Activity-Based Costing

and Cost Management

Systems

By Prof. S.Sriram

S.P.Jain Institute of Management & Research

 Functional-Based Product
Costing Model
Direct Direct Overhead
Materials Labor
Direct Tracing
Driver Tracing
Allocation
Direct Direct
Plant/Departmental
Tracing Tracing
Cost Pools

Unit-Based
Drivers

PRODUCTS
 Goodmark Company

Scented Regular
Card Card Total
Units produced p.a., 20,000 200,000 --
Prime costs $ 160,000 $ 1,500,000 $ 1,660,000
Direct labor hours 20,000 160,000 180,000
 Goodmark Company (continued)

Predetermined
Overhead Rate = Budgeted overhead  Expected activity

= $720,000  180,000 DLH

= $4.00 per DLH
 Goodmark Company –Unit Cost
Computation: Plantwide Rate
Scented Regular
Prime costs $160,000 $1,500,000
Overhead costs:
$4.00 x 20,000 80,000 ---
$4.00 x 160,000 --- 640,000
Total mfg. costs $240,000 $2,140,000
Units of production  20,000  200,000
Unit cost $ 12.00 $ 10.70
 Goodmark Company –
Departmental Data
Direct labor hours: CuttingPrintingTotal
Scented cards 10,00010,00020,000
Regular cards 150,00010,000160,000
Total 160,00020,000180,000
====== ===========

Machine hours:
Scented cards 2,0008,00010,000
Regular cards 8,00072,00080,000
Total 10,00080,00090,000
===== ==========
 Goodmark Company –
Departmental Rates
Overhead Rates:
Cutting Rate = Budgeted OH / Expected DLH
= $216,000/160,000
= $1.35 per DLH
Printing Rate = Budgeted OH / Expected MH
= $504,000/80,000
= $6.30 per MH
Goodmark Company – Unit Cost
Computation: Departmental Rate
Scented Regular
Prime costs $160,000$1,500,000
Overhead costs:
($1.35 x 10,000) + ($6.30 x 8,000) 63,900---
($1.35 x 150,000) + ($6.30 x 72,000) --- 656,100
Total mfg. costs $223,900$2,156,100
Units of production  20,000  200,000
Unit cost $ 11.20$ 10.78
Today’s manufacturers are working in an
increasingly complex environment.

Manufacturing Environment
Manufacturing Characteristics Trend
Use of Advanced Technology

Product Life Cycle

Product Complexity

Capital Intensiveness

Channels of Distribution Key

Change
Quality Requirements Increasing

Number of Products and Product Diversity Decreasing

 A key to understanding ABC is to understand how cost behavior
truly varies in relation to other factors.

Changes in Cost Structure

100%
Overhead
Are these costs really
fixed?

How do we control
these costs?
Material
Manufacturing
Cost
Components

Direct Labor Key

Change
Variable Costs

Tradi- Process Islands Computer Optimised

tional Simplifi- of Auto- integrated Mfgn. Fixed Costs
cation mation Mfgn.
Stages in the Evolution of Manufacturing
 What is wrong with Traditional Costing Approach ?

Illustration - Part 1

Product A Product B

RM Cost Rs 500 Rs 500

Direct LabourRs 300 Rs 300

Overheads* Rs 500 Rs 500

Total Rs 1300 Rs 1300

*The overheads for the company were Rs 1000. This amount
was divided among the two products based on Direct labor cost
What is wrong with Traditional Costing Approach ?
Illustration - Part 2
The company invested in some automation equipment that
will enable them to reduce the labor content in Product B.
The labor cost per unit of Product B reduced by Rs 200/Unit
and the investment cost was worked out to Rs 200/Unit.
Product A Product B
RM Cost Rs 500 Rs 500

Direct Labour Rs 300 Rs 100

The overheads now are Rs 1,200 and to be allocated to

product A & B in the ratio of 3:1.( the ratio of Direct labor
Cost )
What is wrong with Traditional Costing Approach ?

