Activity Based Costing: A Tool to Aid Decision Making 11/16/04 Chapter 8.

Activity Based Costing:A Tool to Aid Decision Making

11/16/04

Chapter 8

© The McGraw-Hill Companies, Inc., 2003McGraw-Hill/Irwin

Activity Based Costing (ABC)

ABC is designed to ABC is designed to provide managers provide managers

with cost with cost information for information for

strategic and other strategic and other decisions that decisions that

potentially affect potentially affect capacity and capacity and

therefore “fixed” therefore “fixed” costs.costs.

ABC is agood supplement to our traditional

cost systemI agree!


How Costs are Treated Under Activity-Based Costing

Level of C

omplexity

Level of C

omplexity

Overhead Allocation

Plantwide Plantwide OverheadOverhead

RateRate

Plantwide Plantwide OverheadOverhead

RateRate

DepartmentalDepartmentalOverheadOverhead

RatesRates

DepartmentalDepartmentalOverheadOverhead

RatesRates

Activity BasedActivity BasedCostingCosting



Plantwide Overhead Rate

Companies tended to use direct labordirect labor as asthe overhead allocation base. There was a

belief that direct labor and overhead costs were highly correlated. Automation changed all that.


Departmental Overhead Rates

Finishing Department

Shipping Department

Painting DepartmentMany companies have a systemMany companies have a systemin which each department hasin which each department has

its own overhead rate.its own overhead rate.

Many companies have a systemMany companies have a systemin which each department hasin which each department has

its own overhead rate.its own overhead rate.


DepartmentDepartment11





DepartmentDepartment33Cost poolsCost pools

IndirectIndirectLaborLabor


IndirectIndirectMaterialsMaterialsIndirectIndirect

MaterialsMaterialsOtherOther

OverheadOverheadOtherOther

OverheadOverheadStage One:Stage One:Costs assignedCosts assignedto poolsto pools
















Products Products Products Products

Stage Two:Stage Two:Costs appliedCosts appliedto productsto products















Products Products Products Products

Stage Two:Stage Two:Costs appliedCosts appliedto productsto products

Departmental Allocation BasesDepartmental Allocation BasesDepartmental Allocation BasesDepartmental Allocation Bases

Direct Labor Hours

MachineHours

RawMaterials

Cost


Cost of Idle Capacity

Traditional Cost Traditional Cost AccountingAccounting

The predetermined The predetermined overhead rate is based overhead rate is based on budgeted activity. on budgeted activity.

This results in applying This results in applying overhead costs of overhead costs of unused, or idle, unused, or idle,

capacity.capacity.

Traditional Cost Traditional Cost AccountingAccounting

The predetermined The predetermined overhead rate is based overhead rate is based on budgeted activity. on budgeted activity.

This results in applying This results in applying overhead costs of overhead costs of unused, or idle, unused, or idle,

capacity.capacity.


Products are charged for Products are charged for the costs of capacity the costs of capacity they use – not for the they use – not for the costs of capacity they costs of capacity they

don’t use.don’t use.


Products are charged for Products are charged for the costs of capacity the costs of capacity they use – not for the they use – not for the costs of capacity they costs of capacity they

don’t use.don’t use.


Designing of an ABC System

Steps for Implementing ABCSteps for Implementing ABC Identify and define major activities and activity Identify and define major activities and activity

cost pools.cost pools. Where possible, trace costs directly to activities Where possible, trace costs directly to activities

and cost objects (products).and cost objects (products). Assign all other traceable costs to activity cost Assign all other traceable costs to activity cost

pools. Non-traceable costs lumped.pools. Non-traceable costs lumped. Calculate activity rates.Calculate activity rates. Assign costs to cost objects.Assign costs to cost objects. Prepare management reports.Prepare management reports.


Identify and Define Activities and Activity Cost Pools

A part of the productionA part of the productionprocess for which managementprocess for which management

wants a separate reporting of thewants a separate reporting of thecosts of the activity involved.costs of the activity involved.

