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

Lecture date: 18 March, 2013

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Lecture Outline
I. ACTIVITY-BASED COSTING (ABC) a. b. c. Traditional Plant-wide, Single Overhead Rate ABC Multiple Overhead Rates Comparison between Traditional Costing vs. ABC

II.

COST-VOLUME-PROFIT ANALYSIS (CVP)

a. b. Costs and Cost Behaviors Contribution Margin Income Statement

c.
d.

Break-even Analysis
Business Applications of CVP

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I. Activity-Based Costing (ABC)

RECAP: Manufacturing Cost Flow
Charge direct material and direct labor costs to each job as work is performed Apply overhead to each job using a predetermined rate (POHR)

Direct Materials
(actual) Direct Labor (actual) Manufacturing Overhead (estimate)

Job No. 1
Job No. 2 Job No. 3

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Traditional Costing System

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 laborintensive 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?
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Traditional Costing System

Indirect Costs

Overhead Cost
Single Plant-Wide Overhead Rate

Cost Allocation Base Cost Objects

Product 1

Product 2

Product 3

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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

How to improve OH allocation?

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Traditional vs. ABC Method

ABC Costing

Traditional Costing
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ActivityBased Costing

In the ABC method, we recognize that many activities within a department drive overhead costs.
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Activities and Cost Pools

Activity An event that causes the consumption of overhead resources.
Repair and Maintenance of Equipment $100,000

Activity Cost Pool

A cost bucket in which costs related to a single activity measure are accumulated.
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Multiple Overhead

Categories

POHR Multiple POHR

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Cost Pools and Cost Drivers

Cost Driver: activity that leads to the incurrence of costs
Cost Pools
Materials purchasing Materials handling Personnel processing Equipment depreciation Quality inspection Indirect labor for equipment setups Engineering costs for product modifications

Cost Drivers
Number of purchase orders Number of materials requisitions Number of employees hired or laid off Number of products produced or hours of use Number of units inspected Number of setups required Number of modifications

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ABC: 5-step Computation

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:
Estimated overhead costs in activity cost pool Rate = Estimated number of activity units

5. Assign costs to products:

Overhead Rate

Actual

Activity
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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 Model $ 150 16 1.6 hours 5,000
1

Direct Material Direct Labor Cost Direct Labor Time Expected Volume (units)

Regular Model $ 112 8 0.8 hours 40,000

: 8

Lets determine the unit cost of each model using traditional costing methods.
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Traditional Costing
Direct Labor Hours 8,000 32,000 40,000

Deluxe Model Regular Model

5,000 units @ 1.6 hours 40,000 units @ 0.8 hours

Total Direct Labor Hours (DLH)

Overhead = Estimated overhead costs Rate Estimated activity base = $2,000,000 40,000 DLH $50 per DLH
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Traditional Costing
ABC will have different overhead per unit.
Direct Material Direct Labor Manufacturing Overhead $50 per hour 1.6 hours $50 per hour 0.8 hours Total Unit Cost

Deluxe Model $ 150 16 80 $ 246

Regular Model $ 112 8

40 160

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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.
Step 1 Identify Activities Step 2 Assign cost to Cost Pools Step 3 Identify Cost Driver

Activity Cost Pool Purchasing Scrap Rework Testing Machine Related Total Overhead

Overhead Cost for Activity $ 84,000 216,000 450,000 1,250,000 $ 2,000,000

Cost Driver Orders Orders Tests Hours

Units of Activity Deluxe Regular 400 800 300 600 4,000 11,000 20,000 30,000
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Activity-Based Costing
400 deluxe + 800 regular = 1,200
Step 4 Compute POHR
Rate $ 70 per order $240 per order $ 30 per test $ 25 per hour

Activity Cost Pool Purchasing Scrap Rework Testing Machine Related Total Overhead

Cost Driver Orders Orders Tests Hours

Overhead Cost for Activity $ 84,000 216,000 450,000 1,250,000 $ 2,000,000

Units of Activity 1,200 900 15,000 50,000

Rate = Overhead Cost for Activity Units of Activity

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Activity-Based Costing
Step 5 Allocate cost to product
Deluxe Model Actual Cost Units of Allocated Activity to Product 400 $ 28,000 300 ? 4,000 ? 20,000 ? ? Regular Model Actual Cost Units of Allocated Activity to Product 800 $ 56,000 600 ? 11,000 ? 30,000 ? ?

Activity Cost Pool Purchasing Scrap Rework Testing Machine Related Total Overhead

Rate $ 70/order $240/order $ 30/test $ 25/hour

Cost Allocated to Product = Rate (POHR) x Actual Units of Activity

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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.

