Activity based costing

Activity Based Costing:A Tool to Aid Decision Making

Overhead rates mayOverhead rates maybe based on activitybe based on activity

at capacity.at capacity.

Overhead rates mayOverhead rates maybe based on activitybe based on activity

at capacity.at capacity.

Activity Based Costing (ABC)Both manufacturingBoth manufacturing

and nonmanufacturingand nonmanufacturingcosts may be costs may be assigned toassigned toproducts.products.

Both manufacturingBoth manufacturingand nonmanufacturingand nonmanufacturing

costs may be costs may be assigned toassigned toproducts.products.

Some manufacturingSome manufacturingcosts may be excludedcosts may be excluded

from productfrom productcosts.costs.

Some manufacturingSome manufacturingcosts may be excludedcosts may be excluded

from productfrom productcosts.costs.

A numberA numberof cost pools each of cost pools each

allocated to a productallocated to a productor cost object.or cost object.

A numberA numberof cost pools each of cost pools each

allocated to a productallocated to a productor cost object.or cost object.

Allocation bases oftenAllocation bases oftendiffer fromdiffer from

traditional costingtraditional costingsystems.systems.

Allocation bases oftenAllocation bases oftendiffer fromdiffer from

traditional costingtraditional costingsystems.systems.

How Costs are Treated Under Activity-Based Costing

Level of C

omplexity

Overhead Allocation

Plantwide Plantwide OverheadOverhead

RateRate

Plantwide Plantwide OverheadOverhead

RateRate

DepartmentalDepartmentalOverheadOverhead

RatesRates

DepartmentalDepartmentalOverheadOverhead

RatesRates

Activity BasedActivity BasedCostingCosting


Cost of Idle Capacity Traditional Cost Traditional Cost

AccountingAccounting The predetermined The predetermined overhead rate is based overhead rate is based on budgeted activity. on budgeted activity.

This results in applying This results in applying overhead costs of overhead costs of unused, or idle, unused, or idle,

capacity.capacity.

Traditional Cost Traditional Cost AccountingAccounting

The predetermined The predetermined overhead rate is based overhead rate is based on budgeted activity. on budgeted activity.

This results in applying This results in applying overhead costs of overhead costs of unused, or idle, unused, or idle,

capacity.capacity.


Products are charged for Products are charged for the costs of capacity the costs of capacity they use – not for the they use – not for the costs of capacity they costs of capacity they

don’t use.don’t use.


Products are charged for Products are charged for the costs of capacity the costs of capacity they use – not for the they use – not for the costs of capacity they costs of capacity they

don’t use.don’t use.

Difference Between ABC and Traditional Product Costs

Batch-level or product-Batch-level or product-level costs will level costs will ordinarily shift ordinarily shift

overhead costs from overhead costs from high-volume high-volume

products produced products produced in large batches to in large batches to

low-volume products low-volume products produced in small produced in small

batches. batches.

Batch-level or product-Batch-level or product-level costs will level costs will ordinarily shift ordinarily shift

overhead costs from overhead costs from high-volume high-volume

products produced products produced in large batches to in large batches to

low-volume products low-volume products produced in small produced in small

batches. batches.

Under ABC both Under ABC both manufacturing and manufacturing and nonmanufacturing nonmanufacturing

costs may be costs may be assigned to products. assigned to products.

Organization-Organization-sustaining costs and sustaining costs and

the costs of idle the costs of idle capacity are not capacity are not

assigned to products.assigned to products.

Under ABC both Under ABC both manufacturing and manufacturing and nonmanufacturing nonmanufacturing

costs may be costs may be assigned to products. assigned to products.

Organization-Organization-sustaining costs and sustaining costs and

the costs of idle the costs of idle capacity are not capacity are not

assigned to products.assigned to products.

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

Designing of an ABC System

Steps for Implementing ABCSteps for Implementing ABC Identify and define activities and activity Identify and define activities and activity

cost pools.cost pools. Trace costs to activities and cost Trace costs to activities and cost

objects.objects. Assign costs to activity cost pools.Assign costs to activity cost pools. Calculate activity rates.Calculate activity rates. Assign costs to cost objects.Assign costs to cost objects.

Identify and Define Activities and Activity Cost Pools

A part of the productionA part of the productionprocess for which managementprocess for which management

wants a separate reporting of thewants a separate reporting of thecosts of the activity involved.costs of the activity involved.

Unit-LevelUnit-LevelActivityActivity

Batch-Level Batch-Level ActivityActivity

Product-LevelProduct-LevelActivityActivity

Customer-LevelCustomer-LevelActivityActivityOrganization-Organization-

sustainingsustainingActivityActivity

Identify and Define Activities and Activity Cost Pools

Activity Cost Activity Cost PoolPool is a “bucket” in which costs are accumulated that relate to a single activity measure

in the ABC system.

