Topic 4

Chapter Five
Activity-Based Costing and Cost Management Systems

Activity Based Costing (ABC)

ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore fixed costs.
ABC is a good supplement to our traditional cost system

I agree!

Activity Based Costing (ABC)

Both manufacturing and nonmanufacturing costs may be assigned to products. Some manufacturing costs may be excluded from product costs. Allocation bases often differ from traditional costing systems.
Overhead rates may be based on activity at capacity.

A number of cost pools each allocated to a product or cost object.

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 P rodu ction : Un its Ru n s 10,000 1 of 10,000 Mode II 20,000 4 of 5,000 Mode III 4,000 10 of 400

Traditional, Volume-Based Product-Costing System

Additional information includes:
Mode I Dire ct mate rials $ 50.00 Dire ct labor (h r/board) 3 Se tu p time (h r/ru n ) 10 Mach in e time (h r/board) 1
Mode I Dire ct m ate rials $ 50.00 Dire ct labor 60.00 Man u factu rin g ove rh e ad 99.00 Total $ 209.00

Mode II $ 90.00 4 10 1.25

Mode II $ 90.00 80.00 132.00 $ 302.00

Mode III $ 20.00 2 10 2

Mode III $ 20.00 40.00 66.00 $ 126.00

Manufacturing overhead is determined as follows

Traditional, Volume-Based Product-Costing System

Un its produ ce d Dire ct labor (h r/u n it) Total h ou rs Total h ou rs re qu ire d Mode I 10,000 3 30,000 Mode II 20,000 4 80,000 118,000 Mode III 4,000 2 8,000

Budgeted manufacturing overhead Budgeted direct-labor hours

Mode I Dire ct labor (h r/u n it) Ove rh e ad rate pe r h ou r Ove rh e ad pe r u n it $ $

$3,894,000 118,000
Mode II $ $

= $33 per hour

3 33 99

4 33 132

Mode III 2 $ 33 $ 66

Traditional, Volume-Based Product-Costing System

With these product costs, Aerotech established target selling prices (Cost 125%).
Mode I Dire ct m ate rials $ 50.00 Dire ct labor 60.00 Man u factu rin g ove rh e ad 99.00 Total $ 209.00 Mode II $ 90.00 80.00 132.00 $ 302.00 Mode III $ 20.00 40.00 66.00 $ 126.00

Cos t pe r u n it Targe t s e llin g price

Mode I $ 209.00 261.25

Mode II $ 302.00 377.50

Mode III $ 126.00 157.50

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.

Lets see how ABC works.

Activity Based Costing System (ABC)

ABC systems follow a twostage procedure to assign overhead costs to products.
Assigning overhead to products is a difficult process.

I agree!

Activity Based Costing System

(ABC)
ABC systems follow a twostage procedure to assign overhead costs to products.
Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.
Lets begin by identifying our major activities.

Activity Based Costing System

(ABC)
ABC systems follow a two-stage procedure to assign overhead costs to products.
Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products.
Overhead assigned to activities are called activity cost pools.

Activity Cost Pools

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

Homogeneous Activity Cost Pools

A homogeneous cost pool is a grouping of overhead costs in which each cost component is consumed in roughly the same proportion by each product line.

A homogeneous cost pool uses a single cost driver.

Cost Drivers
A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .
Degree of Correlation Cost of Measurement Behavioral Effects

Overhead Costs
Total budgeted cost = $3,894,000
Activity must be done on each unit produced.

Activity Cost Pools ProductSustaining Level Engineering cost pool $700,000

Identification of Activity Cost Pools

Unit Level Machinery cost pool $1,212,600

Activity performed on each batch produced.

Batch Level Setup cost pool $3,000

Facility Level Facility cost pool $507,400

Activities needed to support an entire product line

Activity required in order for the production process to occur.

Overhead Costs
Total budgeted cost = $3,894,000

Activity Cost Pools ProductSustaining Level Engineering cost pool $700,000

Identification of Activity Cost Pools

Unit Level Machinery cost pool $1,212,600

Batch Level Setup cost pool $3,000

Facility Level Facility cost pool $507,400

More Cost Pools

Unit Level Machinery cost pool $1,212,600

Batch Level Setup cost pool $3,000 Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000

ProductSustaining Level Engineering cost pool $700,000

Facility Level Facility cost pool $507,400

STAGE ONE
Various overhead costs related to machinery
Maintenance
Depreciation Computer Support

Lubrication
Electricity Calibration

Activity cost pool

Machinery Cost Pool

Total budgeted cost = $1,212,600

STAGE TWO
Calculate the pool rate
Budgeted Machinery Costs = $1,212,600 Budgeted Machine Hours 43,000 = $28.20/hour

Cost Assignment

Mode I: $28.20 per hr. 1 hr. per unit $28.20 per unit

Mode II: $28.20 per hr. 1.25 hr. per unit $35.25 per unit

Mode III: $28.20 per hr. 2 hr. per unit $56.40 per unit

STAGE ONE
Calculation of total setup cost
Total budgeted setup cost $20 per hour 10 hr. per setup $200 cost per setup 15 production runs $ 3,000 Total

Activity cost pool

Setup Cost Pool

Total budgeted cost = $3,000

STAGE TWO
Calculate the pool rate
Budgeted Setup Costs Planned Production Runs = $3,000 15 runs = $200 per run

Cost Assignment

Mode I: (1 Run) $200 per run 10,000 units per run = $.02 per unit

Mode II: (4 Runs) $200 per run 5,000 units per run = $.04 per unit

Mode III: (10 Runs) $200 per run 400 units per run = $.50 per unit

STAGE ONE
Various overhead costs related to engineering
Engineering salaries Engineering supplies Engineering software Depreciation

Activity cost pool

Engineering Cost Pool

Total budgeted cost = $700,000

STAGE TWO
Allocate based on engineering transactions

Engineering Cost Pool

Total budgeted cost = $700,000

Cost Assignment

Mode I: 25% $700,000 10,000 units = $17.50 per unit

Mode II: 45% $700,000 20,000 units = $15.75 per unit

Mode III: 30% $700,000 4,000 units = $52.50 per unit

STAGE ONE
Various overhead costs related to general operations
Plant depr.
Plant mgmt. Plant maint.

