're consumed each time one of the units is produced uh Bachelor L activities um so so the uh behavior of these unit level activities are that the more units that are produced the total cost of the unit level activities increases some examples are uh direct labor machine operation and direct materials and these costs are assigned based on consumption of resources for each individual unit the next are batch batch level activities so they're per formed each time a batch or group of products is produced so it doesn't matter how many numbers um with the number of units are in each batch uh it's based on the batch level itself so the cost is the same whether the batch contains one unit or 1,000 units the costs are incurred once uh per batch so regardless of the size of the batch so examples are machine setup so set up machines for production run uh quality inspections performed on a batch of units um a purchase order processing if somebody's ordering um a group of or a batch of units and these costs are allocated to batches of products then spread across the units within the batch next are product level activities so they're performed to support the production of an entire product line or type of product regardless of how many batches are units some examples of these are product design and development so that occurs once for each product line product testing or certification so something like um a prototype would be tested and certified uh maintaining product specific equipment for instance as well so if you're uh producing a product that can only be produced on one specific equipment in your plant then you need to track your costs at the product level um there so these all these are allocated to specific product line and spread across the units within that um product next we have customer level activities so these are performed to support specific customers or customer groups so they're not tied to production um or a specific product or batch um they're necessary for M maintaining customer relationships so there the costs here are incurred when um customer specific requirements occur so regardless of how many products are being sold to that customer so some examples are sales calls or Customer Support Services order processing and handling special U requests so these costs would not be traced to the product itself you'd have to trace them specifically to the customer level of activity uh finally we have organizational sustaining activities so these are the activities required to support the organization as a whole uh regardless of what products are produced so the costs are not tied to specific units batches or products um these costs are typically fixed and must be incurred to keep the business running so even if no products are being produced or sold so things like General administrations through like HR and accounting uh Building Maintenance or security and companywide advertising and corporate management so um our example in the textbook is classic brat brass and they make stanions and Compass Holdings for Yachts so I wanted to see what a stanion was and it's basically just the um poles that hold up the grading along the side of the boat and then the compass holding is just anything that could put you could put a compass in so there's no specific um look for what a compass holding looks like but let's look at our example for classic brass so here's their um first income statement before they make any changes and you can see that the company's not doing so well they're losing $1,250 so the manager here thinks that the issues issue is with the product costing and it's affecting the price that they can charge because their customer or their competitors are charging a much lower price for their stanions um so in our example we're going to see if an activity-based costing approach can do a better job than the traditional approach approach which is what we've seen what we see here in this income statement so just to note we have the sales on the top we're subtracting the direct uh costs as well as the overhead that's been applied so this manufacturing overhead to get our gross margin and then from our gross margin we're subtracting our total selling and admin expenses of 875,000 to get our operating loss in this case okay and this is the um explanation that the manager in the example tried to give to the department I guess the management accountant um to explain the general structure of activity based costing so the first um aspect of it is that cost objects are those items where costs accumulate costs occur and then uh from those cost objects we have activ activities that Spawn from them that are required to produce our product the activities will consume the resources and then finally this causes costs to be incurred so this is basically just a basic steps of how um costs are developed within an activity based costing system and how they're going to be uh eventually tracked and assigned okay so the steps for implementing an activity based costing system um an effective one anyways requires careful planning and execution so here's a breakdown of the steps so the first is to identify and Define the activities the activity cost Poes and the activity measures so this requires an analysis of the processes that are currently in place in the production facility so examining the manufacturing process and breaking down into distinct activities so these activities can include all the items that we've mentioned before like machine setups or Material Handling Quality Inspection production runs uh packaging and shipping so the level of detail is important here because the more detail you want the more activities you're going to end up and the more work that's going to be involved if you have too few activities you'll lose accuracy but if