Illustration - 3

Product A Product B

RM Cost Rs 500 Rs 500

Direct LabourRs 300 Rs 100

Overheads Rs 900 Rs 300

Total Rs 1700 Rs 900

 Symptoms of seriously flawed Cost
Accounting system
• Achieved gross margins are not easily explained.
• Customers do not object strongly when prices are increased.
• Products that are difficult to make are reported to be very profitable.
• What appear to be very high margin products are not attacked by
competitors. If margins are so good, why do not have more
competition?
• Competitors prices appear to be unrealistically low
• Even though the product mix is moving away from apparently lower
margin products toward apparently higher margin products, overall
profitability is declining.
• Results of bids are hard to explain..
 Cost distortion in Traditional System

Product complexity
Low High

High
Overcosted ?
Production Accurate
Accurate
Volume Costs
Costs
? Undercosted
Low

D
 Traditional View
‘Resources are consumed to produce products and services’

ABC view

‘Resources are consumed to produce activities’

and

‘Activities are consumed to produce products and services’

Activity-Based Costing Model

COST OF RESOURCES

Cost assigned using driver

tracing and direct tracing

ACTIVITIES

Costs assigned
using activity drivers

PRODUCTS
 Traditional Vs ABC

Traditional ABC

Salaries $100 Clean door $40

Equipment $80 Paint door $75

Supplies $20 Inspect door $75

Overhead $45 Send door to

assembly $55

TOTAL $245 TOTAL $245

 Hierarchy of Activities

• Unit level activities

• Batch-level activities
• Product-sustaining activities
• Facility sustaining
 Activity Categories

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 unit-level
activities, even though they are not overhead
costs.
 Activity Categories (continued)

Batch-level Activities are those that are performed

each time a batch of products is produced.
Examples: Setups, inspections, purchasing, and
material handling.
 Activity Categories (continued)

Product-level (Sustaining) Activities are those

activities performed that enable the various products
of a company to be produced. These activities and
their costs tend to increase as the number of different
products increases.
Examples: Engineering changes, developing product-
testing procedures, introducing new
products, and expediting goods.
 Activity Categories (continued)

Facility-level Activities are those that

sustain a factory's general
manufacturing processes.

Examples: Plant management,

landscaping, maintenance,
security, property taxes, and
plant depreciation.
 Exh.
5-2

Traditional, Volume-Based
Product-Costing System
• Aerotech produces three complex printed circuit
boards referred to as Mode I, Mode II, and Mode III.
• The following information is obtained from company
records:

Mode I Mode II Mode III

P rodu ction :
Un its 10,000 20,000 4,000
Ru n s 1 of 10,000 4 of 5,000 10 of 400
 Exh.
5-3

Traditional, Volume-Based
Product-Costing System
Additional information includes:
Mode I Mode II Mode III
Dire ct m ate rials $ 50.00 $ 90.00 $ 20.00
Dire ct labor (h r/board) 3 4 2
Se tu p tim e (h r/ru n ) 10 10 10
Mach in e time (h r/board) 1 1.25 2

Manufacturing overhead is determined as follows

 Exh.
5-3

Traditional, Volume-Based
Product-Costing System

Budgeted manufacturing overhead $3,894,000

= $33 per hour
Budgeted direct-labor hours 118,000
 Exh.
5-4

Traditional, Volume-Based
Product-Costing System
With these product costs, Aerotech established target
selling prices (Cost × 125%).

209.00 x 1.25
 Traditional, Volume-Based
Product-Costing System
Aerotech wishes to see what target selling prices would
be suggested when using activity-based costing.

Let’s see how ABC works.

 Exh.
5-5
Overhead Costs
Total budgeted cost = $3,894,000 Identification
Activity
must be
of Activity
done on Cost Pools
each unit Activity
produced. Cost
Pools

Product-
Unit Batch Sustaining Facility
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Activity Activities needed to support Activity required in order

performed an entire product line. for the production
on each process to occur.
batch
produced.
 Exh.
5-5
Overhead Costs
Total budgeted cost = $3,894,000 Identification
of Activity
Cost Pools
Activity
Cost
Pools

Product-
Unit Batch Sustaining Facility
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

More
Cost
Pools
 Product- Exh.
5-5
Unit Batch Sustaining Facility
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Receiving/Inspection
cost pool $200,000

Material-Handling
cost pool $600,000

Quality-Assurance
cost pool $421,000

Packaging/Shipping
cost pool $250,000
 Exh.

