Chap008 abc

Activity-Based Costing: A Tool to Aid Decision Making

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 agood supplement to our traditional

cost systemI agree!

Learning Objective 1

Understand activity-Understand activity-based costing and how based costing and how

it differs from a it differs from a traditional costing traditional costing

system.system.

How Costs are Treated UnderActivity–Based Costing

ABC differs from traditional cost accounting in three ways.

Manufacturingcosts

Nonmanufacturingcosts

ABC assigns both types of costs to products.

TraditionalTraditionalproduct costingproduct costing

ABCABCproduct costingproduct costing


ABC does not assign all manufacturing costs to products.

Manufacturingcosts

Nonmanufacturingcosts

TraditionalTraditionalproduct costingproduct costing

ABCABCproduct costingproduct costing

All Most, butnot all S

ome



Plantwide Overhead

Rate

DepartmentalOverhead

Rates

Activity–BasedCosting

Number of cost pools

Leve

l of c

ompl

exity

ABC uses more cost pools.



ABC uses more cost pools.

Each ABC cost pool has itsown unique measure of activity.


Traditional cost systems usually relyTraditional cost systems usually relyon volume measures such as direct laboron volume measures such as direct laborhours and/or machine hours to allocatehours and/or machine hours to allocate

all overhead costs to products.all overhead costs to products.

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.

$

$

$ $

$$


Activity Measure

An allocation basein an activity-based

costing system.


The term cost driver is also used to refer to an activity measure.

Simple countSimple countof the number ofof the number oftimes an activitytimes an activity

occurs.occurs.

Transactiondriver

A measureA measureof the amountof the amountof time neededof time neededfor an activity.for an activity.

Durationdriver

Two common types of activity measures:



Traditional cost systems usually rely on volumeTraditional cost systems usually rely on volumemeasures such as direct labor hours and/or machinemeasures such as direct labor hours and/or machine

hours to allocate all overhead costs to products.hours to allocate all overhead costs to products.

ABC definesABC definesfive levels of activityfive levels of activity

that largely do not relatethat largely do not relateto the volume of unitsto the volume of units

produced.produced.

Manufacturingcompanies typically combine

their activities into fiveclassifications.

Unit-LevelActivity

Batch-Level Activity

Product-LevelActivity

Customer-LevelActivityOrganization-

sustainingActivity


Characteristics of Successful ABC Implementations

Strong topmanagement support

Cross-functionalinvolvement

Link to evaluationsand rewards

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 CompanyIncome Statement

Year Ended December 31, 2009

Manufacturing overhead is allocated to products usinga single plantwide overhead rate based on machine hours.

Define Activities, Activity Cost Pools, and Activity Measures

At Baxter Battery, the ABC team, selected the followingactivity cost pools and activity measures:

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 Cost Pools, and Activity Measures


Assign costs to cost Assign costs to cost pools using a first-pools using a first-stage allocationstage allocation. .

Assign Overhead Costs to Activity Cost Pools

Direct materials, direct labor, and shipping are excludedDirect materials, direct labor, and shipping are excludedbecause Baxter Battery’s existing cost system can directlybecause Baxter Battery’s existing cost system can directly

trace these costs to products or customer orders.trace these costs to products or customer orders.


At Baxter Battery the following distribution of resource consumption across activity cost pools is determined.



Indirect factory wages $6,000,000 Percent consumed by customer orders 30%

$1,800,000

Factory equipment depreciation $3,500,000Percent consumed by customer orders 20%

$ 700,000




Compute activityCompute activityrates for cost pools.rates for cost pools.

Calculate Activity Rates

The ABC team determines that Baxter Battery will have these total activities for each activity cost pool . . .

10,000 customer orders,10,000 customer orders, 4,000 design changes,4,000 design changes, 800,000 machine-hours,800,000 machine-hours, 2,000 customers served.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.