$

$

$ $

$$

Activity-Based Costing at Classic Brass

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ShippingCosts

ShippingCosts

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


Activity 1Activity 1Activity 1Activity 1 Activity 2Activity 2Activity 2Activity 2 Activity 3Activity 3Activity 3Activity 3 Activity 4Activity 4Activity 4Activity 4 OtherOtherOtherOther

Overhead CostsOverhead Costs

First-Stage AllocationFirst-Stage Allocation

Assign Costs to Activity Cost Pools

Customer Orders

Product Design

Order Size

Customer Relations Other Total

Production DepartmentIndirect factory wages 25% 40% 20% 10% 5% 100%Factory equipment depreciation 20% 0% 60% 0% 20% 100%Factory utilities 0% 10% 50% 0% 40% 100%Factory building lease 0% 0% 0% 0% 100% 100%

Shipping costs **General Administrative Department

Administrative wages and salaries 15% 5% 10% 30% 40% 100%Office equipment depreciation 30% 0% 0% 25% 45% 100%Administrative building lease 0% 0% 0% 0% 100% 100%

Marketing DepartmentMarketing wages and salaries 20% 10% 0% 60% 10% 100%Selling expenses 10% 0% 0% 70% 20% 100%

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.

Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ Factory equipment depreciationFactory utilitiesFactory building lease

General Administrative DepartmentAdministrative wages and salariesOffice equipment depreciationAdministrative building lease

Marketing DepartmentMarketing wages and salariesSelling expenses

Total

Activity Cost Pools

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


Production DepartmentIndirect factory wages 500,000$ Factory equipment depreciation 300,000 Factory utilities 120,000 Factory building lease 80,000 1,000,000$

Shipping costs traced to customer orders 40,000 General Administrative Department

Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60,000 510,000

Marketing DepartmentMarketing wages and salaries 250,000 Selling expenses 50,000 300,000

Total overhead costs 1,850,000$

Overhead Costs at Classic Brass(Manufacturing and NonManufacturing)

Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ 200,000$ 100,000$ 50,000$ 25,000$ 500,000$ Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000 Factory utilities - 12,000 60,000 - 48,000 120,000 Factory building lease - - - - 80,000 80,000

General Administrative DepartmentAdministrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000 Office equipment depreciation 15,000 - - 12,500 22,500 50,000 Administrative building lease - - - - 60,000 60,000

Marketing DepartmentMarketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000 Selling expenses 5,000 - - 35,000 10,000 50,000

Total 315,000$ 257,000$ 380,000$ 367,500$ 490,500$ 1,810,000$

Activity Cost Pools


Calculate Activity RatesThe ABC team determines that Classic Brass will have these total activities for each activity

cost pool . . . 1,000 customer orders1,000 customer orders 200 new designs200 new designs 20,000 machine-hours20,000 machine-hours 100 customer relations activities100 customer relations activities

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

each activity by the total activity levels.each activity by the total activity levels.

Calculate Activity Rates(a) (b) (a) (b)

Activity Cost Pools Total Cost Total Activity Activity RateCustomer orders 315,000$ 1,000 orders $315 per orderProduct design 257,000 200 designs $1,285 per designOrder size 380,000 20,000 MHs $19 per MHCustomer relations 367,500 100 customer $3,675 per customerOther 490,500 Not applicable Not applicable

Computation of Activity Rates÷

TracedTracedTracedTraced TracedTracedTracedTraced TracedTracedTracedTraced

Activity-Based Costing at Classic Brass

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ShippingCosts

ShippingCosts Overhead CostsOverhead Costs



Activity-Based Costing at Classic BrassDirect

MaterialsDirect

MaterialsDirectLaborDirectLabor

ShippingCosts

ShippingCosts



OrderOrderSizeSize

OrderOrderSizeSize

CustomerCustomerOrdersOrders

CustomerCustomerOrdersOrders

ProductProductDesignDesignProductProductDesignDesign

CustomerCustomerRelationsRelationsCustomerCustomerRelationsRelations OtherOtherOtherOther

Overhead CostsOverhead Costs

First-Stage AllocationFirst-Stage Allocation

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

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

UnallocatedUnallocatedUnallocatedUnallocated

Assigning Costs to Cost ObjectsLet’s take a look at how our system works for 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.

Assigning Costs to Cost Objects

(a) (b) (a) (b)Activity Cost Pools Activity Rate Activity ABC CostCustomer orders 315$ 2 630$ Product design 1,285 0 - Order size 19 200 3,800 Customer relations 3,675 N/A

Overhead Cost for the Standard Stanchions

(a) (b) (a) (b)Activity Cost Pools Activity Rate Activity ABC CostCustomer orders 315$ 1 315$ Product design 1,285 1 1,285 Order size 19 4 76 Customer relations 3,675 N/A

Overhead Cost for the Custom HousingThe customer-level The customer-level cost is assigned to cost is assigned to customers directly; customers directly; it is not assigned to it is not assigned to

products.products.

Limitations of ABC

ABC systems are a ABC systems are a major project requiring major project requiring substantial resources. substantial resources.

The benefits of The benefits of increased accuracy increased accuracy

must outweigh these must outweigh these additional costs.additional costs.

ABC systems are a ABC systems are a major project requiring major project requiring substantial resources. substantial resources.

The benefits of The benefits of increased accuracy increased accuracy

must outweigh these must outweigh these additional costs.additional costs.

ABC produces ABC produces numbers, like product numbers, like product margins, that are at margins, that are at odds with numbers odds with numbers

produced by traditional produced by traditional costing system. Some costing system. Some

managers find it managers find it difficult to adjust to this difficult to adjust to this

change.change.

ABC produces ABC produces numbers, like product numbers, like product margins, that are at margins, that are at odds with numbers odds with numbers

produced by traditional produced by traditional costing system. Some costing system. Some

managers find it managers find it difficult to adjust to this difficult to adjust to this

change.change.

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

Activity based costing

Business