ACCT 102 Management Accounting Lecture 10

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ACCT 102Management AccountingLecture 10 11
Activity-Based-Costing (ABC)
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Allocating Indirect Costs
A cost object is anything to which costs are
assigned
Indirect costs are costs that are not
economically traceable to the cost object.
Assignment of indirect costs to the cost object
is known as allocation of indirect costs using a
cost allocation base.
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Cost Allocation Base
Indirect Cost Category
Allocation Base
Employee health services Personnel. Mainte
nance and repairs Purchasing... Warehouse
...
Number of employees or visits Number of employees
or new hires Number of repair orders or service
hours Number of orders placed Square footage used
or value of materials stored
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Cost Pools

• A cost pool is a collection of related costs that
  is assigned to one or more cost objects.
• Due to feasibility reasons, several similar costs
  are combined into a cost pool, and the entire
  pool is allocated as a single item.
• The key consideration in establishing cost pools
  is that the items pooled together should be
  relatively homogeneous and have a logical
  cause-and-effect relationship to the cost
  allocation base.

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Product Costing Continuum
Also varies in number of cost drivers at each
level.
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OBC
Traditional costing considers the cost of a
product to be its direct costs for materials and
labor, plus some allocated portion of
manufacturing overhead.
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OBC
In OBC, overhead rates are allocated to products
using a plant-wide or departmental overhead
rates, i.e. cost assignment follows the
organization chart.
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ABC
ABC is based on the notion that companies incur
costs because of the activities they conduct in
pursuit of their goals and objectives.
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ABC

• What is ABC?
• is a cost planning system that gives a better
  reflection of what products, processes, and
  customers cost.
• suggests that increasing products, processes,
  customer service level, number of suppliers, etc.
  increase activities within the firm, thus
  resulting in higher overhead costs.
• identifies how activities consume scarce
  resources and how customers and products trigger
  activities
• assigns costs to products or customers based on
  the resources they consume (i.e. cause effect)
• can be used to extend product cost analysis to
  include non-manufacturing processes in the value
  chain

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ABC

• Why ABC?
• Traditional approach fails in 3 areas
• Use of general measures of the volume of
  production as allocation base unable to give
  accurate product cost in modern, complex
  manufacturing environments.
• Financial accounting conventions lead to some
  cost being excluded in the measurement of product
  cost.
• Use of advanced manufacturing technology has led
  to an increase in the proportion of indirect cost
  in the total cost of product. While simple
  allocation bases may be acceptable when only a
  small proportion of total cost was being
  allocated, that is no longer the case and a
  fuller understanding of the behavior of indirect
  costs is needed to measure the costs accurately.

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ABC
ABC involves determining the cost of activities
and tracing their costs to a cost object on the
basis of the cost objects utilization of units
of activity.
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ABC
Activities performed to fill customer needs
consume resources that cost money.
Customer
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ABC
The cost of resources consumed by activities
should be assigned to cost objects.
Costs
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Two-Stage ABC Method
First stage Costs of resources are assigned to
activities.
Continued on next slide
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Two-Stage ABC Method
Second stage Costs assigned to activities are
reassigned to cost objects using an activity cost
driver.
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Characteristics of ABC

• ABC uses a greater number of costs pools than OBC
  allocation methods.
• ABC is more insistent on the use of causal
  factors than OBC.
• ABC assigns costs based on their activity cost
  drivers, and if they cannot be identified, ABC
  cannot be used to assign those costs.

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Characteristics of ABC

• Implementation of ABC requires an understanding
  of the production process, the activities that
  occur in the production process, and the cost
  drivers that generate the costs of those
  activities.
• Implementation and operation of ABC is more
  likely to involve the use of judgment than the
  operation of an OBC system.

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Two-Stage ABC Method
Operationalizing the two-stage model requires

• Identifying/Refining activities.
• Assigning costs to activities.
• Determining the basis for assigning the cost of
  activities to cost objects.
• Determining the cost per unit of activity.
• Reassigning costs from the activity to the cost
  object on the basis of the cost objects
  consumption of activities.

