ACC3200

ACC3200Activity-based Cost Management

Learning ObjectivesCalculate cost and profit under activity-based costing.

Compare results under traditional volume based costing system and ABC

Describe approaches that can be used in activity-based management

Traditional Volume-Based Cost SystemsBecause indirect costs cannot be directly traced to specific products or services, they must be assigned or allocated

based on some other observable measure called an allocation base or cost driver.

IndirectCosts

$$

Cost Driveror

Allocation Base

IndividualProducts

or Services

We have used units produced or direct labor hours to assign indirect manufacturing overhead costs to specific products.

Units produced and direct labor hours are examples of a volume-based allocation measure.

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Volume-Based Cost SystemsAssume that Toyota Motor Manufacturing Kentucky (TMMK) produces three types of automobiles, with the following cost

and production information: Camry

Avalon Camry HybridPer Unit Cost Information Direct Materials 8,000$ 7,000$ 6,500$ Direct Labor 2,800 2,400 2,400 Manufacturing Overhead ? ? ?

Annual Production Information Total Units Produced (in thousands) 100 350 50 500 Direct Labor Hours Per Unit 35 30 30 Total Direct Labor Hours (in thousands) 3,500 10,500 1,500 15,500

The purpose of the cost allocation method is to assign the indirect or manufacturing overhead costs to each product.

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Volume-Based Cost Systems

PredeterminedOverhead

Rate

Estimated TotalManufacturing Overhead Cost

Estimated Units in the Allocation Base=

The total manufacturing overhead cost for the Kentucky plant is estimated at $3,720,000 (in thousands) per year. In

our example, this cost will be assigned to the three products on the basis of direct labor hours. The first step is

to calculate the predetermined overhead rate.

PredeterminedOverhead

Rate=

$3,720,000

$15,500= $240 per direct labor

hour

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Assigning Indirect Cost to Individual Products or ServicesTo assign manufacturing overhead costs to the individual

products, we multiply the $240 overhead rate by the number of direct labor hours required for each product.

CamryAvalon Camry Hybrid Total

Annual Production Information Direct Labor Hours Per Unit 35 30 30 × Predetermined Overhead Rate 240$ 240$ 240$ Manufacturing Overhead Per Unit 8,400$ 7,200$ 7,200$ × Number of Units Produced (thousands) 100 350 50 Total Manufacturing Overhead 840,000$ 2,520,000$ 360,000$ 3,720,000$

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The Camry receives the most total manufacturing overhead cost because it is the highest volume product and thus requires the most total direct

labor hours.

Calculate Total Manufacturing Cost and ProfitabilityTo compute total manufacturing cost, we need to add the

manufacturing overhead cost to the direct material and direct labor cost, which were provided earlier on a per unit basis.

CamryAvalon Camry Hybrid

Per Unit Cost Information Direct Materials 8,000$ 7,000$ 6,500$ Direct Labor 2,800 2,400 2,400 Manufacturing Overhead 8,400 7,200 7,200 Total Manufacturing Cost Per Unit 19,200$ 16,600$ 16,100$

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This analysis shows that the Avalon is the most costly of the three models on a per unit basis.

The Camry is the next most costly model, followed by the Camry-Hybrid.

Calculate Total Manufacturing Cost and ProfitabilityIf we subtract the total manufacturing cost per unit from the unit sales price, we get the gross margin for each product. Remember that gross margin only takes into account the

manufacturing cost of the product, before selling and administrative costs such as distribution fees, advertising,

dealer costs and profit, and corporate administration charges have been deducted.

CamryAvalon Camry Hybrid

Assumed Selling Price to the Consumer 28,000$ 18,000$ 35,000$ Less: Total Manufacturing Cost Per Unit 19,200 16,600 16,100 Gross Profit Per Unit 8,800$ 1,400$ 18,900$

Gross Profit Margin (% of Sales) 31% 8% 54%

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The gross margin analysis suggests that the Camry-Hybrid is the most profitable

product,

Activity Based Costing (ABC)

Activity Based Costing (ABC) is

a method of assigning indirect costs to products

and services based on the activities they

require.

