Activity Based Costing: A Decision Making Tool · Understand how traditional and activity-based costing differ ... Departmental Allocation Bases Departmental Overhead Rates Indirect

Activity Based Costing: A Decision Making Tool

with Dr. Joseph UgrasDecember 2017

1

7-2

Learning Objectives Know the Need for Cost and Profitability

Understand how traditional and activity-based costing

differ

Evaluate the various cost drivers

Understand value-added and non-value-added activities

Compute the product costs using an activity-based

costing system

Know the conditions for usefulness for activity-based

costing

Understand the information provided by activity-based

costing systems for strategic decision making

Know the criticisms directed at activity-based costing?

7-3

How important is cost information?

• Why do we need to know the cost of making the

product or cost of providing a service?

1. Profitability

▫ By Product

▫ By Customer

2. Decision Making using Cost data

▫ Pricing

▫ Value Chain Analysis and Outsourcing Decision

▫ ……

3. Performance Evaluation

7-4

The emergence of ABC/ABM

• 1987 book by Johnson/Kaplan

• Cooper and Kaplan’s re-

introduced ABC in the 90’s

7-5

What are the costs of running a

business in a manufacturing

environment?

▫ Product Costs (Direct Materials, Direct Labor,

Manufacturing Overhead) – become inventory

Balance Sheet prior to moving to the Income

Statement

▫ Period Costs (Selling and Administrative

Expenses)

Income Statement immediately

7-6

Traditional Product Costing System

• Direct Material and Direct Labor traceable to the

product

• Overhead is applied using a cost driver (e.g.,

Labor Cost, Machine Hours, etc.)

▫ Overhead’s growth over time with increased use

of automation

▫ We might have to change from the single OH

driver to multiple cost drivers

7-7

Some Points of Cost Trends

The relative proportions of what go into product

costs have changed significantly with direct labor

content dropping to between 5% to 15%,

materials content falling between 45% and 55%,

and overhead soaring to between 30% and 50%.

7-8

How Overhead Costs are Treated

Under Different Systems

Overhead Allocation

Plantwide

Overhead

Rate

Departmental

Overhead

Rates

Activity Based

Costing

7-9

Plantwide Overhead Rate

Companies tend to use direct labor

as the overhead allocation base.

7-10

A two stage process is

necessary because costs

are allocated to departments

and then to products.

Finishing Department

Shipping Department

Painting Department

Departmental Overhead Rates

7-11

Department

1

Department

2

Department

3Cost pools

Indirect

Labor

Indirect

Materials

Other

OverheadStage One:

Costs assigned

to pools


7-12

Department

1

Department

2

Department

3Cost pools

Stage One:

Costs assigned

to pools

Products

Stage Two:

Costs applied

to products

Direct

Labor

Hours

Machine

Hours

Raw

Materials

Cost

Departmental Allocation Bases


Indirect

Labor

Indirect

Materials

Other

Overhead

7-13

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.

ABC is a

good supplement

to our traditional

cost system

I agree!

7-14

How Costs are Treated UnderActivity–Based Costing

ABC differs from traditional cost accounting in three ways.

Manufacturing

costs

Nonmanufacturing

costs

ABC assigns both types of costs to products.

Traditional

product costing

ABC

product costing

7-15


ABC does not assign all manufacturing costs to products.

Manufacturing

costs

Nonmanufacturing

costs

Traditional

product costing

ABC

product costing

All

Som

e


7-16


Plantwide

Overhead

Rate

Departmental

Overhead

Rates

Activity–Based

Costing

Number of cost pools

Level

of

co

mp

lexit

y

ABC uses more cost pools.


7-17


Each ABC cost pool has its

own unique measure of activity.

Traditional cost systems usually rely

on volume measures such as direct labor

hours and/or machine hours to allocate

all overhead costs to products.


ABC uses more cost pools.

7-18

ActivityAn event that causes the

consumption of overhead

resources.

Activity

Cost Pool

A “cost bucket” in which

costs related to a single

activity measure are

accumulated.

$

$

$ $

$$


7-19

Activity

Measure

An allocation base

in an activity-based

costing system.


