Activity Based Costing: A Tool to Aid Decision Making Chapter 4.

Activity Based Costing:A Tool to Aid Decision Making

Chapter

4

TRADITIONAL COSTING

Allocates Costs Company-wide at One Rate

Allocates overhead using a single predetermined overhead rate.

Historically based on gross profit or relative sales. Now often on direct labor or machine hours.

Process costing: Usuallybased on machine hours.

Allocation accurately shows profitability of the company as a whole.

Problem: Profitability of individual products may not accurately reflect the effort and costs incurred.

Overhead rates maybe based on activity

at capacity.

Overhead rates maybe based on activity

at capacity.

ACTIVITY BASED COSTING (ABC)

Both manufacturingand nonmanufacturing

overhead costs are assigned toproducts.

Both manufacturingand nonmanufacturing

overhead costs are assigned toproducts.

Some manufacturingcosts may be excluded

from productcosts.

Some manufacturingcosts may be excluded

from productcosts.

There are a numberof cost pools each of

which is allocatedusing a unique

measure of activity.

There are a numberof cost pools each of

which is allocatedusing a unique

measure of activity.

Allocation bases oftendiffer from

traditional costingsystems.

Allocation bases oftendiffer from

traditional costingsystems.

A two stage process isnecessary because costsare allocated to activities

and then to products.

A two stage process isnecessary because costsare allocated to activities

and then to products.

Activity 1

Activity 3

Activity 2

Overhead rates based on Activities

Activity Cost PoolActivity Cost Pool is a “bucket” in which costs are

accumulated that relate to a single

activity in the ABC system.

$

$

$ $

$$

Activities and Related Cost Drivers

Designing an ABC System

Steps for Implementing ABCSteps for Implementing ABC Identify and define activities, activity cost pools,

and cost drivers. Trace identifiable costs to activities.Allocate overhead costs to activity cost pools. Calculate activity rates based on expected total

use of cost drivers. Assign costs to products.

Designing an ABC System

Identifiable (Indirect) Costs

Identifiable (Indirect) Costs

Activities(Cost Pools)

Activities(Cost Pools)

Amount of Activity Used

Amount of Activity Used

Costs AppliedCosts Applied

Overhead CostsOverhead Costs

Activity1

Activity2

Activity3Cost poolsCost pools

IndirectLabor

IndirectLabor

IndirectMaterialsIndirect

MaterialsOther

OverheadOther

OverheadStage One:Stage One:Costs assignedCosts assignedto activity poolsto activity pools

ABC Overhead Rates

Activity1

Activity2


Stage One:Stage One:Costs assignedCosts assignedto activity poolsto activity pools

ABC Overhead Rates

IndirectLabor

IndirectLabor


MaterialsOther

OverheadOther

Overhead

SetupsMachine Hours

Inspections

Activity1

Activity2


Stage One:Stage One:Costs assignedCosts assignedto activity poolsto activity pools

Products Products Stage Two:Stage Two:Costs appliedCosts appliedto productsto products

ABC Overhead Rates

IndirectLabor

IndirectLabor


MaterialsOther

OverheadOther

Overhead

SetupsMachine Hours

Inspections

Traditional Costing vs ABC

ABC does segregate overhead into various cost pools to provide more accurate cost information.

ABC supplements – it does not replace – the existing traditional job order/process cost system.

Why? Variances (over/under applied) would become very complex and not very meaningful.

Activities and Related Cost Drivers

The Mechanics of ABC

One overhead cost - shipping - can be traced directly to customer orders.

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)

Activity-Based Costing at Classic Brass

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ShippingCosts

ShippingCosts Overhead CostsOverhead Costs

TracedTraced $/DLH$/DLH TracedTraced

Products or CustomersProducts or Customers


DirectMaterials

DirectMaterials


ShippingCosts

ShippingCosts

CustomerOrders

(# of Orders)

CustomerOrders

(# of Orders)

OrderSize

(Mach Hrs)

OrderSize

(Mach Hrs)

ProductDesignProductDesign

CustomerRelations(# of Customers)

CustomerRelations(# of Customers)

OtherOther



First-Stage Allocation


DirectMaterials

DirectMaterials


ShippingCosts

ShippingCosts


CustomerOrders

CustomerOrders

ProductDesignProductDesign

OrderSize

OrderSize

CustomerRelationsCustomerRelations OtherOther


First-Stage Allocation

Second-Stage Allocations

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

UnallocatedUnallocated

Assigning 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 traced to customer order N/AGeneral 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

Management at Classic Brass believes overhead should be distributed as follows:

Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ 500,000$ 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 $500,000Percent consumed by customer orders 25%

$125,000

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

$125,000

Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

Customer Orders

Product Design

Order Size


Production DepartmentIndirect factory wages 125,000$ 500,000$ Factory equipment depreciation 60,000 300,000 Factory utilitiesFactory building lease



Total

Activity Cost Pools


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

$ 60,000

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

$ 60,000


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



Computation of Activity Rates

The ABC team has determined that Classic Brass has the following total activities for each

activity cost pool . . .1,000 customer orders,200 new designs,20,000 machine-hours100 customers.

