Activity-Based Costing A Tool to Aid Decision Making

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Activity-Based Costing

A Tool to Aid Decision Making


Activity Based Costing (ABC)

ABC is designed to provide managers with

cost information for strategic and other

decisions that potentially affect capacity and

therefore affect fixed as well as variable costs.

It is ordinarily used as a supplement to, rather than as a replacement

for, the company’s usual costing system.


How Costs are Treated UnderActivity–Based Costing

“Best practice” ABC differs from traditional costing in five ways.

Manufacturingcosts

Non-manufacturingcosts

ABC assigns both types of costs to products. For example, ABC systems can assign sales commissions, shipping costs,

and warranty repair costs to specific products.

Traditionalproduct costing

ABCproduct costing



ABC does not assign all manufacturing costs to products. This is because ABC only assigns a cost to a product if decisions

concerning that product will cause changes in the cost.

Manufacturingcosts

Non-manufacturingcosts


Traditionalproduct costing

ABCproduct costing

All Most, butnot all

Som

e



Plantwide Overhead

Rate

DepartmentalOverhead

Rates

Activity–BasedCosting

Number of cost pools

Leve

l of

com

plex

ity

ABC uses more cost pools.

ABC uses more cost pools than traditional cost systems that often use a single plant wide overhead pool or just one overhead pool

per department. Since more than one activity is often performed within each

department.




ABC uses more allocation bases.Traditional Costing

Num

ber o

fA

lloca

tion

Bas

es

ABC

Bases usuallyrely only on

volumemeasures.

Volumemeasuresplus other

bases.




ABC uses more allocation bases.

The most commonly used allocation basein traditional costing is direct labor hours.

Direct labor hours workwell when overheadincreases as direct

labor hours increase.



Problems: In many processes, overhead is increasing while direct labor is decreasing. Variety and complexity of products is increasing.

The most commonly used allocation basein traditional costing is direct labor hours.







All overheadcosts are not related

to volume measures likedirect labor

hours.

ABC usesvolume as well as

other allocation bases notrelated to the volume

of production.




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

This results in applying all overhead costs

including unused, or idle capacity costs to

products.

ABC Products are charged

for the costs of capacity they use – not

for the costs of capacity they don’t

use. Unused capacity costs are treated as

period expenses.

ABC bases level of activity on capacity.


Characteristics of SuccessfulABC Implementations

Strong topmanagement support

Cross-functionalinvolvement

Link to evaluationsand rewards


Designing an ABC System

Cost ObjectsCost Objects(e.g., products(e.g., productsand customers)and customers)

ActivitiesActivities

ConsumptionConsumptionof Resourcesof Resources

CostCost


Designing an ABC System

Steps for Implementing ABCIdentify and define activities and activity cost

pools.Trace costs to activities and cost objects.Assign costs to activity cost pools.Calculate activity rates.Assign costs to cost objects.Prepare management reports.


Identify and Define Activitiesand Activity Cost Pools

ManufacturingManufacturingcompanies typically combinecompanies typically combine

their activities into fivetheir activities into fiveclassifications.classifications.

Unit-LevelUnit-LevelActivityActivity

Batch-Level Batch-Level ActivityActivity

Product-LevelProduct-LevelActivityActivity

Customer-LevelCustomer-LevelActivityActivityOrganization-Organization-

sustainingsustainingActivityActivity


1. Unit-level activities are performed each time a unit is produced. 2. Batch-level activities are performed each time a batch is

handled or processed, regardless of how many units are in the batch. e.g. inspection, setting up equipment and shipping customer orders.

3. Product-level activities relate to specific products and must be carried out regardless of how many batches are run or units produced and sold. For example, designing or advertising a product.

4. Customer-level activities relate to specific customers and are not tied to any specific product. For example, sales calls and catalog mailings.

5. Organization-sustaining activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices.

Identify and Define Activitiesand Activity Cost Pools--Explanation



Activities should only be

combined within a levelif they are highly

correlated.

When combiningactivities, they should be grouped together only at

the appropriatelevel.

Batch-level Activities should not be combined with unit-level

activities, and so on



An Activity Cost Activity Cost PoolPool is a “bucket” in

which costs are accumulated that relate to a single

activity measure in the ABC system.