The term cost driver is

also used to refer to

an activity measure.

7-20

Cost Driver Analysis

•Cost drivers are factors that have a direct cause–effect relationship to a cost▫ Limit the number of cost drivers and

combine into cost pools

▫ Cost of measurement should not exceed benefit of using the cost driver

▫ Easy to understand

▫ Directly related to the activity being performed

▫ Appropriate for measurement

7-21


Traditional cost systems usually rely on volume

measures such as direct labor hours and/or machine

hours to allocate all overhead costs to products.

ABC defines

five levels of activity

that largely do not relate

to the volume of units

produced.

7-22

Manufacturing

companies typically combine

their activities into five

classifications.

Unit-Level

Activity

Batch-Level

Activity

Product-Level

Activity

Customer-Level

ActivityOrganization-

sustaining

Activity


7-23

Some Examples:

• Unit-level costs

▫ direct material, direct labor, some of the utility

costs

• Batch-level costs

▫ setup, inspection

• Product-level costs

▫ engineering changes, product development

• Organization Sustaining costs

▫ building depreciation, plant manager’s salary

• Customer Level costs

▫ Specific customer specific design, inspection, etc.

7-24

Product Cost Behavior

•Unit-level costs are variable in relation

to change in production volume

• Batch, product/process, and

organizational level costs are variable

for reasons other than changes in

production volume

7-25

Product Cost

Batch-Level

CostsCost per unit

in batch

Allocate over number

of units in batch

Product-

Level Costs


of units produced in

related product line

Cost per unit

in product line

Cost per unitUnit-Level

Costs


of units produced

7-26

Activity-Based Costing

Costs in

General Ledger

Accumulate in

Activity Center

Cost PoolsCost

Driver

Activity

Driver

Cost

Objects

7-27

7-28

ABC Steps:

1. Define Activities, Activity Cost Pools, and

Activity Measures

2. Assign Overhead Costs from General Ledger

to Activity Cost Pools

3. Calculate Activity Rates

4. Assigning Overhead to Products

5. Prepare Management Reports such as:

▫ Product Profitability

▫ Customer Profitability

▫ Cost of Non-value adding activities

▫ Other reports

7-29

Baxter Battery – An ABC Example

Sales 50,000,000$

Cost of goods sold

Direct materials 15,000,000$

Direct labor 12,000,000

Manufacturing overhead 14,000,000 41,000,000

Gross margin 9,000,000

Selling and administrative expenses

Shipping expenses 3,000,000

Marketing expenses 2,000,000

General administrative expenses 6,000,000 11,000,000

Net operating incomeoperating loss (2,000,000)$

Baxter Battery Company

Income Statement

Year Ended December 31, 2014

Manufacturing overhead is allocated to products using

a single plantwide overhead rate based on machine hours.

7-30

Define Activities, Activity CostPools, and Activity Measures

At Baxter Battery, the ABC team selected the following

activity cost pools and activity measures:

7-31

• Customer Orders - assigned all costs of resources

that are consumed by taking and processing

customer orders.

• Design Changes - assigned all costs of resources

consumed by customer requested design changes.

• 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 organization-sustaining costs

and unused capacity costs

Define Activities, Activity CostPools, and Activity Measures

7-32

Assign Overhead Costs to

Activity Cost Pools

7-33

Direct materials, direct labor, and shipping are excluded

because Baxter Battery’s existing cost system can directly

trace these costs to products or customer orders.


Activity Cost Pools

7-34

At Baxter Battery the following distribution of resource

consumption across activity cost pools is determined.


Activity Cost Pools

7-35


Activity Cost Pools

Indirect factory wages $6,000,000

Percent consumed by customer orders 30%

$1,800,000

7-36


Activity Cost Pools

Factory equipment depreciation $3,500,000

Percent consumed by customer orders 20%

$ 700,000

7-37


Activity Cost Pools

7-38

Calculate Activity Rates

The ABC team determines that Baxter Battery will

have these total activities for each activity cost

pool:▫ 10,000 customer orders,

▫ 4,000 design changes,

▫ 800,000 machine-hours,

▫ 2,000 customers served.