you have too many then the system becomes too complex um so you want to create those cost pools so you want to group the activities together and that means combine the activities that are similar C with similar cost drivers and put them into those similar cost pools so this simplifies the cost allocation method so for example if you have all the activities related to machine operation so things like setup maintenance running time Etc you can group them into one cost pool called machine costs uh finally there's the assignment of the cost so allocating the overhead cost to each pool that's uh step two in this process um so this involves identifying all the costs associated with the activities in that pool so anything from electricity to um supplies to supervisor salaries uh those could all go in there the um next is to identify the cost drivers um and that's going to be determining the cause and effect for each of each of these cost pools so identifying the factor that drives those costs so a lot of examples I've given already but machine hours number of setups number of inspections units produced could be all valid um cost drivers when you choose the appropriate cost driver you're going to select the ones that have a strong cause and effect relationship with the costs in that pool so next we have the uh step three which is the calculation of activity rates so for each cost pool we divide the total cost um by the total number of cost driver units so this gives you a cost driver rate so for example if you're using machine hours uh you would have a cost per machine hour if you're using setups you'd have a cost per setup then we're going to assign those costs uh overhead costs to our cost objects using the activity rates and the actual activity measures so just like we did in our uh previous chapter we allocated our cost based on a rate that we we determined before the accounting period and we use the actual measure of the cost driver within the accounting period so we're going to track how much each cost driver is consuming uh according to each product so for example how many machine hours were used by uh product a or how many machine hours are used by product B we're going to apply our cost driver rates so we're going to multiply the cost driver whatever it happens to be so if it's machine hours we multiply that by the number of um setups for instance could be one of our our items and then we'll allocate the overhead cost to that product based on the activity cost driver and the activity rate that we calculated and then um finally we want to produce management reports to see how our uh activity based costing method is performing compared to traditional methods and we'll talk more about that because we want to make sure we analyze the results of how ABC is doing to make sure that it's actually giving us the um outcomes that we're hoping hoping for and we can review that with not only managers but also other accountants and other stakeholders to make sure the system's accurate and useful um yeah so you want to also in this uh implementation consider what ABC software you're going to be using cuz it can get very expensive uh what kind of training you want to perform for your employees to make sure they're tracking their costs appropriately and their cost drivers and then finally making sure that our system is accurate you can do that by getting your information from multiple sources and by verifying information that uh you're provided for setting up your activities and your activity cost pools so let's start out with our um step one which is identifying and defining our activities so we'll do that in the next slide uh so we have at Classic brass they've determined um the activities that will be used as the foundation for the system so uh usually this is a very long and difficult process and there's a lot of choices that have to be made based on experience and judgment so the company that's coming in to set up the activity based costing system is usually going to be some consulting firm and they're going to implement this costing by interviewing those who work closely with the product and the production process um so that they can get accurate measures of what activities are actually being actually occurring and what activity cost poll should be set up so we want to make sure in this step that the activities are grouped together at the same level as well so like I said with the unit level activities those should be grouped together batch level activities should be grouped together um so the example given in the textbook is the number of customer orders received so that's likely to be highly correlated to the number of completed customer uh order shipped so these are two batch level activities that could be combined um into one cost pool or activity cost pool so in this table all the customer orders costs are included within the customer order cost pool so this includes taking uh and processing customer orders um and the activity measure is kept simple by using the number of customer orders as um the activity driver so we're going to talk about each of these different costs um activity cost pools separately so the first one is uh customer orders so each of these is an activity cost pool so we're going to assign all the cost of resources that are consumed by taking and processing customer orders you can think of each of these cost pools as containing a number of activities and a number of costs within them uh so next one is the product designs so this assigned all costs of resources consumed by designing the products um then we have order size which is assigning the costs and resources consumed as a consequence of the number of units produced and then we have customer relations so assigning all the costs associated with maintaining