In this managerial accounting lecture video, Activity-Based Costing examples with discussion on cross-subsidization and comparison of simple costing and ABC are discussed (transcript is below).
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Brian Routh: So I believe last time we got to this problem, and this is where we stopped Is this correct for everyone, where we are in the notes, yes okay very good.
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Brian Routh: So cougar testing laboratories does heat testing and stress testing on materials and operates at capacity under its current simple costing system.
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Brian Routh: Now, remember, at this point, we have two types of systems that we're looking at we've got simple costing which used one allocation right.
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Brian Routh: And we do Activity Based costing which is multiple activity rates Okay, so you got to be able to pick out this information.
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Brian Routh: So currently we're using a simple costing system that's what we currently are using cougar aggregates all operating cost of $1,280,000 into a single overhead costs pool.
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Brian Routh: Cooper calculates a rate per test our of $16 okay so that's our current simple costing rate that we use to allocate all call $16 and the way we got, that is to take our total estimated overhead of 1,280,000.
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Brian Routh: And we're allocating it based on test hours, so we divided by the total test hours so that's nothing new that's the way we know how to create our rate and allocate the cost.
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Brian Routh: Alright, so he tests uses 50,000 test hours in stress test uses.
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Brian Routh: 30,000 test hours late them Claire cooper's controller believes that there is enough variation in test procedures and cost structures to establish separate costing and billing rates for heat test and stress test.
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Brian Routh: The market for test services is becoming competitive without this information and we saw that last time we saw how having miss costed information.
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Brian Routh: can cause us to go out of business okay so that's what they're thinking here is their competition is getting or the competition is getting more fierce so they have to be cost competitive.
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Brian Routh: Alright, so clear divides cooper's cost and before activity cost categories, the first one.
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Brian Routh: Our direct costs okay so keep that in mind, those are direct costs, we know direct costs are directly traceable back to the products there's nothing we have to allocate there.
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Brian Routh: Though they'll they'll last three of those these are indirect or overhead costs so those we're going to have to allocate on some method now once we do all this, the ultimate question is.
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Brian Routh: Once we calculate the cost per test our we're going to explain the reasons why these numbers differ from the $16 per test our, then we should already probably know the answer that even without singing.
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Brian Routh: The race that we're going to calculate under Activity Based costing but that's the ultimate goal in this problem okay it's to compare simple costing with Activity Based costing and what the ultimate.
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Brian Routh: outcome could possibly be alright so let's go to the little spreadsheet that you should have this in the lecture notes, if you print these out.
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Brian Routh: Right it's not.
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Brian Routh: got a lot of writing today but.
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Brian Routh: Hopefully, have these in front of you So the first thing we're going to do is do the direct Labor which is given to us, they tell us in the story.
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Brian Routh: So I brought the pertinent information here in this little blue box, this is just direct Labor we're going to do these in pieces okay so right now we're just doing the direct direct Labor part.
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Brian Routh: They tell us that total direct Labor is $240,000 that's total these calls can be directly traced to heat test and stress test so 180 3000 is going directly to heat tests.
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Brian Routh: And 60,000 is going directly to stress test.
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Brian Routh: Now, remember our ultimate goal is to get a per test our so notice I have her hour for each, so this is almost like two columns within this one column here, and this is the number we're ultimate looking for.
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Brian Routh: Because that will be the total cost of each test our once we're finished.
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Brian Routh: So now, I need this direct Labor on a per hour basis well they tell me in the story we go back.
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Brian Routh: They tell me that there are 50,000 heat tests hours and stress test uses 30,000 test hours so i'm going to write this, and so I don't forget it so 50,000 test hours.
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Brian Routh: And stress test uses.
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Brian Routh: 30,000.
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Brian Routh: test hours.
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Brian Routh: So that was given to us.
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Brian Routh: Now, remember, I wanted to own a per hour basis so to get that I would take the 183.
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Brian Routh: And divide it by the 50,000 test hours, and that would give me that on a per hour basis i'll take over here the 60,000 divided by 30,000 hours, and that when I can do in my head that's $2 per test our somebody want to give me the heat test per per hour, please.
