Product Costing for Management Decisions: ActivityBased Costing and ActivityBased Management

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Chapter 4

• Product Costing for Management Decisions
  Activity-Based Costing and Activity-Based
  Management

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Topics to be Discussed
Introduction Activity-Based Costing Choosing Cost
Drivers to Motivate Behavior
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Introduction
Overhead costs have soared to 60 percent or more
of total product costs in heavily automated
manufacturing environments. As overhead costs
increase and make up a larger portion of the
total costs of products, accuracy in overhead
application has become much more important.
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Activity-Based Costing
Overhead Allocation Methods Using Volume-Based
Cost Drivers Using Activity-Based Cost Drivers
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Types of Overhead Costs
Unit-level costs are incurred each time a unit is
produced. Examples Supplies for
factory Depreciation on factory machinery Energy
costs for factory machinery Repairs and
maintenance of factory machinery
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Types of Overhead Costs
Batch-level costs are incurred each time a batch
of goods is produced. Examples Salaries related
to purchasing and receiving Salaries related to
moving material Quality control
costs Depreciation of setup equipment
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Types of Overhead Costs
Product-level costs are incurred as needed to
support the production of each different type of
product. Examples Salaries of
engineers Depreciation of engineering
equipment Product development costs
(testing) Quality control costs
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Types of Overhead Costs
Facility-level costs simply sustain a facilitys
general manufacturing process. Examples
Depreciation of factory building or rent Salary
of plant manager Insurance, taxes, etc. Training
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Activity-Based Costing (ABC)
Key Concept Overhead costs are assigned to
products in an ABC system in two stages Stage 1
Activities are identified and overhead costs are
traced to each activity Stage 2 Cost drivers are
determined for each activity and costs are
assigned to products
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Activities and Cost Drivers Unit Level
Activity Machining Maintenance of machines
Potential Cost Driver Machine hours, labor hours
or number of units Machine hours
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Activities and Cost Drivers Product Level
Activity Product Testing Supervision
Potential Cost Driver Number of change orders,
number of tests, hours of testing time Number of
supervision hours
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Activities and Cost Drivers Batch Level
Activity Purchasing Receiving Machine
setups Customer orders
Potential Cost Driver Number of purchase orders
or number of parts Amount of material or number
of receipts Number of setups Number of orders,
number of customers
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Activities and Cost Drivers Facility Level
Activity Plant Occupancy
Potential Cost Driver Square footage, number of
employees, labor hours, machine hours
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Choosing Cost Drivers
Cost drivers should generally be based on a
cause-and-effect relationship between the driver
and the specific cost being considered.
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Traditional Overhead Allocation and ABC - An
Example
Beach Housing Contractor Builds standard houses
and custom houses
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Estimated Overhead Costs for 2002
Manufacturing Overhead Item Indirect
Materials Construction Supervisors Office
Staff Part-time Workers Office Expenses Tools Truc
ks and Other Equipment Rent on Construction
Trailers Total Manufacturing Overhead
Estimated Cost 180,000 130,000 30,000 30,000 48,0
00 15,000 40,000 12,000 485,000
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Stage 1 Identification of Activities
Activity Inspections Purchasing Supervision Materi
al delivery handling Processing change
orders Total
Estimated Cost 50,000 30,000 100,000 225,000 80,0
00 485,000
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Stage 2 Identification of Cost Drivers
Allocation of Costs
Activity Inspections Purchasing Supervision Mat
erial delivery handling Change orders
Cost Driver Number of inspections Number of
purchase orders Hours of supervisor time Number
of deliveries Number of change orders
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Estimated Cost Driver Activity
Cost Driver Number of Houses Number of
inspections Number of purchase orders Supervision
hours Number of deliveries Number of change orders
Standard Houses (20) 400 600 2,500 600 200
Custom Houses (10) 1,000 600 1,500 600 300
Totals 1,400 1,200 4,00 1,200 500
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Activity-Based Costing
Activity Inspections Purchasing Supervision Mate
rial delivery handling Processing change
orders Total Overhead
Cost 50,000 30,000 100,000 225,000 80,000 485,00
0
/ / / / / /
Cost Driver PDR 1400 35.71/hour 1200
25/order 4000 25/hour 1200
187.50/delivery 500 160/order
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Standard House
Cost Direct materials Direct labor Inspections Pu
rchasing Supervision Material HD Processing
change orders Total Costs
ABC 75,000 60,000 714 750 3,125 5,625 1,600 146,
814
Vol-Based 75,000 60,000 overhead 13,224 148,2
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Custom House
Cost Direct materials Direct labor Inspections Pu
rchasig Supervision Material HD Processing
change orders Total Costs
ABC 112,500 100,000 3,571 1,500 3,750 11,250 4,80
0 237,371
Vol-Based 112,500 100,000 overhead 22,040 234
,540
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ABC
Allocating overhead costs using and
activity-based costing system results in greater
allocations of overhead to the custom house
because it consumes more of the purchasing,
inspection, supervision, material handling, and
processing change order activities than the
standard house.
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ABC
Key Concept Volume-based costing systems often
result in overcosting high-volume products and
undercosting low-volume products. This cross
subsidy is eliminated by the use of ABC.
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ABC Systems in Service Industries
Although ABC was developed for use primarily be
manufacturing companies, it has gained widespread
acceptance in the service sector.
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ABC Systems in Service Industries
Problems Type of work tends to be
non-repetitive Activities differ greatly for each
customer or service Have proportionately more
facility-level costs
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Cost Flows and ABC
The flow of costs from raw materials to work in
process to finished goods and cost of goods sold
is not affected by the implementation of ABC.
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Need for ABC
The higher the potential for cost distortions,
the more likely the company will benefit from
ABC. Distortions result from diverse
products. Diverse products products that consume
resources in different proportions
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Diverse Products
Pause and Reflect Are the standard houses and
custom houses built by TopSail Construction
diverse products?
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Activity-Based Management Topics
Key Concept Activity-based management focuses on
use of ABC to make better decisions.

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Value-Added and Non-Value-Added Activities
Non-value-added activities dont add value to the
finished product or service. Storage of
inventory Moving of materials and parts from
storage to the factory Idle time of employees
while waiting for work

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Successful Implementation of ABC and ABM
Perhaps nowhere else is cooperation among
accountants, marketing managers, production
managers, human resource managers, and finance
managers more critical than in the implementation
of activity-based costing and management systems.

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Successful Implementation of ABC and ABM
Key Concept The successful implementation of ABC
and ABM requires a long-term commitment by top
management and the cooperation of all functional
areas of business organization.


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End of Chapter 4
How do I allocate all of this overhead?