Activity Cost Pool Purchasing Scrap Rework Testing Machine Related Total Overhead

Rate $ 70/order $240/order $ 30/test $ 25/hour

Deluxe Model Actual Cost Units of Allocated Activity to Product 400 $ 28,000 300 72,000 4,000 120,000 20,000 500,000 $ 720,000

Regular Model Actual Cost Units of Allocated Activity to Product 800 $ 56,000 600 144,000 11,000 330,000 30,000 750,000 $ 1,280,000

Cost Allocated to Product = Rate (POHR) Actual Units of Activity

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Activity-Based Costing

Overhead Costs Assigned Products: Overhead Costs Assigned toto Products: Deluxe 5,000 units == $144 per unit DeluxeModel Model$720,000 $720,000 5,000 units $144 per unit Regular $1,280,000 40,000 units == $32 per unit RegularModel Model $1,280,000 40,000 units $32 per unit
Deluxe Deluxe Model Model $ 150 16 144 $ 310 Regular Regular Model Model $ 112 8 32 $ 152

Direct Direct Materials Materials Direct Direct Labor Labor Manufacturing Overhead Manufacturing Overhead Total TotalUnit UnitCost Cost

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Traditional Costing vs. ABC

Cost Distortions
Traditional Costing Deluxe Regular Model Model $ 150 $ 112 16 8 80 40 $ 246 $ 160 ABC Deluxe Model $ 150 16 144 $ 310 Regular Model $ 112 8 32 $ 152

Direct materials Direct labor Overhead Total cost

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.
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ABC Consumption Ratios

Proportion of each activity consumed by a product.
Activity Cost Pool Purchasing Scrap Rework Testing Machine Related
Physical Units

Cost Driver Orders Orders Tests Hours

Deluxe 400 300 4,000 20,000

Activity Levels Consumption Consumption Ratio Regular Ratio 33% 800 67% 33% 600 67% 27% 11,000 73% 40% 30,000 60%

Deluxe
5,000 1 11% :

Regular
40,000 8 89%

Deluxe model consumes more overhead resoures and should be allocated more overhead costs!
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Advantages and Disadvantages of ABC

Advantages Disadvantages

More accurate overhead cost allocation

More effective overhead cost control Many uses: service firms, customer profitability studies (eg, marketing/distribution/ customer service costs)

Costs to implement and maintain

Complexity may hamper support for implementation

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II. Cost-Volume-Profit Analysis (CVP) Understanding 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.

Fixed Costs Variable Costs Semivariable / Mixed Costs

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Fixed Costs
Monthly Basic Telephone Bill per Local Call
Total FC Monthly Basic Telephone Bill FC per unit

Number of Local Calls Total fixed costs remain constant as activity increases.

Number of Local Calls Cost per call declines as activity increases.

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Variable Costs
Total Long Distance Telephone Bill Cost per Minute Total VC VC per unit

Minutes Talked

Minutes Talked

Total variable costs increase as activity increases.

Cost per Minute is constant as activity increases.

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Variable Cost vs. Fixed Cost

Variable Costs Per Unit Remains the same even when activity level changes. Changes as activity level changes. Fixed costs Changes as activity level changes. Remains the same over wide ranges of activity.

Total

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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.

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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

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Semivariable Costs (Mixed Costs)

Slope is variable cost per unit of activity.
Variable

Total Utility Cost

Utility Charge
Fixed Monthly Utility Charge Activity (Kilowatt Hours)
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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

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Separating Semivariable Cost

The Cost Formula

Total Cost = Total Fixed Cost + Total Variable Cost

Total Cost = Total Fixed Cost + Variable Rate x Output

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The High-Low Method

Matrix, Inc. recorded the following production activity and maintenance costs for two months:
High activity level Low activity level Change / Difference Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

Using these two levels of activity, compute: 1. the variable cost per unit. 2. the total fixed cost. 3. total cost formula.

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The High-Low Method

High activity level Low activity level Change
1. Unit variable cost =

Units 9,000 5,000 4,000

Cost $ 9,700 6,100 $ 3,600

in cost = $3,600 = $0.90 per unit in units 4,000 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
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Different Income Statement Formats

Used primarily for external reporting

Used primarily for internal decision making

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Both formats report the same Operating Income!

The Contribution Margin Format

Sales Revenue Less: Variable costs Contribution margin Less: Fixed costs Operating income Total $ 100,000 60,000 $ 40,000 30,000 $ 10,000 Unit $ 50 30 $ 20

The contribution margin format emphasizes cost behavior.

Contribution margin covers fixed costs and provides for income.

Contribution Margin (CM) = Sales Variable Costs

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The Contribution Margin Format

Contribution Margin Ratio (CMR) = Contribution Margin Sales Now that youve learnt Cost Behaviors and CM format income statement, lets start making some decisions..

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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?

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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.