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Brian Routh: Now, in that one we didn't have to calculate a rate right because direct costs are directly traceable back to a product now in the next three we're going to have to follow our process step one calculate the rate allocate the cost okay so two steps need to process all right.
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Brian Routh: So let's go to the equipment related costs.
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Brian Routh: Right.
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Brian Routh: OK so again step one and i'm gonna do it down here to give myself enough enough room is to calculate the rate pay for this particular activity.
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Brian Routh: equipment related costs, so the information, again I put here in the Center equipment related to cost a $400,000 are allocated to heat tests and stress test on the basis of test hours So the first thing we have to figure out the allocation base in this case it actually is test hours.
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Brian Routh: Okay that's our allocation base so we want to take our total cost so 400,000.
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Brian Routh: and divided by our total allocation base well in this case is test hours so again, we have 50,008 test hours and 30,000 hours to stress test there's 80,000 hours total.
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Brian Routh: And that will give me my rate.
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Brian Routh: $5 I think.
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Brian Routh: check my math on that.
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Brian Routh: Think that's right perfect Thank you.
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Brian Routh: $5 per test our.
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Brian Routh: that's step one now we use the rate to allocate the cost and we're only doing equipment related costs right now okay so.
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Brian Routh: We won't like that $5 rate and multiply it times the activity consumed by each type of test, so he tests took 50,000 hours.
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Brian Routh: And that's $250,000 I believe.
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Brian Routh: And my rate times the consumption of stress test hours was 30,000 hours.
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Brian Routh: And that's 150,000 leads.
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Brian Routh: So we're part of the way there.
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Brian Routh: Now we need to take and get our her our.
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Brian Routh: Number so again the 250.
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Brian Routh: divided by the 50,000 hours.
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Brian Routh: Whatever that happens to be in this case it's actually the same as the rate, because the test hours is our allocation base but that's not always going to be the case, particularly these next two okay so that's not always going to be the right number.
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Brian Routh: And then we're going to do the same thing over here under $50,000 divided by the total hours and that's $5 steel okay.
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Brian Routh: Now again.
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Brian Routh: Taking this number dividing it by that to get my rate okay that's what we're doing in every single one.
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Brian Routh: Right that's the process, take the total divided by the number of hours to get.
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Brian Routh: The cost per hour.
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Brian Routh: Any questions on this process.
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Brian Routh: Thank you you're very welcome so remember take the rate.
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Brian Routh: Times whatever it's the activity is consuming Okay, so in this case, this heat tests are consuming 50,000 test hours, the stress tests are consuming 30,000 test hours.
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Brian Routh: Because for equipment related cost the cost driver was test hours, but for the next two types of cost test, ours is not the allocation base, you have to be careful okay any other questions so far.
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Brian Routh: Alright, so here's the rest of the problem.
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Brian Routh: And i'm actually gonna put you into breakout rooms here really quickly for just a few minutes now we need to finish this together, and then i'll bring us back here in just a minute.
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Brian Routh: So just to confirm when I see you all in breakout rooms, you can no longer see my screen is that right okay.
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Brian Routh: Okay, so I think I got to speak with all of the the teams at least briefly about this and if I missed you I apologize.
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Brian Routh: So here's what we stopped as a as a group so let's move on to setup costs so remember.
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Brian Routh: Since Chapter three when we start to about job costing we know, the first step is to calculate the rate, the second step is to take the rate and allocate the cost.
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Brian Routh: Well, that would give us the cost in this total column, can you see my mouse moving moving at all you can okay very good so that would give us this number in the total column so after this point that's all old stuff.
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Brian Routh: This problem actually wants you to go a step further it won't sit on the basis of test our so we have to then take this amount divided by the total of.
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Brian Routh: test hours for this particular test, and that would give us our rate so you'd have to do that for each one okay so let's go ahead and look at setup costs.
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Brian Routh: So setup costs, the total was $385,000.
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Brian Routh: This is the amount of calls that we're trying to allocate and they're allocated based on set up hours and he tests require 13,500 setup hours stress test required 4000 set up our.
