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# TUTORIAL -ABC

## Ir. Haery Sihombing/IP

Pensyarah Pelawat
Fakulti Kejuruteraan Pembuatan
Universiti Teknologi Malaysia Melaka
TOTAL COST for a COST OBJECT

EXAMPLE: 1
Direct Cost (Labor Material)
+
Total Object Cost

##  Total Company’s overhead is allocated

o the products based on volume based
measure (e.g. labor hours, machine hours)

##  Assumption: relation between

measure
•Two products: Product A and Product B

Product A :  Product B:
 1 hours of direct labor  2 hours of direct labor

## (direct labor cost 1 *RM20/hour (direct labor cost 2 *RM20/ hour

=RM 20.00/hours) =RM 40.00/hours)

##  TOTAL OVERHEAD = RM 100,000.00

 TOTAL DIRECT LABOR = 2,000 Hours
RM 100,000/2000 Hours = RM 50/ Hours

##  Product A : 1 hours of direct labor

 Product B : 2 hours of direct labor
 TCA Overhead Allocation : A = RM 50/unit
B = RM 100/unit
ACTIVITY BASED COSTING

##  More Accurate Cost Management Methodology

 Focuses on indirect costs (overhead)
 Traces rather than allocates each expense
category to the particular cost object
 Makes “indirect” expense “direct”
ABC Basic Premise
 Cost objects consume activities
 Activities consume resources
 This consumption of resources is what
driver costs
 Understanding this relationship is critical
When To Use ABC
 Products are diverse: complexity,
volume, amount of direct labor
 Cost of errors are high
 Competition is stiff
ABC Steps
 Identifies activities
 Determine cost for each activity
 Determine cost drivers
 Collect activity data
 Calculate product cost
ABC Illustration

1. INDENTIFY ACTIVITIES

 Set-up
 Machining
 Receiving
 Packing
 Engineering
ABC Illustration

## 2. DETERMINE ACTIVITY COST

 Set-up = RM 10,000
 Machining = RM 40,000
 Receiving = RM 10,000
 Packing = RM 10,000
 Engineering = RM 30,000
ABC Illustration
3. DETERMINE COT DRIVERS

##  Set-up = Number of Setups

 Machining = Machining Hours
 Receiving = Number of Receipt
 Packing = Number of Deliveries
 Engineering = Engineering Hours
ABC Illustration

4. ACTIVITY DATA
ACTIVITY Cost PRODUCT RM PRODUCT RM
(RM) A B
Set-up 10,000 1 2,500 3 7,500
Machining 40,000 100 2,000 1900 38,000
Receiving 10,000 1 2,500 3 7,500
Packing 10,000 1 2,500 3 7,500
Engineering 30,000 500 15,000 500 15,000
24,500 75,500
ABC Illustration

##  Overhead for Product A =

RM 24,500 : 100 = RM 245

##  Overhead for Product B =

RM 75,000 : 950 = RM 79. 47
PRODUCT COST TCA Vs. ABC

## Cost for Product A : Cost for Product B :

Direct Cost TCA RM 20,00 Direct Cost TCA RM 40,00
Direct Cost ABC RM 20,00 Direct Cost ABC RM 40,00
TOTAL TCA RM 70,00 TOTAL TCA RM 140,00
TOTAL ABC RM 265,00 TOTAL ABC RM 119,47
Undercosting & Overcosting

EXAMPLE: 2
Jose, Roberta, and Nancy order
separate items for lunch.
Jose’s order amounts to \$14
Roberta consumed 30
Nancy’s order is 16
Total \$60
What is the average cost per lunch?
Undercosting & Overcosting

\$60 ÷ 3 = \$20

## Jose and Nancy Roberta is

are overcosted. undercosted.
Existing Single Indirect- Cost Pool System

EXAMPLE: 3
Kole Corporation manufactures a normal lens
(NL) and a complex lens (CL).
Kole currently uses a single indirect-cost rate
job costing system.
Cost objects: 80,000 (NL) and 20,000 (CL).
Existing Single Indirect- Cost Pool System

