IE 475

Advanced Manufacturing Costing Techniques

Lecture Notes #4

Activity Based Costing

2

Topic Learning Objectives

After completing this module, IE 475 students should be able to: Understand the strategic role of activity-based costing

(ABC) Understand why traditional (i.e., volume-based) costing

systems tend to overcost/undercost products or services Describe ABC; the steps in developing an ABC system;

and the benefits and limitations of an ABC system Compute and contrast product costs using volume-based

and ABC systems

3

Topic Learning Objectives (cont.)

After completing this module, IE 475 students should be able to (cont.): Understand the objectives of an activity-based

management system Relate activity-based costing to strategic cost management Understand the limitations of a traditional ABC system

when implemented in a large-scale setting Understand the main features of Time-Driven ABC Understand the advantages of Time-Driven ABC and its

reporting capabilities

4

Limitations of TraditionalCosting Systems

Recent changes in manufacturing and business environments have made traditional (i.e., volume-based) costing systems unreliable and inaccurate

Examples

5

Limitations of Volume-BasedCosting Systems

Volume-based costing is often inadequate because indirect costs do not always occur in proportion to output volume

Volume-based costing generally causes miscosting of outputs It generally overcosts some products and undercosts

others Volume-based costing can create inappropriate

incentives for managers e.g., more volume equates to more overhead expense

6

Limitations of Volume-Based Costing Systems (cont.)

Strategies to allocate overhead in volume-based costing systems Plant-wide allocation

Simple but omits allocation of service department costs

Departmental rate Provides more detailed cost measures,

particularly if the departments perform quite different activities

7

Volume-based Costing System Example:Single Plant-wide Overhead Rate

Dole Company has two divisions: Machining (highly Dole Company has two divisions: Machining (highly automated) and Finishing (labor-intensive). The company automated) and Finishing (labor-intensive). The company uses a single plant-wide overhead rate based upon labor uses a single plant-wide overhead rate based upon labor

hours.hours.

Dole Company has two divisions: Machining (highly Dole Company has two divisions: Machining (highly automated) and Finishing (labor-intensive). The company automated) and Finishing (labor-intensive). The company uses a single plant-wide overhead rate based upon labor uses a single plant-wide overhead rate based upon labor

hours.hours.

Annual Budget DataMachining

DivisionFinishing Division Total

Budgeted overhead 400,000$ 200,000$ 600,000$ Budgeted labor hours 10,000 50,000 60,000 Budgeted machine hours 20,000 4,000 24,000

Single Plant-wideOverhead Rate

= =

8

Volume-based Costing System Example:Single Plant-wide Overhead Rate (cont.)

Dole spent the following hours in July to manufacture 2,000 Dole spent the following hours in July to manufacture 2,000 units of each of its two products: Widget and Gidget.units of each of its two products: Widget and Gidget.

Dole spent the following hours in July to manufacture 2,000 Dole spent the following hours in July to manufacture 2,000 units of each of its two products: Widget and Gidget.units of each of its two products: Widget and Gidget.

MachiningDivision

FinishingDivision

TOTAL

Widget:

Labor hrs 500 4,000 4,500

Machine hrs 900 300 1,200

Gidget:

Labor hrs 500 1,000 1,500

Machine hrs 1,000 300 1,300

9

Volume-based Costing System Example:Single Plant-wide Overhead Rate (cont.)

Using the pre-determined plantwide overhead rate of $10 per Using the pre-determined plantwide overhead rate of $10 per direct labor hour, the firm calculates factory overhead costs direct labor hour, the firm calculates factory overhead costs

for these two products as follows:for these two products as follows:

Using the pre-determined plantwide overhead rate of $10 per Using the pre-determined plantwide overhead rate of $10 per direct labor hour, the firm calculates factory overhead costs direct labor hour, the firm calculates factory overhead costs

for these two products as follows:for these two products as follows:

Total DLH Overhead Rate/DLH

Total Overhead

Widget 4,500 $10

Gidget 1,500 $10

Total

Widget Overhead Cost per Unit

=

Gidget Overhead Cost per Unit

=

=

=

10

Volume-based Costing System Example:Single Plant-wide Overhead Rate (cont.)