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Brian Routh: Step one is to calculate the rate, so you take your total overhead costs in this case indirect cost divided by total allocation base so 17,500 hours gives us $22 per set up our so again it's it's.
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Brian Routh: pretty important to go ahead and stick this verbiage, at the end of your rate because that's going to help you see the rest of it Okay, so this is $22 per set up our.
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Brian Routh: So then we're going to multiply it times the number of setup hours consumed by each test, so he tests consumed 13,500 hours gives us $297,000.
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Brian Routh: But, again I want that, on a per test basis, well, the number of test hours for the heat test were 50,000 hours so $297,000 divided by 50,000 hours gives me $5 and 94 cents per hour.
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Brian Routh: For stress test my rate was still $22 per set up our you multiply it times the number of setup hours consumed by stress test which were 4000 hours that gives me a total cost of $88,000.
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Brian Routh: divide that by the number of hours consumed by the stress test which were 30,000 hours gives me the cost per test our for our setup costs three $2 and 93 cents per hour okay any questions i'll set up costs.
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Brian Routh: everybody's okay.
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Brian Routh: All right, let's look at cost of designing I won't go through this one as in detail, as I did the other ones just for sake of time, so look at cost of designing test, and let me know if you have any questions about that one, so we get $3 and 36 cents per test our.
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Brian Routh: For heat test and $2 and 80 cents per hour for stress test.
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Brian Routh: And our rate was $60 per design test our to get our total numbers here.
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Brian Routh: Any questions on the process here on cost of designing.
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Brian Routh: um I just had a quick question for like thing the.
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Brian Routh: But very good question but theoretically, we could but it wouldn't really make any productive information for us there.
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Brian Routh: That other questions.
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Brian Routh: All right, just scanning through to make sure I don't see any bewildered bewildered looks on anybody okay so let's um let's didn't finish the problems, this is not quite all of it now we want to get the total the totals here.
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Brian Routh: So a couple of ways, you can do this, you could take the total all the way down each column and get the total and then take the total and divide by number of test hours.
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Brian Routh: Total divided by number of test hours within give me this number or you could take the test our numbers and just add down but don't forget the direct Labor that's part of the cost.
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Brian Routh: Okay, so you'd have to $3 and 66 cents plus $5 plus 594 plus 336 to give me to $17 and 96 cents per hour.
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Brian Routh: Okay, another thing you could always think of to kind of check yourself is this was the cost, we were trying to allocate.
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Brian Routh: That was the total cost in the in the in the main problem $1,280,000 that's the amount we should have allocated to all of our activities well, if you take the 898 plus the 382 that should equal the 1,280,000
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Brian Routh: Because keep in mind, right now, if you, if you remember back to the main problem it said under simple costing, which is what we're currently using and we know that simple costing is not as accurate as Activity Based costing which we're looking at right now.
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Brian Routh: Under simple costing we think every test costs $16.
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Brian Routh: Regardless of what contest it is whether it's a heat test or stress test, we think it costs us $16 so keep in mind our competition is probably using this method.
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Brian Routh: right here, so, for example, let's just go back to what we did last time just make up some profit let's say that everybody in our industry as $1 to the cost and that's what we charge for a test.
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Brian Routh: So under our current system, which is simple, costing we think every test cost and $16 so we're going to charge $17 for every test we give.
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Brian Routh: You with me so far, everybody following me okay so we're gonna charge $7.
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Brian Routh: How many tests do you think we're gonna sail.
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Brian Routh: A lot a lot and keep in mind that he tests are really costing us $18 and we're charging 17 so for all those he tests, because we're going to sell a lot, because our competition is charging $19.
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Brian Routh: Do you see that.
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Brian Routh: So for every test we sail we're losing $1.
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Brian Routh: Are we going to still are we going to sell any stress test we're selling them for $17.
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Brian Routh: not know if we do, and if we're if we're lucky enough to sell any stress test they're going to subsidize.
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Brian Routh: The losses on our heat test.
