Chapter 5

Activity-Based Costing and Management

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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 Production: Units Runs 10,000 1 run of 10,000 units Mode II 20,000 4 runs of 5,000 units Mode III 4,000 10 runs of 400 units
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Traditional, Volume-Based Product-Costing System

Direct materials Direct labor Manufacturing overhead Total $ Mode I 50.00 60.00 99.00 209.00 Mode II $ 90.00 80.00 132.00 $ 302.00 Mode III $ 20.00 40.00 66.00 $ 126.00

Additional information includes:

Direct materials Direct labor (hr/board) Setup time (hr/run) Machine time (hr/board) $ Mode I 50.00 3 10 1 Mode II $ 90.00 4 10 1.25 Mode III $ 20.00 2 10 2

Manufacturing overhead is determined as follows

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Traditional, Volume-Based Product-Costing System

Units produced Direct labor (hr/unit) Total hours Total hours required 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 Direct labor (hr/unit) Overhead rate per hour Overhead per unit $ $

$3,894,000 118,000
Mode II 3 33 99 $ $

= $33 per hour

Mode III 4 33 132 $ $ 2 33 66

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Traditional, Volume-Based Product-Costing System

With these product costs, Aerotech established target selling prices (Cost 125%).
Direct materials Direct labor Manufacturing overhead Total $ Mode I Mode II Mode III 50.00 $ 90.00 $ 20.00 60.00 80.00 40.00 99.00 132.00 66.00 209.00 $ 302.00 $ 126.00

Cost per unit Target selling price

Mode I 209.00 261.25

Mode II $ 302.00 377.50

Mode III $ 126.00 157.50

209.00 x 1.25
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Activity Based Costing System (ABC)

ABC systems follow a two-stage procedure to assign overhead costs to products. Stage One
Identify significant activities and assign overhead costs to each activity in proportion to resources used.

Stage Two
Identify cost drivers appropriate to each activity and allocate overhead to the products.

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

Activity Cost Pools

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

ProductSustaining Level
Engineering cost pool $700,000

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.

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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

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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

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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
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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
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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
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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

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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

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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

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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
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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
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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
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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
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Distorted Product Costs

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]
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Distorted Product Costs

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.

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Two Key Points

A large proportion of nonunit-level activities A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately.

Product diversity When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs.

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Activity-Based Management

The use of ABC costing information to help management make decisions

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Activity-Based Management
Activity-based costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs. Activity-based management focuses on managing activities to reduce costs.

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Two-Dimensional ABC and Activity-Based Management

Activities

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Two-Dimensional ABC and Activity-Based Management

Cost Assignment View

Resource costs

Activities

Cost Objects
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Two-Dimensional ABC and Activity-Based Management

Cost Assignment View

Resource costs
Process View
Activity Analysis Activity Evaluation

Root Causes

Activity Triggers

Activities

Performance Measures

Cost Objects
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Elimination of Non-Value-Added Costs

Activities

Nonvalueadded activities Unnecessary

Reduce or Eliminate

Necessar y
Continually Evaluate and Improve
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Using ABM to Eliminate NonValue-Added Activities and Costs

1. Identify Activities.

2. Identify Non-Value-Added Activities.

3. Understand Activity Linkages, Root Causes,

and Triggers.
Specify parts Select vendor Receive parts Produce goods Inspect finished goods Rework defective products

4. Establish Performance Measures. 5. Report Non-Value-Added Costs.

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Using ABM to Eliminate NonValue-Added Activities and Costs

Process time

Inspection time

Storage time

Move time

Waiting time
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Customer Profitability Analysis

Customer profitability analysis uses activity-based costing to determine the activities, costs, and profit associated with serving particular customers.

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Customer Profitability Analysis

Required special packaging. Orders small quantities. Demand fast service.

Often changes orders.

Orders frequently.

A costly customer
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Just-in-Time Inventory and Production Management

No materials are purchased and no products are manufactured until they are needed.

The primary goal of a JIT production system is to reduce or eliminate inventories at every stage of production.

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Key Features of the JIT Approach

Smooth, uniform production rate
Pull method of production

Purchase is small lot sizes

Quick, inexpensive setups

High quality materials

Effective preventive maintenance

Teamwork
Multiskilled workers
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JIT Purchasing
Long-term contracts with suppliers.

Only a few suppliers.

Parts delivered in small lots.

Grouped payments to vendor.

Minimal inspection of materials.

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End of Chapter 5
This is my kind of cost pool!

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