Activity-Based Costing Systems

1. 4 Activity-BasedCosting Systems

2. Traditional Costing Systems Traditional cost systems were created whenmanufacturing processes were labor intensive. A single company-wide overhead rate,based on direct labor hours, may be used to allocate overhead to productsin these labor intensive processes.

3. Traditional Costing Systems Overhead is allocated to jobs using directlabor hours. If overhead is $120, how muchoverhead is allocated to each job?

4. Traditional Costing Systems Overhead Rate = $120 ÷ 8 direct labor hours Overhead Rate = $15 per direct labor hour Job 1 = 2 hours × $15 per hour = $30 Job 2 = 6 hours × $15 per hour = $90

5. Automation increasesoverhead from $120 to $420and reduces the Job 2 laborhours from 6 to 1. Allocatethe $420 overhead to the two jobs using direct labor. Traditional Costing Systems

6. Traditional Costing Systems Overhead Rate = $420 ÷ 3 direct labor hours Overhead Rate = $140 per direct labor hour Job 1 = 2 hours × $140 per hour = $280 Job 2 = 1 hour × $140 per hour = $140

7. Traditional Costing Systems Is this reasonable? Automation benefited Job 2, but Job 1 isallocated more overhead. Clearly, we needanother cost driver to allocate overhead.

8. Activity-Based Costing (ABC) A costing method that first assigns costs to activities, then assigns costs to products based on their use of the activities. Directlabor hours Processsetups Lot size Machinehours Designtime Customercontact

9. Activity-Based Costing (ABC) A costing method that first assigns costs to activities, then assigns costs to products based on their use of the activities. Products Require Activities Activities Consume Resources People Manage Activities

10. A C B Activity-Based Costing (ABC) Both manufacturing and nonmanufacturing costs may be assigned to products. ABC is a goodsupplement to our traditionalcost system. Allocation bases often differ from traditional costing systems. ABC is used primarilyfor decision making, notfor inventory valuation for external reporting.

11. Activity-Based Costing (ABC) Activity-Based Costing Level of Complexity Cost of Implementation Level of Benefits TraditionalCosting

12. Activity-Based Costing (ABC) Traditional Costing Activity-Based Costing Resource Costs Resource Costs Directly tracedor allocated Directly tracedor allocated Cost Pools: Plants or Departments Cost Pools: Activities or Activity Centers Predeterminedoverheadrate Cost driverrates foreach activity Cost Objects Cost Objects

13. Activity-Based Costing (ABC) An Activity Cost Pool is a “container” in which costs are accumulated that relate to a single activity in the ABC system. Costs $ $ $ $ $ $

14. Identify and classify the activities related to the company’s products or services. Estimate the cost of each activity identified in . Calculate a cost-driver rate for each activity. Assign activity costs to products using the cost-driver rate. Four Steps in the ABC Process

15. UNIT-LEVEL ACTIVITES Resources acquired and activities performed for individual units.  Identify and Classify Activities BATCH-LEVEL ACTIVITES Resources acquired and activities performed for a group or batch of similar products or services. PRODUCT - LEVEL ACTIVITES Resources acquired and activities performed to produce and sell a specific product or service. CUSTOMER- LEVEL ACTIVITES Resources acquired and activities performed to serve specific customers. FACILITY-LEVEL ACTIVITIES Resources acquired and activities performed to provide general capacity to produce goods or services.

16.  Identify and Classify Activities TOP DOWN APPROACH ABC teams of middle-management or above develop the activity dictionary. INTERVIEW OR PARTICIPATIVE APPROACH ABC teams include or interview operating employees. RECYCLING APPROACH Reuses documentation of processes used for other purposes.

17.  Estimate the Cost of Activities The ABC teams should gather data on the costs of all the activities identified in Step 1. Examine accounting records for recorded cost information. Ask employees to indicate how much timethey work on various activities.

18.  Calculate Cost-Driver Rates for Activities • Two pieces of information are required to compute the cost-driver rate: • Activity Cost • Activity Volume MAY Company has 4 employees in its Quality Control Department. Salaries and costs for the department total $360,000 per year. MAY produces 500,000 units of product a year. What is the cost-driver rate per unit? $360,000 ÷ 500,000 units = $.72 per unit

19.  Calculate Cost-Driver Rates for Activities MAY has a customer service center where customers can call to ask questions. Customers pay a fixed fee for each call they make to the service center. It costs MAY $1,260,000 a year to operate the center. The center receives 120,000 calls per year. The center handles 1,000,000 minutes of calls. What is the appropriate cost driver; total minutes for all calls or number of calls? What is the cost-driver rate?

20.  Calculate Cost-Driver Rates for Activities Since customers are charged “per call”, the proper activity in this case is the number of calls handled by the center. The cost-driver rate would be: $1,260,000 ÷ 120,000 units = $10.50 per call

21. Cause and effectrelationship betweenactivity and costs Measurable Based on resource’spractical capacity tosupport activities Predict or explainan activity’s useof resources  Calculate Cost-Driver Rates for Activities Appropriatecost-driverbase

22. Practical Capacity Note When estimating the cost of an activity, only the costs associated with the product should be used (practical capacity). The cost of “unused capacity” should not be applied to products. EXAMPLE Suppose we rent a 1,000 square foot warehouse for $1,000 per month. Only 800 sq. ft. are used to store Product A. The rest of the warehouse is “unused”. How much rent cost should be allocated to Product A?