Now the team can compute the individual

activity rates by dividing the total cost for

each activity by the total activity levels.

7-39

Calculate Activity Rates

7-40

Traced Traced Traced

Direct

Materials

Direct

Labor

Shipping

CostsOverhead Costs

Cost Objects:

Products, Customer Orders, Customers

Activity–Based Costing at Baxter

Battery

7-41

Direct

Materials

Direct

Labor

Shipping

Costs

Cost Objects:


First-Stage Allocation

Customer

Orders

Order

Size

Customer

RelationsOther

Design

Changes


Battery

Overhead Costs

7-42

Direct

Materials

Direct

Labor

Shipping

Costs

Cost Objects:


Customer

Orders

Order

Size

Customer

RelationsOther

First-Stage Allocation

Second-Stage Allocations

$/Order $/Change $/MH $/Customer

Unallocated

Design

Changes


Battery

Overhead Costs

7-43

Baxter Battery Information

SureStart

1. Requires no new design resources.

2. 800,000 batteries ordered with 4,000 separate orders.

3. Each SureStart requires 36 minutes of machine

time for a total of 480,000 machine-hours.

LongLife

1. Requires new design resources.

2. 400,000 batteries ordered with 6,000 separate orders.

3. 4,000 custom designs prepared.

4. Each LongLife requires 48 minutes of machine

time for a total of 320,000 machine-hours.

Assigning Overhead to Products

7-44

Assigning Overhead to Products

7-45

Let’s take a look at how Baxter Battery’s system works for just one of the 2,000 customers – Acme Auto Parts who placed a total of twelve orders. Note that the four orders

for LongLifes required a design change.

Orders

1. Eight orders for 60 SureStarts per order.

2. Four orders for 50 LongLifes per order.

Machine-hours

1. The 480 SureStarts required 288 machine-hours.

2. The 200 LongLifes required 160 machine hours.

Assigning Overhead to Customers

7-46

Prepare Management Reports

SureStarts LongLifes Total

Sales 31,300,000$ 18,700,000$ 50,000,000$

Direct costs

Direct material 9,000,000 6,000,000 15,000,000

Direct labor 7,000,000 5,000,000 12,000,000

Shipping 2,000,000 1,000,000 3,000,000

Product Margin Calculations

The first step in computing product margins is to

gather each product’s sales and direct cost data.

7-47

Prepare Management ReportsProduct Margin Calculations

The second step in computing product margins is to

incorporate the previously computed activity-based

cost assignments pertaining to each product.


Sales 31,300,000$ 18,700,000$ 50,000,000$

Direct costs

Direct material 9,000,000 6,000,000 15,000,000

Direct labor 7,000,000 5,000,000 12,000,000

Shipping 2,000,000 1,000,000 3,000,000

ABC cost assignments

Customer orders 1,808,000 2,712,000 4,520,000

Design changes 3,040,000 3,040,000

Order size 3,120,000 2,080,000 5,200,000

7-48

Prepare Management ReportsProduct Margin Calculations

The third step in computing product margins is to

deduct each product’s direct and indirect costs

from sales.

Sales 31,300,000$ 18,700,000$

Costs

Direct material 9,000,000$ 6,000,000$

Direct labor 7,000,000 5,000,000

Shipping 2,000,000 1,000,000

Customer orders 1,808,000 2,712,000

Design changes 3,040,000

Order size 3,120,000 2,080,000

Total cost 22,928,000 19,832,000

Product margin 8,372,000$ (1,132,000)$

SureStarts LongLifes

7-49


Sales 31,300,000$ 18,700,000$ 50,000,000$

Total costs 22,928,000 19,832,000 42,760,000

Product margins 8,372,000$ (1,132,000)$ 7,240,000$

Less costs not assigned to products:

Customer relations 3,080,000

Other 6,160,000

Total 9,240,000

Net operating incomet operating loss (2,000,000)$

Product Margin Calculations

The product margins can be reconciled with the

company’s net operating income as follows:


7-50


Customer Margin Analysis

The first step in computing Acme Auto Parts’ customer

margin is to gather its sales and direct cost data.