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Brian Routh: Do you see it because we're selling stress test for $17 apiece and our competition is selling them for about 13 or $14 apiece okay.
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Brian Routh: So we're going to make about 17 little over $4 per stress test if we're able to sell any of them if someone doesn't do their research and search out the best price and we may be lucky enough to sell one okay.
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Brian Routh: Does that make sense.
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Brian Routh: What we just talked about there okay so it's so very important to know what your true costs are.
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Brian Routh: And this is just showing us once again that activity based costing is way more accurate than simple costing using just one rate allocate all of our cost, because we can see that.
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Brian Routh: Certain tests use more hours of certain things than others, and they go through different activities, so you can't just use test hours as a as an appropriate cost driver it wouldn't be appropriate for all of our tests alright.
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Brian Routh: Any questions other questions for move on.
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Brian Routh: alright.
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Brian Routh: So we have here we have automotive products designs and produces automotive parts in 2009 actual variable manufacturing overhead is $308,600 that's our total overhead 308,600.
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Brian Routh: ap simple costing system allocates overhead to its three customers, we have three customers, we have united motors holding motors and leland vehicle free customers.
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Brian Routh: Based on machine hours so that's our simple costing allocation base or cost driver machine hours and prices it's contracts, based on full costs.
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Brian Routh: One of its customers has regularly complained of being charged non competitive prices.
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Brian Routh: So API controller devin Smith realizes that it's time to examine the consumption of overhead resources more closely.
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Brian Routh: He knows that there are three main departments that consume overhead here they are design engineering and production.
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Brian Routh: interviews with department personality examination of time records yield the following detailed information so here i'm giving you all this information, the cost driver.
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Brian Routh: The total overhead allocated each department can here's the total overhead which ultimately is how much we need to allocate, no matter what system we're using simple or Activity Based costing.
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Brian Routh: So our objective compute the overhead allocate each customer using simple costing okay simple costing.
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Brian Routh: So, again we did this last time so once we learned something new it's really hard sometimes to go back and do it the old way, but we still need to know how to do it both ways.
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Brian Routh: So again, the simple costing is using machine hours as it's one allocation based so under simple costing how many rates will we have.
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Brian Routh: One rate right if we were doing Activity Based costing right now how many rates would we have.
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Brian Routh: we'd have three very good three activities one rate for every activity, but this case we're just doing simple costing right now okay so again the the processes, the same calculate your rate which you only have one then use that rate to allocate the cost to your three customers.
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Brian Routh: Okay, so i'll give you a couple minutes to work on this on your own and then we'll come back as together and take a look at it all right.
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Brian Routh: Alright let's take a look and see how we did on this one So the first thing we have to note is the cost driver for simple costing.
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Brian Routh: It is not CAD design hours, so we don't need those it's not engineering hours we don't need those it's machine hours and here is our total machine hours if we add all those guys up that would give us our total.
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Brian Routh: And what does that equal.
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Brian Routh: 4000 4000 perfect.
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Brian Routh: So now we know our total machine hours.
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Brian Routh: And we also know our total overhead costs, so we can easily calculate our rate, so our total overhead cost about about total allocation base so that would be.
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Brian Routh: If I can find it right there okay so 308,600.
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Brian Routh: divided by the 4000 total machine hours.
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Brian Routh: So that's where we're getting that rate of $77 and 15 cents per machine hour, so the next one to calculate the rate.
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Brian Routh: Step two is to take the rate and allocate the cost to our three customers so united holding and label, so we can do that now so united.
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Brian Routh: $77 and 15 cents times the number of machine hours consumed by United because when we take the rate and multiply it times the consumption of the allocation base so united us 220 machine hours and what did you get for that.
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Brian Routh: 9259 to 58 perfect holden use 2800 machine hours, so our rate.
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Brian Routh: 2800 and what does that equal.
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Brian Routh: Perfect Thank you.
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Brian Routh: And leland used 1080.
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Brian Routh: machine hours.
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Brian Routh: And what does that equal.
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Brian Routh: Perfect Thank you.
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Brian Routh: Now, again, remember, we have a check figure.
