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Activity-Based Costing and Activity-Based Management
Activity-Based Costing andActivity-Based Management
Learning Objective 1
Explain undercosting
and overcosting of
products and services.
Undercosting andOvercosting Example
Undercosting andOvercosting Example
Tariq, Nasir, and Hamid orderseparate items for lunch.
Tariq’s order amounts to Rs 14Nasir consumed 30Hamid’s order is 16Total Rs 60
What is the average cost per lunch?
Undercosting andOvercosting Example
Rs 60 ÷ 3 = Rs 20
Tariq and Hamidare overcosted.
Nasir isundercosted.
Learning Objective 2
Present three guidelines for
refining a costing system.
Existing Single Indirect-Cost Pool System Example
Existing Single Indirect-Cost Pool System Example
Super Corporation manufactures a normal lens(NL) and a complex lens (CL).
Super currently uses a single indirect-cost ratejob costing system.
Cost objects: 80,000 (NL) and 20,000 (CL).
Existing Single Indirect-Cost Pool System Example
Existing Single Indirect-Cost Pool System Example
Normal Lenses (NL)Direct materials Rs 1,520,000Direct mfg. labor 800,000
Total direct costs Rs 2,320,000
Direct cost per unit: Rs 2,320,000 ÷ 80,000 = Rs29
Existing Single Indirect-Cost Pool System Example
Existing Single Indirect-Cost Pool System Example
Complex Lenses (CL)Direct materials Rs 920,000Direct mfg. labor 260,000
Total direct costs Rs1,180,000
Direct cost per unit: Rs 1,180,000 ÷ 20,000 = Rs 59
Existing Single Indirect-Cost Pool System Example
Existing Single Indirect-Cost Pool System Example
All Indirect CostsRs 2,900,000
All Indirect CostsRs 2,900,000
50,000 DirectManufacturingLabor-Hours
50,000 DirectManufacturingLabor-Hours
INDIRECT-COSTPOLL
INDIRECTCOST-ALLOCATIONBASE
Rs 58 per DirectManufacturing
Labor-Hour
Existing Single Indirect-Cost Pool System Example
Existing Single Indirect-Cost Pool System Example
Indirect Costs
Direct Costs
Indirect Costs
Direct Costs
COST OBJECT:NL AND CLLENSES
DIRECTCOSTS
DirectMaterials
DirectMaterials
DirectManufacturing
Labor
DirectManufacturing
Labor
Existing Single Indirect-Cost Pool System Example
Existing Single Indirect-Cost Pool System Example
Super uses 36,000 direct manufacturinglabor-hours to make NL and 14,000 directmanufacturing labor-hours to make CL.
How much indirect costs are allocatedto each product?
Existing Single Indirect-Cost Pool System Example
Existing Single Indirect-Cost Pool System Example
NL: 36,000 × Rs 58 = Rs 2,088,000
CL: 14,000 × Rs 58 = Rs 812,000
What is the total cost of normal lenses?
Direct costs Rs 2,320,000 +Allocated costs Rs 2,088,000 = Rs 4,408,000
What is the cost per unit?
Rs 4,408,000 ÷ 80,000 = Rs 55.10
Existing Single Indirect-Cost Pool System Example
Existing Single Indirect-Cost Pool System Example
What is the total cost of complex lenses?
Direct costs Rs 1,180,000 + Allocated costs Rs 812,000 = Rs 1,992,000
What is the cost per unit?
Rs 1,992,000 ÷ 20,000 = Rs 99.60
Existing Single Indirect-Cost Pool System Example
Existing Single Indirect-Cost Pool System Example
Normal lenses sell for Rs 60 each andcomplex lenses for Rs 142 each.
Normal Complex Revenue Rs 60.00 Rs 142.00 Cost 55.10 99.60 Income Rs 4.90 Rs 42.40 Margin 8.2% 29.9%
Refining a Costing System
Direct-cost tracing
Indirect-cost pools
Cost-allocation basis
Refining a Costing SystemRefining a Costing System
1. Design of Products and Process
The Design Department designs the moldsand defines processes needed (details of
the manufacturing operations).
Refining a Costing SystemRefining a Costing System
2. Manufacturing Operations
Lenses are molded, finished,cleaned, and inspected.
3. Shipping and Distribution
Finished lenses are packed andsent to the various customers.
Learning Objective 3
Distinguish between the
traditional and the
activity-based costing
approaches to designing
a costing system.
Activity-Based Costing SystemActivity-Based Costing System
FundamentalCost Objects
Activities
Costs of Activities
Assignment to OtherCost Objects
Cost of:• Product• Service• Customer
Activity-Based Costing SystemActivity-Based Costing System
A cross-functional team at SuperCorporation identified key activities:
Design products and processes.
Set up molding machine.
Operate machines to manufacture lenses.
Maintain and clean the molds.
Activity-Based Costing SystemActivity-Based Costing System
Set up batches of finished lenses for shipment.
Distribute lenses to customers.
Administer and manage all processes.
Activity-Based Costing SystemActivity-Based Costing System
No. ofSetupHours
LensesNL
LensesCL
LensesOther
CostAllocationBase
ProductCostObjects
No. ofShipments
Parts-Square
feet
SetupDesign ShippingActivityIndirect CostPool
Activity-Based Costing SystemActivity-Based Costing System
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 Rs 409,200.
Activity-Based Costing SystemActivity-Based Costing System
What is the setup cost per setup-hour?