Unit-LevelUnit-LevelActivityActivity

(machining)(machining)

Batch-Level Batch-Level ActivityActivity

(customer order)(customer order)

Product-LevelProduct-LevelActivityActivity

(product design)(product design)

Customer-LevelCustomer-LevelActivityActivity

(customer relations)(customer relations)

Organization-Organization-sustainingsustaining

Activity (lumped)Activity (lumped)



At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

Activity Cost Pool Activity MeasureCustomer orders Number of customer ordersProduct design Number of product designsOrder size Machine-hoursCustomer relations Number of active customersOther Not applicable

Activity Cost Pools at Classic Brass



Activity Cost Activity Cost PoolPool is a “bucket” in which OH costs are accumulated that relate to a single activity

measure in the ABC system.

$

$

$ $

$$



Customer OrdersCustomer Orders - assigned all costs of resources - assigned all costs of resources that are consumed by taking and processing that are consumed by taking and processing customer orders.customer orders.Product DesignsProduct Designs - assigned all costs of resources - assigned all costs of resources consumed by designing products.consumed by designing products.Order SizeOrder Size - assigned all costs of resources - assigned all costs of resources consumed as a consequence of the number of units consumed as a consequence of the number of units produced. (in this case, machined)produced. (in this case, machined)Customer RelationsCustomer Relations – assigned all costs associated – assigned all costs associated with maintaining relations with customers.with maintaining relations with customers.OtherOther – assigned all overhead costs that are not – assigned all overhead costs that are not associated with the other cost pools.associated with the other cost pools.

Customer OrdersCustomer Orders - assigned all costs of resources - assigned all costs of resources that are consumed by taking and processing that are consumed by taking and processing customer orders.customer orders.Product DesignsProduct Designs - assigned all costs of resources - assigned all costs of resources consumed by designing products.consumed by designing products.Order SizeOrder Size - assigned all costs of resources - assigned all costs of resources consumed as a consequence of the number of units consumed as a consequence of the number of units produced. (in this case, machined)produced. (in this case, machined)Customer RelationsCustomer Relations – assigned all costs associated – assigned all costs associated with maintaining relations with customers.with maintaining relations with customers.OtherOther – assigned all overhead costs that are not – assigned all overhead costs that are not associated with the other cost pools.associated with the other cost pools.


Production DepartmentIndirect factory wages 500,000$ Factory equipment depreciation 300,000 Factory utilities 120,000 Factory building lease 80,000 1,000,000$

Shipping costs traced to customer orders 40,000 General Administrative Department

Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60,000 510,000

Marketing DepartmentMarketing wages and salaries 250,000 Selling expenses 50,000 300,000

Total overhead costs 1,850,000$

Overhead Costs at Classic Brass

(Manufacturing and NonManufacturing)

Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects


Assign Costs to Activity Cost PoolsExhibit 8-3

Customer Orders

Product Design

Order Size

Customer Relations Other Total

Production DepartmentIndirect factory wages 25% 40% 20% 10% 5% 100%Factory equipment depreciation 20% 0% 60% 0% 20% 100%Factory utilities 0% 10% 50% 0% 40% 100%Factory building lease 0% 0% 0% 0% 100% 100%

Shipping costs **General Administrative Department

Administrative wages and salaries 15% 5% 10% 30% 40% 100%Office equipment depreciation 30% 0% 0% 25% 45% 100%Administrative building lease 0% 0% 0% 0% 100% 100%

Marketing DepartmentMarketing wages and salaries 20% 10% 0% 60% 10% 100%Selling expenses 10% 0% 0% 70% 20% 100%

Activity Cost Pools

At Classic Brass the following distribution of resource consumption across activity cost pools is determined.

**Not included because they are directly traced to customer orders.


Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ Factory equipment depreciationFactory utilitiesFactory building lease

General Administrative DepartmentAdministrative wages and salariesOffice equipment depreciationAdministrative building lease

Marketing DepartmentMarketing wages and salariesSelling expenses

Total

Activity Cost Pools

Indirect factory wages $500,000Indirect factory wages $500,000Percent consumed by customer orders 25%Percent consumed by customer orders 25%

$125,000$125,000

Indirect factory wages $500,000Indirect factory wages $500,000Percent consumed by customer orders 25%Percent consumed by customer orders 25%

$125,000$125,000

Assign Costs to Activity Cost Pools






Overhead Costs at Classic Brass(Manufacturing and NonManufacturing)


Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ Factory equipment depreciation 60,000 Factory utilitiesFactory building lease

General Administrative DepartmentAdministrative wages and salariesOffice equipment depreciationAdministrative building lease

Marketing DepartmentMarketing wages and salariesSelling expenses

Total

Activity Cost Pools






Overhead Costs at Classic Brass(Manufacturing and NonManufacturing)

