# TUTORIAL -ABC

TOTAL COST for a COST OBJECT EXAMPLE: 1
Direct Cost (Labor Material) Overhead Cost

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Ir. Haery Sihombing/IP Sihombing/IP
Pensyarah Pelawat Fakulti Kejuruteraan Pembuatan Universiti Teknologi Malaysia Melaka

Total Object Cost

Arbitrarily allocates to the cost objects Total Company’s overhead is allocated o the products based on volume based measure (e.g. labor hours, machine hours) Assumption: relation between overhead and the volume based measure

•Two products: Product A and Product B Product A :
1 hours of direct labor
(direct labor cost 1 *RM20/hour =RM 20.00/hours) 20.00/hours)

Product B:
2 hours of direct labor
(direct labor cost 2 *RM20/ hour =RM 40.00/hours) 40.00/hours)

Demand = 100

Demand = 950

TOTAL OVERHEAD = RM 100,000.00 TOTAL DIRECT LABOR = 2,000 Hours
RM 100,000/2000 Hours = RM 50/ Hours

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”

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

ABC Basic Premise
Cost objects consume activities Activities consume resources This consumption of resources is what driver costs Understanding this relationship is critical to successfully managing overhead

When To Use ABC
Overhead is high 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 Machining Receiving Packing Engineering = RM 10,000 = RM 40,000 = RM 10,000 = RM 10,000 = RM 30,000

ABC Illustration
3. DETERMINE COT DRIVERS Set-up Machining Receiving Packing Engineering = Number of Setups = Machining Hours = Number of Receipt = Number of Deliveries = Engineering Hours

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

ABC Illustration
5. PRODUCT COST CALCULATION 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 :
Overhead TCA RM 50,00 Overhead ABC RM 245,00 Direct Cost TCA RM 20,00 Direct Cost ABC RM 20,00 TOTAL TCA RM 70,00 TOTAL ABC RM 265,00

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?

Cost for Product B :
Overhead TCA RM 100,00 Overhead ABC RM 79.47 Direct Cost TCA RM 40,00 Direct Cost ABC RM 40,00 TOTAL TCA RM 140,00 TOTAL ABC RM 119,47

Undercosting & Overcosting

Existing Single Indirect- Cost Pool System

EXAMPLE: 3
\$60 ÷ 3 = \$20 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).

Jose and Nancy are overcosted.

Roberta is undercosted.

Existing Single Indirect- Cost Pool System

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

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

Existing Single Indirect- Cost Pool System

INDIRECT-COST POLL

All Indirect Costs \$2,900,000

COST OBJECT: NL AND CL LENSES

Indirect Costs Direct Costs

INDIRECT COST-ALLOCATION BASE

50,000 Direct Manufacturing Labor-Hours \$58 per Direct Manufacturing Labor-Hour DIRECT COSTS Direct Materials Direct Manufacturing Labor

Existing Single Indirect- Cost Pool System

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?

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

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

Normal lenses sell for \$60 each and complex lenses for \$142 each. Normal Complex Revenue \$60.00 \$142.00 99.60 Cost 55.10 Income \$ 4.90 \$ 42.40 Margin 8.2% 29.9%

Refining a Costing System

Refining a Costing System
1. Design of Products and Process

Direct-cost tracing Indirect-cost pools Cost-allocation basis

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 Cost Objects Activities Costs of Activities Assignment to Other Cost Objects Cost of: • Product • Service • 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

Activity-Based Costing System
Activity Indirect Cost Pool Design Setup Shipping

Set up batches of finished lenses for shipment. Distribute lenses to customers. Administer and manage all processes.

Cost Allocation Base

PartsSquare feet

No. of Setup Hours

No. of Shipments

Product Cost Objects

Lenses NL

Lenses CL

Lenses 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. 3. 4. Batch-level costs Product-sustaining costs 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

Implementing Activity-Based Costing
Step 1 Step 2 Identify the direct costs of the products. Direct material Direct labor Mold cleaning and maintenance

These are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. General administration – rent – building security

Identify cost objects.

NL CL

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 Category Description 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 Category Description 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) Cost Hierarchy Total Costs Activity 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. Overhead costs incurred are assigned 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) CL Total NL 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. 2. 3. Direct materials Direct manufacturing labor Cleaning and maintenance

Implementing Activity-Based Costing
NL and CL would show six indirect cost pools. 1. 2. 3. 4. 5. 6. Design Molding machine setups Manufacturing operations Shipment setup Distribution Administration

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 system than Traditional Cost Accounting (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

Limitations of ABC Systems

Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.

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.