relations with customers so that looks like it's going to be a customer level activity so we'll see how that affects the um way that costs are allocated um and then we have finally the other cost pool uh which is assigned all the overhead costs that are not associated with the um product itself so this will be mainly the organization sustaining costs uh and the costs of unused or idle capacity so these costs will not be assigned to the products so remember we're only assigning the unit level batch level and product level cost to the actual product and then customer and um organization sustaining costs are not assigned to the products itself okay so this slide uh summarizes how our costs are going to be allocated so on the left hand side you see the direct costs those are materials labor and other items those are directly related to the cost objects we don't have to worry about um allocating them in any different way and then the assignment of overhead costs is going to be done in two stages so the first stage is to assign the cost to activity pools first so this this will be based on uh the cost pools that we've set up in our case we have uh five of them then we're going to um in the second stage allocate the cost from each activity to the various cost objects so that'll be to our different products so that includes both the um both of the products that classic brass produced produces okay so these are all the overhead costs um the annual overhead costs that classic brass intends to assign to its activity cost pools so right now the information is organized by Department because they came from the financial accounting um data and these are pulled from the general ledger so right now you can see that there's nine types of overhead costs and those will be allocated to activities during the first stage allocation and remember that the first stage allocation means a pro is a process of assigning the overhead cost to activity cost pools only so these allocations are based on judgment and knowledge like I said before and the managers and supervisors who work with the product so they're going to be imperfect uh they're essentially uh best estimates but they can still be used to cost the products more accurately than a traditional um approach we should also note that direct materials direct labor and shipping are not included here because classic brass's existing cost system can directly Trace those costs to the products or customer orders so let's see what the results are from the interviews with managers and supervisors related to um the allocation of costs across activities okay here we see a lot of percentages um we can see how the overhead costs are now allocated to the various cost pools based on knowledge and experience of the managers and supervisors who work with the products again the percentages are not going to be perfect but they're a best estimate of how overhead costs are being consumed um one thing in this chart to note is how 100% of the building lease is assigned to other the other category because it has um the company has a single production facility and they don't have any plans to to to expand so um any excess space the cost um is treated as an organization sustaining cost so it's required to keep the production going because that's all they have in terms of production facility and there's no way to avoid um even a portion of that cost if a particular product or customer is dropped so now these percentage distributions are now established so it's easy to allocate cost to activity cost pools um based on this knowledge so let's look at the results of the first stage allocation for classic brass okay here we can see how the um total amount of indirect Factory wages is $500,000 and we know that customer orders uh uses 25% of that and uh here we just basically take the 500,000 and multiply by 25% the 500,000 time 25% to get the 125,000 of um overhead cost that's going to be allocated to the customer orders um activity cost pool so for the customer orders cost pool we're going to have multiple areas that have cost distributed to it so that will include um the other production Department items it some other General admin and some other marketing items so the next one if we go down the list is the factory equipment depreciation and we can see that here it's going to be 20% so we're going to take the uh 300,000 multiply by 20% to get $660,000 allocated to customer orders uh from the factory equipment depreciation overhead value um overhead total so we would just keep doing that down on the list for all five activities and all nine um nine of the overhead amounts and you can see how this would get fairly repetitive if you had to do 45 calculations every time um we won't do we won't walk through each of them so I'll just show you what the final end result looks like so here we have all the numbers allocated now some sometimes there was 0% allocation so that's where the small line is that shows there's no value there if you think about the factory building lease which we referred to earlier its total of 80,000 was allocated all to other again for the reasons that we specified and uh now that we have all of these amounts we can get the total amount of activity cost or cost that is associated with activity each activity cost pool so from this um once all the calculations are made up we end up with a chart that looks like this uh where we now know the total amounts for each of the activity pools that we defined earlier and that this amount in the other category does not get traced to the products so when I'm referring to other category I'm referring to this category here so other will not be traced to the products these are kind of like the way we treated um non-manufacturing costs when we're doing the traditional