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Break-Even Point A Graphical Representation

Total Revenue

Costs and Revenue in Dollars

Break-even Point

Profit
Total Cost

Loss

Volume in Units

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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 ($50 $30 = $20 in previous example)

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How Much Sales Dollars to Break-Even?

The break-even formula may also be expressed in sales dollars.

Break-even point in dollars

Fixed costs Contribution margin ratio

Unit contribution margin

Unit sales price
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Computing Break-Even Sales Units

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

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Computing Break-Even Sales Dollars

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. b. c. d. $200,000 $300,000 $400,000 $500,000

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Computing Sales Needed to Achieve Target Operating Income

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
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Break-even
Sales Dollars =

Computing Sales Needed to Achieve Target Operating Income

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

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Related Concept: Margin of Safety

Margin of safety is the amount by which sales may decline before reaching break-even sales:
Margin of safety = Actual sales Break-even sales

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

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Business Applications of CVP

Consider the following information developed by the accountant at Speedo, a bicycle retailer:

Sales (500 bikes) Less: variable expenses Contribution margin Less: fixed expenses Operating income

Total $ 250,000 150,000 $ 100,000 80,000 $ 20,000

Per Unit $ 500 300 $ 200

Percent 100% 60% 40%

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Should Speedo spend $12,000 on advertising to increase sales by 10 percent?

Sales (500 bikes) Less: variable expenses Contribution margin Less: fixed expenses Operating income

Total $ 250,000 150,000 $ 100,000 80,000 $ 20,000

Per Unit $ 500 300 $ 200

Percent 100% 60% 40%

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Should Speedo spend $12,000 on advertising to increase sales by 10 percent?

Sales Less: variable expenses Contribution margin Less: fixed expenses Operating income

500 Bikes $ 250,000 150,000 $ 100,000 80,000 $ 20,000

550 $500 550 $300

$80K + $12K

550 Bikes $ 275,000 165,000 $ 110,000 92,000 $ 18,000

No! Income has decreased.

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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 ?

Sales Less: variable expenses Contribution margin Less: fixed expenses Operating income

500 Bikes $ 250,000 150,000 $ 100,000 80,000 $ 20,000

1.25 500

625 $450
625 $300

$80K + $12K

625 Bikes $ 281,250 187,500 $ 93,750 92,000 $ 1,750

No! Income has decreased even more.

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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?
500 Bikes $ 250,000 150,000 $ 100,000 80,000 $ 20,000 750 Bikes 750 $450 $ 337,500 243,750 750 ($300+25) $ 93,750 42,000 $80K+$12K-$50K $ 51,750
1.5 500

Sales Less: variable expenses Contribution margin Less: fixed expenses Operating income

Yes! The combination of advertising, a price cut, and change in compensation increases income.
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CVP
Multiple Products

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?

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Multiple Products Break-even in Sales Dollars

The overall contribution margin ratio is:
Sales Var. exp. Contrib. margin Fixed exp. Net income $ $ Bikes 250,000 100% 150,000 60% 100,000 40% Roller Blades $ 300,000 100% 135,000 45% $ 165,000 55% Total $ 550,000 100% 285,000 52% $ 265,000 48% 170,000 $ 95,000

Weighted
CMR

$265,000 = $550,000

= 48% (rounded)

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Multiple Products Break-even in Sales Dollars

Sales $ Var. exp. Contrib. margin $ Fixed exp. Operating income $250k/550k = 45% Bikes 250,000 100% 150,000 60% 100,000 40% Roller Blades $ 300,000 100% 135,000 45% $ 165,000 55%
$300k/550k = 55%

Total $ 550,000 100% 285,000 52% $ 265,000 48% 170,000 $ 95,000

BE Sales

$170,000 = .48 Dollars

Description Bikes Roller Blades Total units

= $354,167 (combined sales)

% of Total 45.0% 55.0% Individual Sales $159,375 $194,792 $354,167
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Breakeven Sales $354,167 $354,167

Multiple Products Break-even in Units

Sales Var. exp. CM Fixed exp. Net income Bikes $ 250,000 150,000 $ 100,000 Roller Blades $ 300,000 135,000 $ 165,000 Total $ 550,000 285,000 $ 265,000 170,000 $ 95,000 Units 500 300 800

CM / unit =

$265,000 800

= $331.25 (combined)

BE Sales
Units

FC $170,000 = 513.20 (combined) $331.25

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Multiple Products Break-even in Units

Description Bikes Roller Blades Total sold Number of Units 500 300 800 % of Total 62.5% 37.5% 100.0% (500 800) (300 800)

BE Sales (Units)

513.20 (combined)
% of Total 62.5% 37.5% Individual Sales Units 321 192 513
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Description Bikes Roller Blades Total units

Breakeven Units 513.20 513.20

Check List
Do you have a good understanding of: ABC

Activity-based costing (ABC) methodologies

Difference between traditional vs. ABC costing 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
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CVP