Activity Based Costing: A Tool to Aid Decision Making

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Activity Based CostingA Tool to Aid Decision
Making
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LEARNING OBJECTIVES
After studying this chapter, you should be able
to

• 1. Understand activity-based costing and how it
  differs from a traditional costing system.
• 2. Assign costs to cost pools using a first-stage
  allocation.
• 3. Compute activity rates for cost pools.
• 4. Assign costs to a cost object using a
  second-stage allocation.
• 5. Prepare a report showing activity-based
  costing product margins from an activity view.
• 6. (Appendix 8A) Prepare an action analysis
  report using activity-based costing data and
  interpret the report.

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Activity Based Costing (ABC)

• The objective of activity-based costing is to
  understand overhead and the profitability of
  products and customers.

I agree!
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Activity Based Costing (ABC)
Activity-Based Costing
Both manufacturing and nonmanufacturing costs may
be assigned to products.
There are a number of cost pools each ofwhich is
allocated using a unique measure of activity.
Some manufacturing costs may be excluded from
product costs.
Some manufacturing costs may be excluded from
product costs.
Allocation bases often differ from traditional
costing systems.
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How Costs are Treated Under Activity-Based Costing
Activity-Based Costing
Departmental Overhead Rates
Level of Complexity
Plantwide Overhead Rate
Overhead Allocation
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Plantwide Overhead Rate
Companies tend to use direct labour as the
overhead allocation base.
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Example of Plantwide Overhead Rate
Bell Co. produces two telephones a cordless
phone and a regular model. The company has the
following estimated and actual data.
Budgeted overhead 360,000 Expected activity
(in direct labour hours) 100,000 Actual
overhead 380,000 Actual activity (in direct
labour hours) 100,000
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Stage One Pool Formation Overhead costs are
first accumulated in one large plantwide pool,
then a plantwide rate is computed using a single
cost driver (in this case, direct
labour hours). 360,000 / 100,000 DLH 3.60
per DLH
Stage Two Costs Assigned Overhead costs are then
assigned to the products. The plantwide rate is
multiplied by the actual amount of the cost
driver used by each product. 3.60 x 100,000 DLH
360,000 applied overhead
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Lets examine the manufacturing overhead cost
applied to both models
Cordless Regular Units produced 10,000
100,000 Direct labour hours 10,000
90,000 Applied overhead costs 3.60 x 10,000
. 36,000 3.60 x 90,000 ... 324,000
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324,000
36,000
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Departmental Overhead Rates
A two stage process is necessary because
costsare allocated to departmentsand then to
products.
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Departmental Overhead Rates
Indirect Labour
Indirect Materials
Other Overhead
Stage One Costs assigned to pools
Department 1
Department 2
Department 3
Cost pools
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Departmental Overhead Rates
Indirect Labour
Indirect Materials
Other Overhead
Stage One Costs assigned to pools
Department 1
Department 2
Department 3
Cost pools
Stage Two Costs applied to products
Products

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Departmental Overhead Rates
Indirect Labour
Indirect Materials
Other Overhead
Stage One Costs assigned to pools
Department 1
Department 2
Department 3
Cost pools
Direct Labour Hours
Machine Hours
Raw Materials Cost
Stage Two Costs applied to products
Products

Departmental Allocation Bases
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Example of Departmental Overhead Rates
Stage One Pool Formation Overhead costs are
first divided up and assigned to individual
production department, creating departmental
overhead costs pool.
Fabrication Assembly TOTAL Budgeted
OH 252,000 108,000 360,000

• Cost drivers
• Assembly department Direct labour hours (DLH)
• Fabrication department Machine hours (MH)

