Activity-Based Costing and Activity-Based Management Chapter 5

5 - 1©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Activity-Based Costing andActivity-Based Management

Chapter 5


Learning Objective 1

Explain undercostingand overcosting of

products and services.


Undercosting andOvercosting Example

Jose, Roberta, and Nancy orderseparate items for lunch.

Jose’s order amounts to $14Roberta consumed 30Nancy’s order is 16Total $60

What is the average cost per lunch?


Undercosting andOvercosting Example

$60 ÷ 3 = $20

Jose and Nancyare overcosted.

Roberta isundercosted.



Present three guidelines forrefining a costing system.


Existing Single Indirect-Cost Pool System Example

Kole Corporation manufactures a normal lens(NL) and a complex lens (CL).

Kole currently uses a single indirect-cost ratejob costing system.

Cost objects: 80,000 (NL) and 20,000 (CL).



Normal Lenses (NL)Direct materials $1,520,000Direct mfg. labor 800,000Total direct costs $2,320,000Direct cost per unit: $2,320,000 ÷ 80,000 = $29



Complex Lenses (CL)Direct materials $ 920,000Direct mfg. labor 260,000Total direct costs $1,180,000Direct cost per unit: $1,180,000 ÷ 20,000 = $59



All Indirect Costs$2,900,000

50,000 DirectManufacturingLabor-Hours

INDIRECT-COSTPOLL

INDIRECTCOST-ALLOCATIONBASE

$58 per DirectManufacturing

Labor-Hour



Indirect Costs

Direct Costs

COST OBJECT:NL AND CLLENSES

DIRECTCOSTS

DirectMaterials

DirectManufacturing

Labor



Kole uses 36,000 direct manufacturinglabor-hours to make NL and 14,000 directmanufacturing labor-hours to make CL.How much indirect costs are allocated

to each product?



NL: 36,000 × $58 = $2,088,000CL: 14,000 × $58 = $812,000

What is the total cost of normal lenses?Direct costs $2,320,000 +

Allocated costs $2,088,000 = $4,408,000What is the cost per unit?

$4,408,000 ÷ 80,000 = $55.10



What is the total cost of complex lenses?Direct costs $1,180,000 + Allocated costs

$812,000 = $1,992,000What is the cost per unit?

$1,992,000 ÷ 20,000 = $99.60



Normal lenses sell for $60 each andcomplex lenses for $142 each.

Normal Complex Revenue $60.00 $142.00 Cost 55.10 99.60 Income $ 4.90 $ 42.40 Margin 8.2% 29.9%


Refining a Costing System

Direct-cost tracing

Indirect-cost pools

Cost-allocation basis



1. Design of Products and ProcessThe Design Department designs the moldsand defines processes needed (details of

the manufacturing operations).



2. Manufacturing OperationsLenses are molded, finished,

cleaned, and inspected.3. Shipping and Distribution

Finished lenses are packed andsent to the various customers.



Distinguish between thetraditional and the

activity-based costingapproaches to designing

a costing system.


Activity-Based Costing System

FundamentalCost Objects

Activities

Costs of Activities

Assignment to OtherCost Objects

Cost of:• Product• Service• Customer



A cross-functional team at KoleCorporation identified key activities:

Design products and processes.Set up molding machine.

Operate machines to manufacture lenses.Maintain and clean the molds.



Set up batches of finished lenses for shipment.Distribute lenses to customers.

Administer and manage all processes.



No. ofSetupHours

LensesNL

LensesCL

LensesOther

CostAllocationBase

ProductCostObjects

No. ofShipments

Parts-Square

feet

SetupDesign ShippingActivityIndirect CostPool



NL CL Quantity produced 80,000 20,000 No. produced/batch 250 50 Number of batches 320 400 Setup time per batch 2 hours 5 hours Total setup-hours 640 2,000

Total setup costs are $409,200.



What is the setup cost per setup-hour? $409,200 ÷ 2,640 hours = $155

What is the setup cost perdirect manufacturing labor-hour?

$409,200 ÷ 50,000 = $8.184



Allocation using direct labor-hours:NL: $8.184 × 36,000 = $294,624CL: $8.184 × 14,000 = $114,576Total $409,200

Allocation using setup-hours:NL: $155 × 640 = $ 99,200CL: $155 × 2,000 = $310,000Total $409,200



Describe a four-partcost hierarchy.


Cost Hierarchies

A cost hierarchy is a categorizationof costs into different cost pools.

Cost drivers bases (cost-allocation bases)Degrees of difficulty in determining

cause-and-effect relationships


Cost Hierarchies

ABC systems commonly use afour-part cost hierarchy to

identify cost-allocation bases:1. Output unit-level costs2. Batch-level costs3. Product-sustaining costs4. Facility-sustaining costs


Output Unit-Level Costs

These are resources sacrificedon activities performed on each

individual unit of product or service.Energy

Machine depreciationRepairs


Batch-Level Costs

These are resources sacrificed onactivities that are related to a groupof units of product(s) or service(s)rather than to each individual unit

of product or service.Setup-hours

Procurement costs


Product-Sustaining Costs

These are often called service-sustainingcosts and are resources sacrificed on

activities undertaken to supportindividual products or services.

