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Week 5 Lecture Activity-Based Costing

Chapter 7: Activity-Based Costing (ABC) and Activity-Based Management

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Cost Allocation
Assigning indirect costs to cost

objects
These costs are not traced Indirect costs often comprise a large

percentage of total costs

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Purposes of Cost Allocation

1. To provide information for economic

decisions
2. To motivate managers/employees 3. To compute/justify costs 4. To measure income and assets Traditional costing systems may not yield the

costs necessary to meet the four-purposes for cost allocation (above)

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Six-Function Value Chain

Costs necessary for decision-making may

pull costs from some or all of the above six value chain functions

(c) 2009 Pearson Prentice Hall. All rights reserved.

Criteria for Guiding Cost-Allocation Decisions

1. Cause-and-effect: variables are

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identified that cause resources to be consumed

Most credible to operating managers Integral part of activity based costing

(ABC)
2. Benefits received: the beneficiaries

of the outputs of the cost object are charged with costs in proportion to the benefits received

Criteria for Guiding Cost-Allocation Decisions

price satisfactory to the customer
Cost allocation here is viewed as a

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3. Fairness (Equity): the basis for establishing a

reasonable or fair means of establishing selling price 4. Ability to bear: costs are allocated in proportion to the cost objects ability to bear them: Generally, larger or more profitable objects receive proportionally more of the allocated costs

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Background
Recall that factory overhead is applied to

production in a rational systematic manner using some type of averaging There are a variety of methods to accomplish this goal:
These methods often involve trade-offs between

simplicity and realism

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Broad Averaging
Historically, firms produced a limited

variety of goods while their indirect costs were relatively small Allocating overhead costs was simple:
Use broad averages to allocate costs

uniformly regardless of how they are actually incurred Peanut butter costing
End-result:
overcosting and undercosting

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Over and Undercosting

Overcosting: a product consumes a low

level of resources but is allocated high costs per unit Undercosting: a product consumes a high level of resources but is allocated low costs per unit

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Limitations of Traditional Costing Systems

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Departmental Rate

Volume-Based Plantwide Rate

Activity Based Costing

Limitations of Traditional Costing Systems

Plantwide allocation is simple but does not consider other activities

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Limitations of Traditional Costing Systems

A Departmental rate provides more detailed cost measures, particularly if the departments perform quite different activities

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Limitations of Traditional Costing Systems

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I need to know more about ABC before I make my decision. It looks like my decision will be based on a careful cost-benefit analysis

Weight of indirect costs in product costs in the past

In the past, the direct cost component (e.g. direct labour) constituted a high percentage of the total product cost, whereas the indirect cost component constituted a small percentage: Thus, the allocation of indirect costs according to the traditional approach (e.g. direct work hours or machine hours) did not cause significant distortion in the decision about pricing of products

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Weight of indirect costs in product costs at present time

Recently, the weight of

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indirect costs has increased, now reaching a crucial part of total production costs:
So, the allocation of indirect costs according

to the traditional approach has caused considerable distortion in the costing of products

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Problems with traditional cost allocation

Arbitrariness: usually no single correct base Smell test: managers know instinctively that simple allocations are deficient Cost cross-subsidization: products that use proportionately more of allocation basis bear unfair share. Subsidize other products Spiral Death: retained products must carry more excess capacity costs and may be dropped due to reduced profitability

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Reasons for increased demand for improved cost allocation

Increased competition with declining margins: Emphasis on improved productivity Need for more accurate measurements Increased automation and service content: Overhead a larger percentage of total costs Deregulation, globalization of competition, and rapid

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technological change: Increase demand for precise, timely profitability information for strategic purposes Computerized information systems: Reduces cost of more detailed cost allocation Decentralization of profit responsibility: Requires accurate measurement of subunit profits

Companies more likely to benefit from ABC

produce multiple, heterogeneous products highly decentralized have diverse customers and markets use a variety of distribution channels have relatively stable production and

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market environment

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How Costs are Treated Under ActivityBased Costing

ABC differs from traditional cost accounting in three ways Manufacturing costs Nonmanufacturing costs

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Traditional product costing

ABC product costing

ABC assigns both types of costs to products

How Costs are Treated Under ActivityBased Costing

ABC differs from traditional cost accounting in three ways Manufacturing costs All Nonmanufacturing costs Some

