Session 6

Activity-Based Costing (ABC) &

Activity-Based Management (ABM)

1
 Indirect Cost Allocation

Cost Pool

Cost Allocation Base

How many heterogeneous indirect cost pools should

we identify?
2
 Part 6.1.
Explain Undercosting & Overcosting
of Products and Services

3
 Example

1. Suppose a manager needs to determine the manufacturing

costs of two products, A and B, for pricing purpose;
2. For simplicity, assume that MO includes:
1) The depreciation cost of the cutting machine: $300
2) The salary of the packaging worker: $150
3. There is no under-allocation or over-allocation of MO.

Machine Hour (MH) Labor Hour (LH)

A 0.25 H 0.25 H
B 0.25 H 0.5 H
4
 Scenario #1

Suppose that the overhead is applied to products at a single

manufacturing overhead rate: $900/MH.

Single Allocation Base (MH: Machine Hour)

A 900*0.25=$225
B 900*0.25=$225

5
 Scenario #2

Suppose that the firm refines its cost allocation system by

applying two manufacturing overhead rates for two cost pools:
$600/MH, and $200/LH.

Cost Pool #1 Cost Pool #2 Total

(MH) (LH)
A 600*0.25=150 200*0.25=50 $200
B 600*0.25=150 200*0.5=100 $250

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 Example

Single Allocation Base Multiple Allocation Bases

(MH) (MH+LH)
A $225 $200
B $225 $250

7
 Undercosting / Overcosting

Undercosting: Resources actually consumed > Cost reported

Overcosting: Resources actually consumed < Cost reported
Cross Subsidization:
Undercosting one product means overcosting at least one
of the other products

 The overcosted product absorbs too much cost, making it

seem less profitable than it really is;
The undercosted product is left with too little cost, making it
seem more profitable than it really is.

8
 Traditional Plant-wide Overhead Rate

 Plant-wide Overhead Rate: single indirect cost pool

and single cost allocation base

 Using one predetermined manufacturing overhead

cost rate

POHR= Total estimated manuf. overhead costs

Total estimated amount of allocation base

 This type of averaging (peanut-butter costing) results

in overcosting & undercosting.

9
 Departmental Overhead Rates

 Plantwide allocation system ends up distorting costs

 Different departments incur different amounts and
types of MO;
 Different types of MO have different cost drivers

 Solution: separate predetermined manufacturing

overhead rates for each DEPARTMENT (cutting,
grinding, assembly, packaging, etc.)

 STILL NOT ACCURATE ENOUGH !

10
 Reasons for Refining Costing System

 Traditional costing system

 mismatched resource
 cost distortion

 Shortened product life cycles and fierce market

competitive pressure
 Accurate cost information becomes vital for product
pricing

 Computer technology reduces costs of refinement

11
 Part 6.2.
Activity-Based Costing (ABC)

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 Activity-Based Costing (ABC)

 ABC allocates indirect costs to cost objects by

focusing on activities and cost drivers for activities
 Separate allocation rate for each activity

Manufacturing
Activities

Materials Machine Parts Product Product Other

Mixing Setup Processing Testing Packaging activities

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 Activity-Based Costing (ABC)

Indirect Cost Mixing Setup Processing Testing

Pool (Activity)

Cost No. of No. of

Allocation No. of Setup Machine Samples
Base Batches Hours Hours Taken

Product
Cost Product 1 Product 3
Objects Product 2

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 Activity-Based Costing

 ABC is applied to allocate indirect manufacturing

costs;

 ABC is also applied to allocate indirect period costs

for internal use.

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 ABC Steps
Step 1: Identify and estimate indirect costs
Total Activity Cost
Activity MOH Costs for the Activity
Pool
Machine Setup Indirect labor to set up machines $80,000
Materials Handling Forklifts, gas, operators’ wages 200,000
Machine lease payments,
Fabricating Parts
electricity, repairs
300,000

Supervising
Production engineers’ labor 150,000
Assembly
Testing equipment, inspection
Inspecting
labor
170,000

Packaging Packaging equipment 100,000

$1,000,000
16
 ABC Steps
Steps 2-3: Compute cost allocation rate for each activity
Total Cost
Activity Allocation base Cost Allocation Rate
Pool

Machine Set-up Number of set-ups $80,000 $80,000 / 8000 = $10

Number of parts
Materials Handling 200,000 200,000/ 400,000 = $0.50
moved

Fabricating Parts Machine hours 300,000 300,000/ 12,500 = $24

Supervising
Direct labor hours 150,000 150,000 / 50,000 = $3
Assembly

Inspecting Number of inspections 170,000 170,000 / 34,000 = $5

Packaging Cubic feet packaged 100,000 100,000 / 400,000 =$0.25

17

1,000,000
 ABC Steps
Step 4: Allocate MO for each activity to the individual jobs
that use the activities.
Actual Use of Activity
Activity Cost MOH Allocated
Activity Allocation Base
Allocation Rate to Product A
(Product A)
Machine Setup $10 per setup × 2 setups = $20
Materials
$0.50 per part × 20 parts = 10
Handling
$24 per machine
Fabricating × 1 machine hour = 24
hour
Supervising
$3 per DL hour × 9 DL hours = 27
Assembly
Inspecting $5 per inspection × 3 inspections = 15
$0.25 per cubic
Packaging × 52 cubic feet = 13
foot
18
Total $109
 ABC Steps

Activity Cost Actual Use of Activity MOH Allocated

Activity
Allocation Rate Allocation Base (Product B) to One object

Machine
$10 per setup × 4 setups = $40
Setup
Materials
$0.50 per part × 26 parts = 13
Handling
$24 per machine
Fabricating × 4 machine hour = 96
hour
Supervising
$3 per DL hour × 6 DL hours = 18
Assembly
Inspecting $5 per inspection × 6 inspections = 30

Packaging $0.25 per cubic foot × 60 cubic feet = 15

Total $212
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ABC Steps

 The end?