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Two-Stage ABC Method
Worked example Monthly Costs, Purchasing Dept
Placing Purchase Receiving Orders
Materials
Purchasing agent salaries (4,000 x
3) 12,000 Receiving room employees (3,000 x
5) 15,000 Supervisor (6,000 x 3/8 of time
with purch. agent) 2,250 (6,000 x 5/8 of time
with receiving agent) 3,750 Other
costs (12,000 x 0.15 purchasing
space) 1,800 (12,000 x 0.85 receiving
space) 10,200
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Two-Stage ABC Method
Refining into 3 Activities and assigning cost to
activities
Placing Verifying Unloading/
Purchase Purchase Unpacking Orders
Orders Inspecting
Purchasing agent salaries (4,000 x
3) 12,000 Receiving room employees (3,000
x 5 x 0.20 verifying time)
3,000 (3,000 x 5 x 0.80 unloading/
unpacking/inspect time) 12,000
Continue on next slide
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Placing Verifying Unloading/
Purchase Purchase Unpacking Orders
Orders Inspecting
Carried forward 12,000 3,000 12,000 Superviso
r (6,000 x 3/8 of time with purchasing
agents) 2,250 (6,000 x 5/8 of time with
receiving employees x 0.20 employees
verifying time) 750 (6,000 x 5/8 of time
with receiving employees x 0.80
employees unloading/ unpacking/inspecting
time) 3,000
Continue on next slide
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Placing Verifying Unloading/
Purchase Purchase Unpacking Orders
Orders Inspecting
Carried forward 14,250 3,750 15,000 Other
costs (12,000 x 0.15 purchasing
space) 1,800 (12,000 x 0.85 receiving
space) 10,200
Because the purchase order is verified before
delivery trucks are unloaded, the space devoted
to this activity is assumed to be insignificant.
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Two-Stage ABC Method
Determine the basis for assigning the of
activities to cost objects and the cost per unit
of activity cost driver
Placing Purchasing Orders
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Two-Stage ABC Method
Determine the basis for assigning the of
activities to cost objects and the cost per unit
of activity cost driver
Verifying Purchasing Orders
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Two-Stage ABC Method
Determine the basis for assigning the of
activities to cost objects and the cost per unit
of activity cost driver
Unloading/Unpacking/Inspecting
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Two-Stage ABC Method
Reassigning activity costs to the cost objects
based on consumption of activities by the cost
objects
Purchase Purchase Order 1 Order 2
Total
Direct materials costs 5,000.00 3,500.00 8,500.
00 Activity costs Placing purchase order
80.25 80.25 160.50 Verifying purchase
order 18.75 18.75 37.50 Unloading/unpacking/inspe
cting (5,000 x 0.0315) 157.50 (3,500 x
0.0315) 110.25 267.75 Total 256.50
209.25 465.75 Total costs assigned to
cost objective 5,256.50 3,709.25 8,965.75
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Comparison of OBC and ABC
Worked example Krown Drink (Carbonated v Fruit)
Krown Drink produced 232 barrels of Carbonated
drink and 400 barrels of Fruit drink. Estimated
manufacturing overhead is 187,000.
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Comparison of OBC and ABC
Use of plant-wide rates in MOH allocation

• Allocation based on machine hours
• Total machine hours for Mixing Bottling
  Departments 1,496 machine hours

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Comparison of OBC and ABC
Use of plant-wide rates in MOH allocation
Unit Costs Carbonated Fruit

• Direct materials 125 120
• Direct labor 110 30
• Manufacturing overhead
• Carbonated (3 x 125) 375
• Fruit (2 x 125) 250
• Total unit cost 610 400

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Comparison of OBC and ABC
Use of departmental rates in MOH allocation

• Allocation based on
• Mixing Direct labor hours (500 dl/h)
• Bottling Machine hours (800 m/h)
• Consumption of cost drivers
• Carbonated Fruit
• Mixing (59,100) 1 dl/h 0.67 dl/h
• Bottling (127,900) 1 m/h 1.42 m/h

