Activity-Based Costing Systems

1. Activity-Based Costing Systems

2. Activity-Based Costing Activity-based costing (ABC) involves determining the cost of activities and tracing their costs to cost objectives on the basis of the cost objectives utilization of units of activity. Part of “Activity-Based Analysis”

3. FAULTY COST SYSTEMSymptoms • Competitive analysis is confusing • Conflicting signals from functional areas and the accounting system • Accounting system problems

4. WHY ABC NOW? • Competitive demands for diverse products/services • Increased significance of overhead costs • Growth of nonunit-based overhead • Consumption ratios of unit-based and nonunit-based overhead items differ • Improved information technology • Significance of strategic decisions

5. Activities consume resources Activities Served by activities Costs Resources cost money Resources Activity-Based Costing Activities performed to fill customer needs consume resources that cost money. Customer

6. Assigned to activity cost pools Resources Assigned to resources Cost objectives Reassigned to cost objectives Activities Activity-Based Costing The cost of resources consumed by activities should be assigned to cost objectives. Costs

7. Activity-Based Costing Operationalizing the two-stage model requires: • Identifying activities. • Assigning costs to activities. • Determining the basis for assigning the cost of activities to cost objectives. • Determining the cost per unit of activity. • Reassigning costs from the activity to the cost objective on the basis of the cost objective’s consumption of activities.

8. Cost of Resource 1 Cost of Resource 2 Cost of Resource n Activity 2 Activity 3 Activity 4 Activity n Activity 1 Two-Stage Activity Based Costing Method First stage: Costs assigned to resources are reassigned to activities. Continued on next slide

9. Objective 1 Objective 2 Objective n Objective 3 Two-Stage Activity Based Costing Method Second stage: Costs assigned to activities are reassigned to cost objectives using an activity cost driver. Activity 2 Activity 3 Activity 4 Activity n Activity 1

10. Manufacturing Cost Hierarchy • Unit level activities • Batch level activities • Product level activities • Facility level activities

11. Manufacturing Cost Hierarchy This activity is performed for each unit of product produced and sold. Unit Level • Cost of raw materials • Cost of inserting a component • Utilities cost of operating equipment • Some costs of packaging • Sales commissions Examples

12. Manufacturing Cost Hierarchy Batch Level Examples • Cost of processing sales order • Cost of issuing and tracking work order • Cost of equipment setup • Cost of moving batch between workstations • Cost of inspection This activity is performed for each batch of product produced or sold.

13. Manufacturing Cost Hierarchy Product Level Examples This activity is performed to support each different product that can be produced. • Cost of product development • Cost of product marketing, such as advertising • Cost of specialized equipment • Cost of maintaining specialized equipment

14. Manufacturing Cost Hierarchy Facility Level Examples This activity is performed to maintain general manufacturing capabilities. • Cost of maintaining general facilities • Cost of nonspecialized equipment • Cost of maintaining nonspecialized equipment • Cost of real property taxes • Cost of general advertising • Cost of general administration

15. Changing Composition of TotalManufacturing Costs Activity-Based Multiple-Level Analysis Volume-Based Unit Level Analysis Variable: Only one type of variable cost is considered: Variable: Many types of variable cost drivers are considered, including: Unit level Unit level Batch level Product level

16. Changing Composition of TotalManufacturing Costs Activity-Based Multiple-Level Analysis Volume-Based Unit 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

17. Customer Cost Hierarchy A merchandising organization or the sales division of a manufacturing organization might use the following hierarchy: • Unit level activities • Order level activities • Customer level activities • Facilities level activities

18. Customer Cost Hierarchy An organization that sells to distinct market segments might have the following cost hierarchy: • Unit level activities • Order level activities • Customer level activities • Market segment level activities • Facility level activities

19. Benefits Of Activity Based Costing • Greater understanding of the nature of operations • More accurate product costing • Improvement in cost control • Integration with strategic management accounting

20. Limitations Of Activity Based Costing • Costly implementation process • ABC is NOT a guarantee of becoming a “world-class” company

21. Practical Advice for Implementing ABC 1. Capture the attention of top management. 2. Don’t shoot the customer. 3. Decide the form ABC will take. 4. Supplement the ABC measures creativity where appropriate. 5. Be careful in costing bottlenecks that create excess capacity. 6. Challenge managers who believe their costs are fixed. 7. Calculate costs top-down and bottom-up. 8. Account for cost of capital. 9. Use multi-functional teams. 10. Don’t underestimate the need for managing change.

22. 3,200 units of product A and 10,000 units of product B Danger of Error with theUnit Level Approach Using the High-Low Method June: Produced 12,000 units at a cost of $247,250 July: Produced 13,200 units at a cost of $258,900

23. Danger of Error with theUnit Level Approach Using the High-Low Method June: Produced 12,000 units at a cost of $247,250 July: Produced 13,200 units at a cost of $258,900 b = ($258,900 - $247,250)/(13/200 - 12,000) b = $9.708 a = $247,250 - ($9.708 x 12,000 total units) a = $130,754

24. Danger of Error with theUnit Level Approach Using the High-Low Method The formula for predicting total cost is: Y = $130,754 + $9.708X Predicted production for August is 1,500 units of product A and 13,000 units of product B. Y = $130,754 + $9.708(14,500) Y = $271,520

25. Danger of Error with theUnit Level Approach Using the High-Low Method A complete analysis of activities and activity cost gives predicted costs for August of $294,300, which is $22,780 greater than the predicted costs determined by using high-low.

26. Danger of Error with theUnit Level Approach Failure to Separately Account for Batch Level Costs A company produces two products, C and D. Both have identical monthly production volumes of 50,000 units. The only difference is batch size, 50,000 units for C and 5,000 units for D.

27. Both C and D cost $1 per unit Both C and D cost $20,000 per batch Danger of Error with theUnit Level Approach Failure to Separately Account for Batch Level Costs Y = [$1 x (50,000C + 50,000D) units] + [$20,000 x [($20,000 x (1C + 10D) batches] Y = $320,000 The average cost per unit is $3.20 ($320,000/100,000).

28. Compared to $3.20 Danger of Error with theUnit Level Approach Product C Product D Unit level costs: C: $1 x 50,000 $ 50,000 D: $1 x 50,000 $ 50,000 Batch level costs: C: $20,000 x 1 20,000 D: $20,000 x 10 200,000 Total costs $ 70,000 $250,000 Units 50,000 50,000 Average unit cost $ 1.40 $ 5.00

29. Volume based unit level cost analysis assumes units of product is the only cost driver. Activity-based multiple level analysis considers unit and batch level costs. Cost Estimate Errors withUnit Level Analysis $6 --- $5 --- $4 --- $3 --- $2 --- $1 --- $0 --- Average Unit Cost | | 0 5,000 25,000