Activity based costing. There is no true cost of a good or service unless a company manufactures a single product or provides a single service. Otherwise,

Activity based costingActivity based costing

There is no true cost of a good or service unless a There is no true cost of a good or service unless a company manufactures a single product or provides a company manufactures a single product or provides a single service. Otherwise, accountants must allocate single service. Otherwise, accountants must allocate costs for all products and servicescosts for all products and services

Allocating service department costAllocating service department cost Companies normally allocate service department Companies normally allocate service department

costs to production department. Accordingly goods costs to production department. Accordingly goods and services reflect the total full cost of production.and services reflect the total full cost of production.

Direct and indirect costsDirect and indirect costs Direct costs arise within the department and are easily Direct costs arise within the department and are easily

traced.traced. Indirect costs (common costs) serve two or more Indirect costs (common costs) serve two or more

departments or cost centers. Therefore they are departments or cost centers. Therefore they are difficult to trace.difficult to trace.

Cost allocation basis:Cost allocation basis: Estimate the overhead costs for the entire plant. Estimate the overhead costs for the entire plant. We allocate to production only the portion of service We allocate to production only the portion of service

department cost that relate to the production.department cost that relate to the production.

Traditional Costing & Activity based CostingTraditional Costing & Activity based Costing In the traditional method accountants use volume based In the traditional method accountants use volume based

models or unit based drivers are allocations based on labor models or unit based drivers are allocations based on labor hours, machine hours and material costs. Cost drivers are hours, machine hours and material costs. Cost drivers are factors that cause an activity to occur.factors that cause an activity to occur.

Cost can be tied to volume Cost can be tied to volume only ifonly if we are dealing with units- we are dealing with units- related activities. related activities.

However many costs in a plant do not vary with the volume of However many costs in a plant do not vary with the volume of production but with the transaction. E.g. Movement of production but with the transaction. E.g. Movement of material from inventory requires inspection, scheduling and material from inventory requires inspection, scheduling and transportation. transportation.

In activity based costing ABC the performance of In activity based costing ABC the performance of

activities triggers the consumption of resources that activities triggers the consumption of resources that are recorded as costs. are recorded as costs.

Benefits of ABCBenefits of ABC1.Yields more information about activities and the 1.Yields more information about activities and the

resources required to perform the activities.resources required to perform the activities.2. Helps in highlighting high cost activities by 2. Helps in highlighting high cost activities by

identifying the resources. identifying the resources. 3. Assist mangers in to eliminate no value activities and 3. Assist mangers in to eliminate no value activities and

direct resources into more productive areas.direct resources into more productive areas.

4. ABC can be used to study and improve 4. ABC can be used to study and improve marketing and administrative activities costs. marketing and administrative activities costs.

5. The purpose of ABC is to assign costs to the 5. The purpose of ABC is to assign costs to the and activities performed in an organization and activities performed in an organization and then allocate them appropriately to and then allocate them appropriately to productsproducts

LimitationsLimitations ABC is costly and requires a lot of operating ABC is costly and requires a lot of operating

data. data.

Example: Example: Comparison of allocations using traditional and ABC Comparison of allocations using traditional and ABC

method.method. Boni company provides the following information Boni company provides the following information

concerning its two productsconcerning its two productsProduct A Product A

Product B Product B

Unit produced Unit produced 1010 2020 Machine-hrs per unit 3Machine-hrs per unit 3 44 Inspection/PLInspection/PL 55 11 Total budgeted inspection cost $3300 Total budgeted inspection cost $3300

Assume Boni Company used ABC; calculate Assume Boni Company used ABC; calculate how much inspection cost is allocated to how much inspection cost is allocated to each line. What is the cost per unit for each line. What is the cost per unit for product A and B?product A and B?

Determine how much inspection cost is Determine how much inspection cost is allocated if Boni uses a traditional cost allocated if Boni uses a traditional cost allocation system based on machine hours. allocation system based on machine hours. What is the cost per unit for product A and What is the cost per unit for product A and B?B?

