Activity-Based Costing

Accy211: Management Accounting IIAutumn 2013

Week 5 1

Learning Objectives

1. Explain undercosting and overcosting of products or services

2. Understand a traditional product costing system3. Understand guidelines for refining a costing

system4. Understand an Activity Based Costing System 5. Understand how ABC differs from traditional

costing system6. Prepare ABC analysis (Comprehensive example)7. Limitations of activity-based costing systems

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3

Cost AllocationDirect

MaterialsDirect Labour

Direct Costs

Indirect Costs

Manufacturing Overhead

Cost Allocation Base

z One of the most difficult tasks in computing accurate unit costs lies in determining the proper amount of overhead cost to assign to each job.

z Factory overhead is applied to production in a rational systematic manner.

z The methods used often involve tradeoffs between simplicity and realism

z Historically, firms produced a limited variety of goods while their indirect costs were relatively small.

z Used broad averages to allocate costs (Peanut-butter Costing)

Learning Objective

1Explain undercosting and overcosting of products or

services

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Cost Smoothing(Peanut butter costing)

The term cost smoothing describes a particular costing approach that uses broad averages for assigning the cost of resources uniformly to cost objects when the products/services use those resources in a non-uniform way.

Cost smoothing can lead to undercosting or overcosting of product and services

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Undercosting and Overcosting ExampleJose, Rob, and Nancy order separate items for lunch.

Joses order amounts to $14Rob consumed 30Nancys order is 16Total $60What is the average cost per lunch?

$60 3 = $20

Jose and Nancyare overcosted.

Rob isundercosted.

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Learning Objective2

Understand a Traditional Product Cost System.

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Identify MOH costs

Select MOH cost allocation base

Compute MOH cost allocation rate

(1) Identify cost objects

(2) Identify direct costs

MOH costs allocated to the cost object

Product Cost

Direct Materials

Direct Labour

Direct Costs

Indirect Costs (MOH)

Period Costs

(4)Total Costs

(3) Compute the indirect costs of the job

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See example on page 8 for Single Plant Wide Indirect

Cost Pool System (Traditional Costing)

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Learning Objective

3Understand a guidelines for

refining a costing system

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The PresentzNumerous products with

more and complicated production requirements.zLabor is becoming an ever

smaller part component of total production costs.zIncrease in indirect costszAdvances in information

technologyzCompetition in foreign

markets

Rationale for selecting a more refined costing system

The PastzSmall number of

products which did not differ much in required manufacturing support.zLabor was the

dominant element in the cost structure.

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Guidelines for Refining a Costing System

Direct-cost tracing

Indirect-cost pools

Cost-allocation bases

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Learning Objective

4Understand Activity Based

Costing system

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Activity Based Costing

Refines a costing system by identifying individual activities as the fundamental objects.

Attempts to provide a more precise indirect cost allocation by tracing costs from activities to products.

Uses multiple cost drivers.

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Activities and Product CostsProducts require

activities.

Activities consumeresources.

Resources havecosts.

(1) Design products and processes. (2) Set up molding machine. (3) Operate machines to manufacture lenses. (4) Maintain and clean the molds. (5) Set up batches of finished lenses for shipment(6) Distribute lenses to customers. (7) Administer and manage all processes.

Activities-Example

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ActivityAn event that causes the consumption of

overhead resources.

Activity Cost Pool

A cost bucket in which costs related to a single

activity measure are accumulated.

$

$

$ $

$$

Activity Measure

An allocation basein an activity-based

costing system. The term cost driver is also used

to refer to an activity measure.

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Simple countof the number oftimes an activity

occurs.

Transactiondriver

A measureof the amountof time neededfor an activity.

Durationdriver

Two common types of activity measures:

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FundamentalCost Objects

Activity 1 Cost of Activity 1

Assignment toCost Objects

Cost of: Product Service

CustomerActivity 2

Activity 3

Cost of Activity 2

Cost of Activity 3

Cost Pools based on

Cost Hierarchy

Cost driver 2

Cost driver 1

Cost

drive

r 3

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Traditional cost systems usually rely on volumemeasures such as direct labor hours and/or machine

hours to allocate all overhead costs to products.

ABC definesfive levels of activity

that largely do not relateto the volume of units

produced.

