CHAPTER SEVEN

Activity-based Costing

Objectives
Understand ABC and how it differs from a traditional costing system Cost distortion caused by traditional costing system Understand how costs are treated under ABC Designing ABC system

Cost Allocations
Direct Costs

Traditional Costing
Indirect Costs

Cost Objects

ABC

Traditional Costing
Determination of Overhead Rates - Plant-wide rate - Departmental rate Distortions caused by traditional allocations - based on unit-related measures - differences in relative consumption ratios

Determination of overhead rates

Overhead rate = Normal cost of support activity Normal level of cost driver Consider: use of plant-wide overhead rate vs departmental overhead rate

Plant-wide/blanket overhead rate or departmental rate?

Dept A Overheads DLHs

$200,000 20,000

Dept B
$600,000 20,000

Dept C
$100,000 20,000

Total
$900,000 60,000

OH Rate

Product Z: 20 DLH in Dept C; but not pass thru Dept A & B. Overhead costs allocated to Z: If use plant-wide rate: If use dept rate:

Which to use?

Traditional Cost Distortions

Setup Costs Setup hours

Machine Machining Assembly Setup $200,000 $120,000 $80,000

480 320

Traditional Cost Distortions

Products Relevant Factors A B

Batch size, number of units

Setup hours required Machining

800
3

200
3

Assembly
Normal prod., no. of units Normal prod., no. of batches

2
64,000 80

2
16,000 80

Traditional Cost Distortions

Setup costs per hour = = Setup costs = Product A: Product B:

=
=

Trad./two stage allocations

Both products use 0.1 machine hours in each production dept.

Overhead rate:

Machining = = Assembly = = Setup costs/unit for both products =

Reasons for cost distortions:

Allocations based on unit-related measures Product A - produced in larger batches. It is charged the same rate ($2.50) as product B coz of the use of MH as the basis to allocate overhead costs which is driven by batch-related measures (e.g. machine setups) Product A over cost; B under cost.

Reasons for cost distortions:

Differences in relative consumption ratios Product A needs 0.00625 setup hours per unit (5/800), while B needs 0.02500 (5/200) Both need same number of MH/unit (0.1) Actual consumption ratio = 1:4 (0.00625/0.02500) If use MH consumption ratio = 1:1 (0.1:0.1) Product A over cost; B under cost

How to deal with this problem?

Design a costing system that use actual cost driver for each overhead activity to assign costs to products ---- Activity Based Costing - costing systems based on cost drivers that link activities performed to products and allocate overhead activity costs directly to products using these cost drivers (ABKY, 1995: 291)

How Costs are Treated Under ActivityBased Costing

Best practice ABC differs from traditional costing in five ways.
Manufacturing costs Nonmanufacturing costs

Traditional product costing

ABC product costing

ABC assigns both types of costs to products.

How Costs are Treated Under ActivityBased Costing

Best practice ABC differs from traditional costing in five ways.
Manufacturing costs All Nonmanufacturing costs Some

Traditional product costing

ABC product costing

ABC does not assign all manufacturing costs to products.

Selling & distribution costs

Compare between products and determine whether should include or not - which product demand more selling & distribution activities - e.g. order-getting activities -- marketing (mgmt, travel, brochures, catalog), customer service - e.g. order-filling activities -- warehouse, shipping, order execution includes personnel, facilities, equipment and services required for each activity.

How Costs are Treated Under ActivityBased Costing

Best practice ABC differs from traditional costing in five ways.
Level of complexity
ActivityBased Costing Departmental Overhead Rates Plantwide Overhead Rate

Number of cost pools ABC uses more cost pools.

How Costs are Treated Under ActivityBased Costing

Best practice ABC differs from traditional costing in five ways.
Volume measures plus other bases.

Number of Allocation Bases

Bases usually rely solely on volume measures.

Traditional Costing ABC ABC uses more allocation bases.

How Costs are Treated Under ActivityBased Costing

Best practice ABC differs from traditional costing in five ways.
The most commonly used allocation base in traditional costing is direct labor hours.

Direct labor hours work well when overhead increases as direct labor hours increase.

ABC uses more allocation bases.

How Costs are Treated Under ActivityBased Costing

Best practice ABC differs from traditional costing in five ways.
The most commonly used allocation base in traditional costing is direct labor hours. Problems: In many processes, overhead is increasing while direct labor is decreasing. Variety and complexity of products is increasing.

ABC uses more allocation bases.

How Costs are Treated Under ActivityBased Costing

Best practice ABC differs from traditional costing in five ways.
ABC uses volume as well as other allocation bases not related to the volume of production.

All overhead costs are not related to volume measures like direct labor hours.

