Activity Based Costing
Notes to Chapter 7
Examples
• Split a restaurant bill• Split profit in a partnership• Allocate cost to products• Cost of a degree program?
– What is cost of an international student?– What is the cost of an auditing student?– What is the cost of a cand. merc. student?
• Multi-product firms are found everywhere.2
Indirect cost – Classic Pen
• Classic Pen was a low cost producer of pens. They had a profit margin of at least 20% of revenue
• Five years ago the firm started producing red pens• Same production technology• Could be sold at a premium price 3% higher than the two other types of
pens• Last year purple was added
– Profit margin 10% “higher”• The controller of Classic Pen was disappointed by the result from
last quarter– The controller pondered if Classic Pen should continue to introduce new pens
instead of focusing on the blue and black– The production manager pointed out the influence of the new types on the
production
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Indirect cost – Classic Pen
• The costing system of Classic Pen was simple:– All indirect costs were aggregated at factory level and allocated
to products based upon the direct labor cost– At this time the overhead rate was 300% of direct labor cost– Before new types of pens were introduced the overhead rate
was only 200% of direct labor cost– Classical Pen uses only one cost center
• This would not change even if several cost centers were introduced. The biases in the production costs would remain.
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Indirect cost – Classic Pen
Blue Black Red Purple TotalUnits 50.000 40.000 9.000 1.000 100.000Price 4,50 4,50 4,65 4,95SalesMaterialsLaborOverhead
225.0075.00030.00090.000
180.00060.00024.00072.000
41.85014.0405.400
16.200
4.9501.650
6001.800
451.800150.69060.000
180.000Total man. cost.
195.000 156.000 35.640 4.050 390.690
Oper.inc 30.000 24.000 6.210 900 61.110
return. % 13,3% 13,3% 14,8% 18,2% 13,5%
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Indirect cost – Classic Pen• Before:
– Production primarily manual– Total indirect cost were less that the direct labor cost– Classic Pen’s two products were identical with respect to volume
and batch size• Direct labor cost and indirect cost has decreased due to
automation• As low volume products were introduced the result was
increased demand for:– Increased planning– More setups of machines– More quality control– Computers to keep track of jobs and product specifications
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Indirect cost – Classic Pen• Same physical output, same cost of material
• The firm has approximately – Property taxes, security cost and heating cost which are unchanged– Much higher indirect and support costs due to the larger and more
diversified product mix and more complex production
• One unit of the high volume standard product (blue or black) uses approximately the same amount of direct labor as one unit of red or purple
• The traditional costing system would fundamentally report identical costs for the standard and special products, independent of production volume
• The use of indirect and support activities by the special products are higher that the use by the standard products
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Indirect cost – Classic Pen
ABC at Classic Pen - Analysis of the cost structure:
• Indirect labor– 50% of the indirect labor costs are caused by what the controller
called “handling of production batches”– 40% of the indirect labor cost were caused by th physical change
from one color to another and were called setup costs– 10% of the time was used to an activity which the controller labeled
support activities• Computer costs
– 20% allocated to “support activities,” • This is an activity which is already found in the catalogue of
activities as it was used to account for the 4 products– 80% of computer resources were used to produce batches and are
closely related to handling of production batches
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Indirect cost – Classic Pen
Activity Cost Driver Blue Black Red Purple Total**
DL h/unit 0,02 0,02 0,02 0,02 2.000
Mach. h/unit 0,1 0,1 0,1 0,1 10.000
Prod. series 70 65 50 15 200
Setuptime/batch
4 2,4 5,6 5,6 --
Tot.setup.hours 280 156 280 84 800
# products 1 1 1 1 4
**Volume 50.000 40.000 9.000 1.0009
Indirect cost – Classic Pen
Indirect labor IT Depreciation Maintenance Energy
Handling Setup Support activities Operation
50% 40% 10%
80% 20%
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Indirect cost – Classic Pen• Three categories of indirect cost remained:
– Machine depreciation– Machine maintenance– Energy for running the machines
• These costs were incurred to maintain the production capacity for the production of pens.