## Normal Lenses (NL)

Direct materials \$1,520,000
Direct mfg. labor 800,000
Total direct costs \$2,320,000
Direct cost per unit: \$2,320,000 ÷ 80,000 = \$29
Existing Single Indirect- Cost Pool System

## Complex Lenses (CL)

Direct materials \$ 920,000
Direct mfg. labor 260,000
Total direct costs \$1,180,000
Direct cost per unit: \$1,180,000 ÷ 20,000 = \$59
Existing Single Indirect- Cost Pool System

INDIRECT-COST All
POLL AllIndirect
IndirectCosts
Costs
\$2,900,000
\$2,900,000

INDIRECT 50,000
50,000Direct
Direct
COST-ALLOCATION Manufacturing
Manufacturing
BASE Labor-Hours
Labor-Hours

## \$58 per Direct

Manufacturing
Labor-Hour
Existing Single Indirect- Cost Pool System

## COST OBJECT: Indirect

IndirectCosts
Costs
NL AND CL
LENSES Direct
DirectCosts
Costs

DIRECT
COSTS
Direct
Direct
Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor
Existing Single Indirect- Cost Pool System

## Kole uses 36,000 direct manufacturing

labor-hours to make NL and 14,000 direct
manufacturing labor-hours to make CL.
How much indirect costs are allocated
to each product?
Existing Single Indirect- Cost Pool System

## NL: 36,000 × \$58 = \$2,088,000

CL: 14,000 × \$58 = \$812,000
What is the total cost of normal lenses?
Direct costs \$2,320,000 +
Allocated costs \$2,088,000 = \$4,408,000
What is the cost per unit?
\$4,408,000 ÷ 80,000 = \$55.10
Existing Single Indirect- Cost Pool System

## What is the total cost of complex lenses?

Direct costs \$1,180,000 + Allocated costs
\$812,000 = \$1,992,000
What is the cost per unit?
\$1,992,000 ÷ 20,000 = \$99.60
Existing Single Indirect- Cost Pool System

## Normal lenses sell for \$60 each and

complex lenses for \$142 each.
Normal Complex
Revenue \$60.00 \$142.00
Cost 55.10 99.60
Income \$ 4.90 \$ 42.40
Margin 8.2% 29.9%
Refining a Costing System

Direct-cost tracing

Indirect-cost pools

Cost-allocation basis
Refining a Costing System
1. Design of Products and Process
The Design Department designs the molds and defines
processes needed (details of the manufacturing operations).

2. Manufacturing Operations
Lenses are molded, finished, cleaned, and inspected.

## 3. Shipping and Distribution

Finished lenses are packed and sent to the various customers.
Activity-Based Costing System

## Fundamental Assignment to Other

Cost Objects Cost Objects
Activities Cost of:
• Product
• Service
Costs of Activities • Customer
Activity-Based Costing System

## A cross-functional team at Kole

Corporation identified key activities:
Design products and processes.
Set up molding machine.
Operate machines to manufacture lenses.
Maintain and clean the molds.
Activity-Based Costing System

## Set up batches of finished lenses for shipment.

Distribute lenses to customers.
Activity-Based Costing System

Activity
Indirect Cost Design Setup Shipping
Pool

## Cost Parts- No. of

Allocation Square Setup No. of
feet Hours Shipments
Base

## Product Lenses Lenses Lenses

Cost
Objects NL CL Other
Activity-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 \$409,200.
Activity-Based Costing System

## What is the setup cost per setup-hour?

\$409,200 ÷ 2,640 hours = \$155
What is the setup cost per
direct manufacturing labor-hour?
\$409,200 ÷ 50,000 = \$8.184
Activity-Based Costing System

## Allocation using direct labor-hours:

NL: \$8.184 × 36,000 = \$294,624
CL: \$8.184 × 14,000 = \$114,576
Total \$409,200
Allocation using setup-hours:
NL: \$155 × 640 = \$ 99,200
CL: \$155 × 2,000 = \$310,000
Total \$409,200
Cost Hierarchies