Factory equipment depreciation $300,000Factory equipment depreciation $300,000Percent consumed by customer orders 20%Percent consumed by customer orders 20%

$ 60,000$ 60,000

Factory equipment depreciation $300,000Factory equipment depreciation $300,000Percent consumed by customer orders 20%Percent consumed by customer orders 20%

$ 60,000$ 60,000

Assign Costs to Activity Cost Pools


Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ 200,000$ 100,000$ 50,000$ 25,000$ 500,000$ Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000 Factory utilities - 12,000 60,000 - 48,000 120,000 Factory building lease - - - - 80,000 80,000

General Administrative DepartmentAdministrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000 Office equipment depreciation 15,000 - - 12,500 22,500 50,000 Administrative building lease - - - - 60,000 60,000

Marketing DepartmentMarketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000 Selling expenses 5,000 - - 35,000 10,000 50,000

Total 315,000$ 257,000$ 380,000$ 367,500$ 490,500$ 1,810,000$

Activity Cost Pools

Assign Costs to Activity Cost PoolsExhibit 8-4


Calculate Activity Rates

The ABC team determines that Classic Brass will have these total activities for each activity

cost pool . . . 1,000 customer orders1,000 customer orders 200 new designs200 new designs 20,000 machine-hours20,000 machine-hours 100 customer relations activities100 customer relations activities

Now the team can compute the individual Now the team can compute the individual activity rates by dividing the total cost for activity rates by dividing the total cost for

each activity by the total activity levels.each activity by the total activity levels.


Calculate Activity RatesExhibit 8-5

(a) (b) (a) (b)Activity Cost Pools Total Cost Total Activity Activity RateCustomer orders 315,000$ 1,000 orders $315 per orderProduct design 257,000 200 designs $1,285 per designOrder size 380,000 20,000 MHs $19 per MHCustomer relations 367,500 100 customer $3,675 per customerOther 490,500 Not applicable Not applicable

1,810,000

Computation of Activity Rates÷


TracedTracedTracedTraced TracedTracedTracedTraced TracedTracedTracedTraced

Activity-Based Costing at Classic Brass

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ShippingCosts

ShippingCosts Overhead CostsOverhead Costs

Cost Objects:Cost Objects:Products, CustomersProducts, Customers




DirectMaterials

DirectMaterials


ShippingCosts

ShippingCosts



OrderOrderSizeSize

OrderOrderSizeSize

CustomerCustomerOrdersOrders


ProductProductDesignDesignProductProductDesignDesign

CustomerCustomerRelationsRelationsCustomerCustomerRelationsRelations OtherOtherOtherOther

Overhead CostsOverhead Costs

First-Stage AllocationFirst-Stage Allocation



DirectMaterials

DirectMaterials


ShippingCosts

ShippingCosts



OrderOrderSizeSize

OrderOrderSizeSize



ProductProductDesignDesignProductProductDesignDesign

CustomerCustomerRelationsRelationsCustomerCustomerRelationsRelations OtherOtherOtherOther

Overhead CostsOverhead Costs

First-Stage AllocationFirst-Stage Allocation

Second-Stage AllocationsSecond-Stage AllocationsSecond-Stage AllocationsSecond-Stage Allocations

$/MH$/MH$/MH$/MH $/Order$/Order$/Order$/Order $/Design$/Design$/Design$/Design $/Customer$/Customer$/Customer$/Customer

UnallocatedUnallocatedUnallocatedUnallocated


Assigning Costs to Cost ObjectsVG

Let’s take a look at how our system works for just one customer – Windward Yachts.

Standard Stanchions (no design required)1. 400 units ordered with 2 separate orders.1. 400 units ordered with 2 separate orders.2. Each stanchion required 0.5 machine-hours .2. Each stanchion required 0.5 machine-hours .3. Selling price is $34 each.3. Selling price is $34 each.4. Direct materials total $2,110.4. Direct materials total $2,110.5. Direct labor totals $1,850.5. Direct labor totals $1,850.6. Shipping costs total $180.6. Shipping costs total $180.

Custom Compass Housing (requires new design)1. One order during the year.1. One order during the year.2. Each housing required 4 machine-hours .2. Each housing required 4 machine-hours .3. Selling price is $650 each.3. Selling price is $650 each.4. Direct materials total $13.4. Direct materials total $13.5. Direct labor totals $50.5. Direct labor totals $50.6. Shipping costs total $25.6. Shipping costs total $25.


