4 Activity Based Costing Systems Compatibility Mode

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Activity-Based Costing Systems

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Learning Objective 1
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Traditional Costing Systems

Traditional cost systems were created when manufacturing processes were labor intensive.
A single company-wide overhead rate based on direct labor hours may be used to allocate overhead to products in these labor intensive processes.
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In this example, overhead will be allocated to jobs using direct labor hours. If total overhead is $120, how much will be allocated to each job?
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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
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The company introduces automated machinery. Total overhead rises from $120 to $420, while the labor time needed for Job 2 falls from 6 hours to 1 hour. Now allocate the $420 overhead to the two jobs.
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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
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Is this a reasonable costing method? Automation benefited only Job 2, but most of the additional overhead cost was allocated to Job 1. Clearly, we need to look for another cost driver.
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Activity-Based Costing (ABC)

A costing method that identifies the activities performed within the organization as it delivers its goods and services.
Products Require Activities Activities Consume Resources
People Manage Activities

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A costing method that assigns costs to products, based on the number of activities the organization used in producing them.
Process setups
Lot size
Direct labor hours Machine hours
Design time
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Customer contact
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Both manufacturing and nonmanufacturing costs may be assigned to products. ABC is a good supplement to our traditional cost system.
A B C
Used in internal decision making as well as in inventory valuation for external reporting.
Allocation bases often differ from traditional costing systems.

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ABC Compared with Traditional Costing

Activity-Based Costing
Traditional Costing
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ABC Compared with Traditional Costing

Traditional Costing Resource Costs Directly traced or allocated Cost Pools: Plants or Departments Predetermined overhead rate Cost Objects
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Activity-Based Costing Resource Costs Directly traced or allocated Cost Pools: Activities or Activity Centers Cost driver rates for each activity Cost Objects
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An Activity Cost Pool is a common way to collect costs that are related to a specific activity in the ABC system. Activity Costs
$$ $ $ $ $
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Four Steps in the ABC Process
Identify and classify the activities

related to the companys 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.
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Identify and Classify Activities

UNIT-LEVEL ACTIVITIES
Resources acquired and activities performed for individual units of product.
BATCH-LEVEL ACTIVITIES
Resources acquired and activities performed for a group or batch of similar products or services.
PRODUCT-LEVEL ACTIVITIES
Resources acquired and activities performed to produce and sell a specific product or service.
CUSTOMER-LEVEL ACTIVITIES
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.
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Identify and Classify Activities

ABC teams of people from top levels of management generate the activity dictionary.
TOP DOWN APPROACH
RECYCLING APPROACH
Reuses documentation of processes used for other purposes.
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INTERVIEW OR PARTICIPATIVE APPROACH

ABC teams include or interview operating employees.
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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 time they work on various activities.
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Calculate Cost-Driver Rates for Activities

Activity Cost Activity Volume = Cost-Driver Rate
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
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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?
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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
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Measurable Appropriate cost-driver base
Cause and effect relationship between activity and costs
Based on resources practical capacity to support activities
Predict or explain an activitys use of resources
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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.
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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?
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Practical Capacity Note
80%, or $800 should be assigned to Product A

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20%, or $200 should be assigned to unused capacity

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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 costdriver rates for each activity.
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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?
Cost-Driver Activity Cost-Driver Base Rate Factory Floor Space Square Footage $ 50.000 Electricity Kilowatts $ 0.050 Water Gallons $ 0.160 Quality Control Units Inspected $ 0.850 Packaging - Inner Ounces of product $ 0.025 Packaging - Outer Boxes $ 1.250 Resources Used by Product A 20,000 Sq. Ft. 15,000 KW 80,000 Gal. 135,000 Units 270,000 Oz. 135,000 Boxes
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Cost-Driver Activity Base Factory floor Square space footage Electricity Kilowatts Water Gallons Units Quality control inspected Ounces of Inner packaging product Outer packaging Boxes
Cost-Driver Resources Used Cost Rate Assigned by Product A $ 50.000 20,000 sq. ft. $ 1,000,000 $ $ $ $ 0.050 0.160 0.850 0.025 15,000 kw. 80,000 gal. 135,000 units 270,000 oz. $ $ $ $ 750 12,800 114,750 6,750
$ 1.250 135,000 boxes $ 168,750 Total Cost Assigned to Product A $ 1,303,800
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Activity-Based Costing Example
Lets look at an example from the Bilson Company.
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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 direct labor hours (DLH) and Product B requires 2.5 DLH to produce. Employing a traditional costing system, Bilson assigns overhead cost to products using direct labor hours. The predetermined overhead rate is:
Mfg. overhead cost Direct labor hours = $1,550,000 77,500 = $20/DLH
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Bilsons unit product costs using traditional costing are:
Direct material Direct labor Manufacturing overhead 3.0 DLH $20/DLH 2.5 DLH $20/DLH Total unit product cost Product A $ 40.00 30.00 60.00 $ 130.00 50.00 $ 104.00 Product B $ 29.00 25.00
Bilson marks its products up by 50 percent and allocates its $500,000 customer service costs based on revenue.
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$130.00 1.50
Traditional Costing
Product A Volume Sales Price 5,000 $ 195.00 $ 40.00 30.00 60.00 65.00 975,000 200,000 150,000 300,000 325,000 100,000 225,000 $ 156.00 $ 3,900,000 725,000 625,000 1,250,000 $ 1,300,000 400,000 $ 900,000 Product B 25,000
Sales Revenue Direct Material $ Direct Labor Overhead Gross Margin $ Customer Service Costs Product operating income
$ $
29.00 25.00 50.00 52.00
$975,000 ($975,000 +$3,900,000) $500,000

