7/30/2019 Chap 7 - ActivityBasedCosting
1/53
CHAPTER
SEVEN
Activity-basedCosting
7/30/2019 Chap 7 - ActivityBasedCosting
2/53
Object ives
Understand ABC and how it differsfrom a traditional costing system
Cost distortion caused by traditionalcosting system
Understand how costs are treatedunder ABC
Designing ABC system
7/30/2019 Chap 7 - ActivityBasedCosting
3/53
Cost Allocations
DirectCosts
CostObjects
Indirect
Costs
TraditionalCosting
ABC
7/30/2019 Chap 7 - ActivityBasedCosting
4/53
Traditional Costing
Determination of Overhead Rates
- Plant-wide rate
- Departmental rate Distortions caused by traditional
allocations
- based on unit-related measures- differences in relative consumption ratios
7/30/2019 Chap 7 - ActivityBasedCosting
5/53
Determination of overhead rates
Overhead rate = Normal cost of support activity
Normal level of cost driver
Consider: use of plant-wide overhead rate vsdepartmental overhead rate
7/30/2019 Chap 7 - ActivityBasedCosting
6/53
Plant-wide/blanket overhead rate ordepartmental rate?
Dept A Dept B Dept C Total
Overheads $200,000 $600,000 $100,000 $900,000
DLHs 20,000 20,000 20,000 60,000
OH Rate
7/30/2019 Chap 7 - ActivityBasedCosting
7/53
Product Z: 20 DLH in Dept C; but not passthru Dept A & B. Overhead costs allocatedto Z:
If use plant-wide rate:
If use dept rate:
Which to use?
7/30/2019 Chap 7 - ActivityBasedCosting
8/53
Traditional Cost Distortions
Machine
Setup
Machining Assembly
Setup Costs $200,000 $120,000 $80,000
Setup hours 480 320
7/30/2019 Chap 7 - ActivityBasedCosting
9/53
Traditional Cost Distortions
Products
Relevant Factors A B
Batch size, number of units 800 200
Setup hours required
Machining 3 3
Assembly 2 2Normal prod., no. of units 64,000 16,000
Normal prod., no. of batches 80 80
7/30/2019 Chap 7 - ActivityBasedCosting
10/53
Traditional Cost Distortions
Setup costs per hour =
=
Setup costs =Product A: =
Product B: =
7/30/2019 Chap 7 - ActivityBasedCosting
11/53
Trad./two stage allocationsBoth products use 0.1 machine hours in each
production dept.
Overhead rate: Machining ==
Assembly =
=Setup costs/unit for both products
=
7/30/2019 Chap 7 - ActivityBasedCosting
12/53
Reasons for cost distortions:
Allocations based on unit-relatedmeasures
Product A - produced in larger batches.
It is charged the same rate ($2.50) asproduct B coz of the use of MH as thebasis to allocate overhead costs which isdriven by batch-related measures (e.g.
machine setups)Product A over cost; B under cost.
7/30/2019 Chap 7 - ActivityBasedCosting
13/53
Reasons for cost distortions:
Differences in relative consumption ratiosProduct A needs 0.00625 setup hours perunit (5/800), while B needs 0.02500(5/200)
Both need same number of MH/unit (0.1)
Actual consumption ratio = 1:4
(0.00625/0.02500)
If use MH consumption ratio = 1:1
(0.1:0.1)
Product A over cost; B under cost
7/30/2019 Chap 7 - ActivityBasedCosting
14/53
How to deal with this problem?
Design a costing system that use actual costdriver for each overhead activity to assigncosts to products
---- Activity Based Costing- costing systems based on cost drivers
that link activities performed to products
and allocate overhead activity costsdirectly to products using these costdrivers (ABKY, 1995: 291)
7/30/2019 Chap 7 - ActivityBasedCosting
15/53
How Costs are Treated UnderActivityBased Costing
Best practice ABC differs from traditional costing in five ways.