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Stage 1: Assign Indirect Costs To Activities

Level Activities Sample Activities Facility Performed to support all of the Installing and maintaining

level company's products or services. equipment. Paying forinsurance, utilities, and taxes.

Customer Performed for specific Designing for special customerlevel customers. needs. Negotiating prices for a

large customer.

Product Performed to support individual Research and development forlevel product lines. a new product. Special tools

used only for certain models.

Batch Performed for a group of units Resetting robotics for alevel or customers all at once. specific batch run for a

model being produced.

Unit Performed for each unit or Installation of frame,level customer (one at a time). engine, body style, and

tires for a specific model.

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Form Activity Pools and Assign Indirect Costs to Each Pool

Machiningand

InstallationMachine

Setup

ProductEngineeringand Design

QualityControl

TMMK Manufacturing Overhead Cost Pools

TMMK has identified the following cost pools:

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Form Activity Pools and Assign Indirect Costs to Each Pool

Recall that the total manufacturing overhead cost in our Toyota example was $3,720,000 (in thousands). Now we must assign

this total cost to one of the four activity cost pools.

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Form Activity Pools and Assign Indirect Costs to Each Pool

The general production engineer makes $120,000 per year. Allocation of time worked across the four activity cost pools

is as follows:

Activity Cost PoolHours Spent

Production Manager's

SalarySalary

AllocationMachining and Installation 800 ÷ 2,000 = 40% 120,000$ 48,000$ Machine Set-Up 600 ÷ 2,000 = 30% 120,000 36,000 Engineering and Product Design 200 ÷ 2,000 = 10% 120,000 12,000 Quality Control 400 ÷ 2,000 = 20% 120,000 24,000

2,000 100% 120,000$

Allocation Percentage

Since the supervisor spends 40% of his time overseeing machining and installation activities, $48,000 (40% x $120,000)

should be assigned to that activity cost pool.

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Stage 2: Assign Activity Costs to Individual Products or Services

Select an activity cost driver for each of the activity cost pools. A cost driver is a measure of the underlying activity that occurs

in each activity cost pool. The goal is to identify a driver that has a cause and effect relationship with the underlying activity. ABC systems include measures that capture something other than the sheer volume of units produced or customers sold. These measures are called nonvolume-based cost drivers.

Volume-Based Allocation Measures Nonvolume-Based Cost Drivers(used in traditional cost systems) (used in activity based costing)Number of units produced Number of batches or setup timeNumber of direct labor hours Processing time per unitNumber of machine hours Number of quality inspectionsDirect materials cost Number of design changes

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Select an Activity Cost Driver for Each Cost Pool

Machine hours will be used as the driver for the machining and installation activity. Number of set-ups will be used as the activity

driver for the set-up activity. Engineering hours will be used as the driver to assign engineering and design costs. Inspection

time will be used to assign quality control costs.

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Assign Indirect Costs to Products or Services Based on Activity Demands

There are two methods that can be used to assign indirect costs to individual products or services based on their activity requirements: activity rates or activity proportions. The two methods are mathematically equivalent and will provide identical results as long as there are no rounding errors in the rates or proportions. The method used will depend on the type of information provided and whether you have complete information on all product or service lines.

Activity Rates Activity Proportions

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CamryAvalon Camry Hybrid Total

Machine Hours 3,000 10,500 1,500 15,000

Activity Rate MethodThe activity rate method is very similar to the

predetermined overhead rate computed earlier.