Calculate Activity Rates

Traced Traced Traced

DirectMaterials

DirectLabor

ShippingCosts Overhead Costs

Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers

Activity–Based Costing at Baxter Battery

DirectMaterials

DirectLabor

ShippingCosts


Overhead Costs

First-Stage Allocation

Activity–Based Costing at Baxter Battery

CustomerCustomerOrdersOrders

OrderOrderSizeSize

CustomerCustomerRelationsRelations OtherOtherDesignDesign

ChangesChanges

Activity–Based Costing at Baxter BatteryDirect

MaterialsDirectLabor

ShippingCosts


CustomerCustomerOrdersOrders

OrderOrderSizeSize

CustomerCustomerRelationsRelations OtherOther

Overhead Costs

First-Stage Allocation

Second-Stage AllocationsSecond-Stage Allocations

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

Unallocated

DesignDesignChangesChanges


Assign costs to a cost Assign costs to a cost object using a second-object using a second-

stage allocation. stage allocation.

Baxter Battery InformationSureStart1.1. Requires no new design resources.Requires no new design resources.2.2. 800,000 batteries ordered with 4,000 separate orders.800,000 batteries ordered with 4,000 separate orders.3.3. Each SureStart requires 36 minutes of machineEach SureStart requires 36 minutes of machine

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

LongLife1. Requires new design resources.2. 400,000 batteries ordered with 6,000 separate orders.3. 4,000 custom designs prepared.4.4. Each LongLife requires 48 minutes of machineEach LongLife requires 48 minutes of machine

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

Assigning Overhead to Products

Assigning Overhead to Products

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.

Orders1.1. Eight orders for 60 SureStarts per order.Eight orders for 60 SureStarts per order.2.2. Four orders for 50 LongLifes per order.Four orders for 50 LongLifes per order.

Machine-hours1.1. The 480 SureStarts required 288 machine-hours.The 480 SureStarts required 288 machine-hours.2.2. The 200 LongLifes required 160 machine hours.The 200 LongLifes required 160 machine hours.

Assigning Overhead to Customers

Assigning Overhead to Customers


Use activity-based Use activity-based costing to compute costing to compute

product and customer product and customer margins.margins.

Prepare Management Reports

SureStarts LongLifes TotalSales 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 CalculationsThe first step in computing product margins is togather each product’s sales and direct cost data.

Prepare Management ReportsProduct Margin Calculations

The second step in computing product margins is toincorporate the previously computed activity-based

cost assignments pertaining to each product.


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 assignmentsCustomer 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

Prepare Management ReportsProduct Margin Calculations

The third step in computing productmargins is to deduct each product’sdirect 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

SureStarts LongLifes TotalSales 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 CalculationsThe product margins can be reconciled with

the company’s net operating income as follows:

Prepare Management Reports

Prepare Management ReportsCustomer Margin Analysis

The first step in computing Acme Auto Parts’ customer margin is to gather its sales and direct cost data.

Acme AutoParts

Sales 29,200$ Direct costs

Direct material 7,500 Direct labor 6,700 Shipping 1,700


The second step is to incorporate Acme Auto Parts’ previously computed activity-based cost assignments.

Acme AutoParts


Direct material 7,500 Direct labor 6,700 Shipping 1,700

ABC cost assignmentsCustomer orders 5,424 Product design 3,040 Order size 2,912 Customer relations 1,540


The third step is to compute Acme Auto Parts’ customer margin of $384 by deducting all its direct and indirect costs from its sales.


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

Product Margins Computed Using the Traditional Cost System


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 togather each product’s sales and direct cost data.


Plantwide manufacturingoverhead rate

$14,000,000 800,000 MH = $17.50 per machine-hour=

The second step in computing product marginsis to compute the plantwide overhead rate.

Production DepartmentIndirect 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-hoursSureStarts (800,000 @ 0.60 hours) 480,000 LongLifes (400,000 @ 0.80 hours) 320,000 Total machine-hours 800,000


The third step in computing product margins isallocate 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


The fourth step is to actuallycompute 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)$

SureStarts LongLifes Total

Shipping expenses 3,000,000$ Marketing expenses 2,000,000 General administrative expenses 6,000,000

11,000,000$

SureStarts LongLifesProduct 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 costsystem overcosts the

SureStarts and reports a lower product

margin for this product.

