Learning Objectives

Activity-Based Costing

Accy211: Management Accounting II

Autumn 2013 Week 5

1. Explain undercosting and overcosting of products or services 2. Understand a traditional product costing system 3. Understand guidelines for refining a costing system 4. Understand an Activity Based Costing System 5. Understand how ABC differs from traditional costing system 6. Prepare ABC analysis (Comprehensive example) 7. Limitations of activity-based costing systems
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Cost Allocation
Direct Materials Direct Labour

Direct Costs Indirect Costs

Cost Allocation Base

Manufacturing Overhead

One of the most difficult tasks in computing accurate unit costs lies in determining the proper amount of overhead cost to assign to each job. Factory overhead is applied to production in a rational systematic manner. The methods used often involve tradeoffs between simplicity and realism Historically, firms produced a limited variety of goods while their indirect costs were relatively small. Used broad averages to allocate costs (Peanutbutter Costing) 3

Learning Objective

1
Explain undercosting and overcosting of products or services
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Cost Smoothing (Peanut butter costing)

The term cost smoothing describes a particular costing approach that uses broad averages for assigning the cost of resources uniformly to cost objects when the products/services use those resources in a non-uniform way. Cost smoothing can lead to undercosting or overcosting of product and services

Undercosting and Overcosting Example

Jose, Rob, and Nancy order separate items for lunch. Joses order amounts to Rob consumed Nancys order is Total $60 3 = $20 Jose and Nancy are overcosted. Rob is undercosted.
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$14 30 16 $60

What is the average cost per lunch?

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(1) Identify cost objects Direct Materials Direct Labour

Learning Objective

(2) Identify direct costs (3) Compute the indirect costs of the job Select MOH cost allocation base

2
Understand a Traditional Product Cost System.

Direct Costs Indirect Costs (MOH)

Product Cost Period Costs

Identify MOH costs MOH costs allocated to the cost object

Compute MOH cost allocation rate

(4)Total Costs

See example on page 8 for Single Plant Wide Indirect Cost Pool System (Traditional Costing)

Learning Objective

3
Understand a guidelines for refining a costing system
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Rationale for selecting a more refined costing system

The Past Small number of products which did not differ much in required manufacturing support. Labor was the dominant element in the cost structure. The Present Numerous products with more and complicated production requirements. Labor is becoming an ever smaller part component of total production costs. Increase in indirect costs Advances in information technology Competition in foreign 11 markets

Guidelines for Refining a Costing System

Direct-cost tracing Indirect-cost pools Cost-allocation bases

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Activity Based Costing

Refines a costing system by identifying individual activities as the fundamental objects. Attempts to provide a more precise indirect cost allocation by tracing costs from activities to products. Uses multiple cost drivers.

Learning Objective

4
Understand Activity Based Costing system
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Activities and Product Costs

Products require activities. Activities consume resources.
Activities-Example

Activity

An event that causes the consumption of overhead resources.

Activity Cost Pool

$
(1) Design products and processes. (2) Set up molding machine. (3) Operate machines to manufacture lenses. (4) Maintain and clean the molds. (5) Set up batches of finished lenses for shipment (6) Distribute lenses to customers. (7) Administer and manage all processes.

$$ $ $ $

A cost bucket in which costs related to a single activity measure are accumulated.

Resources have costs.

Activity Measure
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An allocation base in an activity-based costing system. The term cost driver is also used to refer to an activity measure.

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Fundamental Cost Objects Two common types of activity measures: Activity 1 Transaction driver
Simple count of the number of times an activity occurs.

Cost Pools based on Cost Hierarchy

Cost of Activity 1 Cost of Activity 2 Cost of Activity 3
Co st dr

Assignment to Cost Objects

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

r1

Activity 2 Activity 3

Cost driver 2

t os

dr

3 er iv

Cost of: Product Service Customer

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Cost Hierarchy (Activity Levels)

Unit-Level Activity Batch-Level Activity

ABC defines five levels of activity that largely do not relate to the volume of units produced.