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Traditional product costing

ABC product costing

ABC does not assign all manufacturing costs to products

How Costs are Treated Under ActivityBased Costing

ABC differs from traditional cost accounting in three ways Level of complexity
ActivityBased Costing Departmental Overhead Rates Plantwide Overhead Rate

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Number of cost pools ABC uses more cost pools

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How Costs are Treated Under ActivityBased Costing

ABC differs from traditional cost accounting in three ways

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Each ABC cost pool has its own unique measure of activity Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products
ABC uses more cost pools

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Activity-Based Costing
ABC is a costing approach that assigns costs to products or services based on their consumption of the resource caused by the activities

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Single Plantwide Overhead Rate

Dole Company has two factories Alpha and Beta. Alpha is a highly automated factory while Beta is a laborintensive factory. The company uses a single plantwide overhead rate based upon labor hours
Alpha Annual Budget Data Division Budgeted overhead $ 400,000 Budgeted labor hours 10,000 Budgeted machine hours 20,000 Beta Division $ 200,000 50,000 40,000

Total $ 600,000 60,000 60,000

Single Plantwide $600,000 = $10 per labor hour = Overhead Rate 60,000

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Single Plantwide Overhead Rate

During the first month of operations the company has the following information for it two products Widget and Gidget

Alpha Division Widget: Labor hours Machine hours Gidget: Labor hours Machine hours 500 800 500 1,200

Beta Division 4,000 200 1,000 400

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Single Plant-wide Overhead Rate

Using the plantwide rate, factory overhead is applied to the two products as shown below.
Widget Alpha Division: $10 x 500 $ 5,000 $10 x 500 Beta Division: $10 x 4,000 40,000 $10 x 1,000 Overhead applied $ 45,000 Gidget

5,000

10,000 $ 15,000

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Departmental Overhead Rates

To obtain more accurate product costing the company decided to use departmental overhead rates. The overhead in Alpha is to based on machine hours, and Beta will use labor hours. Alphas Departmental $400,000 = $20 per machine hour = Overhead Rate 20,000 Betas Departmental Overhead Rate = $200,000 = $4 per labor hour 50,000

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Departmental Overhead Rates

Using the new departmental overhead rates, overhead would be allocated to the two products as shown below:
Widget Alpha Disision: $20 x 800 $20 x 1,200 Beta Division: $4 x 4,000 $4 x 1,000 Overhead applied $ 16,000 $ 24,000 16,000 $ 32,000 4,000 $ 28,000 Gidget

Applied overhead will be $13,000 lower for Widget and $13,000 higher for Gidget as a result of using departmental rates rather than a plantwide rate

Two-Stage Allocation Procedures

Traditional Resource Costs
First stage

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Activity-Based Resource Costs

First stage

Cost Pools: Plants or Departments

Second stage

Cost Pools: Activities or Activity Centers

Second stage

Cost Objects

Cost Objects

Resource Summary Cost Pool Indirect

Indirect Cost pool Indirect Activity 1 Activity 2 Activity 3 Activity 4 Activity 5

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Activity Cost Driver 1

Activity 1 Total # Driver 1

Activity Cost Driver 2

Activity 2 Total # Driver 2

Activity Cost Driver 3

Activity 3 Total # Driver 3

Activity Cost Driver 4

Activity 4 Total # Driver 4

Activity Cost Driver 5

Activity 5 Total # Driver 5

Cost Allocation Base

Allocation Rate 1

Allocation Rate 2

Allocation Rate 3

Allocation Rate 4

Allocation Rate 5

COST OBJECT
Direct Costs
DIRECT LABOUR DIRECT MATERIALS
DIRECT Procurement costs Transaction processing costs

Up-stream Down stream

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Steps in Designing an ABC System

Identify

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resource costs and activities Assign resource costs to activities Assign activity costs to cost objects

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Cost Hierarchies
ABC uses a four-level cost structure to

determine how far down the production cycle costs should be pushed:
Unit-level (output-level) Batch-level Product-sustaining-level Facility-sustaining-level

Activity-based hierarchy of costs and activities

Unit-level activity An activity that is performed for each unit of production (direct materials, direct labor hours, inserting a component) Batch-level activity An activity that is performed for each batch of products rather than for each unit of production (machine setup, purchase ordering, production scheduling)

