Traditional to ABC Costing

8/2/2019 Traditional to ABC Costing

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RESOURCE ALLOCATION

FROM TRADITIONAL

COSTING TO ABC

ASOC. PROF. SYED MOHD. GHAZALI WAFA

B. SYED ADWAM WAFA

GRADUATE SCHOOL OF BUSINESS

UNIVERSITI KEBANGSAAN MALAYSIA


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Classifying Costs

By Behavior Fixed

Variable

By Traceability Direct

Indirect

By FunctionProduct

Period


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2-5

Total Cost Behavior With a

Single Unit Level Cost Driver

Total

costs

(Y)

Value of independent variable (X)0

0

Fixed costs (a)

Variable costs (b)

Total costsY = a + bX

Variable costs are

layered on top of

fixed costs.Slope, b =

Y

X


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2-6

Equation for Total Costs

Y = a + bXtotal costsvertical axis intercept

(an approximation of

FIXED COSTS)

slope (an

approximation ofvariable COSTS PER

UNIT of X)

value of

independentvariable (UNITS)


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2-7

Economists Curvilinear

Total Cost PatternTotal

power

costs

Units produced0

0

Normalactivity

range

Relevant range

for which linear

patterns are valid


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Relevant Costs

Costs that can be eliminated (in whole or inpart) by choosing one alternative overanother are avoidable costs.

Avoidable costs are relevant costs.

Unavoidable costs include:

Sunk costs.

Future costs that do not differ betweenthe alternatives.

Unavoidable costs are never relevant.


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How Costs are Treated:Traditional to Activity-Based Costing

Overhead Allocation

PlantwideOverhead

Rate

DepartmentalOverhead

Rates

Activity BasedCosting

Traditional


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Plantwide Overhead Rate

Companies tend to use direct laboras the overhead allocation base.


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A two stage process isnecessary because costs

are allocated to departmentsand then to products.

Finishing Department

Shipping Department

Painting Department

Departmental Overhead Rates


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Department1

Department2

Department3

Cost pools

IndirectLabor

IndirectMaterials

OtherOverhead

Stage One:Costs assigned

to pools

Departmental Overhead Rates


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Department1

Department2

Department3

Cost pools


to pools

Products

Stage Two:

Costs appliedto products

Departmental Overhead RatesIndirectLabor

IndirectMaterials

OtherOverhead


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Department1

Department2

Department3

Cost pools


to pools

Products

Stage Two:

Costs appliedto products

DirectLaborHours

MachineHours

RawMaterials

Cost

Departmental Allocation Bases

Departmental Overhead RatesIndirectLabor

IndirectMaterials

OtherOverhead


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Designing an ABC SystemCost Objects

(e.g., productsand customers)

ActivitiesConsumptionof Resources

Cost


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Designing an ABC System

Steps for Implementing ABCIdentify and define activities and activity pools.

Where possible, trace costs to activities and costobjects.

Assign costs to activity cost pools.

Calculate activity rates.

Assign costs to cost objects.

Prepare management reports.


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Identifying Activity to Include

A part of the productionprocess for which managementwants a separate reporting of the

costs of the activity involved

Unit-LevelActivity

Batch-LevelActivity

Product-LevelActivity

Customer-LevelActivityOrganization-

sustaining

Activity


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2-18

Manufacturing Cost Hierarchy

Unit level activities

Batch level activities Product level activities

Facility level activities


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2-19


ActivityLevel Reason for Activity Examples of Activity Cost

Unit Performed for each

level unit productproduced or sold

Cost of raw materials

Cost of inserting acomponent

Utilities cost of

operating equipment

Some costs of packaging Sales commissions


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2-20



Batch Performed for each

level batch of productproduced or sold

Cost of processing a

sales order Cost of issuing and

tracking work order

Cost of equipment setup

Cost of moving batchbetween workstations

Cost of inspection


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2-21



Product Performed to support

level each differentproduct that can be

produced

Cost of product

development Cost of product

marketing such as

advertising

Cost of specializedequipment

Cost of maintaining

specialized equipment


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2-22



Facility Performed to

level maintaingeneralmanufacturing

capabilities

Cost of maintaining

general facilities Cost of nonspecialized

equipment

Cost of real property

taxes Cost of general

advertising

Cost of general

administration


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2-23

Changing Composition of Total

Manufacturing Costs

Volume-Based Unit

Level Analysis

Activity-Based

Multiple-Level

Analysis

Variable--only one type of

variable cost is considered:

Unit level

Variable--many types of

variable cost drivers are

considered, including:

Unit levelBatch level

Product level


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2-24

Volume-Based Unit

Level Analysis

Activity-Based

Multiple-Level

Analysis

Fixed--Costs that do not

vary with the number of

units

Fixed--costs that do not

respond to change in

variable cost drivers are

considered:Facility level

Changing Composition of Total

Manufacturing Costs


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2-25

Customer Cost Hierarchy

Unit level activities

Order level activities

Customer level activities Facilities level activities

A merchandising organization or the salesdivision of a manufacturing organization

might use the following hierarchy:


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2-26

Unit level activities Order level activities

Customer level activities

Market segment level activities

Facility level activities

An organization that sells to distinctmarket segments might have the

following cost hierarchy:

Customer Cost Hierarchy


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Cost Drivers Selection

The selection of activity cost drivers requires makingchoices related to how to economize on the number of

activity cost drivers, how to isolate events (because

activities triggered by the same event often can use the

same activity cost driver), and whether to apply transaction

drivers, duration drivers, or intensity drivers.

