Undercosting/Overcosting Example

Joe, Robert, and Nancy order separate items for lunch.

Activity-Based Costing and Joe’s order amounts to $14

Robert consumed 30
Activity-Based Management Nancy’s order is 16
Total $60
What is the average cost per lunch?
Chapter 5
ABC
Joe and Nancy Robert is
1 are _______costed. ______costed. 2

Existing Single Indirect-

Existing Single Indirect-
Cost Pool System Example
Cost Pool System Example
Normal Lenses (NL)
Direct materials $1,520,000
Direct mfg. labor 800,000
Kole Corporation manufactures a normal lens
Total direct costs $2,320,000
(NL) and a complex lens (CL).
Direct cost per unit:
Kole currently uses a single indirect-cost rate
Complex Lenses (CL)
job costing system. Direct materials $ 920,000
Cost objects: 80,000 (NL) and 20,000 (CL). Direct mfg. labor 260,000
Total direct costs $1,180,000
Direct cost per unit: $
3 4
 Existing Single Indirect- Existing Single Indirect-
Cost Pool System Example Cost Pool System Example

INDIRECT-COST All Indirect Costs COST OBJECT: Indirect Costs

POLL $2,900,000 NL AND CL
LENSES Direct Costs
INDIRECT 50,000 Direct
COST-ALLOCATION Manufacturing Labor-
BASE Hours
DIRECT
$58 per Direct COSTS
Direct Direct
Manufacturing Labor- Manufacturing
Hour Materials Labor
5 6

Existing Single Indirect- Existing Single Indirect-

Cost Pool System Example Cost Pool System Example

Kole uses 36,000 direct manufacturing What is the total cost of each product?
labor-hours to make NL and 14,000 direct NL: Direct costs $2,320,000
manufacturing labor-hours to make CL. + Allocated costs 2,088,000 = $4,408,000
How much indirect costs are allocated CL-Direct costs $1,180,000
to each product? + Allocated costs 812,000 = $1,992,000
What is the cost per unit?
NL-
CL-
7 8
 Existing Single Indirect- • NL-the margins are so low, where the company has
strong capabilities.
Cost Pool System Example • CL-the margins are high on this less-established lens.
• Management wonders whether the cost are incorrect.
Normal lenses sell for $60 each and • Operations staff have significant disagreements with
complex lenses for $142 each. the accounting staff about the costs of manufacturing
Normal Complex and marketing products and services.
Revenue $60.00 $142.00
Cost 55.10 99.60
Income $ 4.90 $ 42.40
Margin 8.2% 29.9%
9 10

Reasons For Refining A Costing Using The 5-step Decision Making

System Process
Three principal reasons have accelerated the 1. Identify the Problems & Uncertainties. (Possible
demand for refinements to the costing system. loss of Giovanni business)
1. Increase in product diversity 2. Obtain Information.(Analyze and evaluate the
2. Increase in indirect costs with different cost design, manufacturing, and distribution operations
drivers for the S3 lens.)
3. Competition in product markets
3. Make Predictions about the future. (Obtain a better
cost estimate for the S3)
4. Make Decisions by Choosing among alternatives
(Should they bid and if yes, at what price)
5. Implement the Decision, Evaluate Performance and
11 12
Learn.
 Guidelines for refining a costing system
Guidelines for Refining a Costing
System
• Direct-cost tracing. Identify as many direct costs as
is economically feasible.
Direct-cost tracing • Indirect-cost pools. Expand the number of cost
pools so that each pool is somewhat homogeneous.
Each cost in the pool has a similar cause-and-effect
Indirect-cost pools relationship with a single cost driver.
• Cost-allocation bases. The cost driver serves as the
cost allocation base for each homogeneous indirect-
Cost-allocation basis cost pool.