• The Controller calls the production activities “running the machines”
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Indirect cost – Classic Pen
• Identification of cost hierarchy• Four activities which explain the indirect cost at Classic
Pen represents three levels in the cost hierarchy:
Product Product sustaining
Batch levelSetups of machines
Batch levelHandling of batches
Unit levelRunning machines
Cost hierarchyActivity
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Indirect cost – Classic Pen
Cost-driver rates Aktivity-cost
Aktivity-driver
Driver quantity
Rate
Handling prod.batches
66.000 #Batches 200 330 pr batch
Setups of mach 33.600 #Setup hours 800 42 pr setup hour
Product sustain 14.400 # Products 4 3.600 pr product
Running machines
42.000 # Machine hours
10.000 4,20 per machine ht
156.00013
Indirect cost – Classic Pen
Assigned IPOBlue Black Red Lilla Total**
Handling prod.batches 23.100 21.450 16.500 4.950 66.000Setups of machines
11.760 6.552 11.760 3.528 33.600
Product sustain
3.600 3.600 3.600 3.600 14.400
Running machines
21.000 16.800 3.780 420 42.000
Total cost assigned 59.460 48.402 35.640 12.498 156.000
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Indirect cost – Classic PenProfitability
Blue Black Red Lilla Total**Sales 225.000 180.000 41.850 4.950 451.800MaterialsLabor40%SupportTotal prod.cost
75.00030.00012.00059.460
176.460
60.00024.0009.600
48.402
142.002
14.0405.4002.160
35.640
57.240
1.650600240
12.498
14.988
150.69060.00024.000
156.000
390.690Operating income
48.540 37.998 (15.390) (10.038) 61.110
B.M. % 21,6% 21,1% -36,8% -202,8% 13,5%
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Assigning service department costs to activities
• Untraceable or common costs• Rough estimates of product cost
– This is estimation by means of allocation• Cause and effect relationship• Link cost to activities
– How are the activities using resources– What type of measures do we have– Fixed or variable costs
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Ingredients
• Aggregate cost pools• LLA’s• Allocation
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Example
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Impressionist
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ABC Definitions
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Indirect cost – Classic Pen
Indirect labor IT Depreciation Maintenance Energy
Handling Setup Support activities Operation
50% 40% 10%
80% 20%
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Activity cost drivers
• Unit level activities• Batch level activities• Product sustaining activities• Customer sustaining activities
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Activity cost drivers
• Transaction drivers• Duration drivers• Intensity drivers
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Problem 7.15
1
2
3
4
750,000 0.4200,000 0.2 1.5750,0001,500
OV DLOV DM TOVOV S
= += + +=
=
Problem 7.15
Problem 7.15
Problem 7.15
Problem 7.15
Problem 7.15
q 2500 2500 2400UCI 170 630 1392UCabc 216 631 1343q 5000 500 5200UCI 141 558 1221UCabc 171 562 1192q 2500 0 0UCI 778 0 0UCabc 778 0 0
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Problem 7.15
The Firm’s Technology
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The Firm’s Technology
•Factor inputs z1,…z8
•Production f,g,h•Output q = (q1, …,qn)
z7
q = (q1,…,qn)
z5 z6
h
gf
z4z3
z8
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Account structure
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Marginal costs
Impressionists estimation:
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Marginal costsThe Modernisms estimation:
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Example 7.3
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Example 7.3
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Example 7.3 – Modern School
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41
2 21 2
1 2
1 2
200
: 200, 50, 200200 200
Total cost 100*200 150*50 175*200150, 350
Kq qSolution K L L
MC MC
≤
= = = = =
= + += =
Marginal costs
• The marginal cost have a linear structure
• The ABC cost results in marginal cost• The Impressionist School leads to different
product cost
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Problem 7.8
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8. unit versus marginal costReturn to Example 7.3 and focus on the constantreturns to scale case of α = β = .5. Determinetotal cost, marginal cost of each product, unit costof each product under the impressionism school, and unit cost of each product under the modernism school for each of the following output pairs: q = [3, 8], q = [8, 3] and q = [10, 10]. Alsodetermine the corresponding percentageestimation errors.
Example 7.3
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Example 7.3
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Example 7.3 – Modern School
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Problem 7.8 Product oneExample 7.3
q1 q2 TC MC UCt UCabc
7 9 632.33 47.60 54.99 47.60
3 8 408.70 47.60 58.39 47.60
8 3 480.50 47.60 50.58 47.60
10 10 808.37 47.60 53.89 47.60
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Problem 7.8 Product twoExample 7.3
q1 q2 TC MC UCt UCabc
7 9 632.33 33.24 27.49 33.24
3 8 408.70 33.24 29.19 33.24
8 3 480.50 33.24 25.29 33.24
10 10 808.37 33.24 26.95 33.24
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Problem 7.9
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9. unit versus marginal cost
Repeat the above for the mixed case of α = .55 and β = .45.
Problem 7.9 Product one – non-linear
Example 7.3
q1 q2 TC MC UCt UCabc
3 8 418.73 57.54 59.82 54.50
8 3 549.08 59.49 57.80 56.28
10 10 899.24 60.81 59.95 57.41
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Ex 7.9 Product two – non-linear
q1 q2 TC MC UCt UCabc
3 8 418.73 31.97 29.91 31.90
8 3 549.08 33.03 28.90 32.94
10 10 899.24 32.73 29.97 32.51
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Decreasing ReturnsMarginal Cost for Product 1
Marginal cost for product 1: MC153
Decreasing ReturnsMarginal Cost for Product 2
Marginal cost product 254
Decreasing ReturnsImpressionism Error for First product
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Decreasing ReturnsImpressionism Error for Second product
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Decreasing ReturnsABC Error for First Product
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Decreasing ReturnsABC Error for second Product
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Increasing ReturnsImpressionisms Error for First Product
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Increasing ReturnsImpressionisms error for second product
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Increasing ReturnsABC Error for First Product
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Increasing ReturnsABC Error for Second Product
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Mixed ReturnsImpressionisms error for second product
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Mixed ReturnsImpressionisms error for second product
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Mixed ReturnsABC Error for First Product
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Mixed ReturnsABC Error for Second Product
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Errors• Error is the norm• Errors are functions of the accounting system• Different accounting systems produce different
errors– Which department– Which product
• Where to put errors• Where in the organization is precision
important?• Portfolio of errors
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Conclusion
• ABC costing allows fine tuning of accounting system to technology
• Is usable in a service organization• Requires more data collection• Assumes linearity in
– Use of production factors– Cost functions
• Allocation of errors• Theory of second best
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