Lecture 2 - Activity Based Costing

TOPIC 2

ACTIVITY-BASED COSTING (ABC)

PREVIEW OF PREVIOUS TOPIC

Traditional Costing and Activity-Based Costing

Traditional costing systems

The need for a new approach

Activity-based costing

Illustration of Traditional Costing versus ABC

Unit costs under traditional costing

Unit costs under ABC

Comparing unit costs

ACTIVITY-BASED COSTING VERSUS TRADITIONAL COSTING

Traditional Costing Systems

Allocates overhead using a single predetermined rate.

Job order costing: direct labor cost is assumed to be the relevant activity base.Process costing: machine hours is the relevant activity base.

Assumption was satisfactory when direct labor was a major portion of total manufacturing costs.

Wide acceptance of a high correlation between direct labor and overhead costs.

Traditional Costing Systems:Continued

Direct labor is still often the appropriate basis for assigning overhead costs when:

Direct labor constitutes a significant part of total product cost

and

High correlation exists between direct labor and changes in overhead costs.

Overhead Direct Labor Products

Costs Hours/Dollars

Need for a New Approach

Tremendous change in manufacturing and service industries.

Decrease in amount of direct labor usage.

Significant increase in total overhead costs.

May be inappropriate to use plant-wide predetermined overhead rates based on direct labor or machine hours when a lack of correlation exists.

Complex manufacturing processes may require multiple allocation bases; this approach is called Activity-Based Costing (ABC).

Activity-Based Costing (ABC)

An overhead cost allocation system that allocates overhead to multiple activity cost pools

and Assigns the activity cost pools to products or

services by means of cost drivers that represent the activities used.

Activity-Based Costing (ABC)Terms

Activity: any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service.

Activity Cost Pool: a distinct type of activity.For example: ordering materials or setting up machines.

Cost Drivers: any factors or activities that have a direct cause-effect relationship with the

resources consumed.

The Logic Behind ABC

Products consume activities,

and activities consume resources.

Activity-Based Costing (ABC) – Continued

ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity cost pools.

Stage 2: The overhead costs allocated to the cost pools is assigned to products using cost drivers.

The more complex a product’s manufacturing operation, the more activities and cost drivers likely to be present.

Activities and Related Cost Drivers

ABC System Design – Lift Jack Company

Traditional Costing vs ABC

ABC does not replace an existing job order/process cost system.

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

ABC, thus, supplements – it does not replace – the traditional cost system.

Traditional Costing vs ABCAn Illustration

Atlas Company produces two automotive antitheft devices: The Boot: a high volume item with sales totaling 25,000 per year The Club: a low volume item with sales totaling 5,000 per

year

Each product requires 1 hour of direct labor Total annual direct labor hours (DLH) 30,000 (25,000 + 5000) Direct labor cost $12 per unit for each product

Expected annual manufacturing overhead costs $900,000

Direct materials cost: The Boot - $40 per unit The Club - $30 per unit

Activity-Based Costing:A Closer Look

More accurate product costing through: Use of more cost pools to assign overhead costsEnhanced control over overhead costsBetter management decisions

Activity-Based Costing: A Closer Look

Limitations of ABC

Can be expensive to use Some arbitrary allocations continue

Activity-Based Costing:A Closer Look

Use ABC When One or More of the Following Exist:

Products differ greatly in volume/manufacturing complexity

Products lines are Numerous Diverse Require 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

Study Objective 6

Activity Based Management (ABM):

An extension of ABC from a product costing system to a management function

that focuses on reducing costs and improving processes and decision making

A refinement of ABC used in ABM classifies activities as either value-added or non-value-added.

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

CLASSIFICATION OF ACTIVITY LEVELS

Unit-level activities:Performed for each unit of production

Batch-level activities:Performed for each batch of product

Product-level activities:Performed in support of an entire product

line, but not always performed every time a new unit or batch is produced

Facility-level activities:Required to support or sustain an entire

production process

Hierarchy of Activity LevelsFour Levels Types of Activities Cost DriversUnit-Level Activities Machine-related: Machine Hours

Drilling, cutting, milling

Labor-related Direct labor hours/cost Assembling, painting

Batch-Level Activities Equipment setups Number of setups/setup time

Purchase ordering Number of purchase orders

Inspection Number of inspections or

inspection time

Material handling Number of material moves

Product-Level Activities Product design Number of product designs

Engineering changes Number of changes

Facility-Level Activities Plant management Number of employees salaries managed

Plant depreciation Square footage

Property taxes Square footage

Utilities Square footage

Activity-Based Costing in Service Industries

Similarities with Manufacturing Firms

Overall objective: Identify key cost-generation activities and keep track of quantity of activities performed for each service provided

General approach is to identify activities, cost pools, and cost drivers

Labeling of activities as value-added or non-value-added

Reduction of non-value-added activities

Activity-Based Costing in Service Industries

Major difficulty to implementing ABC:

A larger proportion of overhead

costs are company-wide costs

that cannot be directly traced to

specific services.

Summary of Study Objectives

Recognize the difference between traditional and activity-based costing.

Traditional system allocates overhead to products using predetermined unit-based output rate.ABC allocates overhead to activity cost pools and assigns cost to products using cost drivers.

Identify the steps in the development of an activity-based costing system.

Step 1: Identify the major activities and allocate the overhead costs to cost pools.

Step 2: Identify the cost driver highly correlated to the cost pool.Step 3: Compute the overhead rate per cost driver.Step 4: Assign cost pools to products or services using the

overhead rates.

Summary of Study Objectives Know how companies identify cost pools used in ABC.

Analyze each operation or process, document and time every task, action, or transaction.

Know how companies identify and use cost drivers in ABC.Cost drivers identified for assigning activity cost pools must: Accurately measure the consumption of the activity Have related data easily available.

Understand the benefits and limitations of ABCBenefits: Enhanced control over overhead costs Better management decisions

Limitations: Higher costs accompany multiple activity centers and cost

drivers Some costs must still be allocated arbitrarily

Summary of Study Objectives

Differentiate between value-added and non-value-added activities.

Value-added activities increase the worth of a product or service.

Non-value-added activities add cost to, or increase the time spent on, a product or service without increasing its market

value.

Understand the value of using activity levels in ABCActivities may be classified as:

Unit-level Batch-level Product-level Facility-level

Failure to recognize this classification can resultin distorted product costing.

Summary of Study Objectives

Apply ABC to service industries.Same objective – improved costing of

services provided.

The general approach to costing is also the same: analyze operations identify activities accumulate overhead costs by activity

cost pools identify and use cost drivers to assign

cost to services

AppendixJust-In-Time Processing (JIT)

A processing system dedicated to having the

right amount of materials, products, or parts

arrive as they are needed, thereby reducing

the amount of inventory.

Just-In-Time Processing

Goods Manufactured Goods Shipped to Customer

Susan’s

SoccerSneakers

Sales Order Received

100 pairs of sneakers...

got it!

Send rubber and shoe laces directly

to the factory.

JIT Processing

Objective of JIT: Eliminate all manufacturing inventories

Elements of JIT: Dependable suppliers Multi-skilled work force Total quality control system

Benefits of JIT: Reduced inventory Enhanced product quality Reduced rework and storage costs Savings from improved flow of goods