method so these are the other overhead costs that won't be traced to the next or traced to the products at all because there's no cause and effect relationship between these costs and the products that we're producing so next let's look at calculating the activity rates so in order to calculate activity rates you really have to have an estimate again of what the different cost driver amounts going to be so when we created each of the activity pools we noted the activity measure for each of our activity rates we have to also estimate what the total activity is going to be uh for any given accounting period so in this case the activity based costing um Consulting team determined that the total activity for each cost pool with the help of the company's managers and supervisors are located here uh we can see that the numbers um that they came up with so we can use these numbers to divide into the total cost for each cost pool to come up with an activity rate so this will be the same process that we used when we were uh using our total overhead estimate and our total level of activity estimate to come up with our predetermined overhead rate so the steps are the same we're just doing it multiple times for each of our activity cost pools so here's our calculation for all the um activity rates so each of the um values gets a um activity rate except for other because we're not going to be applying or allocating any of that overhead to our um to our products the items that are listed um at the top the four activities and again when we look at customer relations we'll see that it's a customer related activity so we won't be tracing that directly to our products so the three that we're really worried about are the customer orders the product design activity pool and the order size so here we're going back to this chart where we're looking at the uh values now being entered so we're not going to worry about the directly traced items because those are going straight to the cost object which is each product we're looking at the overhead cost so we have a total of 8 1.81 million uh we're allocating them minus the other costs and customer relations level costs uh these three will be the ones allocated so you'll know that these will be left out and then the rate at which we're allocating them are listed here so $320 per order for customer orders 630 per design for product design and then three uh $19 per machine hour for order size so here we're actually using a volume based measure which is um allowed in activity based costing it's just not as common as it is for traditional costing and then finally the customer relations will be $1,470 per customer but of course that won't be allocated directly to the products uh because that's a customer level activity amount so let's next look at assigning these overhead costs to the various products and for the first product the standard stanions they require no new design so there won't be any um activity from the design side they have 30,000 units ordered um with 600 separate orders and each staning requires uh 35 minutes of machine time and a total of 17,500 machine hours so um this is very similar to what we did in chapter 3 where we allocated overhead cost for job order costing the only difference is that we're using multiple activity rates instead of one predetermined overhead rate um we can see from the stanions they don't require any new design so we really won't have any cost there and we don't have any orders were made and how well uh how many units were sold Etc and then we also have information from uh the custom Compass housing so we definitely have new design resources that are required there we have 400 orders 400 different custom designs for U each order and then we have uh 12,500 Compass housings that we produced for a total of 2500 machine hours so now we'll see how the activity based costing will allow us to assign these overhead costs based on these numbers that were given in our example okay so we start off by uh first saying that the customer level cost which we know as the customer um item will not be assigned to this um to the products because it's focused on tracking the cost at the customer activity level so we want only the unit level batch level and product level cost to be Associated here um this table shows us the results of the overhead assignment to the two products um you can also see that the total overhead cost for the two products is only $952,000 so that's adding the 524 500 plus the 47500 that's way less than the total overhead that we measured which was the 1.81 million ion and that's because we're not including the customer cost pool as well as the other cost pool so that explains why that that is um here you can see for each of our different activity cost pools we're taking the rate and multiplying by the actual activity that occurred during the account Peri accounting period to give us the um cost of that pool and then we add them together remember we didn't have any product design cost for the stanions cuz we're not designing them ourselves and then we have all the information down here for our Uh custom holding and the total cost uh total overhead cost um assigned there based on activity based costing so this is a chart taken out of the out of the textbook and it just shows the um various costs and how they're allocated for each of our two products and then in total and then we're uh including in here the overhead costs that are not assigned to products um so these are the customer relations that we talked about the over uh other and then the subtotal for them that's how we get to our total overhead cost so we'll investigate on the next slide how customer level costs are allocated because we don't want to ignore them we do need to keep that in mind when we're