Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-Based Costing: A Tool to Aid Decision Making Chapter Eight.

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Activity-Based Costing: A Tool to Aid Decision Making

Chapter Eight

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Activity Based Costing (ABC)

ABC is designed to provide more accurate

ways of assigning indirect and support

service costs to activities, processes, products, customers

ABC is agood supplement to our traditional

cost systemI agree!

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ABC differs from traditional costing

• Both manufacturing and non manufacturing costs are allocated

• Use of several cost pools• Different kinds of allocation base• Allocation through capacity vs activity

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Designing an ABC System

Cost ObjectsCost Objects(e.g., products(e.g., productsand customers)and customers)

Cost ObjectsCost Objects(e.g., products(e.g., productsand customers)and customers)

ActivitiesActivitiesActivitiesActivities

ConsumptionConsumptionof Resourcesof ResourcesConsumptionConsumptionof Resourcesof Resources

CostCostCostCost

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Designing an ABC System

Steps for Implementing ABCIdentify and define activities and activity cost

pools.Trace costs to activities and cost objects.Assign costs to activity cost pools.Calculate activity rates.Assign costs to cost objects.Prepare management reports.

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Identify and Define Activitiesand Activity Cost Pools

ManufacturingManufacturingcompanies typically combinecompanies typically combine

their activities into fivetheir activities into fiveclassifications.classifications.

Unit-LevelUnit-LevelActivityActivity

Batch-Level Batch-Level ActivityActivity

Product-LevelProduct-LevelActivityActivity

Customer-LevelCustomer-LevelActivityActivityOrganization-Organization-

sustainingsustainingActivityActivity

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Identify and Define Activitiesand Activity Cost Pools

Activities should only be

combined within a levelif they are highly

correlated.

When combiningactivities, they should be grouped together only at

the appropriatelevel.

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Identify and Define Activitiesand Activity Cost Pools

An Activity Cost Activity Cost PoolPool is a “bucket” in

which costs are accumulated that relate to a single

activity measure in the ABC system.

$

$

$ $

$$

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Identify and Define Activitiesand Activity Cost Pools

Simple countof the number oftimes an activity

occurs.

Transactiondriver

A measureof the amountof time neededfor an activity.

Durationdriver

Two types of activity measures:

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Identify and Define Activitiesand Activity Cost Pools

At Classic Brass, the ABC team, selected the followingactivity cost pools and activity measures:

At Classic Brass, the ABC team, selected the followingactivity cost pools and activity measures:

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Identify and Define Activitiesand Activity Cost Pools

• Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.

• Product Designs - assigned all costs of resources consumed by designing products.

• Order Size - assigned all costs of resources consumed as a consequence of the number of units produced.

• Customer Relations – assigned all costs associated with maintaining relations with customers.

• Other – assigned all overhead costs that are not associated with the other cost pools.

• Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.

• Product Designs - assigned all costs of resources consumed by designing products.

• Order Size - assigned all costs of resources consumed as a consequence of the number of units produced.

• Customer Relations – assigned all costs associated with maintaining relations with customers.

• Other – assigned all overhead costs that are not associated with the other cost pools.

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When Possible, Directly Trace OverheadCosts to Activities and Cost Objects

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Assign Costs to Activity Cost Pools

At Classic Brass the following distribution of resource consumption across activity cost pools is determined.

**Not included because they are directly traced to customer orders.

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Indirect factory wages $500,000Indirect factory wages $500,000Percent consumed by customer orders 25%Percent consumed by customer orders 25%

$125,000$125,000

Indirect factory wages $500,000Indirect factory wages $500,000Percent consumed by customer orders 25%Percent consumed by customer orders 25%

$125,000$125,000

Assign Costs to Activity Cost Pools

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Factory equipment depreciation $300,000Factory equipment depreciation $300,000Percent consumed by customer orders 20%Percent consumed by customer orders 20%

$ 60,000$ 60,000

Factory equipment depreciation $300,000Factory equipment depreciation $300,000Percent consumed by customer orders 20%Percent consumed by customer orders 20%

$ 60,000$ 60,000

Assign Costs to Activity Cost Pools

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Assign Costs to Activity Cost Pools

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Calculate Activity Rates

The ABC team determines that Classic Brass will have these total activities for each activity cost

pool . . . 1,000 customer orders,1,000 customer orders, 200 new designs,200 new designs, 20,000 machine-hours,20,000 machine-hours, 100 customer relations activities.100 customer relations activities.

Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

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Calculate Activity Rates

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TracedTraced TracedTraced TracedTraced

Activity-Based Costing at Classic Brass

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ShippingCosts

ShippingCosts Overhead CostsOverhead Costs

Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers

Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers

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Activity-Based Costing at Classic Brass

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ShippingCosts

ShippingCosts

Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers

Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers

OrderOrderSizeSize

OrderOrderSizeSize

CustomerCustomerOrdersOrders

CustomerCustomerOrdersOrders

ProductProductDesignDesignProductProductDesignDesign

CustomerCustomerRelationsRelationsCustomerCustomerRelationsRelations OtherOtherOtherOther

Overhead CostsOverhead Costs

First-Stage Allocation

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Activity-Based Costing at Classic Brass

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ShippingCosts

ShippingCosts

Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers

Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers

OrderOrderSizeSize

OrderOrderSizeSize

CustomerCustomerOrdersOrders

CustomerCustomerOrdersOrders

ProductProductDesignDesignProductProductDesignDesign

CustomerCustomerRelationsRelationsCustomerCustomerRelationsRelations OtherOtherOtherOther

Overhead CostsOverhead Costs

First-Stage Allocation

Second-Stage AllocationsSecond-Stage AllocationsSecond-Stage AllocationsSecond-Stage Allocations

$/MH$/MH $/Order$/Order $/Design$/Design $/Customer$/Customer

UnallocatedUnallocated

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Assigning Costs to Cost Objects

Let’s take a look at how our system worksfor just one customer – Windward Yachts.

Standard Stanchions (no design required)1. 400 units ordered with 2 separate orders.1. 400 units ordered with 2 separate orders.2. Each stanchion required 0.5 machine-hours.2. Each stanchion required 0.5 machine-hours.3. Selling price is $34 each.3. Selling price is $34 each.4. Direct materials total $2,110.4. Direct materials total $2,110.5. Direct labor totals $1,850.5. Direct labor totals $1,850.6. Shipping costs total $180.6. Shipping costs total $180.

Custom Compass Housing (requires new design)1. One order during the year.1. One order during the year.2. Each housing required 4 machine-hours.2. Each housing required 4 machine-hours.3. Selling price is $650 each.3. Selling price is $650 each.4. Direct materials total $13.4. Direct materials total $13.5. Direct labor totals $50.5. Direct labor totals $50.6. Shipping costs total $25.6. Shipping costs total $25.

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Assigning Costs to Cost Objects

The customer-level cost is assigned to customers directly; it is not assigned to

products.

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Prepare Management Reports

Standard StanchionsSales 13,600$ Cost: Direct materials 2,110$ Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570

Product margin 5,030$

Standard StanchionsSales 13,600$ Cost: Direct materials 2,110$ Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570

Product margin 5,030$

Custom Compass HousingSales 650$ Cost: Direct materials 13$ Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285 Order size 76 1,764

Product margin (1,114)$

Custom Compass HousingSales 650$ Cost: Direct materials 13$ Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285 Order size 76 1,764

Product margin (1,114)$

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Prepare Management Reports

Customer Profitability Analysis

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Product Margins

Traditional Cost Accounting System

Predetermined manufacturingoverhead rate

$1,000,000 20,000 MH

= $50/MH=

400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000

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Differences Between ABC and Traditional Product Costs

Product margins are different for four reasons:

Traditional costing assigns design costs to both products based on machine hours. ABC assigns product design costs to a product only if product design work is required.

Traditional costing assigns customer order costs, a batch- level cost, using a unit-level allocation base, machine hours. ABC assigns these batch-level costs using a batch-level activity measure.

Traditional costing assigns only manufacturing costs to products. ABC also assigns nonmanufacturing costs to products.

Traditional costing assigns all manufacturing costs to products. The ABC system does not assign organization- sustaining manufacturing costs to the products.

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Differences Between ABC and Traditional Product Costs

When batch-level andproduct-level costs are present,

ABC will usually shift costs from highvolume products, produced in large batches,

to low volume products produced in small batches.

This cost shifting will usually have itsgreatest impact on the per

unit cost of the lowvolume products.

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So What????

• Diverse product line various models and variants

• The difference will be felt for specialty and customized products

Cum

ulative products

+ profitability -

WHALE CURVE-After assigning service and Support departments by ABC

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Activity Based Management

• Upon analysis of product costs thru ABC Re-price products Substitute products Redesign products Improve processes and operations strategy Technology investment Eliminate products

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Customer Profitability Analysis

• High Cost to Serve Order custom products Small order quantity Unpredictable orders Customized delivery Large amount of pre-sales

efforts Large amount of post-

sales efforts Pay slow

• High Cost to Serve Order std. products High order quantity Predictable orders Std. delivery No pre-sales efforts No post-sales efforts Pay on time

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highpassiveproduct is crucialgood supplier match

price sensitive agrressivefew special demands low price

lots of customizationlow

low cost to serve high

costly to serve butpay premium

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End of Chapter 8End of Chapter 8