23. Practical Capacity Note 80%, or $800 should be assigned to Product A 20%, or $200 should be assigned to “unused capacity”

24.  Assign Activity Costs to Products 1. Identify all the activities related to a given product or service. 2. Determine how many units of each activity are used per unit of product. 3. Assign costs to products using the cost-driver rates for each activity.

25. Example: Yazz, Inc. produces 130,000 units of Product A and 400,000 units for Product B. Using the following cost information, how much overhead should be allocated to Product A?  Assign Activity Costs to Products

26.  Assign Activity Costs to Products

27. Let’s look at anexample from theBilson Company. Activity-Based Costing Example

28. Mfg. overhead cost Direct labor hours $1,550,000 77,500 = = $20/DLH Activity-Based Costing Example • Bilson, Inc. manufactures and sells 5,000 units of Product A (deluxe model), and 25,000 units of Product B (standard model) each year. • Product A requires 3.0 DLH and Product B requires 2.5 DLH to produce. • Employing atraditionalcosting system, Bilson assigns overhead cost to products using direct labor hours. • The predetermined overhead rate is:

29. Activity-Based Costing Example Bilson’s unit product costs usingtraditionalcosting are: Bilson marks its products up by 50 percent and allocatesits $500,000 customer service costs based on revenue.

30. $130.00 × 1.50 $975,000 ÷ ($975,000 +$3,900,000) × $500,000 Activity-Based Costing Example Traditional Costing

31. Activity-Based Costing Example Sales of Product A have increased steadily since introduction,but company income has declined. Management at Bilson isunhappy with the traditional costing system and they havedecided to try activity-based costing. In addition, management hasobserved that the cost of directlabor is relatively stable.Since labor does not behavelike a unit-level cost, labor willbe combined with overhead andthe total conversion costwill be assigned using ABC.

32. The total conversion cost is: Traditional overhead $1,550,000 Labor (77,500 hours @ $10) 775,000 Total $2,325,000 Activity-Based Costing Example In addition, management hasobserved that the cost of directlabor is relatively stable.Since labor does not behavelike a unit-level cost, labor willbe combined with overhead andthe total conversion costwill be assigned using ABC.

33. Activity-Based Costing Example Management has identified the following five activities and costs in the production of its two products: Total conversion cost

34. Activity-Based Costing Example The following transaction data has been complied by management of Bilson:

35. $ 800,000 ÷ 5,000 Machine setups = $160.00 per setup Activity-Based Costing Example These data can be used to develop predetermined cost-driver rates for each of the five activities:

36. Activity-Based Costing Example The activity-based overhead rates we just calculatedcan be used to assign conversion costs to Bilson’stwo products.

37. Activity-Based Costing Example The activity-based overhead rates we just calculatedcan be used to assign conversion costs to Bilson’stwo products.

38. Activity-Based Costing Example The activity-based overhead rates we just calculatedcan be used to assign conversion costs to Bilson’stwo products.

39. These amounts did not change as a result of using ABC. Activity-Based Costing Example Let’s compute the product cost for A and B using our ABC overhead rates:

40. Activity-Based Costing Example Now compare the unit product costs using the traditional costing system and our ABC system. Remember, we used one overheadrate based on direct labor hours.

41. Activity-Based Costing Example Now compare the unit product costs using the traditional costing system and our ABC system. Adopting activity-based costing usually results in a shift of batch-level and product-level overhead costs from high-volume standardproducts to low-volume, more complex products.

42. Activity-Based Costing Example Now compare the unit product costs using the traditional costing system and our ABC system. Can you see how different allocation methods might lead to making different management decisions?

43. Activity-Based Costing Example Based on these results Bilson also decides to use ABC to assign Its $500,000 customer service costs. The applicable activity isnumber of customer consultations. Customers buying Product A,the deluxe model, require more consultations than those buyingProduct B, the standard model. Cost per consultation = $500,000 ÷ 125,000 consultations = $4.00

44. No change in sales price Activity-Based Costing Example ABC Costing Let’s compare product income using traditional and ABC costing.

45. ABCCosting TraditionalCosting

46. Should Bilsondrop Product A? Should Bilsonincrease the priceof Product A? Should Bilsonreducethe priceof Product B? Activity-Based Costing Example

47. Activity-Based Costing Example • The price of Product A, the deluxe model, should probably be increased. Customers who buy deluxe models may buy based on features instead of price. • The price of Product B, the standard model, may be too high. Customers who buy standard models are price sensitive. Decreasingthe price would increase volume,possibly resulting in more income.

48. ABC– Benefits and Limitations Benefits • More accurate and informative product costs lead to better decisions. • More accurate measurements of the activities driving costs. • Provides managers with easier access to relevant costs. Major Limitation An ABC system is very expensiveto develop and implement; it isalso very time-consuming.

49. When Should a Company Use ABC? • Indirect costs are significant in proportion to direct costs. • Goods are complex, requiring many inputs and processes. • Complex, low-volume products are profitable while standard, high-volume products are not. • Different departments believe costs are assigned inaccurately. • The company loses bids it thought were low, and wins bids it thought were high. • Operations have changed significantly, but the costing system has not changed. • Introduction of new models result in higher sales, apparent profits per unit, but an overall income decline.

50. End of Chapter 4