ACTIVITY BASED COSTING

Learning Objectives

Discuss the importance of unit costs

Describe the functional-based costing approach

Explain why functional-based costing approaches may produce distorted costs

Explain how an activity-based costing system works

Provide a detailed description of how activities can be grouped into homogeneous sets to reduce the number of activity rates.

Describe the role of activity-based costing for organizations with only one product, homogeneous products, or a JIT structure.

Learning Objectives (continued)

Costing Review The unit cost is the total cost associated with the

units produced divided by the number of units produced

A functional-based costing system assigns costs using only unit level drivers (those tied directly to production such as machine hours or units produced)

A predetermined overhead rate is calculated and used to allocate expenses

An activity-based costing system isolates costs by activities (such as taking orders, shipping, etc.) that are not necessarily related to unit-level drivers

Signs that a functional based costing system is providing inaccurate data

The outcome of bids is difficult to explain.

Competitors’ prices appear unrealistically low.

Products that are difficult to produce show high profits.

Operational managers want to drop products that appear profitable.

Symptoms of an Outdated FunctionalCost System (continued)

The company has a highly profitable niche all to itself.

Customers do not complain about price increases.

Some departments are using their own accounting system.

What Gave Rise to ABC? In the early 1980’s:

Direct labor becoming a smaller percentage of total manufacturing cost

Cost (overhead) allocations based on direct labor became increasingly inaccurate

Traditional cost accounting systems valued inventory for external reporting purposes

Increasing pressures on product costing

Types of AllocationPlant-wide Allocation simplest method entire plant = cost pool note: the term plant is used, but doesn’t have

to be a plant; can be hospital, school, store etc.

Departmental Allocation a separate cost pool for each department

Activity Centers a cost pool for each part of a company that

performs some easily described activity

Which Allocation Method to Use?

Decision based on cost-benefit Plant-wide methods cost the least but provide

the least information Maintaining cost pools by activity center

costs the most but provides the most information

Do the benefits justify the costs? Is the data needed attainable? What is the cost of collecting data? What is the cost of processing more data?

Factors That Impair Accuracy of Functional Rates

Non-unit- related OH costs Activities that are not performed each

time a unit of product is produced Machine Setups (occur for each batch) Costs increase for each additional setup, not

an additional unit of product

Product Diversity Different products consume overhead

activities in different proportions Labor intensive products vs. machine

intensive

Benefits of an ABC System

ABC provides: more detailed measures of costs than plant-wide or departmental allocation methodsmore accurate product costs for marketing decisions pricing; products to keep; products to discontinue

better information to production managers costs of each activity identifies previously unknown cost drivers

vehicle to promote teamwork among accounting, production, marketing, management

4 Steps of Activity-Based-Costing

Identify activities that consume resources and assign costs to those activities

Identify cost driver(s) associated with each

activity cost driver = factor that causes or “drives” an

activity’s costs

Compute a cost rate per unit (of cost driver) Assign costs to products

Multiply the cost driver rate times the volume (amount) of cost driver units consumed by product

4 Steps of ABC - ExampleIdentify activities & assign costs to those activities Purchasing materials Accounting costs related to purchasing

Identify cost driver(s) associated with each activity Number of orders

Compute a cost rate per unit (of cost driver) Processing costs per purchase order

Assign costs to products Costs/purchase order x # of orders for October

More About the 4 Steps of ABCStep 1:

Identify activities and assign costs to those activities Most interesting and challenging step Requires people understand all of the

activities required to make the product Managers attempt to identify those

activities that have the greatest impact on costs

More on the 4 Steps of ABC Cont’d

Step 2:

Identify cost driver(s) associated with

each activity Examples of cost drivers

Miles driven Pages typed Machine setupsFlight hoursComputer time Number of surgeriesRework Orders Customers served Quality inspections

How to Decide Which Driver to Use?

Causal Relation Choose cost driver that causes costs Not always feasible as indirect costs are

generally not causally linked to a cost object

Benefits Received Choose cost driver so that costs are assigned in

proportion to the benefits received

Reasonableness Costs that can not be linked based on causality

or benefits received

More on the 4 Steps of ABC (Cont)Step 3: Compute a cost rate per unit (of

cost driver)

Predetermined indirect cost (driver) rate:Estimated indirect costEstimated activity driver

Step 4: Assign costs to products Cost driver rate x volume (amount)

consumed by product = Costs assigned

Belring, Inc. – Activity UsageCordless Regular Total

Units produced per year10,000 100,000 110,000

Prime costs $78,000 $738,000 $816,000

Direct labor hours 10,000 90,000 100,000

Machine hours 5,000 45,000 50,000

Production runs 20 10 30

Number of moves 60 30 90

Belring, Inc. – Additional OH Cost Data

Activity Activity CostSetups $120,000Material handling 60,000Machining 100,000Testing 80,000

Total $360,000

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Belring, Inc. – Activity Rates

Activity rates are computed below:

Setup rate: $120,000/30 =$4,000 per run

Material-handling rate: $60,000/90 = $666.67 per move

Machining rate: $100,000/50,000 = $2 per MH

Testing rate: $80,000/100,000 = $0.80 per DLH

Belring, Inc. – Activity-Based CostingUnit Cost Computation

Cordless Regular

Prime costs $ 78,000 $ 738,000

Overhead costs:

Setups 80,000 40,000

Material handling 40,000 20,000

Machining 10,000 90,000

Testing 8,000 72,000

Total mfg. costs $216,000 $ 960,000

Units produced 10,000 100,000

Unit cost $ 21.60 $ 9.60

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ABC - Not an Easy ProcessConversion to ABC takes a lot of time and resourcesGeneral process: Interview employees Collect data

on time, activities, resources, activity attributes Build initial model of ABC system Cost-out the activities Test model Prepare analysis; Report to management;

Implementation

Just-in-time Manufacturing

Having only as much as you need only when you need it eliminate waste by not keeping excess moves costs to suppliers allows for easier product costing

because there is less to cost and the costs that are present are easier to trace to products