## A cost hierarchy is a categorization

of costs into different cost pools.
Cost drivers bases (cost-allocation bases)
Degrees of difficulty in determining
cause-and-effect relationships
Cost Hierarchies

## ABC systems commonly use a

four-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 Costs

## These are resources sacrificed

on activities performed on each
individual unit of product or service.
Energy
Machine depreciation
Repairs
Batch-Level Costs

## These 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.
Setup-hours
Procurement costs
Product-Sustaining Costs

## These are often called service-sustaining

costs and are resources sacrificed on
activities undertaken to support
individual products or services.
Design costs
Engineering costs
Facility-Sustaining Costs

## These are resources sacrificed on

activities that cannot be traced to
individual products or services but
support the organization as a whole.
– rent – building security
Implementing
Activity-Based Costing

Step 1 Step 2
Identify cost objects. Identify the direct costs
of the products.

NL Direct material
CL Direct labor
Mold cleaning and
maintenance
Implementing
Activity-Based Costing

## Cleaning and maintenance costs of

\$360,000 are direct batch-level costs.
Why?
Because these costs consist of workers’
wages for cleaning molds after each
batch of lenses is run.
Implementing
Activity-Based Costing

## Normal Lenses (NL)

Cost Hierarchy
Description Category
Direct materials Unit-level \$1,520,000
Direct mfg. labor Unit-level 800,000
Cleaning and maint.Batch-level 160,000
Total direct costs \$2,480,000
Implementing
Activity-Based Costing

## Complex Lenses (CL)

Cost Hierarchy
Description Category
Direct materials Unit-level \$ 920,000
Direct mfg. labor Unit-level 260,000
Cleaning and maint.Batch-level 200,000
Total direct costs \$1,380,000
Implementing
Activity-Based Costing
Step 3
Select the cost-allocation bases to use for
allocating indirect costs to the products.
(1) (2) (3)
Activity Cost Hierarchy Total Costs
Design Product-sustaining \$450,000
Setups Batch-level \$409,200
Operations Unit-level \$637,500
Implementing
Activity-Based Costing
Step 4
Identify the indirect costs associated
with each cost-allocation base.
to activities, to the extent possible, on
the basis of a cause-and-effect relationship.
Implementing
Activity-Based Costing
Step 5
Compute the rate per unit.
(1) (5)
NL CL Total
Setup-hours: 640 2,000 2,640
\$409,200 ÷ 2,640 = \$155
Implementing
Activity-Based Costing
Step 6
Compute the indirect costs allocated
to the products.
NL: \$155 × 640 = \$ 99,200
CL: \$155 × 2,000 = 310,000
Total \$409,200
Implementing
Activity-Based Costing
Step 7
Compute the costs of the products.
NL and CL would show three
direct cost categories.
1. Direct materials
2. Direct manufacturing labor
3. Cleaning and maintenance
Implementing
Activity-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
ABC and Department
Indirect-Cost Rates

## Many companies have evolved their

costing system from using a single
cost pool to using separate indirect-cost
rates for each department:
Design
Manufacturing
Distribution
ABC and Department
Indirect-Cost Rates

Why?
Because the cost drivers of resources in each
department or subdepartment differ from the
single, company-wide, cost-allocation base.
ABC systems are a further refinement of
department costing systems.
SUMMARY of ABC APPOACH

##  ABC is more accurate cost management

(TCA)
 Traditional Cost Accounting (TCA) is unable
to calculate the “true” of a product
Benefits of ABC Systems

## 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.
Benefits of ABC Systems

## 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.
Benefits of ABC Systems

## Operations staff have significant

disagreements with the accounting
staff about the costs of manufacturing
and marketing products and services.
Limitations of ABC Systems

## The main limitations of ABC are the

measurements necessary to
implement the system.
ABC systems require management
to estimate costs of activity pools
and to identify and measure cost
drivers for these pools.
Limitations of ABC Systems

## Activity-cost rates also need to be

updated regularly.
Very detailed ABC systems are costly
to operate and difficult to understand.