$

$

$ $

$$



Simple countof the number oftimes an activity

occurs.

Transactiondriver

A measureof the amountof time neededfor an activity.

Durationdriver

Two types of activity measures:

When All Activity takes the same time

Different amount of time required to perform Activities



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



• Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.

• Product Designs - assigned all costs of resources consumed by designing products.

• Order Size - assigned all costs of resources consumed as a consequence of the number of units produced.

• Customer Relations – assigned all costs associated with maintaining relations with customers.

• Other – assigned all overhead costs that are not associated with the other cost pools.


When Possible, Directly Trace OverheadCosts to Activities and Cost Objects


Assign Costs to 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.



• The indirect factory workers allocated twenty-five percent of their time to the customer orders activity, forty percent of their time to the product design activity, twenty percent of their time to the order size activity, ten percent of their time to customer relations, and five percent of their

time to the “other” activity.


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

$125,000$125,000



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

$ 60,000$ 60,000



Calculate Activity Rates

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

pool . . . 1,000 customer orders,1,000 customer orders, 200 new designs,200 new designs, 20,000 machine-hours,20,000 machine-hours, 100 customer relations activities.100 customer relations activities.

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


Calculate Activity Rates


Traced Traced Traced

Activity-Based Costing at Classic Brass

DirectMaterials

DirectLabor

ShippingCosts Overhead Costs

Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers



DirectMaterials

DirectLabor

ShippingCosts


OrderOrderSizeSize

CustomerCustomerOrdersOrders

ProductProductDesignDesign

CustomerCustomerRelationsRelations OtherOther

Overhead Costs

First-Stage Allocation



DirectMaterials

DirectLabor

ShippingCosts


OrderOrderSizeSize




Overhead Costs


Second-Stage AllocationsSecond-Stage Allocations

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

Unallocated



DirectMaterials

DirectLabor

ShippingCosts


OrderOrderSizeSize




Overhead Costs


Second-Stage AllocationsSecond-Stage Allocations

$19/MH $315/Order $257/Design $3675/Customer

Unallocated


Assigning Costs to Cost Objects

Let’s take a look at how our system worksfor 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.

For each activity cost pool, the amount of activity consumed by the product (or customer) is multiplied by the activity rate to arrive at the amount of overhead cost applied to the product (or customer).


Assigning Costs to Cost Objects

The customer-level cost is assigned to customers directly; it is not assigned to

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$

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)$


Prepare Management Reports

Customer Profitability Analysis


Product Margins

Traditional Cost 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 = $10,000


Differences Between ABC and Traditional Product Costs

Product margins are different for four reasons: Traditional costing assigns design costs to both products based on machine hours. ABC assigns product design costs to a product only if product design work is required. Traditional costing assigns customer order costs, a batch- level cost, using a unit-level allocation base, machine hours. ABC assigns these batch-level costs using a batch-level activity measure. Traditional costing assigns only manufacturing costs to products. ABC also assigns nonmanufacturing costs to products. Traditional costing assigns all manufacturing costs to products. The ABC system does not assign organization- sustaining manufacturing costs to the products.


Differences Between ABC and Traditional Product Costs

When batch-level andproduct-level costs are present,

ABC will usually shift costs from highvolume products, produced in large batches,

to low volume products produced in small batches.

This cost shifting will usually have itsgreatest impact on the per

unit cost of the lowvolume products.


Targeting Process Improvement

Activity-based management is used in conjunction with ABC to identify areas that would benefit

from process improvements.

While the theory of constraints approach discussed in Chapter 1 is a

powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on

where to focus improvement efforts.


Activity-Based Costing and External Reporting

Most companies do not use ABCfor external reporting because . . .

1. External reports are less detailed than internal reports.

2. It may be difficult to make changes to the company’s accounting system.

3. ABC does not conform to GAAP.

4. Auditors may be suspect of the subjective allocation process based on interviews with employees.


ABC Limitations

Substantial resourcesrequired to implement

and maintain.

Resistance tounfamiliar numbers

and reports.

Desire to fullyallocate all costs

to products.

Potentialmisinterpretation ofunfamiliar numbers.

Does not conform toGAAP. Two costing

systems may be needed.

Activity-Based Costing A Tool to Aid Decision Making

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