Now the team can compute the individual Now the team can compute the individual activity rates.activity rates.

Simplified Approach to ABC

After the first-stage allocation is complete, computation of activity rates for each activity cost pool can be

simplified as follows:

Computation of the Activity Rates Customer

Orders Product Design Order Size

Customer Relations Other

Costs from first- stage allocation 315,000$ 257,000$ 380,000$ 367,500$ 490,500$ Total activity 1,000 200 20,000 100 N/ACost per unit of activity 315$ 1,285$ 19$ 3,675$

Computation of the Activity Rates Customer

Orders Product Design Order Size

Customer Relations Other

Costs from first- stage allocation 315,000$ 257,000$ 380,000$ 367,500$ 490,500$ Total activity 1,000 200 20,000 100 N/ACost per unit of activity 315$ 1,285$ 19$ 3,675$

÷ ÷ ÷ ÷

1,000 Orders

200 Designs

20,000 machine-

hours 100

Customers Other

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



Total 315$

Activity Cost Pools



1,000 Orders

200 Designs

20,000 machine-

hours 100

Customers Other

Production DepartmentIndirect factory wages 125$ 1,000$ 5$ 500$ N/AFactory equipment depreciation 60 - 9 - Factory utilities - 60 3 - Factory building lease - - - -

General Administrative DepartmentAdministrative wages and salaries 60 100 2 1,200 Office equipment depreciation 15 - - 125 Administrative building lease - - - -

Marketing DepartmentMarketing wages and salaries 50 125 - 1,500 Selling expenses 5 - - 350

Total 315$ 1,285$ 19$ 3,675$

Activity Cost Pools

Assigning Costs to Cost Objects

Let’s take a look at how our system works for just one customer - Windward Yachts.

Windward ordered two products - Stanchions and custom compass housings. Here are the details:

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.

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.


Let’s take a look at how our system works for just one customer - Windward Yachts.

Windward ordered two products - Stanchions and customer compass housings. Here are the details:

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.

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.

2 Orders No new design

200 machine

hours N/A Total




Total

Activity Cost Pools


$125 per order × 2 orders = $250$125 per order × 2 orders = $250

Overhead cost of two orders for standard stanchions.Overhead cost of two orders for standard stanchions.


2 Orders No new design

200 machine

hours N/A Total

Production DepartmentIndirect factory wages 250$ -$ 1,000$ -$ 1,250$ Factory equipment depreciation 120 - 1,800 - 1,920 Factory utilities - - 600 - 600 Factory building lease - - - -

General Administrative DepartmentAdministrative wages and salaries 120 - 400 - 520 Office equipment depreciation 30 - - - 30 Administrative building lease - - - -

Marketing DepartmentMarketing wages and salaries 100 - - - 100 Selling expenses 10 - - - 10

Total 630$ -$ 3,800$ -$ 4,430$

Activity Cost Pools

Overhead cost of two orders for standard stanchions.Overhead cost of two orders for standard stanchions.

1 Order 1 new design

4 machine hours N/A Total




Total

Activity Cost Pools


Overhead cost of one order for custom compass housing.Overhead cost of one order for custom compass housing.

$125 per order × 1 order = $125$125 per order × 1 order = $125


Overhead cost of one order for custom compass housing.Overhead cost of one order for custom compass housing.

1 Order 1 new design

4 machine hours N/A Total

Production DepartmentIndirect factory wages 125$ 1,000$ 20$ -$ 1,145$ Factory equipment depreciation 60 - 36 - 96 Factory utilities - 60 12 - 72 Factory building lease - - - -

General Administrative DepartmentAdministrative wages and salaries 60 100 8 - 168 Office equipment depreciation 15 - - - 15 Administrative building lease - - - -

Marketing DepartmentMarketing wages and salaries 50 125 - - 175 Selling expenses 5 - - - 5

Total 315$ 1,285$ 76$ -$ 1,676$

Activity Cost Pools

Product MarginsStandard Stanchions

Sales 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


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)$







Product MarginsStandard Stanchions

Sales 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


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


Windward YachtsProduct margins: Standard stanchion 5,030$ Custom compass housing (1,114) Total product margin 3,916 Less: Customer relations 3,675 Customer margin 241$

Windward YachtsProduct margins: Standard stanchion 5,030$ Custom compass housing (1,114) Total product margin 3,916 Less: Customer relations 3,675 Customer margin 241$

Example Traditional Using Machine Hours

Total Production Dept O/H

$1,000,000

Total Machine Hours

20,000

Overhead Allocation/Machine Hour

$50/hr.