 End-of-period adjustment for under-

allocation / over-allocation

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 Cost Hierarchy

ABC uses a four-level cost structure to determine how far

down the production cycle costs should be pushed:

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 Example

How do we classify “heating, cleaning, or safe-guarding

a factory”?
A. Output unit-level.
B. Batch-level.
C. Product- (or Service-) sustaining-level.
D. Facility-sustaining-level.

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 Example

How do we classify “designing or advertising a

product/service”?
A. Output unit-level.
B. Batch-level.
C. Product- (or Service-) sustaining-level.
D. Facility-sustaining-level.

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 Example

How do we classify “setting up equipment” before

production begins?
A. Output unit-level.
B. Batch-level.
C. Product- (or Service-) sustaining-level.
D. Facility-sustaining-level.

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 Example

How do we classify “providing power to run manufacturing

equipment for production”?
A. Output unit-level.
B. Batch-level.
C. Product- (or Service-) sustaining-level.
D. Facility-sustaining-level.

25
 Exercise
Dovi’s budgeted ABC manuf. overhead allocation rates are:

Activity Allocation Base Activity Cost

Allocation Rate
Materials Handling Number of parts $3.75 per part
Machine Setup Number of setups $300 per setup
Insertion of Parts Number of parts $24 per part
Finishing Finishing direct $50 per hour
labor hours

26
 Exercise
Dovi produces two models: standard and deluxe. Additional
data are as follows:

Standard Deluxe
Parts per wheel 4 6
Setups per 1,000 wheels 15 15
Finishing direct labor hours per wheel 1 2.5
Production volume (number of units) 1,000 1,000

Required: Allocate MO cost to each wheel for each model

using ABC.
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Exercise

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 Part 6.3.
Activity-Based Management (ABM)

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 Activity-Based Management (ABM)

 Pricing and product mix

 Cutting costs
 Re-evaluating activities to reduce costs
while satisfying customer needs

 Routine planning and control decisions

 Create budgets
 Performance evaluation

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 Example: Plastim Corporation
• Plastim Corp manufactures lenses for rear taillights of
automobiles;

• Plastim makes 2 types of lenses for a customer, Giovanni

Motors:
S3 CL5 (per unit)
Selling price $63 $137
Total cost $58.75 $ 97

• A competitor, Bandix, makes S3 and offers to sell at $53

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Simple Costing at Plastim Corp.

S3: 30,000
CL5: 9,750

14
Simple Costing at Plastim Corp.

33
Plastim’s ABC System

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35
36
Simple vs. ABC

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 ABM: Decision Making

S3 CL5 (per unit)

Selling price $63 $137
Total cost (old) $58.75 $ 97
ABC cost $49.98 $132.07

• A competitor, Bandix, makes S3 and offers to sell at $53

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Cost-Benefit Test of ABC

Cost-Benefit Consideration!!!

 System should be refined enough to provide

accurate product costs;

 ABC and ABM pass the cost-benefit test when the

benefits of adoption exceed the costs of
implementation.

39
 Exercise

Yummy Inc. (Y) is a large store that sells cakes and pies and has a coffee
shop. Y operates at capacity and allocates selling, general, and
administration costs to each product line using cost of merchandise of
each product line.

Y wants to optimize the pricing and cost management of each product

line. Y is wondering whether its accounting system is providing the
company with the best information for making such decisions. Y has the
following information for the year:

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  Yummy Inc.    
 Product Line Information

 For the Year Ended 31 December 2019

  Cake Pie Coffee Shop

Revenue $3,800,000 $2,400,000 $800,000

Cost of merchandise $2,700,000 $1,800,000 $500,000

Cost of coffee shop cleaning $- $- $20,000

No. of purchase orders placed 2,900 2,600 2,200

No. of deliveries received 1,500 1,800 1,700

Hours of shelf stocking time 16,000 15,000 12,000

Items sold 125,000 116,000 370,000

Yummy Inc.
     

 Selling, general, and administration costs

 For the Year Ended 31 December 2019

   

Purchasing department expense $480,000

Receiving department expense $440,000

Shelf stocking, decorating labour expense $490,000

Customer support expense (cashier, floor employees) for selling items $100,000

      $1,510,000 41
 Exercise (Cont’d)
Required:
1. Y uses cost of merchandise to allocate all selling, general, and
administration costs. Prepare product line and total company income
statements.

2. Identify an improved method (ABC) for allocating costs to the three

product lines.

Use this method for allocating selling, general, and administration

costs that you propose to prepare a new product line statement and a
total company income statement. Compare new results to those in
Question 1.

3. If change to ABC, how may this improved system be useful for

managing the store.

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Exercise

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