ABC MethodABC Method The cost driver is the inspections numberThe cost driver is the inspections number 3300 budgeted inspection cost 3300 budgeted inspection cost = $550 application rate= $550 application rate 6 budgeted inspections6 budgeted inspections Product A Product A Product BProduct B Total cost/PLTotal cost/PL $2750 $2750 $550$550 Cost per unitCost per unit $2750/10$2750/10 $550/20$550/20

$275$275 $27.50 $27.50 The results have shown that units of B require less attention The results have shown that units of B require less attention

probably indicating it is a seasonal product. probably indicating it is a seasonal product.

For the traditional volume based cost allocation, For the traditional volume based cost allocation, inspection costs are allocated on machine inspection costs are allocated on machine hours. Total machine hours are budgeted as hours. Total machine hours are budgeted as followsfollows

3 × 10 product A units + 4 × 20 product B 3 × 10 product A units + 4 × 20 product B units = 110 machine hours. This will yield the units = 110 machine hours. This will yield the following ratefollowing rate

$ 3300 (cost)$ 3300 (cost) = $ 30 rate per machine hour = $ 30 rate per machine hour 110( hours)110( hours)

Product A Product A Product B Product B Total cost/ PL $900Total cost/ PL $900 $2400$2400 cost/ unitcost/ unit $900/10 $2400/20 $900/10 $2400/20

$90$90 $ 120$ 120 The traditional method hinders cost reduction The traditional method hinders cost reduction

and gives a wrong signal to management. It and gives a wrong signal to management. It over costs B the higher volume and under over costs B the higher volume and under costs A the lower volume product. costs A the lower volume product.

Assume a production department has 84000 budgeted Assume a production department has 84000 budgeted machine hours and budgeted overhead costs as machine hours and budgeted overhead costs as follows:follows:

Machine dep & maintenance $ 840000Machine dep & maintenance $ 840000 Receiving costsReceiving costs $418000 $418000 Production costs Production costs $360000 $360000 Machine setup costsMachine setup costs $37000 $37000 Inspection costsInspection costs $ $192000192000 TotalTotal $ $18480001848000

Assume that the company manufactures and Assume that the company manufactures and sells three products with the following sells three products with the following attributesattributes

Product x product Y product zProduct x product Y product z

Units produced and sold Units produced and sold 28000 18000 28000 18000 60006000 Unit direct material cost 20Unit direct material cost 20 1515 1313 Unit direct laborUnit direct labor 12 12 1414 1010 Machine hrs /unit 1.5Machine hrs /unit 1.5 22 11

Receiving orders 16Receiving orders 16 4040 200200 Production orders 14Production orders 14 1212 1919

Production runsProduction runs 4 4 88 2222

Inspections Inspections 8 8 44 2020

Allocate the costs using the traditional Allocate the costs using the traditional methods and the ABC methodsmethods and the ABC methods

Using traditional methodUsing traditional method $1848000(costs) $1848000(costs) = $22 / machine hr = $22 / machine hr 84000 budgeted machine hours84000 budgeted machine hours Material + Labor + overhead Material + Labor + overhead Product X costs $20 + 12 + (1.5Product X costs $20 + 12 + (1.5 x 22= 33) =$65x 22= 33) =$65 Product Y costs $15 + 14 + (2Product Y costs $15 + 14 + (2 x 22= 44) =$73x 22= 44) =$73 Product Z costsProduct Z costs $13 + 10 + (1$13 + 10 + (1 x 22= 22) =$45x 22= 22) =$45 If we use activity based costing $840000 equipment If we use activity based costing $840000 equipment

deprecation and maintenance is allocated on deprecation and maintenance is allocated on machine hours. Costs of other activities are machine hours. Costs of other activities are assigned to the relevant cost driver.assigned to the relevant cost driver.