ABC uses more allocation bases.

How Costs are Treated Under ActivityBased Costing

Best practice ABC differs from traditional costing in five ways.

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 dont use. Unused capacity costs are treated as period expenses.

ABC bases level of activity on capacity.

Characteristics of Successful ABC Implementations

Strong top management support

Link to evaluations and rewards

Cross-functional involvement

Designing an ABC System

Cost Objects (e.g., products and customers)
Activities

Consumption of Resources

Cost

Designing an ABC System

Steps for Implementing ABC
Identify 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 Activities and Activity Cost Pools

Unit-Level Activity Batch-Level Activity

Manufacturing companies typically combine their activities into five classifications.

Product-Level Activity

Organizationsustaining Activity

Customer-Level Activity

Classification of Activities
Unit-level activities are those that are performed each time a unit is produced. Examples: Power and machine hours are used each time a unit is produced. Direct materials and direct labor activities are also unitlevel activities, even though they are not overhead costs.

Classification of Activities
Batch-level activities are those that are performed each time a batch of products is produced. Examples: Setups, inspections, production scheduling, and material handling.

Classification of Activities
Product-level (sustaining) activities are those that are performed as needed to support the various products produced by a company. These activities consume inputs that develop products or allow products to be produced and sold. Examples: Engineering changes, process engineering, and expediting.

Classification of Activities
Facility-level activities are those that sustain a factory's general manufacturing processes.

Examples: Plant management, landscaping, maintenance, security, property taxes, and plant depreciation.

Identify and Define Activities and Activity Cost Pools

Activities should only be combined within a level if they are highly correlated. When combining activities, they should be grouped together only at the appropriate level.

Identify and Define Activities and Activity Cost Pools

An Activity Cost
Pool is a bucket in which costs are accumulated that relate to a single activity measure in the ABC system.
$$ $ $ $ $

Identify and Define Activities and Activity Cost Pools

Two types of activity measures: Transaction driver
Simple count of the number of times an activity occurs.

Duration driver
A measure of the amount of time needed for an activity.

Identify and Define Activities and Activity Cost Pools

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

Identify and Define Activities and Activity Cost Pools

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. i.e. organization sustaining activity

When Possible, Directly Trace Overhead Costs 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.

Assign Costs to Activity Cost Pools

Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

Assign Costs to Activity Cost Pools

Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

Assign Costs to Activity Cost Pools

Calculate Activity Rates

The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . .
1,000 customer orders, 200 new designs, 20,000 machine-hours, 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

Activity-Based Costing at Classic Brass

Direct Materials Direct Labor Shipping Costs Overhead Costs

Traced

Traced

Traced

Cost Objects:
Products, Customer Orders, Customers

Activity-Based Costing at Classic Brass

Direct Materials Direct Labor Shipping Costs Overhead Costs

First-Stage Allocation

Order Size

Customer Orders

Product Design

Customer Relations

Other

Cost Objects:
Products, Customer Orders, Customers

Activity-Based Costing at Classic Brass

Direct Materials Direct Labor Shipping Costs Overhead Costs

First-Stage Allocation

Order Size

Customer Orders

Product Design

Customer Relations

Other

Second-Stage Allocations
$/MH $/Order $/Design $/Customer

Cost Objects:
Products, Customer Orders, Customers

Unallocated

Assigning Costs to Cost Objects

Lets 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. 2. Each stanchion required 0.5 machine-hours. 3. Selling price is $34 each. 4. Direct materials total $2,110. 5. Direct labor totals $1,850. 6. Shipping costs total $180. Custom Compass Housing (requires new design) 1. One order during the year. 2. Each housing required 4 machine-hours. 3. Selling price is $650 each. 4. Direct materials total $13. 5. Direct labor totals $50. 6. Shipping costs total $25.

Assigning Costs to Cost Objects

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

Prepare Management Reports

Standard Stanchions Sales Cost: Direct materials Direct labor Shipping costs Customer orders Product design Order size Product margin $ $ 2,110 1,850 180 630 3,800 $ 13,600

8,570 5,030

Custom Compass Housing Sales Cost: Direct materials Direct labor Shipping costs Customer orders Product design Order size Product margin

$ $ 13 50 25 315 1,285 76

650

1,764 $ (1,114)

Prepare Management Reports

Customer Profitability Analysis

Product Margins
Traditional Cost Accounting System

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

Predetermined manufacturing = overhead rate

$1,000,000 20,000 MH

= $50/MH

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 batchlevel 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 non-manufacturing costs to products.

Traditional costing assigns all manufacturing costs to

products. The ABC system does not assign organizationsustaining manufacturing costs to the products.

End of Chapter