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Brian Routh: All three of these things added up.
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Brian Routh: Should equal that 308,000 $600 did he buy check that.
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Brian Routh: Does it equal.
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Brian Routh: Whenever we've got to check figure we definitely need to take advantage of it right so see if these three things add up to 308 600.
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Brian Routh: And they may not I don't know if the $77 and 15 cent was an exact number or if there was a repeating decimal so it may be off a few dollars, if it was do these.
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Brian Routh: It work okay perfect, thank you very good.
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Brian Routh: So we are happy about that.
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Brian Routh: Any questions on this one.
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Brian Routh: Now, of course, in a second we're going to do this with Activity Based costing and then we're going to compare them.
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Brian Routh: All right, and see what's going on with with the simple costing issue alright so let's get some.
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Brian Routh: terminology in your notes, I know we've talked about it a couple of times but i'll make sure it's in your notes this idea of subsidization or cross subsidization has been one product is subsidizing another, so this is when the over.
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Brian Routh: costed product absorbs too much cost, making it seem less profitable than it really is because we've it's absorb too much costs we've over cost at it.
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Brian Routh: it's when the under.
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Brian Routh: costed product is left with two little cost, making it seem more profitable than it really is.
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Brian Routh: Okay, so we've seen this a few times we're going to see it here in just a second it's when one product is subsidizing another because of our.
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Brian Routh: Efficiency at assigning costs is where that comes down to so to not make this happen, is why we need to use Activity Based costing okay so we're more accurate with our costing more efficient.
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Brian Routh: All right.
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Brian Routh: questions.
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Brian Routh: All right, very good all right let's go to our last problem which actually is the same problem you just did except now using the exact same information.
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Brian Routh: we're going to allocate these costs to our three customers based on Activity Based costing so again, you just told me a few minutes ago there's three activities.
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Brian Routh: Therefore, will have three rates and now you're going to allocate the cost of those three customers based on those three activities okay so i'm going to put you back into your the teams, you were just in.
00:42:41.430 --> 00:42:47.520
Brian Routh: And I want you to finish this problem together now don't forget, I want you to go beyond this problem.
00:42:48.360 --> 00:42:56.190
Brian Routh: I want you to think about the two that we just did so you just did simple costing and you're about to do the activity based costing method.
00:42:56.790 --> 00:43:05.490
Brian Routh: So just as we've done before I want you to compare them what is happening under simple costing which product is under costed which product is over costed.
00:43:05.880 --> 00:43:16.290
Brian Routh: Okay, which one's subsidizing the other, in other words okay so think through that process don't just calculate the numbers, think about it okay and i'll stop into your rooms here in just a few minutes okay all right.
00:47:40.110 --> 00:47:44.760
Brian Routh: Okay, just hold tight we've got a few that have not okay all right.
00:52:10.530 --> 00:52:12.600
Brian Routh: seem to have lost a few people.
00:52:14.340 --> 00:52:15.510
Brian Routh: don't know what happened.
00:52:22.770 --> 00:52:25.440
Brian Routh: Maybe they'll come back or maybe they're still in the Red Sea.
00:52:28.260 --> 00:52:29.370
Brian Routh: they're still in the breakout.
00:52:30.780 --> 00:52:41.520
Brian Routh: No okay alright so let's um I think I was able to speak with everyone, at least for a short period of time on this one again if I didn't please forgive me.
00:52:42.810 --> 00:52:46.350
Brian Routh: That was my intent to speak with everyone, but I think.
00:52:47.460 --> 00:52:52.500
Brian Routh: we're on the right track here and, if not just stop me and ask questions as we move forward.
00:52:53.670 --> 00:52:59.370
Brian Routh: Alright, so now we're using Activity Based costing to allocate our total amount of overhead costs.
00:53:00.630 --> 00:53:19.470
Brian Routh: But you have to be careful with this we're only allocating these individual cost per activity Okay, so that was step one to calculate the rate, based on the overhead costs in that activity divided by the allocation base alright so let's take a look and see what that looked like.