Manufacturing companies typically combine their activities into five classifications.

Product-Level Activity Customer-Level 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.
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Organizationsustaining Activity

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Unit-Level Activity Costs

These are resources sacrificed on activities performed on each individual unit of product or service. Examples: Energy, Machine deprecation, Repairs. These are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. Examples: Setup hours, procurement cots. These are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services. Examples: Design costs Engineering costs. 21

Batch-Level Activity Costs

Facility Level Activity Cost

These are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. Examples: General Administration, rent, building security
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Product-Level Activity Costs

Quiz -1
Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009. Indirect manufacturing labor costs such as supervision that supports direct manufacturing labor, $1,000,000 (A)unit-level costs. (B)batch-level costs. (C)product-sustaining costs (D) facility-sustaining costs. 23

Quiz - 2
Teleport, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009. Procurement costs of placing purchase orders, receiving materials, and paying suppliers related to the number of purchase orders placed, $500,000. (A) unit-level costs. (B) batch-level costs. (C) product-sustaining costs (D)facility-sustaining costs.

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Quiz - 3
Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009. Costs incurred to set up machines each time a different product needs to be manufactured, $600,000. (A)unit-level costs. (B)batch-level costs. (C)product-sustaining costs (D) facility-sustaining costs.
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Quiz - 4
Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009. Designing processes, drawing process charts, making engineering process changes for products, $800,000. (A)unit-level costs. (B)batch-level costs. (C)product-sustaining costs (D) facility-sustaining costs.

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Quiz - 5
Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009. Plant management, plant rent, and plant insurance, $900,000. (A)unit-level costs. (B)batch-level costs. (C)product-sustaining costs (D) facility-sustaining costs.

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How ABC differs from traditional cost accounting Learning Objective

ABC assigns both types of costs to products. Manufacturing costs

5
Understand how activity-based costing differs from a traditional costing system.

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Traditional product costing

ABC product costing

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Nonmanufacturing costs

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Page 5 of 13

 ABC does not assign all manufacturing costs to products. Manufacturing costs
Mo st, not but all

ABC uses more cost pools.

Level of complexity

All

ActivityBased Costing Departmental Overhead Rates Plantwide Overhead Rate

Each ABC cost pool has its own unique measure of activity.

Some

Traditional product costing

ABC product costing

Traditional cost systems usually rely on volume measures such as direct laborhours and/or machine hours to allocateall overhead costs to products.

Number of cost pools

Nonmanufacturing costs

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Product costing with Activity Based Costing System

(1) Identify cost objects Direct Materials Direct Labour

Product costing with Activity Based Costing System

Direct Materials Direct Labour

(2) Identify direct costs

(3) Define activities, Activity Cost Pools, and Activity Measures Direct Costs (4) Assign overhead costs to activity cost pools (5) Calculate activity rates Indirect Costs (7) Compute the total costs

Direct Costs Indirect Costs

Total cost

(6) Assign overhead costs to cost object using activity rates and activity measures

Activity 1

Activity 2

Activity 3

Activity 4

Activity 5

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In this process it is possible to trace some indirect costs as direct costs

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Learning Objective

6
Prepare ABC analysis (Comprehensive example)
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See Activity Based Costing System Example on page 9

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ActivityBased Costing Example Baxter Battery Company

Direct Materials Direct Labor Shipping Costs Overhead Costs

Activities, Activity Cost Pools and Activity Measures at Baxter Battery Company
Customer

First-Stage Allocation

Customer Orders

Design Changes

Order Size

Other

Second-Stage Allocations
$/Order $/Change $/MH

Unallocated

SS

LL

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Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Design Changes - assigned all costs of resources consumed by customer requested design changes. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Other assigned all organization-sustaining costs and unused capacity costs