ActivityRate

Total Activity CostTotal Activity Driver

=

Total indirect costs assigned to the machining pool was $825,000, the total machine hours required by each of the

three Toyota models is as follows:

Activity Rate = $825,00015,000 = $55 per machine hour

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Activity Rate MethodTo assign the cost to the products, we multiply the activity

rate by the activity requirements of each individual product.Camry

Avalon Camry Hybrid TotalMachine Hours 3,000 10,500 1,500 15,000 Activity Rate 55$ 55$ 55$ 55$ Allocated to Product 165,000$ 577,500$ 82,500$ 825,000$

3,000 × $55 = $165,00

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Activity Proportion MethodLet's assign the total cost of the set-up activity ($795,000),

which will be allocated based on the number of set-ups. A set-up occurs every time the company switches from producing one product to another. Once the set-up activities are complete, a

production batch for that specific product is run. The batch size is the number of units produced after each set-up.

CamryAvalon Camry Hybrid Total

Total Units Produced 100,000 350,000 50,000 500,000 Average Batch Size* 250 1,000 200 Number of Set-Ups 400 350 250 1,000

Proportion of Set-Ups 40% 35% 25% 100%

*Units per batch

100,000 ÷ 250 = 400 400 ÷ 1,000 = 40%

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Activity Proportion Method

CamryAvalon Camry Hybrid Total

Machine Set-Up Cost 795,000$ 795,000$ 795,000$ 795,000$ Activity Proportion 40% 35% 25% 100%Allocated to Product 318,000$ 278,250$ 198,750$ 795,000$

The allocation of the machine set-up cost to the specific models is shown in the table below.

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Stage 2: Assign Activity Costs to Individual Products or Services

CamryAvalon Camry Hybrid Total

Machining and Installation 165,000$ 577,500$ 82,500$ 825,000$ Machine Set-Up 318,000 278,250 198,750 795,000 Engineering and Product Design 240,000 120,000 840,000 1,200,000 Quality Control 270,000 180,000 450,000 900,000 Total Manufacturing Overhead Cost 993,000$ 1,155,750$ 1,571,250$ 3,720,000$

To complete the Stage 2 ABC allocations, we need to add up the cost of all four activities for each product line.

Notice that the total amount of overhead cost is the same as in the traditional costing example ($3,720,000).

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Stage 2: Assign Activity Costs to Individual Products or Services

CamryAvalon Camry Hybrid Total

Machining and Installation 165,000$ 577,500$ 82,500$ 825,000$ Machine Set-Up 318,000 278,250 198,750 795,000 Engineering and Product Design 240,000 120,000 840,000 1,200,000 Quality Control 270,000 180,000 450,000 900,000 Total Manufacturing Overhead Cost 993,000$ 1,155,750$ 1,571,250$ 3,720,000$

HOWEVER!!! Under ABC, the Camry-Hybrid receives the highest total overhead allocation, even though it is the lowest volume product. The reason is that this product is produced in small batches and requires a lot of engineering and product

design, and quality inspections.

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Stage 2: Assign Activity Costs to Individual Products or Services

To calculate the cost per unit, we need to divide the total manufacturing overhead by the number of

units of each product.

CamryAvalon Camry Hybrid Total

Total Manufacturing Overhead Cost 993,000$ 1,155,750$ 1,571,250$ 3,720,000$ Units Produced (Thousands) 100 350 50 Manufacturing Overhead Cost Per Unit 9,930$ 3,302$ 31,425$

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Comparison of Volume-Based and Activity Based Cost Systems

Avalon Camry Camry-Hybrid $-

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

Traditional vs. ABC Costing Method

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Calculate Total Manufacturing Cost and Gross MarginThe ABC analysis shows that the Toyota Camry is the most profitable product, with a 29.4% gross margin, compared to

26% for the Avalon and negative 15.2% for the Camry-Hybrid.Camry

Avalon Camry HybridDirect Materials 8,000$ 7,000$ 6,500$ Direct Labor 2,800 2,400 2,400 Manufacturing Overhead 9,930 3,302 31,425 Total Manufacturing Cost 20,730 12,702 40,325 Unit Selling Price to Customer 28,000 18,000 35,000 Gross Profit Per Unit 7,270$ 5,298$ (5,325)$ Gross Profit Margin (% of Sales) 26.0% 29.4% -15.2%

$28,000 - $20,730 = $7,270$5,298 ÷ $18,000 = 29.4%

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Activity Based Management

Activity based management (ABM) includes all the actions that managers take to improve operations or reduce costs based on the ABC data. The first step in any improvement program is to target areas that need improvement.

