Chap 7 - ActivityBasedCosting

7/30/2019 Chap 7 - ActivityBasedCosting

1/53

CHAPTER

SEVEN

Activity-basedCosting


2/53

Object ives

Understand ABC and how it differsfrom a traditional costing system

Cost distortion caused by traditionalcosting system

Understand how costs are treatedunder ABC

Designing ABC system


3/53

Cost Allocations

DirectCosts

CostObjects

Indirect

Costs

TraditionalCosting

ABC


4/53

Traditional Costing

Determination of Overhead Rates

- Plant-wide rate

- Departmental rate Distortions caused by traditional

allocations

- based on unit-related measures- differences in relative consumption ratios


5/53

Determination of overhead rates

Overhead rate = Normal cost of support activity

Normal level of cost driver

Consider: use of plant-wide overhead rate vsdepartmental overhead rate


6/53

Plant-wide/blanket overhead rate ordepartmental rate?

Dept A Dept B Dept C Total

Overheads $200,000 $600,000 $100,000 $900,000

DLHs 20,000 20,000 20,000 60,000

OH Rate


7/53

Product Z: 20 DLH in Dept C; but not passthru Dept A & B. Overhead costs allocatedto Z:

If use plant-wide rate:

If use dept rate:

Which to use?


8/53

Traditional Cost Distortions

Machine

Setup

Machining Assembly

Setup Costs $200,000 $120,000 $80,000

Setup hours 480 320


9/53


Products

Relevant Factors A B

Batch size, number of units 800 200

Setup hours required

Machining 3 3

Assembly 2 2Normal prod., no. of units 64,000 16,000

Normal prod., no. of batches 80 80


10/53


Setup costs per hour =

=

Setup costs =Product A: =

Product B: =


11/53

Trad./two stage allocationsBoth products use 0.1 machine hours in each

production dept.

Overhead rate: Machining ==

Assembly =

=Setup costs/unit for both products

=


12/53

Reasons for cost distortions:

Allocations based on unit-relatedmeasures

Product A - produced in larger batches.

It is charged the same rate ($2.50) asproduct B coz of the use of MH as thebasis to allocate overhead costs which isdriven by batch-related measures (e.g.

machine setups)Product A over cost; B under cost.


13/53

Reasons for cost distortions:

Differences in relative consumption ratiosProduct A needs 0.00625 setup hours perunit (5/800), while B needs 0.02500(5/200)

Both need same number of MH/unit (0.1)

Actual consumption ratio = 1:4

(0.00625/0.02500)

If use MH consumption ratio = 1:1

(0.1:0.1)

Product A over cost; B under cost


14/53

How to deal with this problem?

Design a costing system that use actual costdriver for each overhead activity to assigncosts to products

---- Activity Based Costing- costing systems based on cost drivers

that link activities performed to products

and allocate overhead activity costsdirectly to products using these costdrivers (ABKY, 1995: 291)


15/53

How Costs are Treated UnderActivityBased Costing

Best practice ABC differs from traditional costing in five ways.

Manufacturing

costs

Nonmanufacturing

costs

ABC assigns both types of costs to products.

Traditionalproduct costing

ABCproduct costing


16/53


ABC does not assign all manufacturing costs to products.

Manufacturing

costs

Nonmanufacturing

costs


Traditionalproduct costing

ABCproduct costing

All

Some


17/53

Selling & distribution costs

Compare between products and determinewhether should include or not- which product demand more selling &distribution activities

- e.g. order-getting activities-- marketing (mgmt, travel, brochures, catalog),customer service

- e.g. order-filling activities

-- warehouse, shipping, order executionincludes personnel, facilities, equipment and

services required for each activity.


18/53


Plantwide

OverheadRate

DepartmentalOverhead

Rates

ActivityBasedCosting

Number of cost pools

Levelofcom

plexity


ABC uses more cost pools.


19/53



ABC uses more allocation bases.

Traditional Costing

Numbero

f

AllocationBa

ses

ABC

Bases usuallyrely solely onvolume

measures.

Volumemeasuresplus other

bases.


20/53




The most commonly used allocation basein traditional costing is direct labor hours.

Direct labor hours workwell when overhead

increases as directlabor hours increase.


21/53


Problems:

In many processes, overhead is increasing

while direct labor is decreasing. Variety and complexity of products is increasing.

The most commonly used allocation basein traditional costing is direct labor hours.




22/53




All overheadcosts are not related

to volume measures like

direct laborhours.

ABC usesvolume as well as

other allocation bases notrelated to the volume

of production.


23/53



Traditional CostingThe predetermined

overhead rate is basedon budgeted activity.

This results in applyingall overhead costs

including unused, oridle capacity costs toproducts.

ABCProducts are charged

for the costs ofcapacity they use not

for the costs ofcapacity they dont

use. Unused capacitycosts are treated asperiod expenses.

ABC bases level of activity on capacity.


24/53

Characteristics of SuccessfulABC Implementations

Strong topmanagement support

Cross-functionalinvolvement

Link to evaluationsand rewards


25/53

Designing an ABC System

Cost Objects(e.g., productsand customers)

Activities

Consumptionof Resources

Cost


26/53

Designing an ABC System

Steps for Implementing ABC Identify and define activities and activity cost

pools.

Trace costs to activities and cost objects.

Assign costs to activity cost pools.

Calculate activity rates.

Assign costs to cost objects.

Prepare management reports.


27/53

Identify and Define Activitiesand Activity Cost Pools

Manufacturingcompanies typically combinetheir activities into five

classifications.

Unit-LevelActivity

Batch-LevelActivity

Product-LevelActivity

Customer-LevelActivityOrganization-

sustaining

Activity


28/53

Unit-level activities are those that areperformed each time a unit is produced.