13 14

Refining a Costing System

Activity-Based Costing System
1. Design of Products and Process
Fundamental Assignment to Other The Design Department designs the molds and defines
Cost Objects Cost Objects processes needed (details of the manufacturing
operations).
Activities Cost of:
• Product 2. Manufacturing Operations
• Service Lenses are molded, finished, cleaned, and inspected.
Costs of Activities • Customer
3. Shipping and Distribution
Finished lenses are packed and sent to the various customers.
15 16
 Cost Hierarchies
Activity-Based Costing System
A cost hierarchy is a categorization of costs into
different cost pools.
Activity Design Setup Shipping
Indirect Cost Cost drivers bases (cost-allocation bases)
Pool
ABC systems commonly use a four-part cost hierarchy to
Parts- No. of identify cost-allocation bases:
Cost Square No. of
Allocation Setup Shipments
Base feet Hours

Product
Cost Lenses Lenses Lenses
Objects CL Other
NL
17 18

Output Unit-Level Costs
These are resources sacrificed
on activities performed on each
individual unit of product or service.
Energy, 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
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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
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.
General administration
– rent – building security 20
 Implementing Activity-Based Costing
Implementing Activity-Based Costing

Step 1 Step 2 Cleaning and maintenance costs of

$360,000 are direct batch-level costs.
Identify cost objects. Identify the direct costs Why?
of the products.
Because these costs consist of workers’
NL Direct material wages for cleaning molds
CL Direct labor after each batch of lenses is run.
Mold cleaning and
maintenance

21 22

Implementing Activity-Based Costing

Implementing Activity-Based Costing
Normal Lenses (NL) -Cost Hierarchy
Description Category
Direct materials Unit-level $1,520,000
Step 3
Direct mfg. labor Unit-level 800,000 Select the cost-allocation bases to use for
Cleaning and maint. Batch-level 160,000 allocating indirect costs to the products.
Total direct costs $2,480,000
(1) (2) (3)
Complex Lenses (CL)
Direct materials Unit-level $ 920,000 Activity Cost Hierarchy Total Costs
Direct mfg. labor Unit-level 260,000 Design Product-sustaining $450,000
Cleaning and maint. Batch-level 200,000 Setups Batch-level $300,000
Total direct costs $1,380,000 Operations Unit-level $637,500
23 24
 Activity-Based Costing System Implementing Activity-Based Costing

A cross-functional team at Kole

Corporation identified key activities: NL and CL would show six indirect cost pools.
a. Design products and processes. 1. Design
b. Set up molding machine. 2. Molding machine setups
c. Operate machines to manufacture lenses. 3. Manufacturing operations
d. Maintain and clean the molds. 4. Shipment setup
e. Distribute lenses to customers. 5. Distribution
f. Administer and manage all processes. 6. Administration
25 26

Implementing Activity-Based Costing

Design Setups of Mnfg Shipment
Distribution Administration
$450,000 machine operations setup
$300,000 $637,500
$391,500 $300,000
$81,000
Step 4. Identify the indirect costs associated
with each cost-allocation base.
100 2,000 12,750 200 67,500 50,000
Overhead costs incurred are assigned Parts- Setup Machin Shipments Cubic DL hours
square feet hours e hours feet
to activities, to the extent possible, on
the basis of a cause-and-effect relationship.
$4,500 $150 $50 $405 $5.8 $6
Step 5. Compute the rate per unit. Per part per Per MH Per Per cubic Per DL
-sq.ft. Setup Shipment foot hours
Step 6. Compute the indirect costs allocated hr.

to the products.
Indirect Costs
Step 7. Compute the costs of the products. 27 Direct Costs 28
 NL Unit cost CL Unit cost