Rs 409,200 ÷ 2,640 hours = Rs 155
What is the setup cost perdirect manufacturing labor-hour?
Rs 409,200 ÷ 50,000 = Rs 8.184
Activity-Based Costing SystemActivity-Based Costing System
Allocation using direct labor-hours:NL: Rs 8.184 × 36,000 = Rs 294,624CL: Rs8.184 × 14,000 = Rs114,576
Total Rs409,200
Allocation using setup-hours:NL: Rs155 × 640 = Rs 99,200CL: Rs155 × 2,000 = Rs310,000Total Rs409,200
Learning Objective 4
Describe a four-part
cost hierarchy.
Cost HierarchiesCost Hierarchies
A cost hierarchy is a categorizationof costs into different cost pools.
Cost drivers bases (cost-allocation bases)
Degrees of difficulty in determiningcause-and-effect relationships
Cost HierarchiesCost Hierarchies
ABC systems commonly use afour-part cost hierarchy to
identify cost-allocation bases:
1. Output unit-level costs
2. Batch-level costs
3. Product-sustaining costs
4. Facility-sustaining costs
Output Unit-Level CostsOutput Unit-Level Costs
These are resources sacrificedon activities performed on each
individual unit of product or service.
Energy
Machine depreciation
Repairs
Batch-Level CostsBatch-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 CostsProduct-Sustaining Costs
These are often called service-sustainingcosts and are resources sacrificed on
activities undertaken to supportindividual products or services.
Design costs
Engineering costs
Facility-Sustaining CostsFacility-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
Learning Objective 5
Cost products or services using
activity-based costing.
ImplementingActivity-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
ImplementingActivity-Based Costing
ImplementingActivity-Based Costing
Cleaning and maintenance costs ofRs360,000 are direct batch-level costs.
Why?
Because these costs consist of workers’wages for cleaning molds after each
batch of lenses is run.
ImplementingActivity-Based Costing
ImplementingActivity-Based Costing
Normal Lenses (NL)Cost Hierarchy
Description CategoryDirect materials Unit-level Rs1,520,000Direct mfg. labor Unit-level 800,000Cleaning and maint. Batch-level 160,000Total direct costs Rs2,480,000
ImplementingActivity-Based Costing
ImplementingActivity-Based Costing
Complex Lenses (CL)Cost Hierarchy
Description CategoryDirect materials Unit-level Rs 920,000Direct mfg. labor Unit-level 260,000Cleaning and maint. Batch-level 200,000Total direct costs Rs1,380,000
ImplementingActivity-Based Costing
ImplementingActivity-Based Costing
Select the cost-allocation bases to use forallocating indirect costs to the products.
(1) (2) (3)Activity Cost Hierarchy Total CostsDesign Product-sustaining Rs450,000Setups Batch-level Rs409,200Operations Unit-level Rs637,500
Step 3
ImplementingActivity-Based Costing
ImplementingActivity-Based Costing
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
ImplementingActivity-Based Costing
ImplementingActivity-Based Costing
Compute the rate per unit.
(1) (5)NL CL Total
Setup-hours: 640 2,000 2,640
Step 5
Rs409,200 ÷ 2,640 = Rs155
ImplementingActivity-Based Costing
ImplementingActivity-Based Costing
Compute the indirect costs allocatedto the products.
NL: Rs155 × 640 = Rs 99,200CL: Rs155 × 2,000 = 310,000
Total Rs409,200
Step 6
ImplementingActivity-Based Costing
ImplementingActivity-Based Costing
Compute the costs of the products.
NL and CL would show threedirect cost categories.
Step 7
1. Direct materials
2. Direct manufacturing labor
3. Cleaning and maintenance
ImplementingActivity-Based Costing
ImplementingActivity-Based Costing
NL and CL would show six indirect cost pools.
1. Design
2. Molding machine setups
3. Manufacturing operations
4. Shipment setup
5. Distribution
6. Administration
Learning Objective 6
Use activity-based
costing systems for
activity-based management.
Activity-Based ManagementActivity-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 decisions
Design decisions
Product Pricing andMix 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
Cost Reduction and ProcessImprovement Decisions
Manufacturing and distribution personnel useABC systems to focus on cost-reduction efforts.
Managers set cost-reduction targets in terms ofreducing the cost per unit of the cost-allocation base.
Design DecisionsDesign 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 toevaluate the costs and prices of alternative designs.
Learning Objective 7
Compare activity-based costing
systems and department-
costing systems.
ABC and DepartmentIndirect-Cost Rates
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:
Design
Manufacturing
Distribution
ABC and DepartmentIndirect-Cost Rates
ABC and DepartmentIndirect-Cost Rates
Why?
Because the cost drivers of resources in eachdepartment or sub department differ from thesingle, company-wide, cost-allocation base.
ABC systems are a further refinement ofdepartment costing systems.
Learning Objective 8
Evaluate the costs and benefits
of implementing activity-based
costing systems.
Benefits of ABC SystemsBenefits 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.
Benefits of ABC SystemsBenefits of ABC Systems
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 veryprofitable and simple products
appear to be losing money.
Benefits of ABC SystemsBenefits of ABC Systems
Operations staff have significantdisagreements with the accounting
staff about the costs of manufacturingand marketing products and services.
Limitations of ABC SystemsLimitations 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 SystemsLimitations 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
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
ABC In Service andMerchandising Companies
The cost pools correspond to key activities.
Costs are allocated to products or customersusing activity drivers or cost-allocation
bases that have a cause-and-effectrelationship with the cost in the cost pool.
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