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Comparison of OBC and ABC
Use of departmental rates in MOH allocation
Mixing Bottling
Total Departmental Manufacturing
Overhead 59,100 127,900 Quantity of
Base Direct Labor Hours ? 500 Machine
Hour ? 800 Overhead Rates 118.2 159.875
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Comparison of OBC and ABC
Use of departmental rates in MOH allocation
Unit Costs Carbonated Fruit
Direct materials 125 120 Direct
labor 110 30 Manufacturing overhead Mixing (l/h
x 118.2) 118 79 Bottling (m/h x
159.875) 160 227 Total costs 513 456
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Comparison of OBC and ABC
Use of ABC in MOH allocation
Overhead Activity and Cost
Unit Activity Rates
Direct departmental overhead costs Mixing 40,00
0/500 80 per dl/h Bottling 90,000/800
112.50 per m/h Common overhead
costs Support Services Receiving
14,000/100 140 per order Inventory
Control 13,000/632 20.57 per unit
continued
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Comparison of OBC and ABC
Use of ABC in MOH allocation
Overhead Activity and Cost
Unit Activity Rates
Engineering Resources Production Setup
12,000/20 600 per run Engineering and
Testing 8,000/800 10 per m/h Building and
Grounds Maintenance, machines 4,000/800
5 per m/h Depreciation, machines 6,000/632
9.49 per unit

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Comparison of OBC and ABC
Use of ABC in MOH allocation
Carbonated
Mixing (80 x 232 labor hours) 18,560 Bottling
(112.50 x 174 machine hours) 19,575 Receiving
(140 x 40 orders) 5,600 Inventory control
(20.57 x 232 units) 4,772 Production setup (600
x 5 runs) 3,000 Engineering and Testing (10 x
174 m/h) 1,740 Maintenance, machines (5 x 174
m/h) 870 Depreciation, machines (9.49 x 232
units) 2,202 Total factory overhead product
cost 56,319
Factory overhead cost per unit (56,319/232)
243
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Comparison of OBC and ABC
Use of ABC in MOH allocation
Fruit
Mixing (80 x268 labor hours) 21,440 Bottling
(112.50 x 626 machine hours) 70,425 Receiving
(140 x 60 orders) 8,400 Inventory control
(20.57 x 400 units) 8,228 Production setup (600
x 15 runs) 9,000 Engineering and Testing (10 x
626 m/h) 6,260 Maintenance, machines (5 x 626
m/h) 3,130 Depreciation, machines (9.49 x 400
units) 3,796 Total factory overhead product
cost 130,679
Factory overhead cost per unit (130,679/400)
327
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Comparison of OBC and ABC
Use of ABC in MOH allocation
Unit Costs Carbonated Fruit
Direct materials 125 120 Direct
labor 110 30 Manufacturing overhead 243 327 Total
costs 479 477
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Comparison of OBC and ABC
Summary of costs
Activity-based costing 479
477
What errors might management make if they only
know the product costs as determined with the
plant-wide or departmental overhead rates?
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Deciding the number of cost drivers

• To decide on the number of cost drivers, the
  following factors can be considered
• Purpose of the system
• The objectives of the system will determine how
  many cost drivers are needed
• The greater the number of cost drivers, the
  greater will be the cost of designing and
  maintaining the system
• Resources availability
• Cost benefit analysis can be applied, companies
  should always ask the question as to whether the
  incremental benefit is justifiable in terms of
  the incremental cost incurred. The ultimate
  question is whether the company can afford the
  best system available given its requirements.

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Deciding the number of cost drivers

• To decide on the number of cost drivers, the
  following factors can be considered
• Company complexity
• Product as the cost object
• Number of production processes
• Total indirect costs
• Product diversity
• Customer as the cost object
• Number of distribution channels
• Steps in distribution system
• Variety in items
• Customer diversity

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Pros and Cons of ABC

• Pros
• Overhead costs are allocated more accurately to a
  specific product. ABC, unlike OBC, avoids
  problems of arbitrary allocation across all
  products.
• ABC focuses attention on the consumption of
  activities by the cost objects and can lead to
  efforts in reducing the cost of the activities or
  utilization of the activities.
• Cons
• More costly as there is a need to estimate costs
  of activity pools and to identify and measure
  cost drivers e.g. number of POs, setups for these
  pools.
• Activity-cost rates need to be updated regularly
• Very detailed ABC systems are costly to operate
  and difficult to understand.

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Summary of ABC

• ABC is most useful when
• More than one product produced
• Significant amounts of non-volume related
  indirect costs are allocated using only one or
  two cost pools
• Products make diverse demands on resources
  because of differences in batch size or
  complexity
• Indications of poor costing systems
• Complex products appear to be very profitable and
  simple products appear to be losing money
• Competitors prices appear to be unrealistically
  low or firms prices appear to be too high