Manufacturing
costs
Nonmanufacturing
costs
ABC assigns both types of costs to products.
Traditionalproduct costing
ABCproduct costing
7/30/2019 Chap 7 - ActivityBasedCosting
16/53
How Costs are Treated UnderActivityBased Costing
ABC does not assign all manufacturing costs to products.
Manufacturing
costs
Nonmanufacturing
costs
Best practice ABC differs from traditional costing in five ways.
Traditionalproduct costing
ABCproduct costing
All
Some
7/30/2019 Chap 7 - ActivityBasedCosting
17/53
Selling & distribution costs
Compare between products and determinewhether should include or not- which product demand more selling &distribution activities
- e.g. order-getting activities-- marketing (mgmt, travel, brochures, catalog),customer service
- e.g. order-filling activities
-- warehouse, shipping, order executionincludes personnel, facilities, equipment and
services required for each activity.
7/30/2019 Chap 7 - ActivityBasedCosting
18/53
How Costs are Treated UnderActivityBased Costing
Plantwide
OverheadRate
DepartmentalOverhead
Rates
ActivityBasedCosting
Number of cost pools
Levelofcom
plexity
Best practice ABC differs from traditional costing in five ways.
ABC uses more cost pools.
7/30/2019 Chap 7 - ActivityBasedCosting
19/53
How Costs are Treated UnderActivityBased Costing
Best practice ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
Traditional Costing
Numbero
f
AllocationBa
ses
ABC
Bases usuallyrely solely onvolume
measures.
Volumemeasuresplus other
bases.
7/30/2019 Chap 7 - ActivityBasedCosting
20/53
How Costs are Treated UnderActivityBased Costing
Best practice ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
The most commonly used allocation basein traditional costing is direct labor hours.
Direct labor hours workwell when overhead
increases as directlabor hours increase.
7/30/2019 Chap 7 - ActivityBasedCosting
21/53
How Costs are Treated UnderActivityBased Costing
Problems:
In many processes, overhead is increasing
while direct labor is decreasing. Variety and complexity of products is increasing.
The most commonly used allocation basein traditional costing is direct labor hours.
Best practice ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
7/30/2019 Chap 7 - ActivityBasedCosting
22/53
How Costs are Treated UnderActivityBased Costing
Best practice ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
All overheadcosts are not related
to volume measures like
direct laborhours.
ABC usesvolume as well as
other allocation bases notrelated to the volume
of production.
7/30/2019 Chap 7 - ActivityBasedCosting
23/53
How Costs are Treated UnderActivityBased Costing
Best practice ABC differs from traditional costing in five ways.
Traditional CostingThe predetermined
overhead rate is basedon budgeted activity.
This results in applyingall overhead costs
including unused, oridle capacity costs toproducts.
ABCProducts are charged
for the costs ofcapacity they use not
for the costs ofcapacity they dont
use. Unused capacitycosts are treated asperiod expenses.
ABC bases level of activity on capacity.
7/30/2019 Chap 7 - ActivityBasedCosting
24/53
Characteristics of SuccessfulABC Implementations
Strong topmanagement support
Cross-functionalinvolvement
Link to evaluationsand rewards
7/30/2019 Chap 7 - ActivityBasedCosting
25/53
Designing an ABC System
Cost Objects(e.g., productsand customers)
Activities
Consumptionof Resources
Cost
7/30/2019 Chap 7 - ActivityBasedCosting
26/53
Designing an ABC System
Steps for Implementing ABC Identify and define activities and activity cost
pools.
Trace costs to activities and cost objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.
7/30/2019 Chap 7 - ActivityBasedCosting
27/53
Identify and Define Activitiesand Activity Cost Pools
Manufacturingcompanies typically combinetheir activities into five
classifications.
Unit-LevelActivity
Batch-LevelActivity
Product-LevelActivity
Customer-LevelActivityOrganization-
sustaining
Activity
7/30/2019 Chap 7 - ActivityBasedCosting
28/53
Unit-level activities are those that areperformed each time a unit is produced.