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Cost Hierarchy (Activity Levels)

Manufacturingcompanies typically combine

their activities into fiveclassifications.

Unit-LevelActivity

Batch-Level Activity

Product-LevelActivity

Customer-LevelActivityOrganization-

sustainingActivity

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Unit-Level Activity CostsThese are resources sacrificed on activities performed on each individual unit of product or service. Examples: Energy, Machine deprecation, Repairs.

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Batch-Level Activity CostsThese are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. Examples: Setup hours, procurement cots.

Product-Level Activity CostsThese are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services. Examples: Design costs Engineering costs.

Facility Level Activity CostThese are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. Examples: General Administration, rent, building security

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Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009.

Indirect manufacturing labor costs such as supervision that supports direct manufacturing labor, $1,000,000(A)unit-level costs.(B)batch-level costs.(C)product-sustaining costs(D) facility-sustaining costs.

Quiz -1

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Teleport, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009.

Procurement costs of placing purchase orders, receiving materials, and paying suppliers related to the number of purchase orders placed, $500,000.

(A) unit-level costs.(B) batch-level costs.(C) product-sustaining costs(D)facility-sustaining costs.

Quiz - 2

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Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009.Costs incurred to set up machines each time a different product needs to be manufactured, $600,000.

(A)unit-level costs.(B)batch-level costs.(C)product-sustaining costs(D) facility-sustaining costs.

Quiz - 3

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Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009.

Designing processes, drawing process charts, making engineering process changes for products, $800,000.

(A)unit-level costs.(B)batch-level costs.(C)product-sustaining costs(D) facility-sustaining costs.

Quiz - 4

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Teledor, Inc., manufactures boom boxes. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2009.

Plant management, plant rent, and plant insurance, $900,000.

(A)unit-level costs.(B)batch-level costs.(C)product-sustaining costs(D) facility-sustaining costs.

Quiz - 5

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Learning Objective

5Understand how activity-based

costing differs from a traditional costing system.

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How ABC differs from traditional cost accounting

Manufacturingcosts

Nonmanufacturingcosts

n ABC assigns both types of costs to products.

Traditionalproduct costing

ABCproduct costing

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o ABC does not assign all manufacturing costs to products.

Manufacturingcosts

Nonmanufacturingcosts

Traditionalproduct costing

ABCproduct costing

All Most, butnot all

Som

e

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PlantwideOverhead

Rate

DepartmentalOverhead

Rates

ActivityBasedCosting

Number of cost pools

Leve

l of c

ompl

exity

p ABC uses more cost pools.

Each ABC cost pool has its own unique measure of activity.

Traditional cost systems usually rely on volume measures such as direct laborhours and/or machine hours to allocateall overhead costs to products.

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(4) Assign overhead costs to activity cost pools

(3) Define activities, Activity Cost Pools, and Activity Measures

(5) Calculate activity rates

(1) Identify cost objects

(2) Identify direct costs

(6) Assign overhead costs to cost object using activity rates and activity measures

(7) Compute the total

costs

Product costing with Activity Based Costing System

Direct Materials

Direct Labour

Direct Costs

Indirect Costs

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Activity 1

Total cost

Product costing with Activity Based Costing System

Direct Materials

Direct Labour

Direct Costs

Indirect Costs

Activity 2 Activity 3 Activity 4 Activity 5

In this process it is possible to trace some indirect costs as direct costs 34

Learning Objective

6Prepare ABC analysis

(Comprehensive example)

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See Activity Based Costing System Example

on page 9

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ActivityBased Costing ExampleBaxter Battery Company

DirectMaterials

DirectLabor

ShippingCosts Overhead Costs

First-Stage Allocation

Second-Stage Allocations

$/Order $/Change $/MH

UnallocatedSS LL

CustomerOrders

OrderSize Other

DesignChanges

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zCustomer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.zDesign Changes - assigned all costs of

resources consumed by customer requested design changes.zOrder Size - assigned all costs of resources

consumed as a consequence of the number of units produced.zOther assigned all organization-sustaining

costs and unused capacity costs

Activities, Activity Cost Pools and Activity Measures at Baxter Battery Company

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SureStarts LongLifesProduct margins traditional 7,600,000$ 1,400,000$ Product margins ABC 9,290,000 (5,230,000) Change in reported margins 1,690,000$ (6,630,000)$

The traditional cost system overcosts the SureStarts and

reports a lower product margin for this product.