Acme Auto

Parts

Sales 29,200$

Direct costs

Direct material 7,500

Direct labor 6,700

Shipping 1,700

7-51



The second step is to incorporate Acme Auto Parts’

previously computed activity-based cost assignments.

Acme Auto

Parts

Sales 29,200$

Direct costs

Direct material 7,500

Direct labor 6,700

Shipping 1,700

ABC cost assignments

Customer orders 5,424

Product design 3,040

Order size 2,912

Customer relations 1,540

7-52



The third step is to compute Acme Auto Parts’ customer

margin of $384 by deducting all its direct and indirect

costs from its sales.

Sales 29,200$

Direct costs

Direct material 7,500$

Direct labor 6,700

Shipping 1,700

Customer orders 5,424

Product design 3,040

Order size 2,912

Customer relations 1,540 28,816

Customer margin 384$

Acme Auto Parts

7-53

Product Margins Computed Using the

Traditional Cost System


Sales 31,300,000$ 18,700,000$ 50,000,000$

Direct costs

Direct material 9,000,000 6,000,000 15,000,000

Direct labor 7,000,000 5,000,000 12,000,000

The first step in computing product margins is to

gather each product’s sales and direct cost data.

7-54

Plantwide manufacturing

overhead rate

$14,000,000

800,000 MH= $17.50 per machine-hour=

The second step in computing product margins is

to compute the plantwide overhead rate.

Production Department

Indirect factory wages 6,000,000$

Factory equipment depreciation 3,500,000

Factory utilities 2,500,000

Factory building lease 2,000,000

Total manufacturing overhead 14,000,000$

Manufacturing Overhead Costs at Baxter Battery

Machine-hours

SureStarts (800,000 @ 0.60 hours) 480,000

LongLifes (400,000 @ 0.80 hours) 320,000

Total machine-hours 800,000



7-55

The third step in computing product margins is

allocate manufacturing overhead to each product.

Machine Overhead Overhead

Hours Rate Allocated

SureStarts 480,000 17.50$ 8,400,000$

LongLifes 320,000 17.50 5,600,000

Total overhead allocated to products 14,000,000$

480,000 hours × $17.50 per hour = $8,400,000



7-56

The fourth step is to actually compute the

product margins.

Sales 31,300,000$ 18,700,000$ 50,000,000$

Cost of goods sold

Direct materials 9,000,000$ 6,000,000$ 15,000,000$

Direct labor 7,000,000 5,000,000 12,000,000

Manufacturing overhead 8,400,000 24,400,000 5,600,000 16,600,000 14,000,000 41,000,000

Product margin 6,900,000$ 2,100,000 9,000,000

Selling and administrative 11,000,000

Net operating incomet operating loss (2,000,000)$


Shipping expenses 3,000,000$

Marketing expenses 2,000,000

General administrative expenses 6,000,000

11,000,000$



7-57

SureStarts LongLifes

Product margins – traditional 6,900,000$ 2,100,000$

Product margins – ABC 8,372,000 (1,132,000)

Change in reported margins 1,472,000$ (3,232,000)$

The traditional cost

system overcosts the

SureStarts and reports

a lower product

margin for this product.

The traditional cost

system undercosts the

LongLifes and reports

a higher product

margin for this product.

Differences Between ABC and Traditional Product Costs

7-58

Let us Practice –

Gallatin Carpet Cleaning

7-59


Traditional costing allocates all manufacturing

overhead to products. ABC costing only assigns

manufacturing overhead costs consumed by

products to those products.

There are three reasons why the

reported product margins for the two

costing systems differ from one another.

7-60


Traditional costing allocates all manufacturing

overhead costs using a volume-related allocation

base. ABC costing also uses non-volume related

allocation bases.




7-61


Traditional costing disregards selling and

administrative expenses because they are

assumed to be period expenses. ABC costing

directly traces shipping costs to products and

includes nonmanufacturing overhead costs caused

by products in the activity cost pools that are

assigned to products.