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Differences Between ABC and Traditional Product Costs and Major Reasons for the differences
Product margins traditional Product margins ABC Change in reported margins SureStarts $ 7,600,000 9,290,000 $ 1,690,000 LongLifes $ 1,400,000 (5,230,000) $ (6,630,000)

1. traditional cost system allocates all manufacturing overhead costs using a volume-related allocation base (machine-hours). The ABC system uses volume-related related allocation SS and non-volume LL bases to assign manufacturing overhead to products

Order Size

60 100 40
20% 40% 60%

40

$6,350,000 Customer Orders $6,040,000 Design changes

The traditional cost system overcosts the SureStarts and reports a lower product margin for this product.

The traditional cost system undercosts the LongLifes and reports a higher product margin for this product.

Design Changes 0 Customer Orders

60
80% 100%

$3,450,000 Machine Hours $15,840,000

0%

Can you see how different allocation methods might lead to making different management decisions? 39

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2. The ABC did not assign the manufacturing overhead costs included in the other activity ($3.7million) to products because these organization-sustaining and SS LLunused capacity costs are not caused by products. 3. traditional cost system disregards selling and administrative expenses because they are assumed to be period expenses. The ABC system directly traces shipping costs ($3,000,000) to products and includes nonmanufacturing overhead costs caused by products ($5,540,000)in the activity cost pools that are assigned to products

Learning Objective

7
Limitations of ABC costing system

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Activity-Based Costing and External Reporting

Most companies do not use ABC for external reporting because . . . 1. External reports are less detailed than internal reports. 2. It may be difficult to make changes to the companys 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 resources required to implement and maintain. Resistance to unfamiliar numbers and reports.

Desire to fully allocate all costs to products.

Potential misinterpretation of unfamiliar numbers.

Does not conform to GAAP. Two costing systems may be needed.

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Signs that indicate ABC system is likely to provide most benefits

Significant amounts of indirect costs are allocated using only one or two cost pools. All or most costs are identified as output unit-level costs. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity. Products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits. Complex products appear to be very profitable and simple products appear to be losing money. Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services. 45

ABC In Service and Merchandising Companies

The general approach is very similar to the approach in manufacturing. Costs are divided into homogeneous cost pools and classified as output unit-level, batch-level, productor service-sustaining, and facility-sustaining costs. The cost pools correspond to key activities. Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool.
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Activity-Based Management

End
There is ABC in your future!

A method of management that used 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
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Example-Single Plant-wide Indirect Cost Pool System [Traditional Cost Accounting]

Baxter Company manufactures 800,000 Sure starts batteries (SS) and 400,000 LongLifes batteries (LL). Direct costs for SS are: Direct materials $9,000,000; Direct labor $7,000,000. Direct costs for the LL are: Direct materials $6,000,000; Direct labour $5,000,000.Baxter currently uses a single plantwide overhead rate based on machine hours to allocate manufacturing overhead costs and 480,000 machine hours and 320,000 machine hours were used respectively to make SS and LL batteries. Total manufacturing overhead and the selling and administrative expenses for the year were $14,000,000 and $11,000,000 respectively. SS sells for $40 each and LL for $45 each. The income statement of the company for the year ended 31 December 2009 is as follows: Baxter Battery Company Income Statement Year Ended December 31, 2009 Sales Cost of goods sold Direct materials Direct labor Manufacturing overhead Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease Gross margin Selling and administrative expenses Shipping expenses Marketing expenses General administrative expenses Net operating loss $ $ 15,000,000 12,000,000 $ 6,000,000 3,500,000 2,500,000 2,000,000 50,000,000

$ 14,000,000

41,000,000 9,000,000

3,000,000 2,000,000 6,000,000 $

11,000,000 (2,000,000)

Calculate the profit margin of each product using traditional costing system. Step 1: Identify the product that are the chosen cost objects SETP-2: Identify direct costs of the products
800,000 SureStart Sales Direct Costs Direct materials Direct labour 400,000 LongLifes