Depreciation Depreciation 840000 deprecation and maintenance840000 deprecation and maintenance = $10.M. hour = $10.M. hour

84000 84000 Receiving orderReceiving order $418000 receiving co$418000 receiving costs = $1635 per receiving ordersts = $1635 per receiving order 256 receiving order256 receiving order Product X (1635 x 16)/ 28000= $0.93Product X (1635 x 16)/ 28000= $0.93 Product Y (1635 x 40)/ 18000= $3.63Product Y (1635 x 40)/ 18000= $3.63 Product Z (1635 x 200)/ 6000= $54.50Product Z (1635 x 200)/ 6000= $54.50

Production costProduction cost 360000 Production cost360000 Production cost = $8000= $8000 45 production orders45 production orders Product X ($8000 x 14)/ 28000= $4Product X ($8000 x 14)/ 28000= $4 Product Y ($8000 x 12)/ 18000= $5.33Product Y ($8000 x 12)/ 18000= $5.33 Product Z ($8000 x 19) / 6000= $25.33Product Z ($8000 x 19) / 6000= $25.33

Setup costs Setup costs $37400 setup costs$37400 setup costs = $ 1100 = $ 1100 34 production runs34 production runs Product X ($1100 x 4)/ 28000= $0.16Product X ($1100 x 4)/ 28000= $0.16 Product Y ($1100 x 8)/ 18000= $0.49Product Y ($1100 x 8)/ 18000= $0.49 Product Z ($1100 x 22) / 6000= $4.03Product Z ($1100 x 22) / 6000= $4.03

Inspection costsInspection costs $19200 inspection costs$19200 inspection costs = $ 6000 = $ 6000 32 inspections32 inspections Product X ($6000 x 8)/ 28000= $1.71Product X ($6000 x 8)/ 28000= $1.71 Product Y ($6000 x 4)/ 18000= $1.33Product Y ($6000 x 4)/ 18000= $1.33 Product Z ($6000 x 20) / 6000= $20.0Product Z ($6000 x 20) / 6000= $20.0 Therefore the unit cost for the three products Therefore the unit cost for the three products

using ABCusing ABC

X Y X Y Z Z Unit direct material cost Unit direct material cost $20 15$20 15 1313 Unit direct laborUnit direct labor 12 14 12 14 1010 Machine related overheadMachine related overhead 15 15 2020 1010 Receiving cost Receiving cost 0.930.93 3.633.63 54.5054.50 Production cost Production cost 4 4 5.335.33 25.3325.33 Machine setup costMachine setup cost 0.160.16 0.490.49 4.034.03

Inspections Inspections 1.711.71 1.331.33 2020

Total Total 53.8053.80 59.7859.78 136.86136.86

Faisal Company has the following marketing costs in Faisal Company has the following marketing costs in the company records.the company records.

TransportationTransportation 79207920

Sales promotion Sales promotion 80008000 Credit and collection Credit and collection

50005000 Marketing salariesMarketing salaries 36000 3600036000 36000

An analysis of the their records produced the following statisticsAn analysis of the their records produced the following statistics Order sizeOrder size SmallSmall medium medium largelarge

Units shippedUnits shipped 500500 18001800 21002100 Circulation pieced distributed Circulation pieced distributed 5000050000 7500075000 125000125000 No. of ordersNo. of orders 150150 7070 3030

Marketing salariesMarketing salaries $2400$2400 1690016900 1670016700

Allocate the costs using the traditional methods and the ABC method.Allocate the costs using the traditional methods and the ABC method.

Solution Solution Marketing cost Marketing cost Transportation = $ 7920/ 4400= $1.8Transportation = $ 7920/ 4400= $1.8 Sales promotion = $8000/ 250000= $0.032Sales promotion = $8000/ 250000= $0.032 Credit and collection = $5000/ 250= $20Credit and collection = $5000/ 250= $20

Cost Cost SmallSmall Medium Medium Large Large

TransTrans 900 = (1.8x500)900 = (1.8x500) 3240= (1.8x1800) 3780=(1.8x2100) 3240= (1.8x1800) 3780=(1.8x2100)

S. pro S. pro 1600= (0.032x 50000) 1600= (0.032x 50000) 2400= (0.032x 75000) 4000= 2400= (0.032x 75000) 4000= (0.032x125000)(0.032x125000)

Cre& coll 3000= (150x20)Cre& coll 3000= (150x20) 1400= (70x20) 1400= (70x20) 600= (30x20) 600= (30x20)

Salary Salary 24002400 1690016900 1670016700

Total Total 7900 7900 23940 23940 25080 25080

Cost/ unit 15.80Cost/ unit 15.80 13.30 13.30 11.9411.94 (7900/500)(7900/500) (23940/1800) (23940/1800) ( 25080/ 2100) ( 25080/ 2100)