What Activities

Are Performed?

How Much Does it Cost to Perform

Each Activity?

Does the Activity Add Value to the Customer?

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Activity Based ManagementIn our Toyota example, the ABC analysis revealed that the Camry-Hybrid was much more costly to produce than the other models. If this had been a realistic scenario, what

should Toyota managers do with this information?

One possibility is for managers to rethink the pricing of the Camry-Hybrid. The price would need to be increased

substantially, and it is not clear that customers would be willing to pay that kind of premium.

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Activity-based ManagementLife Cycle Cost Management

TQM

Target Costing

JIT

Life Cycle Cost Management

In pursuing cost management, managers need to set their cost reduction goals across all stages of the product life cycle, including1. product introduction, 2. growth, 3. maturity, and 4. eventual decline.

Costs tend to be higher.

Most revenue earned.

In today’s digital and technological age, product life cycles become increasingly short.

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Total Quality Management

The second highest cost assigned to the Camry-Hybrid was due to quality control. In managing quality costs, managers must balance four types of quality costs: 1. Prevention costs,2. Appraisal or inspection costs,3. Internal failure costs, and4. External failure costs.

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Target CostingThe basic idea behind target costing is to determine what the target cost must be in order to meet the market price and still provide a profit for the company's shareholders. The target cost should reflect all of the costs that are incurred across the entire value chain. In target costing, the price is set by the market based on what consumers are willing to pay for a product or service. Let’s begin to look at target pricing at Toyota by using the following estimates:

Estimated Market Price 30,000$ Annual Demand in Units 20,000 Life Cycle in Years 3 Target Profit (Return on Sales) 20%

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Target CostingThe target cost would be computed by subtracting the target profit from the market price, as follows:

Market Price

$30,000

Target Profit(20% × $30,000)

$6,000

TargetCost

$24,0000̶ =

The $24,000 target cost is the most that can be spent on the product and still achieve the 20% return on sales (given a market sales price of $30,000). It is important to realize that the target cost includes more than just the manufacturing costs.

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Target CostingGiven the target unit cost, how much can Toyota

spend on the new model across its entire life cycle and still meet the target profit?

Units Sold Each Year 20,000 Life Cycle in Years 3 Total Units 60,000 Target Cost Per Unit 24,000$ Total Target Cost 1,440,000,000$

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Target CostingOnce the target cost is set, the next step is to determine

whether it is feasible to design, develop, manufacture and deliver the product at this target cost.

Target Cost

Design Product

DevelopProcess

EstimateCost

Cost Reduction Goals

MakeProduct

?

Compare the estimated cost with the target cost to see if cost reduction is necessary.

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Just-in-Time (JIT) Inventory

In a JIT system, materials are purchased and units are made only as they are needed to satisfy customer demand. JIT is a

"demand pull" system, where materials and products are pulled through the manufacturing system based on customer

demand. In a traditional manufacturing setting where products are

pushed through the system and often end up sitting in inventory. One advantage of a JIT system is that it eliminates problems in product costing associated with holding inventory.

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Summary of ABC and ABMTo gain the true benefits of activity based costing, managers

must move from simply measuring costs, to find ways to manage or reduce costs. Although ABC and ABM have many potential benefits, these benefits must be weighed against the costs of

obtaining the more accurate information. Implementing an ABC can be a difficult task. It requires a great deal of time and effort

from many employees across the entire organization.

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End of Topic 6