The traditional cost system undercosts the LongLifes and

reports a higher product margin for this product.

Differences Between ABC and Traditional Product Costs and Major

Reasons for the differences

Can you see how different allocation methods might lead to making different management decisions? 39

40 60

0 100

60 40

0% 20% 40% 60% 80% 100%

Customer Orders

Design Changes

Order Size

SS LL

$6,350,000 Customer Orders

$6,040,000 Design changes

$3,450,000 Machine Hours

$15,840,000

1. traditional cost system allocates all manufacturing overhead costs using a volume-related allocation base (machine-hours). The ABC system uses volume-related and non-volume related allocation bases to assign manufacturing overhead to products

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SS LL

2. The ABC did not assign the manufacturing overhead costs included in the other activity ($3.7million) to products because these organization-sustaining and unused capacity costs are not caused by products.

3. traditional cost system disregards selling and administrative expenses because they are assumed to be period expenses. The ABC system directly traces shipping costs ($3,000,000) to products and includes nonmanufacturing overhead costs caused by products ($5,540,000)in the activity cost pools that are assigned to products

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Learning Objective

7Limitations of ABC costing

system

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Activity-Based Costing and External Reporting

Most companies do not use ABCfor external reporting because . . .1. External reports are less detailed than internal

reports.2. It may be difficult to make changes to the

companys accounting system.3. ABC does not conform to GAAP.4. Auditors may be suspect of the subjective

allocation process based on interviews with employees.

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ABC LimitationsSubstantial resourcesrequired to implement

and maintain.

Resistance tounfamiliar numbers

and reports.

Desire to fullyallocate all costs

to products.

Potentialmisinterpretation ofunfamiliar numbers.

Does not conform toGAAP. Two costing

systems may be needed.

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Signs that indicate ABC system is likely to provide most benefits

Significant amounts of indirect costs are allocated using only one or two cost pools. All or most costs are identified as output unit-level costs. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.Products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits.Complex products appear to be very profitable and simple products appear to be losing money. Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.

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ABC In Service andMerchandising Companies

z The general approach is very similar to the approach in manufacturing.

z Costs are divided into homogeneous cost pools and classified as output unit-level, batch-level, product-or service-sustaining, and facility-sustaining costs.

z The cost pools correspond to key activities. z Costs are allocated to products or customers using

activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool.

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Activity-Based Management

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

decisionsz Design decisionsz Planning and managing activities

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There is ABCin your future!

End

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Sales 50,000,000$ Cost of goods sold

Direct materials 15,000,000$Direct labor 12,000,000 Manufacturing overhead Indirect factory wages 6,000,000$ Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 14,000,000$ 41,000,000

Gross margin 9,000,000 Selling and administrative expenses

Shipping expenses 3,000,000 Marketing expenses 2,000,000 General administrative expenses 6,000,000 11,000,000

Net operating loss (2,000,000)$

Calculate the profit margin of each product using traditional costing system.

Step 1: Identify the product that are the chosen cost objects

SETP-2: Identify direct costs of the products800,000 400,000

SureStart LongLifesSalesDirect CostsDirect materialsDirect labour

Plant-wide POHR = $14,000,000 = 17.5mh800,000mh

SS:LL:

SureStart LongLifesTotal direct costs [STEP-2]Total indirect costs [STEP-3]Total product costsProduct marginLess: Selling & admin expenses

Net operating profit / (loss)Profit Margin per unit SS LL

RevenueLess: CostGross profitMargin

STEP 4: Compute the Total cost and profit margin of the products

STEP 3: Compute the indirect costs of the products

Example-Single Plant-wide Indirect Cost Pool System [Traditional Cost Accounting]

Baxter Battery CompanyIncome Statement

Year Ended December 31, 2009

Baxter Company manufactures 800,000 Sure starts batteries (SS) and 400,000 LongLifes batteries (LL). Direct costs for SS are: Direct materials $9,000,000; Direct labor $7,000,000. Direct costs for the LL are: Direct materials $6,000,000; Direct labour $5,000,000.Baxter currently uses a single plantwide overhead rate based on machine hours to allocate manufacturing overhead costs and 480,000 machine hours and 320,000 machine hours were used respectively to make SS and LL batteries. Total manufacturing overhead and the selling and administrative expenses for the year were $14,000,000 and $11,000,000 respectively. SS sells for $40 each and LL for $45 each. The income statement of the company for the year ended 31 December 2009 is as follows:

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Sales 50,000,000$ Cost of goods sold

Direct materials 15,000,000$Direct labor 12,000,000 Manufacturing overhead Indirect factory wages 6,000,000$ Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 14,000,000$ 41,000,000

Gross margin 9,000,000 Selling and administrative expenses

Shipping expenses 3,000,000 Marketing expenses 2,000,000 General administrative expenses 6,000,000 11,000,000

Net operating loss (2,000,000)$

1

2Activity Cost Pool Activity Measure Total activitiesCustomer orders Number of customer orders 10,000 customer ordersDesign changes Number of design changes 4,000 design changesOrder size Machine-hours 800,000 machine hrsOther Not applicable Not applicable

Continued next page

Baxter Company manufactures 800,000 Sure starts batteries (SS) and 400,000 LongLifes batteries (LL). Direct costs for SS are: Direct materials $9,000,000; Direct labor $7,000,000. Direct costs for the LL are: Direct materials $6,000,000; Direct labour $5,000,000.Baxter currently uses a single plantwide overhead rate based on machine hours to allocate manufacturing overhead costs and 480,000 machine hours and 320,000 machine hours were used respectively to make SS and LL batteries. Total manufacturing overhead and the selling and administrative expenses for the year were $14,000,000 and $11,000,000 respectively. SS sells for $40 each and LL for $45 each. The income statement of the company for the year ended 31 December 2009 is as follows:

Example-Activity Based Costing System

All indirect cost items are now classified as follows:

The Company is implementing an activity based costing system that has four activity cost pools. You are provided the following information

Direct materials and direct labor are remained to be direct costs. With the ABC analysis, the costs of Shipping ($3,000,000) have also been traced to the two products directly as follows:SS $2,000,000 and LL $1,000,000

Baxter Battery CompanyIncome Statement

Year Ended December 31, 2009

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Production Department Indirect factory wages 6,000,000$ Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 14,000,000$General Administrative Department Administrative wages and salaries 4,000,000 Office equipment depreciation 900,000 Administrative building lease 1,100,000 6,000,000 Marketing Department Marketing wages and salaries 1,500,000 Selling expenses 500,000 2,000,000 Total overhead costs 22,000,000$

Customer Orders

Design changes

Order Size Other Total

Production DepartmentIndirect factory wages 40% 30% 20% 10% 100%Factory equipment depreciation 0% 60% 30% 10% 100%Factory utilities 0% 40% 30% 30% 100%Factory building lease 0% 0% 0% 100% 100%

General Administrative DepartmentAdministrative wages and salaries 60% 10% 10% 20% 100%Office equipment depreciation 50% 10% 0% 40% 100%Administrative building lease 0% 0% 0% 100% 100%

Marketing DepartmentMarketing wages and salaries 60% 30% 0% 10% 100%Selling expenses 40% 40% 10% 10% 100%

5)

Customer OrdersDesign changes

Order Size

Calculate the profit margin of each product using ABC system.

To

requires 36 minutes of machine time for a total

of 480,000 machine hours

requires 48 minutes of machine time for a total of 320,000 machine-hours

4000 custom designsRequires no new design changes

(Manufacturing and Nonmanufacturing)

Activity Cost Pools

SureStart LongLifeActivity usage by each product is as follows:

4) At Baxter Battery the following distribution of resource consumption across activity cost pools is determined.

3) The total overhead costs to be analyzed using ABC are as follows:

4000 separate orders 6000 separate orders

Overhead Costs at Baxter Battery

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Step 1: Identify the product that are the chosen cost objectsSS-800,000 LL-400,000

SETP-2: Identify direct costs of the products800,000 400,000

SureStart LongLifesSales $32,000,000 $18,000,000 $50,000,000Direct CostsDirect materials $9,000,000 $6,000,000 $15,000,000Direct labour $7,000,000 $5,000,000 $12,000,000Shipping expenses $2,000,000 $1,000,000 $3,000,000Total direct costs $18,000,000 $12,000,000 $30,000,000