A plantwide overhead rate assumes that all products or services benefit from or consume overhead costs in proportion to the quantity of the chosen activity (driver) for applying overhead In the previous example, the assumption is that each

direct labor hour spent on Widget uses the same amount of overhead as each direct labor hour spent on Gidget

11

Volume-based Costing System Example:Departmental Overhead Rates

To obtain more accurate product costing, the company To obtain more accurate product costing, the company decided to use departmental overhead rates. The overhead decided to use departmental overhead rates. The overhead

in Machining is to be based on machine hours, and in Machining is to be based on machine hours, and Finishing will use labor hours. Finishing will use labor hours.

To obtain more accurate product costing, the company To obtain more accurate product costing, the company decided to use departmental overhead rates. The overhead decided to use departmental overhead rates. The overhead

in Machining is to be based on machine hours, and in Machining is to be based on machine hours, and Finishing will use labor hours. Finishing will use labor hours.

Machining Overhead Rate

=

Finishing Overhead Rate

=

=

=

12

Volume-based Costing System Example:Departmental Overhead Rates (cont.)

Using the new departmental overhead rates, the factory Using the new departmental overhead rates, the factory overhead cost assigned to the two products is:overhead cost assigned to the two products is:

Using the new departmental overhead rates, the factory Using the new departmental overhead rates, the factory overhead cost assigned to the two products is:overhead cost assigned to the two products is:

Widget Gidget

Machining Division

Finishing Division

Overhead applied

Units manufactured

Overhead / unit

13

Volume-based Costing System Example:Departmental Overhead Rates (cont.)

The following table summarizes the amounts of applied The following table summarizes the amounts of applied overhead in July with different overhead application rates:overhead in July with different overhead application rates:The following table summarizes the amounts of applied The following table summarizes the amounts of applied

overhead in July with different overhead application rates:overhead in July with different overhead application rates:

Total OverheadOverhead /

UnitTotal

OverheadOverhead /

Unit

Widget 45,000$ 22.50$ 34,000$ 17.00$

Gidget 15,000 7.50 24,000 12.00

Total 60,000$ 58,000$

Plantwide Rate Based on DLH Departmental Rate

14

Limitations of Volume-Based Costing Systems

A traditional volume-based overhead costing system, whether plantwide or departmental, often leads to inaccurate product costs Especially for firms with complex manufacturing operations

Distortions of volume-based overhead cost systems increase as product diversity increases

Inaccurate cost information can lead to undesirable strategic results Wrong product-line decisions Unrealistic pricing Ineffective resource allocations

15

Applicability of Volume-Based Costing Systems

Volume-based costing systems are appropriate generally when direct costs are the major cost of the product or service and the activities supporting its production are relatively simple, low-cost, and homogeneous across different product lines

Although often inadequate, volume-based costing may be a good strategic choice for some firms, e.g., Paper product manufacturers Producers of agricultural products, and Professional service firms

16

Activity-Based CostingDefinition

Activity-Based Costing (ABC) is a costing approach that assigns resource costs to cost objects based on activities performed for the cost objects ABC uses detailed information about the activities that

make up indirect (support) costs so that outputs are charged only for resources consumed

Volume-based costing systems allocate cost

ABC costing traces the significant activities (and ultimately the cost)

17

Strategic Role ofActivity-Based Costing

ABC is a method for determining accurate costs Accurate cost information provides a competitive

advantage It helps a company or organization to develop and to

execute its strategy by providing accurate information about the cost of Products and services Serving its customers Dealing with its suppliers Supporting business processes within the company

18

Strategic Role ofActivity-Based Costing (cont.)

For firms following a cost leadership strategy, ABC helps in identifying key activities, cost drivers, and ways to improve processes to reduce cost

For firms following a differentiation strategy, ABC can help to:1. Identify value-enhancement opportunities

2. Develop a customer strategy

3. Support a technological leadership strategy

4. Establish a pricing strategy

19

Activity-Based Costing Terminology

Activity Action or an aggregation of actions performed

within an organization E.g., production setup, customer inquires, etc.