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Stage One Pool Formation
252,000
108,000
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Fabrication Assembly TOTAL Budgeted
OH 252,000 108,000 360,000 Expected/actual
DLH Cordless 7,000 3,000
10,000 Regular 13,000 77,000 90,000
Total 20,000 80,000 100,000 MH
Cordless 4,000 1,000 5,000
Regular 36,000 9,000 45,000 Total
40,000 10,000 50,000
Fabrication rate 252,000 40,000 MH 6.30
per MH
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Fabrication Assembly TOTAL Budgeted
OH 252,000 108,000 360,000 Expected/actual
DLH Cordless 7,000 3,000
10,000 Regular 13,000 77,000 90,000
Total 20,000 80,000 100,000 MH
Cordless 4,000 1,000 5,000
Regular 36,000 9,000 45,000 Total
40,000 10,000 50,000
Assembly rate 108,000 80,000 DLH 1.35 per
DLH
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Stage Two Costs Assigned Overhead costs are then
assigned to products. The departmental rates are
multiplied by the actual amount of the cost
drivers used in each department by each product.
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Lets examine the manufacturing overhead cost
applied to both models
Cordless Regular Units produced 10,000
100,000 Direct labour hours 10,000
90,000 Machine hours 5,000
45,000 Applied overhead costs 1.35 x 3,000 DLH
6.30 x 4,000 MH 29,250 1.35 x 77,000 DLH
6.30 x 36,000 MH ... 330,750
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Stage Two Cost Allocation
330,750
29,250
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COST DISTORTIONS
Total overhead costs applied to each product
Cordless Regular
Plantwide rate 36,000 324,000
Departmental rates 29,250 330,750
Cost distortion 6,750 (6,750)
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Cost Distortion
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Designing an ABC System
Cost Objects (e.g., products and customers)
Consumption of Resources
Activities
Cost
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Designing an ABC System

• Steps for Implementing ABC
• Identify and define activities and activity cost
  pools.
• Whenever possible, directly trace overhead costs
  to activities and cost objects.
• Assign costs to activity cost pools.
• Calculate activity rates.
• Assign costs to cost objects using the activity
  rates and activity measures.
• Prepare management reports.

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Identifying Activity to Include
Unit-Level Activity
Batch-Level Activity
A part of the production process for which
management wants a separate reporting of
the costs of the activity involved.
Product-Level Activity
Customer-Level Activity
Organization-Sustaining Activity
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Identifying Activity to Include

• Activity Cost Pool is a bucket in which costs
  are accumulated that relate to a single activity
  in the ABC system.

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Lets revisit our example of telephones
Bell Co. produces two telephones a cordless
phone and a regular model. The company has the
following estimated and actual data.
Budgeted overhead 360,000 Expected activity
(in direct labour hours) 100,000 Actual
overhead 380,000 Actual activity (in direct
labour hours) 100,000
The main problem with using either a plantwide
rate or departmental rates for assigning overhead
costs is the assumption that direct labour hours
and/or machine hours drive all overhead costs.
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In fact, a significant portion of overhead costs
is not driven or caused by direct labour hours.
Look below.
Activity Cost Data (overhead
activities) Activity Activity
Costs Setup 120,000 Material handling
60,000 Machining 100,000 Testing
80,000 Total 360,000
Setup and materials handling activities (50 of
the overhead costs) are batch-level activities
related to the number of production runs and
material moves, respectively.
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The following shows the activity usage measures
Cordless Regular Total Units produced per yr
10,000 90,000 100,000 Prime
costs 78,000 738,000 816,000 Direct
labour hours 10,000 90,000
100,000 Machine hours 5,000 45,000
50,000 Production runs 20 10
30 Number of moves 60
30 90
Now, lets compute a rate for each overhead
activity, then use these activity rates to assign
overhead costs.
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Activity Cost Data (overhead
activities) Activity Activity Activity
Rate Costs Measures Setup 120,000 30
runs 4,000/run Material handling 60,000 90
moves 666.67/move Machining 100,000 50,000
MH 2.00/MH Testing 80,000 100,000 DLH
0.80/DLH Total 360,000
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Lets examine the manufacturing overhead cost
applied to both models
Cordless Regular Applied overhead costs
Setups (4,000 x 20 runs) 80,000
(4,000 x 10 runs) 40,000 Material
handling (666.67 x 60 moves) 40,000
(666.67 x 30 moves) 20,000 Machining
(2 x 5,000 MH) 10,000 (2 x 45,000
MH) 90,000 Testing (0.80 x 10,000
DLH) 8,000 (0.80 x 90,000 DLH)
72,000 Manufacturing
costs 138,000 222,000
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Stage Two Cost Allocation
222,000
138,000
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COST DISTORTIONS
Total overhead costs applied to each product
Cordless Regular
ABC 138,000 222,000
Departmental rates 29,250 330,750
Cost distortion 108,750 (108,750)
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Cost Distortion
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The Mechanics of ABC

• At Classic Brass, the ultimate cost objects are
• Products,
• Customer orders, and
• Customers.
• One overhead cost - shipping - can be traced
  directly to customer orders.
• The companys overhead costs are shown on the
  next slide.

