Activity-Based Costing A Tool to Aid Decision Making

1. Activity-Based CostingA Tool to Aid Decision Making

2. Activity Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect fixed as well as variable costs. It is ordinarily used as a supplement to, rather than as a replacement for, the company’s usual costing system.

3. How Costs are Treated UnderActivity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Manufacturingcosts Non-manufacturingcosts Traditionalproduct costing ABCproduct costing  ABC assigns both types of costs to products. For example, ABC systems can assign sales commissions, shipping costs, and warranty repair costs to specific products.

4. How Costs are Treated UnderActivity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Manufacturingcosts Non-manufacturingcosts Some Most, butnot all All Traditionalproduct costing ABCproduct costing • ABC does not assign all manufacturing costs to products. This is because ABC only assigns a cost to a product if decisions concerning that product will cause changes in the cost.

5. How Costs are Treated UnderActivity–Based Costing ABC uses more cost pools than traditional cost systems that often use a single plant wide overhead pool or just one overhead pool per department. Since more than one activity is often performed within each department. Activity–Based Costing Departmental Overhead Rates Level of complexity Plantwide Overhead Rate Number of cost pools • ABC uses more cost pools.

6. How Costs are Treated UnderActivity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Volumemeasuresplus otherbases. Bases usuallyrely only onvolumemeasures. Number ofAllocation Bases Traditional Costing ABC • ABC uses more allocation bases.

7. How Costs are Treated UnderActivity–Based Costing “Best practice” ABC differs from traditional costing in five ways. The most commonly used allocation basein traditional costing is direct labor hours. Direct labor hours workwell when overheadincreases as directlabor hours increase. • ABC uses more allocation bases.

8. How Costs are Treated UnderActivity–Based Costing “Best practice” ABC differs from traditional costing in five ways. The most commonly used allocation basein traditional costing is direct labor hours. • Problems: • In many processes, overhead is increasing while direct labor is decreasing. • Variety and complexity of products is increasing. • ABC uses more allocation bases.

9. How Costs are Treated UnderActivity–Based Costing “Best practice” ABC differs from traditional costing in five ways. ABC usesvolume as well asother allocation bases notrelated to the volumeof production. All overheadcosts are not relatedto volume measures likedirect laborhours. • ABC uses more allocation bases.

10. How Costs are Treated UnderActivity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses. • ABC bases level of activity on capacity.

11. Strong topmanagement support Link to evaluationsand rewards Cross-functionalinvolvement Characteristics of SuccessfulABC Implementations

12. Activities Consumption of Resources Cost Designing an ABC System Cost Objects (e.g., products and customers)

13. Designing an ABC System Steps for Implementing ABC • Identify and define activities and activity cost pools. • Trace costs to activities and cost objects. • Assign costs to activity cost pools. • Calculate activity rates. • Assign costs to cost objects. • Prepare management reports.

14. Unit-Level Activity Batch-Level Activity Manufacturingcompanies typically combinetheir activities into fiveclassifications. Product-Level Activity Customer-Level Activity Organization-sustaining Activity Identify and Define Activitiesand Activity Cost Pools

15. Identify and Define Activitiesand Activity Cost Pools--Explanation • Unit-level activities are performed each time a unit is produced. •  Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. e.g. inspection, setting up equipment and shipping customer orders. • Product-level activities relate to specific products and must be carried out regardless of how many batches are run or units produced and sold. For example, designing or advertising a product. • Customer-level activities relate to specific customers and are not tied to any specific product. For example, sales calls and catalog mailings. • Organization-sustaining activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices.

16. Identify and Define Activitiesand Activity Cost Pools Activities should only becombined within a levelif they are highlycorrelated. When combiningactivities, they should be grouped together only atthe appropriatelevel. Batch-level Activities should not be combined with unit-level activities, and so on

17. $ $ $ $ $ $ Identify and Define Activitiesand Activity Cost Pools An Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system.