Property taxes
Insurance Security

Activity cost pool

Facility Cost Pool

Total budgeted cost = $507,400

STAGE TWO
Calculate the pool rate
Budgeted Facilities Cost = $507,400 Budgeted Direct-Labor Hours 118,000 = $4.30/hour

Cost Assignment

Mode I: $4.30 per hr. 3 hr. per unit $12.90 per unit

Mode II: $4.30 per hr. 4 hr. per unit $17.20 per unit

Mode III: $4.30 per hr. 2 hr. per unit $8.60 per unit

Product Cost from ABC

Here are the new product costs so far . . .
Direct materials Direct labor Machinery Setup Engineering Facilities Mode I $ 50.00 60.00 28.20 0.02 17.50 12.90 Mode II $ 90.00 80.00 35.25 0.04 15.75 17.20 Mode III $ 20.00 40.00 56.40 0.50 52.50 8.60

Other Overhead Costs

Re c e ivin g an d In s pe c t ion Cos t P ool
Board Mode I Mode II Mode III Ove rh e ad $ 200,000 200,000 200,000 % 6% 24% 70% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 1.20 = 2.40 = 35.00

Mat e rial-Han dlin g Cos t P ool

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

Qu alit y-As s u ran c e Cos t P ool

Board Mode I Mode II Mode III Ove rh e ad $ 421,000 421,000 421,000 % 20% 40% 40% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 8.42 = 8.42 = 42.10

P ac kagin g an d Sh ippin g Cos t P ool

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

Other Overhead Costs

Re c e ivin g an d In s pe c t ion Cos t P ool
Board Mode I Mode II Mode III Ove rh e ad $ 200,000 200,000 200,000 % 6% 24% 70% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 1.20 = 2.40 = 35.00

Mat e rial-Han dlin g Cos t P ool

$14.82

Board Mode I Mode II Mode III

Ove rh e ad $ 600,000 600,000 600,000

% 7% 30% 63%

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 4.20 = 9.00 = 94.50

Qu alit y-As s u ran c e Cos t P ool

Board Mode I Mode II Mode III Ove rh e ad $ 421,000 421,000 421,000 % 20% 40% 40% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 8.42 = 8.42 = 42.10

P ac kagin g an d Sh ippin g Cos t P ool

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

Product Cost from ABC

These are the new product costs when Aerotech uses ABC.
Mode I Direct materials $ 50.00 Direct labor 60.00 Machinery 28.20 Setup 0.02 Engineering 17.50 Facilities 12.90 Other 14.82 Total $ 183.44 Mode II $ 90.00 80.00 35.25 0.04 15.75 17.20 23.57 $ 261.81 Mode III $ 20.00 40.00 56.40 0.50 52.50 8.60 212.85 $ 390.85

Product Diversity
Both original and ABC target selling prices are based on (Cost 125%).
Tradition al cos tin g ABC cos tin g Origin al targe t s e llin g price ABC targe t s e llin g price Mode I $ 209.00 183.44 261.25 229.30 Mode II $ 302.00 261.81 377.50 327.26 Mode III $ 126.00 390.85 157.50 488.56

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?
Mode I Tradition al cos tin g $ 209.00 ABC cos tin g 183.44 Cos t dis tortion pe r u n it 25.56 Un its produ ce d 10,000 Total cos t dis tortion 255,600 Mode II $ 302.00 261.81 40.19 20,000 803,800 Mode III $ 126.00 390.85 (264.85) 4,000 (1,059,400)

Traditional costing understates the cost of complex, low volume products.

Difference Between ABC and Traditional Product Costs

Batch-level or product-level costs will ordinarily shift overhead costs from high-volume products produced in large batches to low-volume products produced in small batches.
Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organizationsustaining costs and the costs of idle capacity are not assigned to products.

ABC: Some Key Issues

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.

Direct versus Indirect Costs

Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production.

Indirect Costs

Indicators of Need for ABC

Direct labor is a small percentage of total costs Product-line profit margins are hard to explain

Sales are increasing, but profits are declining.

Line managers do not believe the product costs reports

Some products that have reported high profit margins are not sold by competitors

Marketing does not use costs reports for pricing decisions

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.

Targeting Process Improvement

Activity-based costing can be used to identify areas that would benefit from process improvements.

The theory of constraints approach is a powerful tool for targeting the area in an organization whose improvement will yield the greatest benefits.

Non-Value-Added Costs
Suppose our production process looks like this:

Storage Waiting Process TimeNVA TimeNVA Time VA

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

Move Inspection TimeNVA TimeNVA

Non-Value-Added Costs
Our goal is to reduce or eliminate the non-value-added activities.

Storage Waiting Process TimeNVA TimeNVA Time VA

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

Move Inspection TimeNVA TimeNVA

ABC in the Service Industry

Activities tend to be nonrepetitive human tasks.

Implementation Problems
High proportion of facility-level costs

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.

Limitations of ABC
ABC systems are a major project requiring substantial resources. The benefits of increased accuracy must outweigh these additional costs. ABC produces numbers, like product margins, that are at odds with numbers produced by traditional costing system. Some managers find it difficult to adjust to this change.

ABC data can be misinterpreted and must be used with care when making decisions.

End of Chapter 5

This is real value-added time!