STEP 3: Compute the indirect costs of the products

Plant-wide POHR = $14,000,000 800,000mh SS: LL: = 17.5mh

STEP 4: Compute the Total cost and profit margin of the products
SureStart Total direct costs [STEP-2] Total indirect costs [STEP-3] Total product costs Product margin Less: Selling & admin expenses Net operating profit / (loss) Profit Margin per unit Revenue Less: Cost Gross profit Margin LongLifes

SS

LL

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Example-Activity Based Costing System

Baxter Company manufactures 800,000 Sure starts batteries (SS) and 400,000 LongLifes batteries (LL). Direct costs for SS are: Direct materials $9,000,000; Direct labor $7,000,000. Direct costs for the LL are: Direct materials $6,000,000; Direct labour $5,000,000.Baxter currently uses a single plantwide overhead rate based on machine hours to allocate manufacturing overhead costs and 480,000 machine hours and 320,000 machine hours were used respectively to make SS and LL batteries. Total manufacturing overhead and the selling and administrative expenses for the year were $14,000,000 and $11,000,000 respectively. SS sells for $40 each and LL for $45 each. The income statement of the company for the year ended 31 December 2009 is as follows: Baxter Battery Company Income Statement Year Ended December 31, 2009 Sales Cost of goods sold Direct materials Direct labor Manufacturing overhead Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease Gross margin Selling and administrative expenses Shipping expenses Marketing expenses General administrative expenses Net operating loss $ 50,000,000 $ 15,000,000 12,000,000 $ 6,000,000 3,500,000 2,500,000 2,000,000

$ 14,000,000

41,000,000 9,000,000

3,000,000 2,000,000 6,000,000

11,000,000 $ (2,000,000)

The Company is implementing an activity based costing system that has four activity cost pools. You are provided the following information

Direct materials and direct labor are remained to be direct costs. With the ABC analysis, the costs of Shipping ($3,000,000) have also been traced to the two products directly as follows:SS $2,000,000 and LL $1,000,000 All indirect cost items are now classified as follows: Activity Cost Pool Activity Measure Customer orders Number of customer orders Design changes Number of design changes Order size Machine-hours Other Not applicable

Total activities 10,000 customer orders 4,000 design changes 800,000 machine hrs Not applicable Continued next page

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3) The total overhead costs to be analyzed using ABC are as follows:

Overhead Costs at Baxter Battery (Manufacturing and Nonmanufacturing) Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total overhead costs

$ 6,000,000 3,500,000 2,500,000 2,000,000 4,000,000 900,000 1,100,000 1,500,000 500,000

$ 14,000,000

6,000,000

2,000,000 $ 22,000,000

4) At Baxter Battery the following distribution of resource consumption across activity cost pools is determined.
Customer Orders Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses 40% 0% 0% 0% 60% 50% 0% 60% 40% Activity Cost Pools Design Order Size Other changes 30% 60% 40% 0% 10% 10% 0% 30% 40% 20% 30% 30% 0% 10% 0% 0% 0% 10% 10% 10% 30% 100% 20% 40% 100% 10% 10% Total

100% 100% 100% 100% 100% 100% 100% 100% 100%

5) Activity usage by each product is as follows:

Customer Orders Design changes Order Size SureStart 4000 separate orders Requires no new design changes LongLife 6000 separate orders 4000 custom designs

requires 36 minutes of requires 48 minutes of machine machinetime for a total time for a total of 320,000 machineof 480,000 machine hours hours

Calculate the profit margin of each product using ABC system.

