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Activity-Activity-Based Based

Costing and Costing and ManagementManagement

Prepared by Douglas Cloud

Pepperdine University

44

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Explain and illustrate the traditional method of calculating average costs of products.

Explain why the traditional method does not adequately serve modern organizations.

Explain how complexity and diversity are important cost drivers.

Explain and illustrate the activity-based costing method of calculating average costs of products.

ObjectivesObjectives

After reading this After reading this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinued

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Explain and illustrate activity-based management.

Prepare ABC-formatted income statements.

ObjectivesObjectives

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The Traditional ApproachThe Traditional Approach

A company makes two products, A and B, and uses machine hours as its cost driver.

Machine hours per unit 2 4Total units 100,000 25,000Total hours 200,000 100,000 300,000Total overhead cost $900,000

A B Total

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The overhead rate is $3 ($900,000 ÷ 300,000), and the allocations of overhead to products are:

Total hours 200,000 100,000 300,000Rate x $3 x $3 x $3Total overhead $600,000 $300,000 $900,000

A B Total

The Traditional ApproachThe Traditional Approach

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Activity-Based Costing ApproachActivity-Based Costing Approach

Volume is one major driver, measured either in output (units produced) or input (labor hours, machine hours, etc.)

Accountants today recognize two other major influences on cost, complexity and diversity of operations.ABC is concerned with resource consumption.

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MultiBrick also makes 10,000,000 total brick, but in a dozen colors, four textures, and eight sizes/shapes, a total of 384

possibilities. The firm mixes and bakes 10 to 18 batches of

bricks per day. MultiBrick sells to over 1,000 customers whose

orders typically include 15 to 20 different kinds of bricks.

MultiBrick Cost Determination Data

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Total manufacturing overhead $800,000Total output 10,000,000 bricks Model A-42 Model A-88 Model C-11Total production 6,000 4,000 100,000Material cost per brick $0.05 $0.04 $0.03Direct labor cost per brick $0.06 $0.07 $0.04

Overhead rate = $800,000 ÷ 10,000,000 = $0.08 per brick

MultiBrick Cost Determination Data

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Cost calculations: Model A-42 Model A-88 Model C-11Material cost per brick $0.05 $0.04 $0.03Direct labor cost per brick 0.06 0.07 0.04Overhead cost at $0.08 0.08 0.08 0.08

Total unit cost $0.19 $0.19 $0.15

MultiBrick Cost Determination Data

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Activity-Based Costing TermsActivity-Based Costing Terms

A cost object refers to whatever segment for which you are estimating the cost.

Examples: Products, customers, geographical areas, and channel of distribution

Cost drivers are activities that cause costs.Examples: Sales, production, number of

products, and number of customers.

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Resource Driver refer to activities that drive resource requirements, and therefore drive costs.

Examples: People, machinery, space, and utilities

An activity driver relates resource-driving activities to products, customers, geographical areas, or other segments of interest.

Activity-Based Costing TermsActivity-Based Costing Terms

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MultiBrick Data for Illustration Total AmountResource Driver Costs in Pool of Driver RateSetups $120,000 10,000 setups $12Baking time 600,000 300,000 hours $2Customer orders 80,000 5,000 orders $18 Total cost $800,000

÷

÷÷

===

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Activity Data per YearModel A-42 Model A-88 Model C-11

Number of setups 150 180 30baking time, hours 60 50 300Number of customer orders 30 40 20

Costs, excluding overheadMaterial cost per brick $0.05 $0.04 $0.03Direct labor cost per brick 0.06 0.07 0.04

MultiBrick Data for Illustration

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ABC Analysis of Bricks

Material cost $ 300$ 160 $ 300Direct labor cost 360280 400Overhead:

Setup-based 1,800960 360Baking time 120100 600Customer order based 480 640 320

Total Cost $3,060$3,340 $ 8,280Divided by annual volume 6,000 4,000 100,000Average cost per brick $ 0.51$0.835 $ 0.83

MultiBrick Data for Illustration

Model A-42 Model A-88 Model C-11

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Comparison of Traditional Costs and Comparison of Traditional Costs and Activity-Based CostsActivity-Based Costs

Traditional Cost Approach:

Material cost $ 300 $160 $ 300Direct labor cost 360 280 400Overhead 480 320 8,000Total cost $1,140 $760 $15,000

Model A-42 Model A-88 Model C-11

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Comparison of Traditional Costs and Comparison of Traditional Costs and Activity-Based CostsActivity-Based Costs

Activity-Based Cost Approach:

Material cost $ 300 $ 160 $ 300Direct labor cost 360 280 400Overhead 2,400 2,900 1,200Total cost $3,080 $3,340 $8,200

Model A-42 Model A-88 Model C-11

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Consumption RatiosConsumption Ratios

Consumption ratios is the resource utilized by a given product divided by the total amount of the resource available.