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Activity-based hierarchy of costs and activities

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Product-sustaining activity An activity that is performed to support the production of a given product (product design, parts administration, issuance of engineering change orders, expediting) Facility-sustaining activity An activity that is performed to sustain the production of products in general (security, safety, rent, maintenance, plant management)

Sample Activity Drivers at a Manufacturing Firm

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Materials purchasing Direct labor support Machine operation Setup Production order Materials handling Parts administration General and administrative

Identify these activities as: (1) Unit, (2) Batch, (3) Product, or (4) Facility

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Sample Activity Drivers at a Manufacturing Firm

Materials purchasing Direct labor support Machine operation Setup Production order Materials handling Parts administration General & administrative

Unit Unit Unit Batch Batch Batch Product Facility

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Steps in Designing an Activity-Based Costing System

Identify

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resource costs and activities Assign resource costs to activities Assign activity costs to cost objects

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Typical Resource Drivers

Meters for utilities Number of employees for payroll-related

activities
Number of setups for the machine setup

activity
Number of moves for the material handling

activity
Machine hours for machine power running

activities

Steps in Designing an Activity-Based Costing System

Identify

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resource costs and activities Assign resource costs to activities Assign activity costs to cost objects

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Activity Drivers at a Manufacturing Firm

Activity
Materials purchasing Direct labor support Machine operation Setup Production orders Material handling Part administration General and administrative

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Driver
Material cost Direct labor cost Machine hours Setup hours Number of orders Number of loads Number of parts Amount of value-added

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Activity-Based Costing
Benefits
It provides more accurate and informative product costs It provides managers with easier access to relevant costs

Limitations
Expensive to develop and implement Time-consuming

Lecture example: Traditional Cost vs. ABC

Wombat company has identified the following overhead activities, costs and cost drivers for the coming year: Activity Setup costs Ordering costs Machine costs Receiving Expected cost $60 000 45 000 90 000 25 000 Cost driver Number of setups Number of orders Machine hours Number of parts Activity capacity 300 4 500 18 000 50 000

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The following two jobs were completed during the year: Job 600 Direct material Direct labour (50 hours per job) Units completed Number of setups Number of orders Machine hours Parts used $750 $600 100 1 4 20 20 Job 700 $850 $600 50 1 2 30 40

The company's normal activity is 4000 direct labour hours (DLH).

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Traditional (volume-based) costing approach

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Activity-based costing approach

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Conclusions
Each method is mathematically correct Each method is acceptable (?) Each method yields a different cost figure,

which will lead to different gross margin calculations Only overhead is involved:
Total costs for the entire firm remain the

same (they are just allocated to different cost objects within the firm)
Selection of the appropriate method and

cost drivers should be based on experience, and a cost-benefit analysis of each option under consideration

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A Cautionary Tale
A number of critical decisions can

be made using this information:

Should one product be pushed over

another?
Should one product be dropped?

Accounting for overhead costs is an

imprecise science:
Best efforts should be put forward to

arrive at a cost that is fair and reasonable

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Rationale for selecting a more refined costing system:

Increase in product diversity: Growing demand for customised products has led to product diversity (i.e. products demand a different level of resources) Increase in indirect costs: Due to modern technology Advances in information technology:
Makes it easier to assign/estimate costs to

products
Competition in foreign markets: Need for more accurate cost information

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ABC vs. Simple Costing Schemes

ABC is generally perceived to produce

superior costing figures due to the use of multiple cost drivers across multiple levels But remember, ABC is only as good as the cost drivers selected and their actual relationship to costs:
Poorly chosen cost drivers will produce

inaccurate costs, even with ABC!

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Signals that suggest that ABC implementation could help a firm:

Significant overhead costs allocated using one

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or two cost pools

Most or all overhead is considered unit-level Products that consume different amounts of

resources
Products that a firm should successfully make

and sell consistently show small profits

Operations staff disagreeing with accounting

over manufacturing and marketing costs

ABC and Service / Merchandising Firms

ABC implementation is widespread in

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a variety of applications outside manufacturing, including:

Health Care Banking Telecommunications Retailing Transportation

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Activity-Based Management
A method of management that uses ABC as

an integral part in critical decision-making situations, including:

Pricing and product-mix decisions Cost reduction and process improvement

decisions
Design decisions Planning and managing activities