7-62

Let us Practice –

Derinice Icecream

7-63

• ABC models are useful in process analysis and

continuous improvement initiatives, some

consulting firms coined the term activity-based

management (ABM). ABM refers to any of the

actions that might be taken based on the ABC

information.

Activity Based Management

7-64

• Focus might shift toward more profitable

businesses / customers

• Find ways of performing tasks better, faster, and

cheaper

• Connections to total quality management,

process improvement, reengineering,

elimination of non-value-added activities, lean

management

Through ABC/ABM

7-65

Activity Analysis (Value-added)

Value-added activity• Increases worth of

product or service to a customer

• Customer is willing to pay for it

Non-value-added activity• Increases time spent on

product or service but does not increase worth

• Unnecessary from customer perspective

• Can be reduced, redesigned or eliminated without affecting market value or quality

7-66

Activity Analysis• Create a “Process Map” (detailed flowchart) for

each process

▫ Identify each step the product goes through

• Create “Value Chart”

▫ Identify stages and time spent in stages from

beginning to end of process

Value-Added

Examples:

Processing Time

Service Time

Non-Value-Added

Examples:

Inspection Time

Transfer Time

Idle Time

7-67

Cycle Time Analysis

Goal: Eliminate or minimize activities that add the

most time and cost and the least value

Cycle Value- Non-

Time = Added + Value-Added

Time Time

7-68

Manufacturing Cycle Efficiency Ratio

Value-Added

Processing Time

Total Cycle Time

Manufacturing

Cycle Efficiency

(MCE)=

• 100% efficiency unrealistic

• Reducing non-value-added activities will increase MCE

• Value-added activity usually represents about 10%-20% of total cycle time

7-69

Non-Value-Added Activities

• Attributed to following factors

▫ Systemic

▫ Physical

▫ Human

• Eliminating or reducing non-value-added

activities that create the most costs will

▫ Increase product/service quality

▫ Decrease cycle time and cost

▫ JIT & Lean Implementations are geared to

reduce non-value-added activities

7-70

Targeting Process ImprovementActivity-based management is used

in conjunction with ABC to identify

areas that would benefit from

process improvements by focusing

on activities to eliminate waste,

decrease processing time, and

reduce defects.

Benchmarking can be used to compare activity cost

information with standards of performance achieved by

other organizations.

ABC activity rates can also provide valuable clues concerning

where there is waste and the opportunity for improvement.

7-71

Activity-Based Costing and External

Reporting

Most companies do not use ABC

for external reporting because . . .

1. External reports are less detailed than internal

reports.

2. It may be difficult to make changes to the company’s

accounting system.

3. ABC does not conform to GAAP.

4. Auditors may be suspect of the subjective allocation

process based on interviews with employees.

7-72

When to Use ABCCompanies use ABC when:

They have a wide variety of products or services

High overhead costs are not proportional to the

unit volume of individual products

Automation makes it difficult to assign overhead to

products using direct labor or machine hours

Profit margins are difficult to explain

Hard-to-make products show big profits and easy-

to-make products show losses

7-73

The Symptoms of a Broken System

“Do I really know what my products costs?”

• Cooper’s Diagnostic Tools:

▫ Functional managers want to drop seemingly

profitable lines;

▫ Hard-to-make products show big profits;

▫ Departments have their own cost systems;

▫ You have a high-margin niche all to yourself;

▫ Competitors’ prices are unrealistically low.

▫ The existing cost systems were meant primarily to

value inventory and provide data for the profit and

loss statements but are being now used for other

reasons

7-74

Benefits of Activity-Based Costing and

Activity-Based ManagementEnhanced product profitability analysis

Enhanced customer profitability analysis

More accurate cost determination and analysis of the

true cost of product and customer diversification

Should we outsource some part of the process?