Resource Economic element needed or consumed in

performing activities E.g., salaries and supplies, space, time

20

Activity-Based Costing Terminology (cont.)

A cost driver is either a resource consumption cost driver or an activity consumption cost driver Resource consumption cost driver

Measures the amount of resources consumed by an activity, e.g., number of minutes used to fulfill a customer order

Activity consumption cost driver Measures the amount of activity performed for a

cost object, e.g., number of batches used to manufacture product Y

21

Activity-Based Costing Terminology (cont.)

Resource vs. Activity Consumption Cost Drivers

Source: Roztocki, N., Porter, J.D., Thomas, R.M., Needy, K.L. (2004). “A Procedure for Smooth Implementation of Activity Based Costing in Small Companies,” ASEM Engineering Management Journal, Vol. 16, No. 4, pp. 19-27.

22

Activity-Based CostingTwo-Stage Cost Assignment

A two-stage cost assignment assigns factory overhead costs to activity centers or cost pools and then to costs objects

ABC systems differ from traditional volume-based costing systems in two ways: Defines cost pools as activities or activity centers

rather than production plant or department cost centers

The cost drivers used to assign activity costs to cost objects are based on an activity or activities performed for the cost objects

23

Two-Stage Cost Assignment:Traditional vs. ABC

Resources

Direct Materialsand Direct Labor

Indirect Costs(Overhead)

Cost Pools: The plant or the

departments in the plant

Cost Objects

Resources

Direct Materialsand Direct Labor

Indirect Costs(Overhead)

Cost Pools: The activities in the

plant

Cost Objects

First stage: Direct mat’s and labor assigned to cost objects

First stage: overhead costs assigned to department directly or aggregated to plant level

First stage: Direct mat’s and labor assigned to cost objects

First stage: overhead costs assigned to activities using resource consumption cost drivers

Second stage: Plant level or departmental costs assigned to cost objects using volume-based cost drivers

Second stage: Activity cost pools assigned to cost objects using activity consumption cost drivers

Exhibit 5.1 The Volume-Based Two-Stage Procedure Exhibit 5.2 The Activity-Based Two-Stage Procedure

24

Steps in Designing anABC System

There are three steps in the development of an ABC system: 1. Identify resource costs and activities (Stage One)

An activity analysis is performed to identify key activities and the way in which the activities consume resources

2. Assign resource costs to activities (Stage One) Use resource consumption cost drivers based on cause-

and-effect relationships, such as the number of labor hours, setups, moves, machine-hours, employees, or square feet to assign resource costs

The assignment is made through either direct tracing or estimation

25

Steps in Designing anActivity-Based Costing System

3. Assign activity costs to cost objects (Stage Two) Use activity consumption cost drivers, such as purchase

orders, receiving reports, parts stored, direct labor-hours, or manufacturing cycle time to assign activity costs

26

Activity-Based CostingTwo-Stage Cost Assignment

Source: Roztocki, N., Porter, J.D., Thomas, R.M., Needy, K.L. (2004). “A Procedure for Smooth Implementation of Activity Based Costing in Small Companies,” ASEM Engineering Management Journal, Vol. 16, No. 4, pp. 19-27.

27

Applicability of Activity-Based Costing Systems

ABC should be implemented when The cost of measuring the activities and their

costs is reduced, perhaps because of computerized scheduling systems on the production floor

Stronger competition increases the cost of errors caused by erroneous pricing

Product diversity is high in volume, size, or complexity

28

Activity Analysis for ABC

This process includes gathering data from existing documents and records, as well as collecting additional data using questionnaires, observations, or interviews of key personnel

Sample questions include: What work or activities do you do? How much time do you spend performing these activities? What resources are required to perform these activities? What value does the activity have for the product, service,

customer, or organization?