00:53:22.140 --> 00:53:37.500
Brian Routh: So these are the rates, you should have got so Part One is the rates so I got $100 per CAD design our for design I got $80 per engineering hour for engineering and $60 per machine hour for production.
00:53:39.420 --> 00:53:42.900
Brian Routh: Any questions on calculating the rate or the rate.
00:53:44.640 --> 00:53:49.080
Brian Routh: The rate for each activity so again three activities equal three rates.
00:53:53.100 --> 00:53:59.940
Brian Routh: i'm just scanning through everybody to see if I see any concern on faces all right everybody's good.
00:54:00.990 --> 00:54:06.240
Brian Routh: Alright, so step two, then, is we take these rates to allocate the cost so step two.
00:54:07.020 --> 00:54:25.110
Brian Routh: So the rate for design was $100 now some of you be very careful with this if you'll write out what your rate is it's not 100 it's not $100 it's $100 per CAD design our that will help you to see what i'm supposed to multiply it by.
00:54:26.250 --> 00:54:35.730
Brian Routh: Okay, because some of you wanting to multiply it times $39,000 Well, we know we're not multiplying at times $35 because it's based on CAD design hours.
00:54:36.240 --> 00:54:45.780
Brian Routh: Okay, so just go ahead and write out the whole rate like I did here with dollars and its name that away, it makes it so much easier when you're multiplying it through okay.
00:54:47.160 --> 00:54:53.850
Brian Routh: Alright, so I took the hundred dollar rate multiplied it through the $80 rate multiplied it through the $60 rate multiplied it through.
00:54:54.660 --> 00:55:07.230
Brian Routh: And I got $39,000, which is a check figure they tell me that when I added all those across 29 six to 40 and Lo and behold, my total of 308 600 was allocated to all three of my clients.
00:55:08.520 --> 00:55:17.910
Brian Routh: 23,800 guy allocated to United 192 800 got allocated to holden and 92,000 got allocated to leland.
00:55:19.350 --> 00:55:26.820
Brian Routh: yee questions with those numbers and everybody get these totals down here and 23,801 92 890 2000.
00:55:28.320 --> 00:55:31.290
Brian Routh: If not you're well on your way to getting them, I hope, yes.
00:55:32.670 --> 00:55:36.870
Brian Routh: All right now the last part I asked you to kind of think about in your teams.
00:55:37.680 --> 00:55:44.490
Brian Routh: Was if you go back at the top of my screen right now, as the simple costing version at the bottom is the activity based costing version.
00:55:45.390 --> 00:56:03.300
Brian Routh: So at the top, is what we're currently doing this is what we think our customers are costing us at the bottom is really what they're costing us okay So who is this customer that keeps complaining, do you think is complaining about being charged non competitive prices who's complaining.
00:56:10.800 --> 00:56:12.810
Brian Routh: It would be holding okay.
00:56:12.900 --> 00:56:24.690
Brian Routh: Because this is what we think hold on it's costing us so we're charging them, maybe 250, but this is what actually holding is costing us so we probably should be charging them around to 10 to 15 something like that, whatever.
00:56:25.710 --> 00:56:32.070
Brian Routh: Okay, so they're the ones complaining leland and united they're pretty happy when you think.
00:56:33.240 --> 00:56:35.820
Brian Routh: Because holden is subsidizing both of them.
00:56:37.020 --> 00:56:45.840
Brian Routh: Okay, so hold it is subsidizing both united and leland so what's going to happen if we fix this problem, united and leland are going to be mad holden is going to be happy.
00:56:46.140 --> 00:56:52.200
Brian Routh: You know the lead and they're going to be had because their their costs are going to go way up so we may end up losing them as clients.
00:56:52.950 --> 00:57:02.670
Brian Routh: So you always have to think about about these things you know you have to explain things to your clients course so management management job, not the account the account is just prepare this information, give it to management.
00:57:03.390 --> 00:57:15.660
Brian Routh: And that's it Okay, we can give some advice on what should happen, but itself me management job to smooth it over with the clients okay any questions on Activity Based costing.