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Sales of Product A have increased steadily since introduction, but company income has declined. Management at Bilson is unhappy with the traditional costing system and they have decided to try activity-based costing. In addition, management has observed that the cost of direct labor is relatively stable. Since labor does not behave like a unit-level cost, labor will be combined with overhead and the total conversion cost will be assigned using ABC.
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The total conversion cost is: Traditional overhead Labor (77,500 hours @ $10) Total In addition, management has observed that the cost of direct labor is relatively stable. Since labor does not behave like a unit-level cost, labor will be combined with overhead and the total conversion cost will be assigned using ABC.
$1,550,000 775,000 $2,325,000
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Management has identified the following five activities and costs in the production of its two products:
Activity Machine setups Quality inspections Production orders Machine-hours worked Material receipts Total
Total conversion cost
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Cost $ 800,000 450,000 225,000 650,000 200,000 $ 2,325,000
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The following transaction data has been complied by management of Bilson:
Activity Machine setups Quality inspections Production orders Machine-hours worked Material receipts Total 5,000 9,000 600 50,000 800 Product A 3,000 6,000 200 15,000 150 Product B 2,000 3,000 400 35,000 650
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These data can be used to develop predetermined cost-driver rates for each of the five activities:
Activity Costs Machine setups $ 800,000 Quality inspections 450,000 Production orders 225,000 Machine-hours worked 650,000 Material receipts 200,000 Total $ 2,325,000 Total Transactions 5,000 9,000 600 50,000 800 Rate per Transaction $ 160.00 50.00 375.00 13.00 250.00
per per per per per
setup inspection order hour receipt
$ 800,000 5,000 Machine setups = $160.00 per setup

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The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilsons two products.
Product A
Activity ABC Rate Machine setups $ 160.00 Quality inspections 50.00 Production orders 375.00 Machine-hours worked 13.00 Material receipts 250.00 Total overhead assigned Number of units produced Conversion per unit Transactions 3,000 6,000 200 15,000 150 Amount $ 480,000 300,000 75,000 195,000 37,500 $ 1,087,500 5,000 $217.50
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Product B
Activity ABC Rate Machine setups $160.00 Quality inspections 50.00 Production orders 375.00 Machine-hours worked 13.00 Material receipts 250.00 Total overhead assigned Number of units produced Conversion per unit Transactions 2,000 3,000 400 35,000 650 Amount $ 320,000 150,000 150,000 455,000 162,500 $ 1,237,500 25,000 $ 49.50
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Product B
Activity ABC Rate Transactions Amount Machine setups $160.00 2,000 $ 320,000 Quality inspections 50.00 3,000 150,000 Production orders 375.00 400 150,000 Machine-hours worked 13.00 35,000 455,000 Material receipts 250.00 650 162,500 Total overhead assigned $ 1,237,500 Total conversion assigned to Product A $ 1,087,500 Number of units produced 25,000 Total conversion assigned 1,237,500 Overhead per unit to Product B $ 49.50
Total overhead
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$ 2,325,000
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Lets compute the product cost for A and B using our ABC overhead rates:
Activity Based Costing Direct materials Conversion Total unit product cost Product A $ 40.00 217.50 $ 257.50 Product B $ 29.00 49.50 $ 78.50
These amounts did not change as a result of using ABC.

