Chapter 5

Activity-Based Costing

Undercosting and Overcosting

• Consider the costing of a bill for four friends who go for dinner. • Each diner orders separate entrees, desserts, and drinks. • Bill details are as follows:

Entrée Dessert Drinks Total Emma $11 $0 $4 $15 J ames 20 8 14 42 J essica 15 4 8 27 Matthew 14 4 6 24 Total $60 $16 $32 $108

Average $15 $4 $8 $27

Over- and Undercosting

• Overcosting – a product consumes a low level of resources (costs) but is allocated high costs per unit

• Undercosting – a product consumes a high level of resources (costs) but is allocated low costs per unit

Plastim Corporation

• Manufactures lenses for rear taillights of automobiles

• Makes two types of lenses for Giovanni Motors– A complex lens, CL5– A simple lens, S3

• Processes at Plastim include:– Design products– Manufacture lenses– Distribute lenses

Some Basic Data at Plastim• Simple S3 lenses – 60,000 units (sales) budgeted

for 2010– Uses 30,000 DLH’s– Sells for $63 each– Competitor has offered this product for $53 to Giovanni

• Complex CL5 lenses – 15,000 units (sales) budgeted for 2010– Uses 9,750 DLH’s– Sells for $137 each– No price pressure exists

Product Costing at Plastim

• To guide pricing and cost-management decisions, Plastim assigns all costs (both mfg. and non-mfg.) to its products

• Plastim’s simple costing system traces direct materials and direct labor costs to products (CL5 and S3 lenses)

• All other costs in the value chain are allocated to products using a single overhead rate using DLH as the allocation base

Overview of Plastim’s Simple Costing System

Allocation Rate per DLH (Step 5)

Budgeted indirect-cost

rate =

Budgeted total costs in indirect-cost pool

Budgeted total quantity of cost-allocation base

=

$2,385,000

39,750 direct manufacturing labor-hours

= $60 per direct manufacturing labor-hour

Allocation of Indirect Costs to Products (Step 6)

• Plastim expects to use 30,000 total direct manufacturing labor-hours to make the 60,000 S3 lenses, and • 9,750 total direct manufacturing labor-hours to make the 15,000 CL5 lenses.• Thus, indirect costs of $1,800,000 are allocated to the simple lens, and• $585,000 are allocated to the complex lens.

Plastim’s Product Costs Using Simple Costing

Product Profitability Using Simple Costing

60,000

15,000

Simple Lenses (S3)

Complex Lenses (CL5)

Total

Total Per Unit

Total Per Unit

Revenues $3,780,000 $63.00

$2,055,000 $137.00

$5,835,000

Costs 3,525,000 58.75

1,455,000 97.00

4,980,000

Operating Income

$ 255,000 $ 4.25

$ 600,000 $ 40.00

$ 855,000

Profit margin percentage

6.75%

29.20%

Guidelines for Refining a Cost System

• Direct-cost tracing - categorize as many of the overall costs as direct costs (as economically feasible)

• Divide indirect-cost pool into several homogeneous groups (pools) with cause-and-effect relationships between the cost driver and indirect cost

• Define cost-allocation bases (cost drivers) for each cost pool using cause-and-effect criterion

ActivitiesCosts of

Activities

* Customers

Costs of:

Assignment to Other Cost

Objects

Fundamental Cost Objects

* Products* Services

Activity-Based Costing Systems

Plastim's ABC System - Activities

a. Design products and processes

b. Set up molding machines to ensure that the molds are properly held in place and parts are properly aligned before manufacturing starts c. Operate molding machines to manufacture lenses

d. Clean and maintain the molds after lenses are manufactured

e. Prepare batches of finished lenses for shipment

f. Distribute lenses to customers

g. Administer and manage all processes at Plastim

Setup Data For Products

Simple Complex

S3 Lens CL5 Lens Total

Quantity of lenses produced

60,000 15,000

Number of lenses produced per batch

240 50

Number of batches

250 300

Setup time per batch

2 hours 5 hours

Total setup-hours

500 hours

1,500 hours 2,000 hours

Alternative Allocation Rates For Setup Cost to Products

• Of the $2,385,000 in the total indirect-cost pool, Plastim identifies the total costs of setups to be $300,000. • Of the $60 total rate per direct manufacturing labor-hour, the setup cost per direct manufacturing labor-hour amounts to $7.54717 ($300,000/39,750 total direct manufacturing labor-hours). • The setup cost per setup-hour equals $150 ($300,000 / 2,000 total setup-hours).

Allocation of Setup Costs to Products

Simple ComplexS3 Lens CL5 Lens Total

Setup cost allocated using direct manufacturing

$ 226,415 $ 73,585 $ 300,000

labor-hours:$7.54717 X 30,000; $7.54717 X 9,750

Setup cost allocated using setup-hours:

$ 75,000 $ 225,000 $ 300,000

$150 X 500; $150 X 1,500

Cost Hierarchies

• A cost hierarchy defines each activity cost pool as falling into one of four categories

• The four categories in ABC systems are as follows:– Unit-level (output-level) costs– Batch-level costs– Product-sustaining-level costs– Facility-sustaining-level costs

Definitions

• Unit-level – activities undertaken for every part made (machining operations)

• Batch-level – activity is related to a group of units produced (setup, move material)

• Product-sustaining – activity supports individual products regardless of the number of units or batches produced

• Facility-sustaining – activities that support the organization as a whole. Assigned costs cannot be traced to any particular product (administrative costs, building rent, landscaping services)

Overview of Plastim’s ABC System

Total

Description Total Per Unit Total Per Unit

Direct Materials

Output unit-level

$1,125,000 $18.75 $675,000 $45.00 $1,800,000

Direct Manuf. Labor

Output unit-level

600,000 10.00 195,000 13.00 795,000

Mold cleaning & maintenance

Batch-level 120,000$ 2.00$ 150,000$ 10.00$ 270,000$

Total direct costs

1,845,000$ 30.75$ 1,020,000$ 68.00$ 2,865,000$

Cost Hierarchy Category

60,000 15,000

Simple Lenses (S3) Complex Lenses (CL5)

Direct Costs Using ABC Costing

Activity-Cost Rates for Plastim’s Indirect Costs Pools

Plastim’s Product Costs Using ABC

Plastim: Simple & ABC Compared

Activity-Based Management

• A method of management that used ABC as an integral part in critical decision-making situations, including:– Pricing and product-mix decisions– Cost reduction and process improvement

decisions– Design decisions– Planning and managing activities