To

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Answer: Activity Based Costing Sample Question

Step 1: Identify the product that are the chosen cost objects
SS-800,000 LL-400,000

SETP-2: Identify direct costs of the products

800,000 SureStart $32,000,000 $9,000,000 $7,000,000 $2,000,000 400,000 LongLifes $18,000,000 $6,000,000 $5,000,000 $1,000,000 $12,000,000

Sales Direct Costs Direct materials Direct labour Shipping expenses

$50,000,000 $15,000,000 $12,000,000 $3,000,000 $30,000,000 Total activities 10,000 customer orders 4,000 design changes 800,000 machine hrs Not applicable

Total direct costs $18,000,000 STEP 3: define activity cost pools and activity measures Activity Cost Pool Customer orders Design changes Order size Other

Activity Measure Number of customer orders Number of design changes Machine-hours Not applicable

STEP 4: Assign overhead costs to activity cost pools

Activity Cost Pools Customer orders Design changes Order size Other Total Total Cost $ 6,350,000 6,040,000 3,450,000 6,160,000 $ 22,000,000

STEP 5: Calculates activity rates

Activity Cost Pools Customer orders Design changes Order size Other Total (a) Total Cost $ 6,350,000 6,040,000 3,450,000 6,160,000 $ 22,000,000 (b) Total Activity 10,000 orders 4,000 changes 800,000 MHs Not applicable (a) (b) Activity Rate $635 per order $1510 per change $4.3125 per MH Not applicable

STEP 6: assigning overheads to products

Quantitiy of allocation base Customer orders Design changes Order size SS 4000 orders 0 new designs 480000 mh LL 6000 orders 4000 new designs 320000 mh

Overehad costs for two products

Customer orders Design changes Order size Total indirect costs-STEP-6

SS
$2,540,000 $0 $2,070,000 $4,610,000

LL
$3,810,000 $6,040,000 $1,380,000 $11,230,000

Total
$6,350,000 $6,040,000 $3,450,000 $15,840,000

STEP 7: Compute the product Margins

Sales Direct costs (STEP-2) Indirect costs (STEP-6) Total product costs Product margin Less: Other Net operating profit/ (loss) $32,000,000 $18,000,000 $4,610,000 $22,610,000 $9,390,000
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$18,000,000 $12,000,000 $11,230,000 $23,230,000 -$5,230,000

$50,000,000 $30,000,000 $15,840,000 $45,840,000 $4,160,000 6,160,000 (2,000,000)

Workings-1: Step-4 assign overhead costs to activity cost

Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total overhead costs $ 6,000,000 3,500,000 2,500,000 2,000,000 4,000,000 900,000 1,100,000 1,500,000 500,000

$ 14,000,000

6,000,000

2,000,000 $ 22,000,000 Activity Cost Pools Order Size Other

Customer Orders Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses 40% 0% 0% 0% 60% 50% 0% 60% 40%

Design changes 30% 60% 40% 0% 10% 10% 0% 30% 40%

Total

20% 30% 30% 0% 10% 0% 0% 0% 10%

10% 10% 30% 100% 20% 40% 100% 10% 10%

100% 100% 100% 100% 100% 100% 100% 100% 100%

Activity Cost Pools Customer Design Orders changes Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries To Selling expenses Total Activity Cost Pools Customer orders Design changes Order size Other Total $ 2,400,000 2,400,000 450,000 900,000 200,000 $ 6,350,000 Total Cost $ 6,350,000 6,040,000 3,450,000 6,160,000 $ 22,000,000 $ 1,800,000 2,100,000 1,000,000 400,000 90,000 450,000 200,000 $ 6,040,000

Order Size $ 1,200,000 1,050,000 750,000 400,000 50,000 $ 3,450,000 $

Other 600,000 350,000 750,000 2,000,000 800,000 360,000 1,100,000 150,000 50,000 $ 6,160,000 $

Total 6,000,000 3,500,000 2,500,000 2,000,000 4,000,000 900,000 1,100,000 1,500,000 500,000 $ 22,000,000

ABC Profit Margin per unit

Revenue Less: Cost Gross profit Margin SS $40.00 $28.26 $11.74 29%
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LL $45.00 $58.08 -$13.08 -29%