calculating what customers are profitable and which ones are not so we have the assign assed uh overhead assignment of overhead to customers so here for classic brass they work for just uh one of their 250 customers so this is Winward Yachts so here's some details about Winward Yachts they had a total of three orders um two orders 450 standard stanions per order and then one custom order so they used a total of 177 machine hours um and the 300 standard stanions required 75 machine hours and then the custom Compass housing only required two so let's go back to our um activity rates just to understand how we're going to be allocating to this company so we have customer orders are $320 per order we know they made three orders the customer design is 630 per design they made one design and then for machine hours for order size they had 177 machine hours so that's $19 per machine hour and then because they're one customer will be allocating $1,470 to them for um calculating their total overhead cost so here's what it looks like in terms of the um actual calculations and remember this is a customer um that we're trying to cost out not a product so we can include the customer relations cost and so they have a total of 6,400 $23 of um overhead allocated to them so what does that look like in terms of their um I guess profitability of as a customer we'll find that out in a few slides but let's first go back to our products and calculate their profitability or product margins so that we can prepare uh management reports for each of those products so here we have the first standard sanctions on the left hand side so we have their sales and their direct costs so here we're just including the direct cost for both of our products and in total we're not going to be calculating that uh overall profitability yet until we include our overhead costs uh that we included that we concluded or calculated in the previous step um we also have to include the sales data here to uh make sure that we're calculating a product margin for each of the products so let's see what we look like when we include the activity based costing that was assigned here we're now including that those costs on the bottom um so we had the customer orders order size and then for compasses we had both the same Cost Plus the product design so we're including those in total over here as well so let's do our calculation for each of our product margins based on the data that we have here so we can see here uh according to our allocation of overhead and our direct costs that we have total costs uh that are less than sales for standard St uh stanions so a pro a product margin of 96,000 250 and then for custom uh Compass Holdings we see that we have now a much higher amount than previous for allocated overhead which results in a negative product margin of 49,500 so the report shows that the standard stanions are profitable with a pro uh positive product margin uh but the custom Compass housings are unprofitable with a negative product margin so we're not going to include the costs uh in customer relations or other activities because they aren't caused by the two products um it's important to note that the customer relations costs are caused by the customers not the products themselves so we can also present this information in a different way by reconciling it with the overall operating income of the company so let's see what that looks like in terms of um the product margins and the company's net operating income so here we see the stanions are in a profitable range whereas the custom Compass housings are not and here the overall product margin for the two products is still good because the uh loss produced by custom Compass housings is relatively small from there we can then subtract our customer relations costs and our other overhead costs to get our net operating loss of $1,250 that's what we saw in the very first um income income statement for this company so this shows how each of the two products affect the overall operating income and we're also including here the customer relations and activity costs like I said and you'll note uh in the textbook if you see the version of this it said instead of net op operating loss it says net income still or operating income which it shouldn't it should say um net operating loss okay so now going back to our customer we want to look at Windward yachts and see if they're profitable for us so let's start off with the same process where we include the sales and the direct costs and then from there we can now include the um the costs that are allocated based on activity based costing so we're going to add those in we have the four costs that we calculated before and uh we want to take these four costs or these four costs now are included so we can calculate our overall profitability based on that so we have all the direct end our um overhead costs so adding them all together we get 10,651 of total costs um and compared with the sales amount we actually have a positive or profitable um customer it's not a huge amount but at least it's something it's fairly better so um we can see that Windward Yachts is actually profitable for classic brass so we can have more confidence in the customer profitability calculation because we we've only included the costs that are uh caused by that customer so a similar report could be prepared for each of the 250 customers that classic brass um actually has and that will allow them to focus on those customers that are more profitable and then maybe see about uh maybe no longer working with those customers that are um unprofitable so this was actually part of a um business strategy and it's called The Pumpkin plan so um it's based on people who grow pumpkins tend to um basically remove the smaller pumpkins