Activity-Based Activity-Based Costing SystemsCosting Systems

Chapter 4Chapter 4

Traditional overhead allocation system

Single predetermined rate is used to allocate overhead to productsEasy to useAssumes all overhead is correlated with the

activity baseAssumes all overhead costs are related to all

productsDoes not consider the product’s consumption

of resources other than the base

An ideal systemTreat indirect costs like direct costs

Accurate assignment of the resources consumed by the individual cost objectsDifferent types and amounts of overhead charged

to different cost objectsNo allocation based on estimates

Not possibleCost element shared by many cost objectsCost element not related to cost objectsNot cost effective to trace accurately

Activity-based costing

RecognizesNot all costs are related to the same cost

driver

Not all costs are incurred at the unit levelUnit level

Batch level

Product level

Customer level

Facility level

Activity-based costing

RecognizesThat activities are performed to produce or

support the cost object

Those activities consume resources

Can identify resources with the activities

Can identify the activities with the cost objects

Can be used for any cost objectNot GAAP for financial reporting

Activity-based costing

Traditional allocation method

Activity-based allocation method

Costs Products

Costs ProductsActivities

First stage Second stage

Implementation of an ABC system

Step 1 – Develop activity dictionary

List of activities related to the cost object

How precise?

Only major activities if purpose is better cost information

More detailed if purpose is process improvement

Will probably have an “other” activity

Implementation of an ABC system

Identify activities (cost pools)

Interview employees

Process flowcharts

Etc.

At which level do they occur?

Unit, batch, etc.

May not want to allocate facility level costs to products

Implementation of an ABC systemHow are the activities performed?

Inputs and outputs

What causes the activity to commence?

Production order, material requisition, etc.

What is the output of the activity?

Units produced, pieces assembled, time consumed, etc.

How can the activity be measured?

Transactions, time, etc.

For use as possible cost drivers

Implementation of an ABC system

Step 2 – Determine the significant costs related to each activityResources used

Employee timeWages and benefits

AssetsDepreciation, taxes, insurance, etc.

ConsumablesSupplies, utilities, maintenance, etc.

“Other”

Implementation of an ABC system

Material handling Set-up Assembly

Testing and inspection Rework Packaging

Breaks and meetings Other Total

Indirect labor 10% 15% 5% 50% 5% 5% 5% 5% 100%

Indirect materials 20% 45% 20% 10% 5% 100%

Depreciation 15% 5% 25% 15% 10% 30% 100%

Insurance and taxes 10% 5% 30% 20% 5% 30% 100%

Utilities 5% 5% 50% 5% 5% 30% 100%

Repairs and maintenance 25% 25% 20% 5% 25% 100%

Factory administration 10% 90% 100%

Other 100% 100%

Alpha Manufacturing CompanyFirst-stage allocation percentages

Exhibit 1

Implementation of an ABC system

CostMaterial handling Set-up Assembly

Testing and inspection Rework Packaging

Breaks and meetings Other Total

Indirect labor 1,600,000$ 160,000$ 240,000$ 80,000$ 800,000$ 80,000$ 80,000$ 80,000$ 80,000$ 1,600,000$ 10% 15% 5% 50% 5% 5% 5% 5% 100%

Indirect materials 250,000$ -$ 50,000$ 112,500$ 50,000$ 25,000$ 12,500$ -$ -$ 250,000$ 0% 20% 45% 20% 10% 5% 0% 0% 100%

Depreciation 500,000$ 75,000$ 25,000$ 125,000$ 75,000$ 50,000$ 150,000$ -$ -$ 500,000$ 15% 5% 25% 15% 10% 30% 0% 0% 100%

Insurance and taxes 225,000$ 22,500$ 11,250$ 67,500$ 45,000$ 11,250$ 67,500$ -$ -$ 225,000$ 10% 5% 30% 20% 5% 30% 0% 0% 100%

Utilities 800,000$ 40,000$ 40,000$ 400,000$ 40,000$ 40,000$ 240,000$ -$ -$ 800,000$ 5% 5% 50% 5% 5% 30% 0% 0% 100%

Repairs and maintenance 175,000$ 43,750$ -$ 43,750$ 35,000$ 8,750$ 43,750$ -$ -$ 175,000$ 25% 0% 25% 20% 5% 25% 0% 0% 100%

Factory administration 1,250,000$ -$ -$ -$ -$ -$ -$ 125,000$ 1,125,000$ 1,250,000$ 0% 0% 0% 0% 0% 0% 10% 90% 100%

Other 200,000$ -$ -$ -$ -$ -$ -$ -$ 200,000$ 200,000$ 0% 0% 0% 0% 0% 0% 0% 100% 100%

Total 5,000,000$ 341,250$ 366,250$ 828,750$ 1,045,000$ 215,000$ 593,750$ 205,000$ 1,405,000$ 5,000,000$