Transaction drivers count how often an activity is

performed. Duration drivers represent the amount of time

required to perform an activity. Intensity drivers directly

charge for the resources used each time an activity isperformed. Also, rather than using intensity drivers, a

weighted index approach might be used to simulate an

intensity driver.


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ABC COST DRIVERS

Activity Transaction

Driver

Duration Driver Intensity Driver

MACHINEMAINTENANCE # of machines Machine hours

Actual times for variousmaintenances of various machines

MACHINE SETUP # of setups Setup hours

Actual times for various setups forvarious machines

QUALITY CONTROL # of inspections Inspection hoursActual times for variousinspections for various controls

MATERIALORDERING # of orders Ordering hours

Actual times for various orders forvarious materials

PRODUCTION

SCHEDULING

# of runs Scheduling hours

Actual times for various runs forvarious schedules

WAREHOUSING # of bins, aisles Picking hours Actual times for various parts forvarious warehousing activities

ENGINEERINGDESIGN

# of engineers# of designs Engineering hours

Actual times for variousengineering designs


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Traditional Costing

Addison Company Addison Company has two products: A and B.

Annual production and sales are 800 units of

Product A and 700 units of Product B. Thecompany has traditionally used direct labor-

hours as the basis for applying all manufacturing

overhead to products. Product A requires 0.2

direct labor hours per unit and Product Brequires 0.6 direct labor hours per unit. The total

estimated overhead for next period is $71,286.


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To Calculate:a. The predetermined overhead rate under the

traditional costing system.

b. The overhead cost per unit of Product B under the

traditional costing system.


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Predetermined Overhead Rate

Total Direct Labor-Hours:

Product A: 800 units .2 DLHs per unit 160 DLHs

Product B: 700 units .6 DLHs per unit 420 DLHs

Total 580 DLHs

Predetermined overhead rate:

= $71,286 580 DLHs = $122.91

Total overhead cost applied to Product B using traditional

costing: $122.9069 420 DLHs = $51,621 (rounded)

Overhead cost per unit = $51,621 700 units = $73.74

ie: $122.9069 x .6 = $73.74


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Addisonss Change to ABC System

The company is considering switching to an activity-based costing system forthe purpose of computing unit product costs for external reports. The new

activity-based costing system would have three overhead activity cost

poolsActivity 1, Activity 2, and General Factory--with estimated overhead

costs and expected activity as follows:

Expected Activity

Activity Cost Pool Estimated Product A Product B Total

Overhead Costs

Activity 1 $20,272 300 500 800

Activity 2 29,380 800 500 1,300

General Factory 21,634 160 420 580 Total $71,286

(Note: The General Factory activity cost pool's costs are allocated on the basis of

direct labor hours) :A = {800 x 0.2}; B = {700 x 0.6}


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To Calculate:

a. The predetermined overhead rate (i.e.,

activity rate) under the activity-based

costing system. b. The overhead cost per unit of Product B

under the activity-based costing system.


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The overhead activity rate and overhead cost per unit of Product B under the

ABC system :

(a) (b) (a) (b)Activity Cost Pool Estimated Cost Estimated Activity Activity Rate

Activity 1 $20,272 800 $25.34

Activity 2 $29,380 1,300 $22.60

General Factory $21,634 580 $37.30

Total Cost ofProduct B:

(a) (b) (a) (b)

Activity Cost Pool Activity Rate Activity ABC Cost

Activity 1 $25.34 500 $12,670

Activity 2 $22.60 500 11,300

General Factory $37.30 420 15,666

$39,636

Overhead cost per unit = $39,636 700 units = $56.62 per unit (rounded)


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CABIO COMPANY

CABIO COMPANY manufactures two products, Product C and Product D.

The company estimated it would incur $119,100 in manufacturingoverhead costs during the current period. Overhead currently is applied to

the products on the basis ofdirect labor hours. Data concerning the

current period's operations appear below:

Product C Product D

Estimated volume 400 units 3,000 unitsDirect labor hours per unit 1.20 hours 1.30 hours

Direct materials cost per unit $4.00 $22.80

Direct labor cost per unit $12.00 $13.00

Compute the predetermined overhead rate under the current method, and

determine the unit product cost of each product for the current year.


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Change to ABC System

The company is considering using an activity-based costing system to

compute unit product costs for external financial reports instead of itstraditional system based on direct labor hours. The activity-based costing

system would use three activity cost pools. Data relating to these activities

for the current period are given below:

Expected Activity

EstimatedOverhead

Activity Cost Pool Costs Product C Product D Total

Machine setups $ 10,440 60 120 180

Purchase orders 78,000 820 1,180 2,000

General factory 30,660 480 3,900 4,380

Total $119,100

Determine the unit product cost of each product for the current period

using the activity-based costing approach.


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Traditional to ABC Costing

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