throughout the growing process so all the focus of the vine is on the uh fewer and fewer pumpkins so those pumpkins get bigger and bigger um so just like you would for uh customer relations if you are removing the customers that are unprofitable you can focus more attention on those that are profitable and they will get uh larger become larger and larger in terms of Revenue and customer margin as they become fewer and fewer okay so moving on to the next learning objective and that's comparing traditional and activity based costing um approaches so um what we want to do is basically use the same information that we did for our activity based costing example and just use a traditional approach and then we'll compare the two values so the product um we're going to have the same two products we're have the same direct costs uh so those are not going to change between the two examples the next part is where the change is going to occur because we have the manufacturing overhead costs remember this is the manufactur these are the manufacturing costs it doesn't include the selling and admin overhead costs that we included before so we have $1 million in estimated overhead costs uh for manufacturing and then we have our cost driver which we're going to use uh machine hours is estimated to be $20,000 for the um accounting period whatever the whatever they're using probably a year um so we can calculate our plantwide overhead rate based on those two values and since we only have one Department that produces two products we don't really need to worry about departmental rates and our predetermined overhead rate here is $50 per machine hour so this is the same as we did in chapter five for job order costing okay so when we allocate our um overhead to these two products we see that the um amount of machine hours used is the volume based um allocation driver and we have our rate that we calculated previously and that gives us the overhead that we're going to allocate to each of our two products so much simpler in terms of How It's allocated than the activity based costing method uh we can now calculate the total product cost based on these uh this allocation so for our standard uh stanions we see that our manufacturing overhead of 850 or 75,000 is uh traced here and then our Compass housings amount is uh traced here so that gives you your total manufacturing overhead of 1 million and we from here we can calculate the product margin so for stanion it's 615,000 and for housings it's 258,000 and we'll compare that with the activity based costing amount shortly and then finally for the selling and admin expenses uh these are the values where they came from so that um is subtracted from the 32 uh the 873 850 of gross margin um to get our net operating loss of $1,250 which we we saw on the initial um income statement so um much of the over or under costing is related to product volumes so we see here the traditional cost system over costs the standard stanions and reports a lower Pro um product margin than it did with the um activity based costing so it's actually $290,000 lower um under the traditional method and then for the traditional cost system under for Uh custom Holdings is actually providing a higher product margin than activity based costing does by 307,000 that's where the 258,000 comes in here so this is the lower volume item and standard stanions is the higher volume item so we can say that the traditional cost system will overcost the higher volume product when compared to activity based costing and we can say that the traditional costing system will under cost the lower volume Prof um product when compared to activity based costing um so we can see that it's quite a big difference between um the product margins for each of the two different types of value uh system so what what are the difference main differences between um ABC and product uh traditional product cost ing so first um the first main difference is that traditional costing allocates all manufacturing overhead to products whereas activity based costing only assigns that which is uh directly traced to those products so everything else that's not directly traceable goes to the other uh the allocation cost pool that we call other next we have uh traditional costing allocates all manufacturing overhead cost using a volume related allocation base whereas activity based costing will use uh a non-volume related allocation base so this is somewhat true uh there are instances where activity based costing will use a volume based approach uh if necessary as long as it has is the best predictor of cause and effect so machine hours are a volume related allocation based that may or may not reflect the actual causes of these costs and activity based costing uses more unique activity measures which are not volume related to allocate cost to each activity pool so they try to use still machine hours um but try not to make it as a a volume based uh measure although that's kind of the way it is uh but they will only use it if it has that cause and effect relationship so it is going to be more accurate and more unique and specific to that activity so next we have uh traditional costing disregards selling in admin expenses because they're classified as period costs but activity based costing will um include them if they are uh causing the cost to be incurred in that activity so if they can be directly traced to that activ AC ity then they will be used even if they are a selling and admin or a period expense okay so here's some just some key differences between activity based costing and traditional costing so cost drivers uh activity based costing systems use multiple cost drivers while traditionals usually only use one the accuracy of the activity based costing is higher um for the