18. Transactiondriver Durationdriver Simple countof the number oftimes an activityoccurs. A measureof the amountof time neededfor an activity. Identify and Define Activitiesand Activity Cost Pools Two types of activity measures: When All Activity takes the same time Different amount of time required to perform Activities

19. Identify and Define Activitiesand Activity Cost Pools At Classic Brass, the ABC team, selected the followingactivity cost pools and activity measures:

20. Identify and Define Activitiesand Activity Cost Pools • Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. • Product Designs - assigned all costs of resources consumed by designing products. • Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. • Customer Relations – assigned all costs associated with maintaining relations with customers. • Other – assigned all overhead costs that are not associated with the other cost pools.

21. When Possible, Directly Trace OverheadCosts to Activities and Cost Objects

22. Assign Costs to Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity cost pools is determined. **Not included because they are directly traced to customer orders.

23. Assign Costs to Activity Cost Pools • The indirect factory workers allocated twenty-five percent of their time to the customer orders activity, forty percent of their time to the product design activity, twenty percent of their time to the order size activity, ten percent of their time to customer relations, and five percent of their time to the “other” activity.

24. Assign Costs to Activity Cost Pools Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

25. Assign Costs to Activity Cost Pools Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

26. Assign Costs to Activity Cost Pools

27. Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . . • 1,000 customer orders, • 200 new designs, • 20,000 machine-hours, • 100 customer relations activities. Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

28. Calculate Activity Rates

29. Traced Traced Traced Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers

30. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Cost Objects: Products, Customer Orders, Customers

31. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Second-Stage Allocations $/MH $/Order $/Design $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated

32. Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Second-Stage Allocations $19/MH $315/Order $257/Design $3675/Customer Cost Objects: Products, Customer Orders, Customers Unallocated

33. Assigning Costs to Cost Objects Let’s take a look at how our system worksfor just one customer – Windward Yachts. 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 labor totals $1,850. 6. Shipping costs total $180. For each activity cost pool, the amount of activity consumed by the product (or customer) is multiplied by the activity rate to arrive at the amount of overhead cost applied to the product (or customer). 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 labor totals $50. 6. Shipping costs total $25.

34. Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.

35. Prepare Management Reports

36. Prepare Management Reports Customer Profitability Analysis

37. Predetermined manufacturing overhead rate $1,000,000 20,000 MH = = $50/MH Product Margins Traditional Cost Accounting System 400 units x 0.5 MH/unit x $50/MH = $10,000

38. Differences Between ABC and Traditional Product Costs • Product margins are different for four reasons: • Traditional costing assigns design costs to both products based on machine hours. ABC assigns product design costs to a product only if product design work is required. • Traditional costing assigns customer order costs, a batch- level cost, using a unit-level allocation base, machine hours. ABC assigns these batch-level costs using a batch-level activity measure. • Traditional costing assigns only manufacturing costs to products. ABC also assigns nonmanufacturing costs to products. • Traditional costing assigns all manufacturing costs to products. The ABC system does not assign organization- sustaining manufacturing costs to the products.

39. Differences Between ABC and Traditional Product Costs When batch-level andproduct-level costs are present,ABC will usually shift costs from highvolume products, produced in large batches,to low volume products produced in small batches. This cost shifting will usually have itsgreatest impact on the perunit cost of the lowvolume products.

40. Targeting Process Improvement Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements. While the theory of constraints approach discussed in Chapter 1 is a powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on where to focus improvement efforts.

41. Activity-Based Costing and External Reporting Most companies do not use ABCfor external reporting because . . . • External reports are less detailed than internal reports. • It may be difficult to make changes to the company’s accounting system. • ABC does not conform to GAAP. • Auditors may be suspect of the subjective allocation process based on interviews with employees.

42. ABC Limitations Substantial resourcesrequired to implementand maintain. Resistance tounfamiliar numbersand reports. Desire to fullyallocate all coststo products. Potentialmisinterpretation ofunfamiliar numbers. Does not conform toGAAP. Two costingsystems may be needed.