Examples:Power and
mach ine hours are used each
t ime a un i t is produced.
Direct materials and d irectlabo r act iv i t ies are also un it-
level act iv i t ies, even though
they are no t overhead cos ts.
Classification of Activities
7/30/2019 Chap 7 - ActivityBasedCosting
29/53
Batch-level activities are those that are
performed each time a batch of products isproduced.
Examples:Setups,
inspect ions , product ionschedu l ing, and mater ial
handl ing.
Classification of Activities
7/30/2019 Chap 7 - ActivityBasedCosting
30/53
Product-level (sustaining) activities are those thatare performed as needed to support the various
products produced by a company. These activitiesconsume inputs that develop products or allowproducts to be produced and sold.
Examples:Engineer ing changes, pro cesseng ineer ing , and expedi t ing .
Classification of Activities
7/30/2019 Chap 7 - ActivityBasedCosting
31/53
Facility-level activities are those that
sustain a factory's general manufacturingprocesses.
Examples: Plant
management, landscaping,main tenance, secu ri ty, p roperty
taxes, and p lan t depreciat ion .
Classification of Activities
7/30/2019 Chap 7 - ActivityBasedCosting
32/53
Identify and Define Activitiesand Activity Cost Pools
Activitiesshould only be
combined within a levelif they are highly
correlated.
When combiningactivities, they should begrouped together only at
the appropriatelevel.
7/30/2019 Chap 7 - ActivityBasedCosting
33/53
Identify and Define Activitiesand Activity Cost Pools
An Activity Cost
Poolis a bucketin which costs areaccumulated that
relate to a singleactivity measure inthe ABC system.
$
$
$ $
$
$
7/30/2019 Chap 7 - ActivityBasedCosting
34/53
Identify and Define Activitiesand Activity Cost Pools
Simple count
of the number oftimes an activity
occurs.
Transactiondriver
A measure
of the amountof time neededfor an activity.
Durationdriver
Two types of activity measures:
7/30/2019 Chap 7 - ActivityBasedCosting
35/53
Identify and Define Activitiesand Activity Cost Pools
At Classic Brass, the ABC team, selected the followingactivity cost pools and activity measures:
7/30/2019 Chap 7 - ActivityBasedCosting
36/53
Identify and Define Activitiesand Activity Cost Pools
Customer Orders - assigned all costs of resourcesthat are consumed by taking and processingcustomer orders.
Product Designs - assigned all costs of resourcesconsumed by designing products.
Order Size - assigned all costs of resourcesconsumed as a consequence of the number ofunits produced.
Customer Relations assigned all costsassociated with maintaining relations with
customers. Other assigned all overhead costs that are notassociated with the other cost pools. i.e.organization sustaining activity
When Possible Directly Trace Overhead
7/30/2019 Chap 7 - ActivityBasedCosting
37/53
When Possible, Directly Trace OverheadCosts to Activities and Cost Objects
Assign Costs to Activity Cost
7/30/2019 Chap 7 - ActivityBasedCosting
38/53
Assign Costs to Activity CostPools
At Classic Brass the following distribution of resourceconsumption across activity cost pools is determined.
**Not included because they are directly traced to customer orders.
Assign Costs to Activity Cost
7/30/2019 Chap 7 - ActivityBasedCosting
39/53
Indirect factory wages $500,000Percent consumed by customer orders 25%
$125,000
Assign Costs to Activity CostPools
Assign Costs to Activity Cost
7/30/2019 Chap 7 - ActivityBasedCosting
40/53
Factory equipment depreciation $300,000Percent consumed by customer orders 20%
$ 60,000
Assign Costs to Activity CostPools
Assign Costs to Activity Cost
7/30/2019 Chap 7 - ActivityBasedCosting
41/53
Assign Costs to Activity CostPools
7/30/2019 Chap 7 - ActivityBasedCosting
42/53
Calculate Activity Rates
The ABC team determines that ClassicBrass will have these total activities for
each activity cost pool . . .