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Now compare the unit product costs using the traditional costing system and our ABC system.
Costing Method Activity-based costing Traditional costing
Product A $ 257.50 130.00
Product B $ 78.50 104.00
Remember, we used one overhead rate based on direct labor hours.
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Product A $ 257.50 130.00
Product B $ 78.50 104.00
Adopting activity-based costing usually results in a shift of batch-level and product-level overhead costs from high-volume standard products to low-volume, more complex products.
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Product A $ 257.50 130.00
Product B $ 78.50 104.00
Can you see how different allocation methods might lead to making different management decisions?
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Based on these results Bilson also decides to use ABC to assign its $500,000 customer service costs. The applicable activity is number of customer consultations. Customers buying Product A, the deluxe model, require more consultations than those buying Product B, the standard model.
Cost per consultation = $500,000 125,000 consultations = $4.00

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No change in sales price
ABC Costing
Product A Volume Sales Price 5,000 $ 195.00 $ 975,000 200,000 1,087,500 $ (312,500) 200,000 $ (512,500) $ 156.00 $ 3,900,000 725,000 1,237,500 $ 1,937,500 300,000 $ 1,637,500 Product B 25,000
Sales Revenue Direct Material $ 40.00 Conversion 217.50 Gross Margin $ (62.50) Customer Service Costs Product operating income
$ $
29.00 49.50 77.50
Lets compare product income using traditional and ABC costing.

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Product A 5,000 $ 195.00 $ 975,000 200,000 1,087,500 $ (312,500) 200,000 $ (512,500)
Product B 25,000 $ 156.00 $ 3,900,000 725,000 1,237,500 $ 1,937,500 300,000 $ 1,637,500
Volume Sales Price
Sales Revenue Direct Material $ 40.00 Conversion 217.50 Gross Margin $ (62.50) Customer Service Costs Product operating income
$ $
29.00 49.50 77.50
ABC Costing
Product A Volume Sales Price 5,000 $ 195.00 $ 40.00 30.00 60.00 65.00 975,000 200,000 150,000 300,000 325,000 100,000 225,000
Product B 25,000 $ 156.00 $ 3,900,000 725,000 625,000 1,250,000 $ 1,300,000 400,000 $ 900,000
Sales Revenue Direct Material $ Direct Labor Overhead Gross Margin $ Customer Service Costs Product operating income
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$ $
29.00 25.00 50.00 52.00
Traditional Costing
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Product Profitability
Should Bilson drop Product A? Should Bilson increase the price of Product A? Should Bilson reduce the price of Product B?
Now that we have measured product costs accurately, we see how profitable each product really is.
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Product Profitability
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. Decreasing the price would increase volume, possibly resulting in more income.
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Customer Profitability
Service calls What are the costs and benefits of serving specific customers? Buy/sell orders Order changes Activity-based analysis can be used to track the costs of serving customers and those customers contribution to company profits.
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Estimating Costs of New Products
Apply ABC analysis of present product lines to proposed new products. This is valid as long as the activities involved with the new products are similar to those for the present products.
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ABC in Service and Merchandising Companies

The process is exactly the same as for manufacturing!
Identify and classify the activities

related to the companys 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 relevant cost-driver rates.
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ABC Benefits and Limitations

More accurate and informative product costs lead to better pricing decisions. The activities driving costs are more accurately measured. Managers gain easier access to the relevant costs.
An ABC system is very expensive to develop and implement, and very time-consuming to maintain.
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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.
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End of Chapter 4
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4 Activity Based Costing Systems Compatibility Mode

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Activity-Based Costing Systems

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Traditional Costing Systems

Traditional Costing Systems

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Traditional Costing Systems

Traditional Costing Systems

Traditional Costing Systems

Traditional Costing Systems

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Activity-Based Costing (ABC)

People Manage Activities

Activity-Based Costing (ABC)

Direct labor hours Machine hours

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Activity-Based Costing (ABC)

Allocation bases often differ from traditional costing systems.

ABC Compared with Traditional Costing

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

ABC Compared with Traditional Costing

Activity-Based Costing (ABC)

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Four Steps in the ABC Process

Identify and classify the activities

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Identify and Classify Activities

Identify and Classify Activities

TOP DOWN APPROACH

INTERVIEW OR PARTICIPATIVE APPROACH

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Estimate the Cost of Activities

Examine accounting records for recorded cost information.

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Calculate Cost-Driver Rates for Activities

Calculate Cost-Driver Rates for Activities

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Calculate Cost-Driver Rates for Activities

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Calculate Cost-Driver Rates for Activities

Cause and effect relationship between activity and costs

Based on resources practical capacity to support activities

Predict or explain an activitys use of resources

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Practical Capacity Note

Practical Capacity Note

80%, or $800 should be assigned to Product A

20%, or $200 should be assigned to unused capacity

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Assign Activity Costs to Products

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Assign Activity Costs to Products

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Assign Activity Costs to Products

$ 1.250 135,000 boxes $ 168,750 Total Cost Assigned to Product A $ 1,303,800

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Activity-Based Costing Example

Lets look at an example from the Bilson Company.

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Activity-Based Costing Example

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Activity-Based Costing Example

Activity-Based Costing Example

29.00 25.00 50.00 52.00