$4,500 $150 $50 $405 $5.8 $6 DM $1520,000 $920,000

Per part per Per MH Per Per cubic Per DL DL 800,000 260,000
-sq.ft. Setup Shipment foot hours
hr. CL 160,000 200,000
DC 2,480,000 $31 1180,000 $69
NL-500
NL-30
CL-1500
NL-9,000 NL-100 NL-45000 NL-36,000 IC
CL-70 CL-3,750 CL-100 CL-22500 CL-14,000
Design
Setup
Indirect Costs Operations 450,000 187,500
Direct Costs Shipping 40,500 40,500
Distribution 261,000 130,500
Administration 216,000 84,000
Direct Direct Cleaning &
IC 1,177,500 982,500
Materials Manufacturing Maintenance 29
Total Costs $3,657,500 $45.72 $2,362,500 118.13
30
Labor

Existing Single Indirect- ABC Vs. Simple Costing

Cost Pool System Example
ABC is generally perceived to produce superior
costing figures due to the use of multiple drivers
Existing Job costing system ABC across multiple levels.
ABC is only as good as the drivers selected, and
Normal Complex Normal Complex
their actual relationship to costs. Poorly chosen
Revenue $60.00 $142.00 $60.00 $142.00
drivers will produce inaccurate costs, even with
Cost 55.10 99.60
ABC.
Income $ 4.90 $ 42.40 $
Margin 8.2% 29.9% 23.81% 16.81% Using ABC does not guarantee more accurate
costs!
-Overcosted
-Undercosted
31 32

ABC Vs. Simple Costing
ABC is an alternate way to allocate costs. It is generally
considered to be more accurate and more costly to
implement.
A company should consider refining their cost system when
evidence begins to suggest that their existing system is
flawed.
Because a number of critical decisions, such as pricing,
whether or not one product should be “pushed” over
another, whether or not a product should be dropped, etc.
will be made using cost information, best efforts should be
used to arrive at a cost that is fair and reasonable for each
product. The goal isn’t to attain a cost that serves the
current purposes.
This is an imprecise science and differences of opinion are
33
likely to occur.
Behavioral Issues in Implementing ABC
Gain the support of top management and create
a sense of urgency.
Create a guiding coalition of managers
throughout the value chain for the ABC effort.
Educate and train employees in ABC as a basis
for employee empowerment
Seek small short-run success as proof that the
ABC implementation is yielding results.
Recognize that ABC is not perfect. (better costs
but complex system)
35
Signals that suggest that ABC Implementation
could help a Firm:
1. Significant amounts of indirect costs are allocated
using only one or two cost pools.
2. All or most indirect costs are identified as output unit-
level costs.
3. Products make diverse demands on resources
because of volume, process steps, batch size or
complexity.
4. Products that a company is well-suited to make show
small profits whereas products that a company is
less suited to make show large profits.
5. Operations staff has substantial disagreement with
the reported costs of manufacturing and marketing
products or services
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Activity-Based Management
ABM describes management decisions that use
activity-based costing information to
improve customer satisfaction and profitability.
Define ABM broadly to include decisions about
pricing and product mix, cost reduction, process
improvement and product and process design.
It provides more accurate product cost
information and more detailed information
on costs of activities and the drivers of those costs.
36
 Cost Reduction and Process Costs and Benefits of ABC
Improvement Decisions
Manufacturing and distribution personnel use
ABC systems to focus on cost-reduction efforts. Main benefit
Managers set cost-reduction targets in terms of Accurate cost
reducing the cost per unit of the cost-allocation base. The main limitations of ABC are the
measurements necessary to
Design Decisions implement the system.
Management can identify and evaluate new designs Very detailed ABC systems are costly
to improve performance by evaluating how product to operate and difficult to understand.
and process designs affect activities and costs. 37 38

ABC In Service and ABC In Service and

Merchandising Companies Merchandising Companies

The general approach to ABC in the
service and merchandising areas is very
similar to the approach in manufacturing.
Costs are divided into homogeneous cost
pools and classified as output unit-level,
batch-level, product- or service-sustaining,
and facility-sustaining costs.
39
The cost pools correspond to key activities.
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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ABC and Service/Merchandising Firms

ABC implementation is widespread in a variety of

applications outside manufacturing, including:
• Health Care
• Banking
• Telecommunications
• Retailing
• Transportation

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