1,000 customer orders,
200 new designs,
20,000 machine-hours,
100 customer relations activities.Now the team can compute the individualactivity rates by dividing the total cost foreach activity by the total activity levels.
7/30/2019 Chap 7 - ActivityBasedCosting
43/53
Calculate Activity Rates
7/30/2019 Chap 7 - ActivityBasedCosting
44/53
Traced Traced Traced
Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingCosts
Overhead Costs
Cost Objects:Products, Customer Orders, Customers
7/30/2019 Chap 7 - ActivityBasedCosting
45/53
Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingCosts
Cost Objects:Products, Customer Orders, Customers
OrderSize
CustomerOrders
ProductDesign
CustomerRelations
Other
Overhead Costs
First-Stage Allocation
7/30/2019 Chap 7 - ActivityBasedCosting
46/53
Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingCosts
Cost Objects:Products, Customer Orders, Customers
OrderSize
CustomerOrders
ProductDesign
CustomerRelations
Other
Overhead Costs
First-Stage Allocation
Second-Stage Allocations
$/MH $/Order $/Design $/Customer
Unallocated
7/30/2019 Chap 7 - ActivityBasedCosting
47/53
Assigning Costs to Cost Objects
Lets take a look at how our system worksfor just one customer Windward Yachts.
Standard Stanchions (no design required)1. 400 units ordered with 2 separate orders.2. Each stanchion required 0.5 machine-hours.
3. Selling price is $34 each.4. Direct materials total $2,110.5. Direct labor totals $1,850.6. Shipping costs total $180.
Custom Compass Housing (requires new design)1. One order during the year.2. Each housing required 4 machine-hours.3. Selling price is $650 each.4. Direct materials total $13.5. Direct labor totals $50.
6. Shipping costs total $25.
7/30/2019 Chap 7 - ActivityBasedCosting
48/53
Assigning Costs to Cost Objects
The customer-levelcost is assigned tocustomers directly;it is not assigned to
products.
7/30/2019 Chap 7 - ActivityBasedCosting
49/53
Prepare Management Reports
Standard StanchionsSales 13,600$
Cost:
Direct materials 2,110$
Direct labor 1,850
Shipping costs 180
Customer orders 630
Product design -Order size 3,800 8,570
Product margin 5,030$
Custom Compass Housing
Sales 650$
Cost:Direct materials 13$
Direct labor 50
Shipping costs 25
Customer orders 315
Product design 1,285
Order size 76 1,764
Product margin (1,114)$
7/30/2019 Chap 7 - ActivityBasedCosting
50/53
Prepare Management Reports
Customer Profitability Analysis
7/30/2019 Chap 7 - ActivityBasedCosting
51/53
Product Margins
Traditional Cost Accounting System
Predetermined manufacturingoverhead rate
$1,000,00020,000 MH
= $50/MH=
400 units x 0.5 MH/unit x $50/MH = $10,000
Differences Bet een ABC and
7/30/2019 Chap 7 - ActivityBasedCosting
52/53
Differences Between ABC andTraditional Product Costs
Product margins are different for four reasons:
Traditional costing assigns design costs to both productsbased on machine hours. ABC assigns product designcosts to a product only if product design work is required.
Traditional costing assigns customer order costs, a batch-level cost, using a unit-level allocation base, machine hours.
ABC assigns these batch-level costs using a batch-levelactivity measure.
Traditional costing assigns only manufacturing costs to
products. ABC also assigns non-manufacturing costs toproducts.
Traditional costing assigns all manufacturing costs toproducts. The ABC system does not assign organization-
sustaining manufacturing costs to the products.
7/30/2019 Chap 7 - ActivityBasedCosting
53/53
End of Chapter