STAGE ONE 5-6

Maintenance Lubrication
Various overhead
costs related Depreciation Electricity
to machinery Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600
 Exh.

STAGE TWO 5-6

Calculate Budgeted Machinery Costs= $1,212,600

the pool Budgeted Machine Hours 43,000
rate = $28.20/hour

Cost
Assignment
 Exh.

STAGE ONE 5-7

Calculation of
total setup cost

Activity
cost Setup Cost Pool
pool Total budgeted cost = $3,000
 Exh.

STAGE TWO 5-7

Calculate Budgeted Setup Costs = $3,000

the pool Planned Production Runs 15 runs
rate = $200 per run

Cost
Assignment
 Exh.

STAGE ONE 5-8

Various overhead Engineering salaries Engineering software

costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool
pool Total budgeted cost = $700,000
 Exh.

STAGE TWO 5-8

Allocate based
on engineering Engineering Cost Pool
transactions Total budgeted cost = $700,000

Cost
Assignment
 Exh.

STAGE ONE 5-9

Various overhead Plant depr. Property taxes

costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507,400
 Exh.

STAGE TWO 5-9

Calculate Budgeted Facilities Cost = $507,400

the pool Budgeted Direct-Labor Hours 118,000
rate = $4.30/hour

Cost
Assignment
Product Cost from ABC
Here are the new product costs so far . . .
 Other Overhead Costs
Re c e ivin g a n d In s pe c t ion Cos t P ool
Board Ove rh e ad × % ÷ U n its = Cos t/Un it
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Mat e ria l-Ha n dlin g Co s t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

P ac kagin g a n d Sh ippin g Cos t P o ol

Board Ove rh e ad × % ÷ U n its = Cos t/U n it
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25

Qu alit y -As s u ra n c e Co s t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10
 Other Overhead Costs
Re c e ivin g a n d In s pe c t ion Cos t P ool
Board Ove rh e ad × % ÷ U n its = Cos t/Un it
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Mat e ria l-Ha n dlin g Co s t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
$14.82 Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

P ac kagin g a n d Sh ippin g Cos t P o ol

Board Ove rh e ad × % ÷ U n its = Cos t/U n it
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25

Qu alit y -As s u ra n c e Co s t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10
 Product Cost from ABC
These are the new product costs when Aerotech uses
ABC.
 Product Diversity
Both original and ABC target selling prices are
based on (Cost × 125%).

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]
 Product Diversity
Can you identify any problems Aerotech is likely to
face as a result of this distortion?

Traditional costing understates the cost

of complex, low volume products.
 ABC: Some Key Issues
The Past The Present
– Small number of – Numerous products
products which did not with more and
differ much in required complicated production
manufacturing support. requirements.
– Labor was dominant – Labor is becoming an
element in the cost ever smaller part
structure. component of total
production costs.
 Indicators of Need for ABC
Direct labor is a Product-line profit
small percentage margins are hard
of total costs. to explain.

Line managers do not

Sales are increasing,
believe the product
but profits are declining.
cost reports.

Some products that

Marketing does not
have reported high
use costs reports for
profit margins are not
pricing decisions.
sold by competitors.
 Cost Management Systems
Objectives

– Measure the cost of resources consumed.

– Identify and eliminate non-value-added costs.
– Determine the efficiency and effectiveness of all major
activities.
– Identify and evaluate new activities that can improve
future performance.
 Non-Value-Added Costs
Suppose our production process looks like this:

Storage Waiting Process Move Inspection

TimeNVA TimeNVA Time VA TimeNVA TimeNVA

VA = Valued-added activity
NVA = Non-value-added activity
 Non-Value-Added Costs
Our goal is to reduce or eliminate the non-value-added activities

Storage Waiting Process Move Inspection

TimeNVA TimeNVA Time VA TimeNVA TimeNVA

VA = Valued-added activity
NVA = Non-value-added activity