The traditional costsystem undercosts theLongLifes and reports

a higher productmargin for this product.

Differences Between ABC and Traditional Product Costs


There are three reasons why thereported product margins for the two

costing systems differ from one another.

Traditional costing allocates all manufacturing overhead to products. ABC costing only assigns manufacturing overhead costs consumed by products to those products.


Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. ABC costing also uses non-volume related allocation bases.




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.



Targeting Process ImprovementActivity-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.

Benchmarking Benchmarking can be used to compare activity cost can be used to compare activity cost information with world-class standards of performance information with world-class standards of performance

achieved by other organizations.achieved by other organizations.

Activity-Based Costing and External Reporting

Most companies do not use ABCfor 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.

ABC Limitations

Substantial resourcesSubstantial resourcesrequired to implementrequired to implement

and maintain.and maintain.

Resistance toResistance tounfamiliar numbersunfamiliar numbers

and reports.and reports.

Desire to fullyDesire to fullyallocate all costsallocate all costs

to products.to products.

PotentialPotentialmisinterpretation ofmisinterpretation ofunfamiliar numbers.unfamiliar numbers.

Does not conform toDoes not conform toGAAP. Two costingGAAP. Two costing

systems may be needed.systems may be needed.

ABC Action Analysis

Appendix 8A


(Appendix 8A)(Appendix 8A)Prepare an action Prepare an action

analysis report using analysis report using activity-based costing activity-based costing data and interpret the data and interpret the

report. report.

Appendix 8A: ABC Action Analysis

Conventional ABC analysis does not identify potentially relevant costs. An

action analysis report helps because it:• Shows what costs have been assigned to a cost object.• Indicates how difficult it would be to adjust those costs in response to changes in the level of activity.

Constructing an action analysis report begins with the first-stage allocation process. In addition to computing an overall activity rate for each activity cost pool, an activity

rate is computed for each type of overhead cost that is consumed supporting a given

activity.

Let’s revisit the stage-one allocationsfrom the Baxter Battery Company example

that we discussed earlier.



$1,800,000 ÷ 10,000 orders = $180 per orderOther entries in the table are computed similarly.

$180 per order × 4,000 orders = $720,000Other entries in the table are computed similarly.

$180 per order × 6,000 orders = $1,080,000Other entries in the table are computed similarly.

Next, label each cost using an ease of adjustment code:• Green costs adjust more or less automatically to changes in activity level without any action by managers.• Yellow costs can be adjusted to changes in activity level, but it would require management action to realize the change in cost.• Red costs can be adjusted to changes in activity level only with a great deal of difficulty and with management intervention.


Sales 18,700,000$

Green costsDirect materials 6,000,000$ Shipping costs 1,000,000 7,000,000

Green margin 11,700,000$

Yellow costsDirect labor 5,000,000 Indirect factory wages 3,360,000 Factory utilities 850,000 Administrative wages and salaries 1,280,000 Office equipment depreciation 252,000 Marketing wages and salaries 420,000 Selling expenses 60,000 11,222,000

Yellow margin 478,000$

Red costsFactory equipment depreciation 1,610,000 Factory building lease - Administrative building lease - 1,610,000

Red margin (1,132,000)$

Action Analysis of LongLife Batteries


Using a Modified Form of Activity-Based Costing to Determine Product Costs for

External Reports

Appendix 8B


(Appendix 8B)(Appendix 8B)Use activity-based Use activity-based

costing techniques to costing techniques to compute unit product compute unit product

costs for external costs for external reports. reports.

Appendix 8B

ABC product costs:• Include organization-sustaining costs and unused capacity costs.• Exclude nonmanufacturing costs even if they are caused by the products.

A modified form of activity-basedcosting can be used to develop product

costs for external financial reports.

Appendix 8B

Total estimated manufacturing overhead 1,800,000$ Total estimated direct labor hours 400,000

Deluxe StandardDirect materials cost per unit 38.00$ 28.00$ Direct labor cost per unit 24.00$ 12.00$ Direct labor hours per unit 2.0 1.0 Units produced 100,000 200,000

Simmons’ Industries provides the following informationfor the company as a whole and for its only twoproducts—deluxe and standard hedge trimmers.