Exhibit 2Alpha Manufacturing Company

First-stage allocation

Implementation of an ABC system

Step 3 – Determine cost drivers and ratesWhat activity measures correlate with each

cost?Measurable

Statistically or logically have a cause-and-effect relationship with the cost

Predict or explain the consumption of resources with reasonable accuracy

Based on practical capacity for the activityUnused capacity is its own “activity”

Implementation of an ABC system

Driver base A B C D E Total

Pounds moved 410 9,600 90 5,700 2,000 17,800

Set-up hours 10 60 6 44 40 160

Pieces assembled 3,500 108,000 800 54,000 21,700 188,000

Number of tests performed 14 120 10 90 31 265

Rework hours 80 400 30 48 42 600

Cubic feet of packaged goods 30 1,100 5 385 280 1,800

Total direct labor hours 4,000 85,000 500 34,000 26,500 150,000

Number of units produced 350 12,000 50 4,500 3,100 20,000

Job

Exhibit 3Alpha Manufacturing Company

Driver base quantities

Implementation of an ABC system

Activity Activity cost Driver base Driver quantity

Material handling 341,250$ Pounds moved 17,800 19.17$ per pound moved

Set-up 366,250 Set-up hours 160 2,289.06$ per set-up hour

Assembly 828,750 Pieces assembled 188,000 4.41$ per piece assembled

Testing and inspection 1,045,000 Number of tests performed 265 3,943.40$ per test performed

Rework 215,000 Rework hours 600 358.33$ per rework hour

Packaging 593,750 Cubic feet of packaged goods 1,800 329.86$ per cubic foot packaged

Breaks and meetings 205,000 Total direct labor hours 150,000 1.37$ per direct labor hour

Other 1,405,000 Number of units produced 20,000 70.25$ per unit produced

Total 5,000,000$

Driver rate

Exhibit 4Alpha Manufacturing Company

Driver rate calculations

Implementation of an ABC system

Step 4 – Assign costs to cost objects

Determine the amount of each activity consumed by the cost object

Multiply by the rate for that activity

Total the activity costs for each cost object

Divide total by quantity of the cost object to determine unit cost

Implementation of an ABC system

ActivityActivity quantity

Cost assigned

Activity quantity

Cost assigned

Activity quantity

Cost assigned

Activity quantity

Cost assigned

Activity quantity

Cost assigned

Activity quantity

Cost assigned

Material handling 19.17$ per pound moved 410 7,860$ 9,600 184,045$ 90 1,725$ 5,700 109,277$ 2,000 38,343$ 17,800 341,250$

Set-up 2,289.06$ per set-up hour 10 22,891 60 137,344 6 13,734 44 100,719 40 91,563 160 366,250

Assembly 4.41$ per piece assembled 3,500 15,429 108,000 476,090 800 3,527 54,000 238,045 21,700 95,659 188,000 828,750

Testing and inspection 3,943.40$ per test performed 14 55,208 120 473,208 10 39,434 90 354,906 31 122,245 265 1,045,000

Rework 358.33$ per rework hour 80 28,667 400 143,333 30 10,750 48 17,200 42 15,050 600 215,000

Packaging 329.86$ per cubic foot packaged 30 9,896 1,100 362,847 5 1,649 385 126,997 280 92,361 1,800 593,750

Breaks and meetings 1.37$ per direct labor hour 4,000 5,467 85,000 116,167 500 683 34,000 46,467 26,500 36,217 150,000 205,000

Other 70.25$ per unit produced 350 24,588 12,000 843,000 50 3,513 4,500 316,125 3,100 217,775 20,000 1,405,000

Total job cost 170,004$ 2,736,034$ 75,015$ 1,309,735$ 709,212$ 5,000,000$

Units in job 350 12,000 50 4,500 3,100

Cost per unit 485.73$ 228.00$ 1,500.31$ 291.05$ 228.78$

Driver rate

Job A Job B Job C Job D Job E Total

Exhibit 5Alpha Manufacturing Company

Second-stage allocation

Advantages of ABC

Better allocation of costsNot perfect

Useful for estimating costs of future projects

Can be extended to activity-based management“Now that we know what it costs, how can we

do it more efficiently?”

Advantages of ABC

Cost object can be anythingProductServiceProcessCustomerEmployeeLocationEtc.

Advantages of ABC

Aids in recognizing, measuring and controlling complexity

Promotes understanding of why costs are incurred

Shifts focus from managing costs to managing activities

When to use ABC

High proportion of indirect costs

Complex products or processes

High volume vs. low volume products

Diverse indirect costs

Cost accounting system hasn’t evolved

Distrust of current system

Different products place different demands on resources

Disadvantages of ABC

Costly to implement

Costly to maintain

Likely to meet substantial resistance

Not the “real” system

“Why do you want to know what I do?”