Design costsEngineering costs


Facility-Sustaining Costs

These are resources sacrificed onactivities that cannot be traced to

individual products or services butsupport the organization as a whole.

General administration– rent – building security



Cost products or services usingactivity-based costing.


ImplementingActivity-Based Costing

Identify cost objects.

NLCL

Identify the direct costsof the products.

Direct materialDirect labor

Mold cleaning and maintenance

Step 1 Step 2



Cleaning and maintenance costs of$360,000 are direct batch-level costs.

Why?Because these costs consist of workers’

wages for cleaning molds after eachbatch of lenses is run.



Normal Lenses (NL)Cost HierarchyDescription Category

Direct materials Unit-level $1,520,000Direct mfg. labor Unit-level 800,000Cleaning and maint. Batch-level 160,000Total direct costs $2,480,000



Complex Lenses (CL)Cost HierarchyDescription Category

Direct materials Unit-level $ 920,000Direct mfg. labor Unit-level 260,000Cleaning and maint. Batch-level 200,000Total direct costs $1,380,000



Select the cost-allocation bases to use forallocating indirect costs to the products.

(1) (2) (3)Activity Cost Hierarchy Total CostsDesign Product-sustaining $450,000Setups Batch-level $409,200Operations Unit-level $637,500

Step 3



Identify the indirect costs associatedwith each cost-allocation base.

Overhead costs incurred are assignedto activities, to the extent possible, on

the basis of a cause-and-effect relationship.

Step 4



Compute the rate per unit. (1) (5)NL CL Total

Setup-hours: 640 2,000 2,640

Step 5

$409,200 ÷ 2,640 = $155



Compute the indirect costs allocatedto the products.

NL: $155 × 640 = $ 99,200CL: $155 × 2,000 = 310,000Total $409,200

Step 6



Compute the costs of the products.NL and CL would show three

direct cost categories.

Step 7

1. Direct materials2. Direct manufacturing labor3. Cleaning and maintenance



NL and CL would show six indirect cost pools.1. Design2. Molding machine setups3. Manufacturing operations4. Shipment setup5. Distribution6. Administration



Use activity-basedcosting systems for

activity-based management.


Activity-Based Management

ABM describes management decisions that useactivity-based costing information to satisfy

customers and improve profits.Product pricing and mix decisions

Cost reduction and process improvement decisionsDesign decisions


Product Pricing andMix Decisions

ABC gives management insight into the coststructures for making and selling diverse products.

It provides more accurate product costinformation and more detailed information

on costs of activities and the drivers of those costs.


Cost Reduction and ProcessImprovement Decisions

Manufacturing and distribution personnel useABC systems to focus on cost-reduction efforts.Managers set cost-reduction targets in terms of

reducing the cost per unit of the cost-allocation base.


Design Decisions

Management can identify and evaluate new designsto improve performance by evaluating how product

and process designs affect activities and costs.Companies can work with their customers to

evaluate the costs and prices of alternative designs.



Compare activity-based costingsystems and department-

costing systems.


ABC and DepartmentIndirect-Cost Rates

Many companies have evolved theircosting system from using a single

cost pool to using separate indirect-costrates for each department:

DesignManufacturing

Distribution


ABC and DepartmentIndirect-Cost Rates

Why?Because the cost drivers of resources in eachdepartment or subdepartment differ from thesingle, company-wide, cost-allocation base.

ABC systems are a further refinement ofdepartment costing systems.



Evaluate the costs and benefitsof implementing activity-based

costing systems.


Benefits of ABC Systems

Significant amounts of indirect costs areallocated using only one or two cost pools.

All or most costs are identifiedas output unit-level costs.

Products make diverse demands onresources because of differences involume, process steps, batch size,

or complexity.



Products that a company is well-suited tomake and sell show small profits whileproducts for which a company is less

suited show large profits.Complex products appear to be very

profitable and simple productsappear to be losing money.



Operations staff have significantdisagreements with the accounting

staff about the costs of manufacturingand marketing products and services.


Limitations of ABC Systems

The main limitations of ABC are themeasurements necessary to

implement the system.ABC systems require managementto estimate costs of activity poolsand to identify and measure cost

drivers for these pools.


Limitations of ABC Systems

Activity-cost rates also need to beupdated regularly.

Very detailed ABC systems are costlyto operate and difficult to understand.


ABC In Service andMerchandising Companies

The general approach to ABC in theservice and merchandising areas is very

similar to the approach in manufacturing.Costs are divided into homogeneous costpools and classified as output unit-level,

batch-level, product- or service-sustaining,and facility-sustaining costs.


ABC In Service andMerchandising Companies

The cost pools correspond to key activities.Costs are allocated to products or customers

using activity drivers or cost-allocationbases that have a cause-and-effect

relationship with the cost in the cost pool.


End of Chapter 5

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Activity-Based Costing and Activity-Based Management Chapter 5