Appendix 8B

Assuming that Simmons’ traditional cost system relies Assuming that Simmons’ traditional cost system relies on one predetermined plantwide overhead rate with on one predetermined plantwide overhead rate with

direct labor-hours (DLHs) as the allocation base, then direct labor-hours (DLHs) as the allocation base, then its plantwide overhead rate is computed as follows:its plantwide overhead rate is computed as follows:

Predeterminedoverhead rate = $4.50 per DLH=

$1,800,000400,000 DLHs

Appendix 8B

Deluxe StandardDirect materials cost per unit 38.00$ 28.00$ Direct labor cost per unit 24.00 12.00 Manufacturing overhead per unit 9.00 4.50 Unit product cost 71.00$ 44.50$

Simmons’ traditional cost system wouldreport unit product costs as follows:

2.0 DLH × $4.50 per DLH

1.0 DLH × $4.50 per DLH

Appendix 8B

The ABC project team at Simmons hasdeveloped the following basic information.

Activity and Activity Measures

Estimated Overhead

Cost Deluxe Standard Total

Direct labor support (DLHs) 900,000$ 200,000 200,000 400,000 Machine setups (setups) 600,000 400 100 500 Parts administration (part types) 300,000 200 100 300 Total manufacturing overhead 1,800,000$

Expected Activity

Appendix 8B

We can calculate the following activity rates:

Activity and Activity Measures

Estimated Overhead

Cost

Total Expected Activity

Direct labor support (DLHs) 900,000$ ÷ 400,000 = 2.25$ per DLHMachine setups (setups) 600,000 ÷ 500 = 1,200$ per setupParts administration (part types) 300,000 ÷ 300 = 1,000$ per part typeTotal manufacturing overhead 1,800,000$

Activity Rate

Using the new activity rates, let’s assign overheadto the two products based upon expected activity.

Appendix 8B

Activity and Activity MeasuresExpected Activity

Activity Rate

Direct labor support (DLHs) 200,000 × 2.25$ = 450,000$ Machine setups (setups) 400 × 1,200$ = 480,000 Parts administration (part types) 200 × 1,000$ = 200,000 Total overhead cost assigned 1,130,000$

Amount

Deluxe Product

Activity and Activity MeasuresExpected Activity

Activity Rate

Direct labor support (DLHs) 200,000 × 2.25$ = 450,000$ Machine setups (setups) 100 × 1,200$ = 120,000 Parts administration (part types) 100 × 1,000$ = 100,000 Total overhead cost assigned 670,000$

Amount

Standard Product

Appendix 8B

Premium StandardDirect materials cost per unit 38.00$ 28.00$ Direct labor cost per unit 24.00 12.00 Manufacturing overhead per unit 11.30 3.35 Unit product cost 73.30$ 43.35$

Activity-based unit product costs for both product lines

Premium StandardDirect materials cost per unit 38.00$ 28.00$ Direct labor cost per unit 24.00 12.00 Manufacturing overhead per unit 11.30 3.35 Unit product cost 73.30$ 43.35$

Appendix 8B

Activity-based unit product costs for both product lines

$1,130,000 ÷ 100,000 units

$670,000 ÷ 200,000 units

Appendix 8B

Note that the unit product cost of a Standard unitNote that the unit product cost of a Standard unitdecreased from $44.50 to $43.35 . . . . .decreased from $44.50 to $43.35 . . . . .

. . . . . while the unit cost of a Deluxe unit increased from . . . . . while the unit cost of a Deluxe unit increased from $71.00 to $73.30.$71.00 to $73.30.

Deluxe Standard Deluxe StandardDirect material 38.00$ 28.00$ 38.00$ 28.00$ Direct labor 24.00 12.00 24.00 12.00 Manufacturing overhead 11.30 3.35 9.00 4.50 Unit product cost 73.30$ 43.35$ 71.00$ 44.50$

Activity-Based Costing Traditional Costing

Comparing the two approaches

End of Chapter 8

Environment

Chap008 abc