Product Margins

Standard Stanchions

Compass Housing

Sales 13,600$ 650$ Costs

Direct materials (2,110) (13) Direct labor (1,850) (50) Manufacturing overhead (10,000) (200)

Product margin (360)$ 387$

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 = $10,000

Comparison of Unit CostsTraditional vs ABC

Standard CompassStanchion Housing

Traditional Traditional Costing ABC Costing ABC

Sales $ 13,600 $ 13,600 $ 650 $ 650

Manufacturing CostsDirect Materials 2,110 2,110 13 13Direct Labor 1,850 1,850 50 50Overhead 10,000 4,610 200 1,701

Total Cost per Product 13,960 8,570 263 1,764

Overstated Understated $5,390 $1,438

Comparison of Unit CostsTraditional vs ABC

Standard CompassStanchion Housing

Traditional Traditional Costing ABC Costing ABC

Sales $ 13,600 $ 13,600 $ 650 $ 650

Manufacturing CostsDirect Materials 2,110 2,110 13 13Direct Labor 1,850 1,850 50 50Overhead 10,000 4,610 200 1,701

Total Cost per Product 13,960 8,570 263 1,764

Product Margin (360) 5,030 387 (1,114)

Difference Between ABC and Traditional Product Costs

ABC will ordinarily shift batch-level and product-level

overhead costs from high-volume

products produced in large batches to low-

volume products produced in small

batches.

Difference Between ABC and Traditional Product Costs

Under ABC both manufacturing and nonmanufacturing

costs may be assigned to products.

Organization-sustaining costs and

the costs of idle capacity are not

assigned to products.

Ease of Adjustment

Costs that adjust automatically to changes in activity: Direct materials. Shipping.

Costs that could be adjusted to changes in activity: Direct labor. Factory utilities. Administrative wages and salaries. Office equipment depreciation. Marketing wages and salaries. Selling expenses.

Costs that are difficult to adjust to changes in activity: Factory equipment depreciation. Factory building lease. Administrative building lease.


Standard Stanchions: Sales 13,600$ Costs: Direct materials 2,110$ Direct labor 1,850 Shipping costs 180 Customer orders (2) 630 Product design - Order size (200) 3,800 8,570 Product margin 5,030$

2 orders @ $315 per order2 orders @ $315 per order


Custom Compass Housing Sales 650$ Costs: Direct materials 13$ Direct labor 50 Shipping costs 25 Customer orders (1) 315 Product design 1,285 Order size 76 1,764 Product margin (1,114)$

1 design @ $1,285 per design1 design @ $1,285 per design


Customer margin for Windward Yachts is shown below:

Customer Profitability AnalysisProduct margins: Standard stanchion $ 5,030 Custom compass housing (1,114) Total product margins 3,916 Less: Customer relations (3,675) Customer margin 241

Activity-Based Costing

Use ABC When One or More of the Following Exist:

Products differ greatly in volume/manufacturing complexity

Products lines areNumerousDiverseRequire different degrees of support services

Overhead costs are a significant portion of total costs

Significant change in manufacturing process or number of products

Managers ignore data from existing system and instead use “bootleg” costing data

Value-Added vs.Non-Value-Added Activities

Value-Added Activity

An activity that increases the worth

of a product or service such as:

Manufacturing Company Service Company

engineering design performing surgery

machining legal research services

assembly delivering packages

painting

packaging

Value-Added vs.Non-Value-Added Activities

Non-Value-Added ActivitiesAn activity that adds cost to, or increases the time

spent on, a product/service without increasing its

market value such as:

Manufacturing Company Service Company

Repair of machines Taking appointments

Storage of inventory Reception

Moving of raw materials, Bookkeeping/billing

assemblies, and finished goods Traveling

Building maintenance Ordering supplies

Inspections

Inventory Control

End of Chapter 4End of Chapter 4 I call thisI call thisquality quality

time!time!

Activity Based Costing: A Tool to Aid Decision Making Chapter 4.

Documents

activity cost pools

total overhead costs

shipping costs

sheet1overhead costs

assign costs

activities activity

activity rates

single activity