29

Benefits and Limitations of an ABC System

1. Better profitability measures due to more accurate costs

2. Identification of value-added vs. non-value-added activities and associated costs

3. Information for process improvement

4. Improved cost estimation5. Helps identify and control

the cost of unused capacity

1. Some costs may require allocations to departments and products based on arbitrary volume measures

2. Some costs that can be identified with specific products are omitted

3. Expensive and time-consuming to develop and implement

4. Possible managerial resistance to ABC results

Benefits Limitations

30

Comparison of Volume-Based and Activity-Based Costing Systems

The following example (Haymarket BioTech, Inc.) contrasts Steps 2 and 3 of the traditional

volume-based costing system using direct labor-hours as the cost driver with an activity-based costing system that uses both volume-based

and non-volume based cost drivers

31

Comparison of Volume-Based and Activity-Based Costing Systems (cont.)

Haymarket BioTech, Inc. (HBT) produces and sells two Haymarket BioTech, Inc. (HBT) produces and sells two secure communication systems, AW (Anywhere) and SZ secure communication systems, AW (Anywhere) and SZ

(SecureZone). HBT has the following operating data for the (SecureZone). HBT has the following operating data for the two products:two products:

Haymarket BioTech, Inc. (HBT) produces and sells two Haymarket BioTech, Inc. (HBT) produces and sells two secure communication systems, AW (Anywhere) and SZ secure communication systems, AW (Anywhere) and SZ

(SecureZone). HBT has the following operating data for the (SecureZone). HBT has the following operating data for the two products:two products:

AW SZ

Production Volume 5,000 20,000

Selling Price $400.00 $200.00

Unit Direct Materials and Labor

$200.00 $80.00

Total Direct Labor Hours 25,000 75,000

Direct Labor Hours per Unit 5 3.75

32

Volume-Based Costing System

The traditional volume-based costing system that the firm uses assigns The traditional volume-based costing system that the firm uses assigns factory overhead (OH) based on direct labor-hours (DLH). The firm has a factory overhead (OH) based on direct labor-hours (DLH). The firm has a total budgeted overhead of $2,000,000. Since the firm budgeted 100,000 total budgeted overhead of $2,000,000. Since the firm budgeted 100,000 direct labor hours for the year, the overhead rate per direct labor hour is direct labor hours for the year, the overhead rate per direct labor hour is

$20 per direct labor hour:$20 per direct labor hour:

The traditional volume-based costing system that the firm uses assigns The traditional volume-based costing system that the firm uses assigns factory overhead (OH) based on direct labor-hours (DLH). The firm has a factory overhead (OH) based on direct labor-hours (DLH). The firm has a total budgeted overhead of $2,000,000. Since the firm budgeted 100,000 total budgeted overhead of $2,000,000. Since the firm budgeted 100,000 direct labor hours for the year, the overhead rate per direct labor hour is direct labor hours for the year, the overhead rate per direct labor hour is

$20 per direct labor hour:$20 per direct labor hour:

Total Overhead =Total Direct Labor Hours =

Overhead rate per DLH =

33

Volume-Based Costing System (cont.)

Since the firm spent 25,000 direct labor hours to manufacture 5,000 units Since the firm spent 25,000 direct labor hours to manufacture 5,000 units of AW, the factory overhead assigned to AW is $500,000 in total and $100 of AW, the factory overhead assigned to AW is $500,000 in total and $100

per unit:per unit:

Since the firm spent 25,000 direct labor hours to manufacture 5,000 units Since the firm spent 25,000 direct labor hours to manufacture 5,000 units of AW, the factory overhead assigned to AW is $500,000 in total and $100 of AW, the factory overhead assigned to AW is $500,000 in total and $100

per unit:per unit:

The factory overhead for SZ is $1,500,000 in total and $75 per unit since The factory overhead for SZ is $1,500,000 in total and $75 per unit since the firm spent 75,000 direct labor hours to manufacture 20,000 units of SZ:the firm spent 75,000 direct labor hours to manufacture 20,000 units of SZ:The factory overhead for SZ is $1,500,000 in total and $75 per unit since The factory overhead for SZ is $1,500,000 in total and $75 per unit since

the firm spent 75,000 direct labor hours to manufacture 20,000 units of SZ:the firm spent 75,000 direct labor hours to manufacture 20,000 units of SZ:

Total OH assigned to AW =Number of units of AW =

Factory Overhead per unit of AW =

Total OH assigned to SZ =Number of units of SZ =

Factory Overhead per unit of SZ =

34

Product Profitability AnalysisVolume-Based Costing System

AW SZ

Unit Selling Price $400 $200

Unit Product Cost:

Direct Materials and Labor $200 $80

Factory Overhead

Cost per unit

Product Margin

35

Activity-Based Costing System

In an attempt to use an activity-based costing, HBT has In an attempt to use an activity-based costing, HBT has identified the following activities, budgeted costs, and activity identified the following activities, budgeted costs, and activity

consumption cost drivers:consumption cost drivers:

In an attempt to use an activity-based costing, HBT has In an attempt to use an activity-based costing, HBT has identified the following activities, budgeted costs, and activity identified the following activities, budgeted costs, and activity

consumption cost drivers:consumption cost drivers:

Budgeted Activity Consumption

Activity Cost Cost Driver

Engineering $125,000 Engineering hours

Setups 300,000 Number of setups

Machine running 1,500,000 Machine-hours

Packing 75,000 Number of packing orders

Total $2,000,000

36

Activity-Based Costing System (cont.)

HBT also has gathered the following operating data pertaining HBT also has gathered the following operating data pertaining to each of its products:to each of its products:

HBT also has gathered the following operating data pertaining HBT also has gathered the following operating data pertaining to each of its products:to each of its products:

AC Cost Driver AW SZ Total

Engineering Hours 5,000 7,500 12,500

Number of Setups 200 100 300

Machine Hours 50,000 100,000 150,000

Packing Orders 5,000 10,000 15,000

37

Activity-Based Costing System (cont.)

Using the gathered data, the cost driver rate for each activity Using the gathered data, the cost driver rate for each activity consumption cost driver is calculated as follows:consumption cost driver is calculated as follows:

Using the gathered data, the cost driver rate for each activity Using the gathered data, the cost driver rate for each activity consumption cost driver is calculated as follows:consumption cost driver is calculated as follows:

(1)

AC Cost Driver

(2)

Budgeted Cost

(3)

Activity Consumption

(4) = (2)/(3)

Activity Rate

Engineering Hours

Number of Setups

Machine Hours

Packing Orders

38

Activity-Based Costing System (cont.)

Factory overhead costs are assigned to both products by Factory overhead costs are assigned to both products by these calculations:these calculations:

Factory overhead costs are assigned to both products by Factory overhead costs are assigned to both products by these calculations:these calculations:

(1)

AC Cost Driver

(2)

Activity Rate

(3)

Activities

(4) = (2)x(3)

Total OH Rate

(5)

OH per unit

Engineering Hours $10 5,000

Number of Setups $1,000 200

Machine Hours $10 50,000

Packing Orders $5 5,000

AW = 5,000 units

39

Activity-Based Costing System (cont.)

Factory overhead costs are assigned to both products by Factory overhead costs are assigned to both products by these calculations:these calculations:

Factory overhead costs are assigned to both products by Factory overhead costs are assigned to both products by these calculations:these calculations:

(1)

AC Cost Driver

(2)

Activity Rate

(3)

Activities

(4) = (2)x(3)

Total OH Rate

(5)

OH per unit

Engineering Hours $10 7,500

Number of Setups $1,000 100

Machine Hours $10 100,000

Packing Orders $5 10,000

SZ = 20,000 units

40

Product Profitability Analysis Activity-Based Costing System

AW SZ

Unit Selling Price $400.00 $200.00

Unit Product Cost:

Direct Materials and Labor $200.00 $80.00

Factory Overhead:

Engineering Hours

Number of Setups

Machine Hours

Packing Orders

Cost per unit

Product Margin

41

Comparison of AlternativeCosting Approaches

42

Comparison of Volume-based and ABC: Conclusions

One major limitation of a traditional volume-based costing system is that it tends to undercost complex low-volume products and overcost high-volume products Referred to as cross-subsidization

Distorted or inaccurate product costing can lead to inappropriate inventory valuations, unrealistic pricing, ineffective resource allocations, misplaced strategic focus, misidentified CSFs, and lost competitive advantage

The ABC system presents a more accurate measurement of product costs by tracing overhead consumption

43

Time-Driven ABC1

Overcomes the time and cost demands of creating and maintaining large-scale ABC systems

Provides managers with a far more flexible cost model to capture the complexities of their operations

Relies on informed managerial estimates rather than on employee surveys

1 Kaplan, R.S. and Anderson, S.R. (2004). Time-Driven Activity-Based Costing. Harvard Business Review, Vol. 82, Issue 11, pp. 131-138.