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Assigning Costs to Activity Cost Pools
Management at Classic Brass believes overhead
should be distributed as follows
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Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption
of overhead, costs are assigned to activity pools.
Indirect factory wages
500,000 Percent consumed by customer orders
25 125,000
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Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption
of overhead, costs are assigned to activity pools.
Factory equipment amortization
300,000 Percent consumed by customer orders
20 60,000
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Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption
of overhead, costs are assigned to activity pools.
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Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption
of overhead, costs are assigned to activity pools.
These costs should be cross-added to get the total
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Computation of Activity Rates

• After the first-stage allocation is complete,
  computation of activity rates for each activity
  cost pool is as follows

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Activity-Based Costing at Classic Brass
Direct Materials
Direct Labour
Shipping Costs
Overhead Costs
Traced
Traced
Traced
Cost Objects Products, Customer Orders, Customers
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Activity-Based Costing at Classic Brass
Direct Materials
Direct Labour
Shipping Costs
Overhead Costs
First-Stage Allocation
Customer Orders 315,000
Product Design 257,000
Product Units 380,000
Customer Relations 367,500
Other 490,500
Cost Objects Products, Customer Orders, Customers
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Activity-Based Costing at Classic Brass
Direct Materials
Direct Labour
Shipping Costs
Overhead Costs
First-Stage Allocation
Customer Orders
Product Design
Product Units
Customer Relations
Other
Second-Stage Allocations
315/Order
1,285/Design
19/MH
3,675/Customer
Cost Objects Products, Customer Orders, Customers
Unallocated
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Assigning Costs to Cost Objects

• Lets take a look at how our system works for
  just one customer - Windward Yachts.
• Windward ordered two products - Stanchions
• and Custom Compass Housings.
• The details are outlined on the following slide.

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Assigning Costs to Cost Objects
Standard Stanchions (no design required) 1. 400
units ordered with 2 separate orders. 2. Each
stanchion required 0.5 machine-hours . 3. Selling
price is 34 each. 4. Direct materials total
2,110. 5. Direct labour totals 1,850. 6.
Shipping costs total 180.
Custom Compass Housing (requires new design) 1.
One order during the year. 2. Each housing
required 4 machine-hours . 3. Selling price is
650 each. 4. Direct materials total 13. 5.
Direct labour totals 50. 6. Shipping costs total
25.
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Product Margin Standard Stanchions
2 orders _at_ 315 per order
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Product Margin Custom Compass
1 design _at_ 1,285 per design
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Customer Margin

• Customer margin for Windward Yachts is shown
  below

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Product Margins
Traditional Cost Accounting System
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Product Margins
Traditional Cost Accounting System
400 units x 0.5 MH/unit x 50/MH 10,000
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Product Margins
Traditional Cost Accounting System
1 units x 4.0 MH/unit x 50/MH 200
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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.

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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.

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ABC Action Analysis
Appendix8A
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First-Stage Allocations to Activity Cost Pools
Using the total costs and percentage consumption
of overhead, costs are assigned to activity pools.
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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-hours
• 100 customers.

Now the team can compute the individual activity
rates.
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Computation of Activity Rates for the Action
Analysis Report
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Computation of Activity Rates for the Action
Analysis Report
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Action Analysis Cost Matrix
Overhead cost of two orders for standard
stanchions.
125 per order 2 orders 250
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Action Analysis Cost Matrix
Overhead cost of two orders for standard
stanchions.
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Action Analysis Cost Matrix
Overhead cost of one order for custom compass
housing.
125 per order 1 order 125
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Action Analysis Cost Matrix
Overhead cost of one order for custom compass
housing.
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Ease of Adjustment Codes (Green, Yellow, and
Red Costs)

• Costs that adjust automatically to changes in
  activity
• Direct materials.
• Shipping.
• Costs that could be adjusted to changes in
  activity
• Direct labour.
• Factory utilities.
• Administrative wages and salaries.
• Office equipment amortization.
• Marketing wages and salaries.
• Selling expenses.
• Costs that are difficult to adjust to changes in
  activity
• Factory equipment amortization.
• Factory building lease.
• Administrative building lease.

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End of Chapter 8
I call this quality time!