Since MultiBrick is producing a total of 10,000,000 bricks, the consumption ratio of each model is:Model A-42: 6,000 bricks ÷ 10,000,000 = 0.06%Model A-88: 4,000 bricks ÷ 10,000,000 = 0.04%Model C-11: 100,000 bricks ÷ 10,000,000 = 1.00%

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Consumption RatiosConsumption Ratios

Model A-42: 120 setups ÷ 10,000 total = 1.50%Model A-88: 180 setups ÷ 10,000 total = 1.80%Model C-11: 30 setups ÷ 10,000 total = 0.30%

Model A-42: 60 hours ÷ 300,000 total = 0.0200%Model A-88: 50 hours ÷ 300,000 total = 0.0167%Model C-11: 300 hours ÷ 300,000 total = 0.1000%

Model A-42: 30 orders ÷ 5,000 total = 0.60%Model A-88: 30 orders ÷ 5,000 total = 0.80%Model C-11: 30 orders ÷ 5,000 total = 0.40%

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Who Uses ABC?Who Uses ABC?

• Productive/Service Costing 50%• Process Analysis 51%• Performance Management 49%• Profitability Assessment 38%• Value-Based Management 18%

Primary Objective

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Who Uses ABC?Who Uses ABC?

• Public Sector

40%• Service

24%• Manufacturing

24%• Consulting

11%

Industry

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Kinds of Variability

1. Unit level activities2. Batch level activities3. Sustaining activities4. Facility-sustaining or company-

sustaining activities

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Types of Activities (continued)

Unit level activities are those performed each time a unit is produced or sold.

Examples: Materials, components, drilling and welding

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Batch level activities are those that a company performs when it makes a group of units, regardless of how many units are in the batch.

Examples: Machine setups

Types of Activities (continued)

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Sustaining activities arise because a company does particular types of business, or maintains a particular product or service.

Examples: Advertising devoted to the product, engineering and development related to the product.

Types of Activities (continued)

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Facility-sustaining or company-sustaining activities and costs relate to an entire plant, office, or company as a whole.

Examples: Rent of the corporate headquarters building

Types of Activities (continued)

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ABC and EthicsABC and Ethics

Because some costs are on the borderline between being direct or indirect to a product or line, managerial accountants must use some judgment in assigning costs to products. Whenever decisions involve judgment, the potential for an ethical conflict exists.

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Activity-Based Management Activity-Based Management (ABM)(ABM)

Activity-Based Management (ABM) is using information about activities to

manage many aspects of an organization, rather than simply managing costs.

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Re-engineering describes the development of new ways to perform existing activities and ways to stop performing non-value-adding activities.

Benchmarking is the practice of comparing your company with some of the industry leaders.

Process value analysis (PVA) uses activity analysis to manage costs. PVA focuses on manufacturing processes and seeks to reduce or optimize the activities performed within a process.

Activity-Based Management Activity-Based Management (ABM)(ABM)

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Process Value Analysis (PVA)Process Value Analysis (PVA)

PVA focuses on manufacturing processes and seeks to reduce or optimize the activities

performed within a process.

Value-added: An operation that actually changes the physical aspects of the part.

Examples: Turning, milling, and drilling

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Process Value Analysis (PVA)Process Value Analysis (PVA)

PVA focuses on manufacturing processes and seeks to reduce or optimize the activities

performed within a process.Non-Value-added, but necessary: An

operation/activity that does not changes the physical aspects of the part, but is necessary in order to do so.

Examples: Setup time and inspecting

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Process Value Analysis (PVA)Process Value Analysis (PVA)

PVA focuses on manufacturing processes and seeks to reduce or optimize the activities

performed within a process.Non-Value-added, and unnecessary: An activity

that does not changes the physical aspects of the part and is not necessary for value added operations to be performed.

Examples: Queue time

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ABC/ABM and World-Class ABC/ABM and World-Class ManufacturingManufacturing

ABC is most beneficial for companies with a great deal of complexity and

diversity in their products and operations.

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ABC/ABM Analysis and ABC/ABM Analysis and Income ReportingIncome ReportingPatterson Homewares, Inc.

Income Statement for 20X4, in thousandsSales $300.4 $503.5 $623.3 $1,427.2Unit-level variable costs 190.1 161.1 249.3 600.5Unit-level C/M $110.3 $342.4 $374.0 $ 826.7Batch-level variable costs 9.6 26.4 52.8 88.8Batch-level C/M $100.7 $316.0 $321.2 $ 737.9Product-sustaining costs 89.2 56.7 73.7 219.6Product margin $ 11.5 $259.3 $247.5 $ 518.3Facility-sustaining costs 220.5Income $ 297.8

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The End

Chapter 4Chapter 4

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