More efficient production

Connects well with Quality, Lean Management, JIT

implementations

Ability to link with the ERP system in place

Setting up an activity-based costing system as a

prerequisite for improving business processes and for

any re-engineering program

More effective performance evaluation

7-75

Traditional vs. ABC Costing

•When ABC is implemented cross

subsidy is reduced, i.e.,

▫Cost is reduced for high-volume,

standard products

▫Cost is increased for low-volume,

complex specialty products

7-76

New Cost drivers recognized by

ABC

▫Product variety—number of different

types of products

▫Product complexity—number of

processes through which a product

flows

7-77

ABC Costing Considerations

• Number and diversity of products/services produced

• Diversity and differential degree of support services used for different products

• Extent to which common processes are used

• Effectiveness of current cost allocation methods

• Rate of growth of period costs

7-78

Use ABC Costing for…

1. Product Variety and Process Complexity

2. Lack of Commonality in Overhead Costs

3. Problems with Current Cost Allocations

4. Changes in Business Environment

7-79

Use ABC Costing for…1. Product Variety and Process Complexity

▫ Caused by mass customization

Too many choices, opportunity for errors

Pareto Principle

Commonality of parts

▫ Reduced by

Simultaneous (or Concurrent) Engineering

Design for Manufacturability

7-80

Use ABC Costing when…

2. Lack of Commonality in Overhead Costs

Some products/services use substantially more

overhead than others

3. Problems with Current Cost Allocations

Significant changes in process with no change

in cost allocations

Expense majority of period costs when incurred

4. Changes in Business Environment

Increase in competition or change in

management strategy

7-81

Continuous Improvement• Eliminates non-value-added activities to reduce

cycle time

• Makes products/performs services with zero defects

• Reduces product costs on an ongoing basis

• Simplifies products and processes

ABC Costing Supports

Continuous Improvement

7-82

Advantages of ABC and ABM

• Identify and monitor

significant technology costs

• Trace technology costs

directly to products

• Increase market share

• Identify the cost drivers that

create or influence cost

• Identify activities that do not

contribute to perceived

customer value

• Understand the impact of

new technologies on all

elements of performance

• Translate company goals

into activity goals

• Analyze the performance of

activities across business

functions

• Analyze performance

problems

• Promote standards of

excellence

7-83

ABC Limitations

Substantial resources

required to implement

and maintain.

Resistance to

unfamiliar numbers

and reports.

Desire to fully

allocate all costs

to products.

Potential

misinterpretation of

unfamiliar numbers.

Does not conform to

GAAP. Two costing

systems may be needed.

7-84

Criticisms of ABC

• Significant amount of time and cost

to implement

•Must overcome barriers to change

•Does not conform to GAAP

7-85

Time-Based Activity-Based Costing• One recent development aimed both at improving

the accuracy of ABC data and reducing the

administrative burden involved with developing

and maintaining the systems is called time-based

ABC. Time-based ABC involves making direct

estimates of the resource demands imposed by

each transaction, product, service, or customer.

• Traditionally, to build an ABC model, employees

are asked to estimate the proportion of their total

time spent in the various activities in which they

are engaged. These estimates are now made by

managers saving time and improving

consistency.

7-86

Characteristics of Successful ABC Implementations

Strong top

management support Link to evaluations

and rewards

Cross-functional

involvement

7-87

Some Further Reading

• R. S. Kaplan “The Evolution of Management Accounting.”

Accounting Review (July 1984): 390-418.

• H. T Johnson and R. S. Kaplan. Relevance Lost: The Evolution of

Management Accounting (Boston: Harvard Business School Press,

1987):

• R. Cooper, “Does Your Company Need a New Cost System?”

Journal of Cost Management (Spring 1987): 45-49

• R. S. Kaplan, and R. Cooper, “Make Cost Right: Make the Right

Decisions”, Harvard Business Review, September–October 1988

• R. S. Kaplan and R. Cooper, “Cost and Effect: Using Integrated

Cost Systems to Drive Profitability and Performance”, Harvard

Business School Press, 1997

• R. S. Kaplan, and S. Anderson, “Time-Driven Activity Based

Costing”, Harvard Business School Press, 2007

Documents

Activity Based Costing: A Decision Making Tool · Understand how traditional and activity-based costing differ ... Departmental Allocation Bases Departmental Overhead Rates Indirect