allocation of overhead costs uh um the complexity of activity based cost are more complex to implement and maintain and activity based costing systems can provide better information for decision-making especially internal decision- making such as pricing and products mix decisions okay the uh last part of the chapter mentions activity based management which would be used in conjunction with activity based costing to improve processes and to reduce costs um the textbook also mentions the theory of constraints which will be discussed more in chapter 12 the theory of constraints analyzes production processes um to try to find out where the bottlenecks are and then makes changes to reduce those effects um benchmarking is also another way to utilize information um in activity rates so it's an approach to identifying the activities with greatest room for improvement and is based on comparison between the performance of the company or Department with the performance of another department or another company so some companies use internal benchmarking While others will use external benchmarking so this uh most companies do not use activity based costing for external reporting um which we mentioned before mainly because it doesn't um track the costs of your products in a way that is um required by generally accepted accounting principles so in general the external reports are usually less detailed than internal reports uh it might be difficult to make changes to the company's accounting system so they will maintain two systems of uh cost measurement activity based costing doesn't conform to generally accepted accounting principles as I mentioned and then Auditors may be uh suspect of the subjective allocation of the activity based costing process so it's highly important that um financial accounting is reliable and uh repeatable so they have they if it's um too subjective like activity based costing is then they could have two different results based on who is actually being interviewed so that's why Auditors don't uh wouldn't like to have to audit an activity based costing system okay so then the next SL SL just summarizes everything that we've done so the different items and their different treatments under traditional and activity based costing systems so it's important to go through this chart and to understand uh what the differences are between traditional and ABC and I can guarantee that there will at least be one question on the midterm based on this um slide so make sure you Commit This to Memory so finally some of the benefits um improve cost control better pricing decisions more informed product mixed decisions enhanced understanding of cost Behavior so there um there are a lot of benefits to activity based costing there are however some limitations so it's it uses substantial resources to implement it and maintain it uh there will often be internal resistance to it because people don't like change all that much there's um often a desire to fully allocate all the cost to the products and then there's potential for Mis interpretation and then it doesn't conform to Gap so you usually require two costing systems so that's sort of associated with the use of substantial resources um so a lot of times when the these systems are implemented you'll have to hire a consultant to come in and do that for you for you and that gets very expensive and it's very highly data intensive so you have to make sure you have the right software and system storage and um Hardware to be able to uh keep all that data and then also the big part was the subjectivity of it so you could have two different implementations in the same company and end up with completely different results depending on who you speak with and uh who's giving you the information so those can be some of the issues so just to sum up the chapter chapter what we talked about uh we use um under traditional cost accounting methods all manufacturing costs are included in product costs even if they're not causing or not caused by those products um whereas activity based costing will estimate the cost of the resources consumed by the cost objects um based on a cause and effect relationship ABC is obviously concerned with overhead head so it includes both manufacturing and um selling and admin or non-manufacturing overhead depending on whether it's a cause and effect relationship we want to uh we walk through the all the steps to develop an ABC system so the companies typically choose a small set of activities to summarize much of the work that's performed in the overhead department so uh they try to group them together and make sure they're grouped in the same uh um activity levels remember we had unit level batch level product level customer level and um organization sustaining level so we want to make sure that if you have two activities that are both are are not on the same activity level you don't group them into the same uh activity cost pool um an activity rate is computed for each of the cost pools that we create and then um all the overhead costs are at some assigned to those uh different cost pools or distributed to them then using the activity rates we will allocate the activity cost pool um overhead to our products based on what their use is or uh of the activity cost driver so we also want to make sure that we're um we know that the customer level cost project um um cost objects are not treated the same way as the product cost objects so keep those separate in the overall cost calculations so that includ that concludes our um slide presentation for chapter 7 I apologize for all the background noise and my voice I'm recovering hopefully will be recovered soon and um I I will make a post about the midterm coming up and also about uh some of the questions that are on connect