44

Traditional ABC and Large-Scale Implementations

Large-scale implementations require lots of data collection A bank’s brokerage operation required 70,000 employees

at 100 locations to submit monthly reports of their time allocation

The ABC system needed 14 full-time employees to do data-collection, processing and reporting

Large-scale ABC systems are updated infrequently due to the time and costs required to re-interview and re-survey employees Under these conditions, estimates of costs of processes,

products and customers soon become inaccurate

45

Traditional ABC and Complex Operations

Consider the activity “ship order to customer”

Example Hendee Enterprises’ ABC system took three days to

calculate costs for its 40 departments, 150 activities, 10,000 orders, and 45,000 line items

46

Estimating Time in Traditional ABC Systems

Time spent by employees on activities is collected via interviews and/or surveys

People invariably report percentages that add up to 100 Few report idle or unused time

Cost driver rates are calculated assuming resources are working at full capacity Thus, estimated cost-driver rates are usually much too

high

47

Approach of Time-Driven ABC

Managers directly estimate resource demands imposed by each transaction, product, or customer

For each group of resources, only two parameters are required

Provides more accurate cost-driver rates by allowing unit times to be estimated even for complex, specialized transactions

48

Estimate #1: Cost per Time Unit of Capacity

Estimated by managers as a percentage of the theoretical capacity ~ 85% for machines; ~ 80% for people

Could also review past activity levels Period with largest volume of activity handled w/o excessive

delays, poor quality, overtime or stressed employees Do not be overly sensitive to small errors

Objective within 5% to 10% of actual number Process of running the model will eventually reveal big errors

49

Estimate #2: Unit Times of Activities

Obtained through employee interviews or by direct observation

In large organizations, surveying may be helpful However, question is not about the % of time an employee

spends doing an activity (e.g., processing orders) but how long it takes to complete one unit of that activity (e.g., time to process one order)

Cost-driver rates can now be calculated by multiplying the two estimates

50

Time Equations to Capture Complexity

Traditional ABC assumption: “All transactions of a particular type are the same and

require the same amount of time to process” Time-driven ABC models reflect how order and

activity characteristics cause processing times to vary

Key insights: Managers can usually identify which variables make

transactions complicated These variables are typically already recorded in a

company’s information system

51

Time Equations to Capture Complexity: Example

Traditional ABC model Three separate activities in the inside sales department at Hunter

Corporation Customer setup, order entry and order expediting

Time-driven ABC Single departmental process Inside sales order entry

5 min to enter basic order info +3 min for each line item +10 min if order needs to be expedited +15 min if new customer

52

Advantages of Time-Driven ABC

Enables managers to report costs on an on-going basis Reveals both the cost of a business’ activities and the time

spent on them Reports highlight the difference b/w capacity supplied (both

quantity and cost) and the capacity used

Managers can easily update cost-driver rates Model is updated on the basis of events rather than

on the calendar (quarterly or annually) Provides more accurate reflection of current conditions

53

Time-Driven ABC Reporting

This reporting template for time-driven ABC shows the customer service department's costs in the second quarter of operations. Here we assume that the department processes 51,000 customer orders, handles 1,150 inquiries, and performs 2,700 credit checks. The data reveal that the company supplied $85,120 worth of unused resource capacity during this period, representing opportunities for savings or growth depending on the company's circumstances. Activity Quantity Unit Time Total Time Used

(in minutes) Cost-Driver

Rate Total Cost Assigned

Process customer order

51,000 8 408,000 $6.40 $326,400

Handle customer inquires

1,150 44 50,600 $35.20 $40,480

Perform Credit Checks

2,700 50 135,000 $40.00 $108,000

Total Used 593,600 $474,880

Total Supplied 700,000 $560,000

Unused Capacity 106,400 $85,120