Activity Cost Pool Activity Measure Total activitiesCustomer orders Number of customer orders 10,000 customer ordersDesign changes Number of design changes 4,000 design changesOrder size Machine-hours 800,000 machine hrsOther Not applicable Not applicable

Activity Cost Pools Total CostCustomer orders 6,350,000$ Design changes 6,040,000 Order size 3,450,000 Other 6,160,000 Total 22,000,000$

(a) (b) (a) (b)Activity Cost Pools Total Cost Total Activity Activity Rate

Customer orders 6,350,000$ 10,000 orders $635 per orderDesign changes 6,040,000 4,000 changes $1510 per changeOrder size 3,450,000 800,000 MHs $4.3125 per MHOther 6,160,000 Not applicable Not applicableTotal 22,000,000$

Quantitiy of allocation base SS LLCustomer orders 4000 orders 6000 ordersDesign changes 0 new designs 4000 new designsOrder size 480000 mh 320000 mh

Overehad costs for two products SS LL TotalCustomer orders $2,540,000 $3,810,000 $6,350,000Design changes $0 $6,040,000 $6,040,000Order size $2,070,000 $1,380,000 $3,450,000 Total indirect costs-STEP-6 $4,610,000 $11,230,000 $15,840,000

Sales $32,000,000 $18,000,000 $50,000,000Direct costs (STEP-2) $18,000,000 $12,000,000 $30,000,000Indirect costs (STEP-6) $4,610,000 $11,230,000 $15,840,000Total product costs $22,610,000 $23,230,000 $45,840,000Product margin $9,390,000 -$5,230,000 $4,160,000Less: Other 6,160,000 Net operating profit/ (loss) (2,000,000)

STEP 3: define activity cost pools and activity measures

Answer: Activity Based Costing Sample Question

STEP 4: Assign overhead costs to activity cost pools

STEP 5: Calculates activity rates

STEP 6: assigning overheads to products

STEP 7: Compute the product Margins

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Production Department Indirect factory wages 6,000,000$ Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 14,000,000$General Administrative Department Administrative wages and salaries 4,000,000 Office equipment depreciation 900,000 Administrative building lease 1,100,000 6,000,000 Marketing Department Marketing wages and salaries 1,500,000 Selling expenses 500,000 2,000,000 Total overhead costs 22,000,000$

Customer Orders

Design changes

Order Size Other Total

Production DepartmentIndirect factory wages 40% 30% 20% 10% 100%Factory equipment depreciation 0% 60% 30% 10% 100%Factory utilities 0% 40% 30% 30% 100%Factory building lease 0% 0% 0% 100% 100%

General Administrative DepartmentAdministrative wages and salaries 60% 10% 10% 20% 100%Office equipment depreciation 50% 10% 0% 40% 100%Administrative building lease 0% 0% 0% 100% 100%

Marketing DepartmentMarketing wages and salaries 60% 30% 0% 10% 100%Selling expenses 40% 40% 10% 10% 100%

Customer Orders

Design changes Order Size Other Total

Production DepartmentIndirect factory wages 2,400,000$ 1,800,000$ 1,200,000$ 600,000$ 6,000,000$ Factory equipment depreciation - 2,100,000 1,050,000 350,000 3,500,000 Factory utilities - 1,000,000 750,000 750,000 2,500,000 Factory building lease - - - 2,000,000 2,000,000

General Administrative Department - - - - - Administrative wages and salaries 2,400,000 400,000 400,000 800,000 4,000,000 Office equipment depreciation 450,000 90,000 - 360,000 900,000 Administrative building lease - - - 1,100,000 1,100,000

Marketing Department - - - - - Marketing wages and salaries 900,000 450,000 - 150,000 1,500,000

To Selling expenses 200,000 200,000 50,000 50,000 500,000 Total 6,350,000$ 6,040,000$ 3,450,000$ 6,160,000$ 22,000,000$

Activity Cost Pools Total CostCustomer orders 6,350,000$ Design changes 6,040,000 Order size 3,450,000 Other 6,160,000 Total 22,000,000$

SS LLRevenue $40.00 $45.00Less: Cost $28.26 $58.08Gross profit $11.74 -$13.08Margin 29% -29%

Workings-1: Step-4 assign overhead costs to activity cost

ABC Profit Margin per unit

Activity Cost Pools

Activity Cost Pools

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