Assigning Costs to Cost Objects

(a) (b) (a) (b)Activity Cost Pools Activity Rate Activity ABC CostCustomer orders 315$ 2 630$ Product design 1,285 0 - Order size 19 200 3,800 Customer relations 3,675 N/A

Overhead Cost for the Standard Stanchions

(a) (b) (a) (b)Activity Cost Pools Activity Rate Activity ABC CostCustomer orders 315$ 1 315$ Product design 1,285 1 1,285 Order size 19 4 76 Customer relations 3,675 N/A

Overhead Cost for the Custom HousingThe customer-level The customer-level cost is assigned to cost is assigned to customers directly; customers directly; it is not assigned to it is not assigned to

products.products.


Prepare Management Reports

Standard StanchionsSales 13,600$ Cost: Direct materials 2,110$ Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570

Product margin 5,030$

Standard StanchionsSales 13,600$ Cost: Direct materials 2,110$ Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570

Product margin 5,030$

Custom Compass HousingSales 650$ Cost: Direct materials 13$ Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285 Order size 76 1,764

Product margin (1,114)$

Custom Compass HousingSales 650$ Cost: Direct materials 13$ Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285 Order size 76 1,764

Product margin (1,114)$


Windward YachtsProduct margins: Standard stanchion 5,030$ Custom compass housing (1,114) Total product margin 3,916 Less: Customer relations 3,675 Customer margin 241$

Prepare Management Reports

Customer Profitability AnalysisCustomer Profitability Analysis


Product Margins

Standard Stanchions

Compass Housing

Sales 13,600$ 650$ Costs

Direct materials (2,110) (13) Direct labor (1,850) (50) Manufacturing overhead (10,000) (200)

Product margin (360)$ 387$

Traditional Traditional Cost Accounting SystemCost Accounting System

Predetermined manufacturingoverhead rate

$1,000,000 20,000 MH

= $50/MH=

400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000


Comparison of ABC and Traditional Overhead Product Costs

Product Standard Custom

ABC Trad ABC Trad

Overhead $10,000 $200

Shipping $ 180 $ 25

Cust Order 630 315

Design 1,285

Order size 3,800 76

OH assigned $4,610 $1,701


Difference Between ABC and Traditional Product Costs

Batch-level or product-Batch-level or product-level costs will level costs will ordinarily shift ordinarily shift

overhead costs from overhead costs from high-volume high-volume

products produced products produced in large batches to in large batches to

low-volume products low-volume products produced in small produced in small

batches. batches.

Batch-level or product-Batch-level or product-level costs will level costs will ordinarily shift ordinarily shift

overhead costs from overhead costs from high-volume high-volume

products produced products produced in large batches to in large batches to

low-volume products low-volume products produced in small produced in small

batches. batches.

Under ABC both Under ABC both manufacturing and manufacturing and nonmanufacturing nonmanufacturing

costs may be costs may be assigned to products. assigned to products.

Organization-Organization-sustaining costs and sustaining costs and

the costs of idle the costs of idle capacity are not capacity are not

assigned to products.assigned to products.

Under ABC both Under ABC both manufacturing and manufacturing and nonmanufacturing nonmanufacturing

costs may be costs may be assigned to products. assigned to products.

Organization-Organization-sustaining costs and sustaining costs and

the costs of idle the costs of idle capacity are not capacity are not

assigned to products.assigned to products.


Benefits of ABC

More cost pools = more accurate per unit costsCosts are assigned using relevant versus arbitrary driversMakes overhead costs more manageable (traceable)Shifts costs from high to low volume products as appropriateMakes for better cost/pricing decisions


Activity-Based Costing and Reporting Limitations

Most companies do not use ABC because . . .Most companies do not use ABC because . . .

1.1. ABC does not conform to GAAP.ABC does not conform to GAAP.

2.2. High costs associated with ABC implementationHigh costs associated with ABC implementation

3.3. High time commitment and discipline requiredHigh time commitment and discipline required

4.4. Limited benefit if organization sustaining costs too Limited benefit if organization sustaining costs too highhigh


End of Chapter 8End of Chapter 8

Activity Based Costing: A Tool to Aid Decision Making 11/16/04 Chapter 8.

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