Examples:Power and

mach ine hours are used each

t ime a un i t is produced.

Direct materials and d irectlabo r act iv i t ies are also un it-

level act iv i t ies, even though

they are no t overhead cos ts.

Classification of Activities


29/53

Batch-level activities are those that are

performed each time a batch of products isproduced.

Examples:Setups,

inspect ions , product ionschedu l ing, and mater ial

handl ing.



30/53

Product-level (sustaining) activities are those thatare performed as needed to support the various

products produced by a company. These activitiesconsume inputs that develop products or allowproducts to be produced and sold.

Examples:Engineer ing changes, pro cesseng ineer ing , and expedi t ing .



31/53

Facility-level activities are those that

sustain a factory's general manufacturingprocesses.

Examples: Plant

management, landscaping,main tenance, secu ri ty, p roperty

taxes, and p lan t depreciat ion .



32/53


Activitiesshould only be

combined within a levelif they are highly

correlated.

When combiningactivities, they should begrouped together only at

the appropriatelevel.


33/53


An Activity Cost

Poolis a bucketin which costs areaccumulated that

relate to a singleactivity measure inthe ABC system.

$

$

$ $

$

$


34/53


Simple count

of the number oftimes an activity

occurs.

Transactiondriver

A measure

of the amountof time neededfor an activity.

Durationdriver

Two types of activity measures:


35/53


At Classic Brass, the ABC team, selected the followingactivity cost pools and activity measures:


36/53


Customer Orders - assigned all costs of resourcesthat are consumed by taking and processingcustomer orders.

Product Designs - assigned all costs of resourcesconsumed by designing products.

Order Size - assigned all costs of resourcesconsumed as a consequence of the number ofunits produced.

Customer Relations assigned all costsassociated with maintaining relations with

customers. Other assigned all overhead costs that are notassociated with the other cost pools. i.e.organization sustaining activity

When Possible Directly Trace Overhead


37/53

When Possible, Directly Trace OverheadCosts to Activities and Cost Objects

Assign Costs to Activity Cost


38/53

Assign Costs to Activity CostPools

At Classic Brass the following distribution of resourceconsumption across activity cost pools is determined.

**Not included because they are directly traced to customer orders.



39/53

Indirect factory wages $500,000Percent consumed by customer orders 25%

$125,000




40/53

Factory equipment depreciation $300,000Percent consumed by customer orders 20%

$ 60,000




41/53



42/53

Calculate Activity Rates

The ABC team determines that ClassicBrass will have these total activities for

each activity cost pool . . .

1,000 customer orders,

200 new designs,

20,000 machine-hours,

100 customer relations activities.Now the team can compute the individualactivity rates by dividing the total cost foreach activity by the total activity levels.


43/53

Calculate Activity Rates


44/53

Traced Traced Traced

Activity-Based Costing at Classic Brass

DirectMaterials

DirectLabor

ShippingCosts

Overhead Costs

Cost Objects:Products, Customer Orders, Customers


45/53


DirectMaterials

DirectLabor

ShippingCosts


OrderSize

CustomerOrders

ProductDesign

CustomerRelations

Other

Overhead Costs

First-Stage Allocation


46/53


DirectMaterials

DirectLabor

ShippingCosts


OrderSize

CustomerOrders

ProductDesign

CustomerRelations

Other

Overhead Costs

First-Stage Allocation

Second-Stage Allocations

$/MH $/Order $/Design $/Customer

Unallocated


47/53

Assigning Costs to Cost Objects

Lets take a look at how our system worksfor just one customer Windward Yachts.

Standard Stanchions (no design required)1. 400 units ordered with 2 separate orders.2. Each stanchion required 0.5 machine-hours.

3. Selling price is $34 each.4. Direct materials total $2,110.5. Direct labor totals $1,850.6. Shipping costs total $180.

Custom Compass Housing (requires new design)1. One order during the year.2. Each housing required 4 machine-hours.3. Selling price is $650 each.4. Direct materials total $13.5. Direct labor totals $50.

6. Shipping costs total $25.


48/53

Assigning Costs to Cost Objects

The customer-levelcost is assigned tocustomers directly;it is not assigned to

products.


49/53

Prepare Management Reports

Standard StanchionsSales 13,600$

Cost:

Direct materials 2,110$

Direct labor 1,850

Shipping costs 180

Customer orders 630

Product design -Order size 3,800 8,570

Product margin 5,030$

Custom Compass Housing

Sales 650$

Cost:Direct materials 13$

Direct labor 50

Shipping costs 25

Customer orders 315

Product design 1,285

Order size 76 1,764

Product margin (1,114)$


50/53

Prepare Management Reports

Customer Profitability Analysis


51/53

Product Margins

Traditional Cost Accounting System

Predetermined manufacturingoverhead rate

$1,000,00020,000 MH

= $50/MH=

400 units x 0.5 MH/unit x $50/MH = $10,000

Differences Bet een ABC and


52/53

Differences Between ABC andTraditional Product Costs

Product margins are different for four reasons:

Traditional costing assigns design costs to both productsbased on machine hours. ABC assigns product designcosts to a product only if product design work is required.

Traditional costing assigns customer order costs, a batch-level cost, using a unit-level allocation base, machine hours.

ABC assigns these batch-level costs using a batch-levelactivity measure.

Traditional costing assigns only manufacturing costs to

products. ABC also assigns non-manufacturing costs toproducts.

Traditional costing assigns all manufacturing costs toproducts. The ABC system does not assign organization-

sustaining manufacturing costs to the products.


53/53

End of Chapter

Documents

Chap 7 - ActivityBasedCosting