Topic 4

Chapter Five
Activity-Based Costing
and Cost Management
Systems

Activity Based Costing

(ABC)
ABC is designed to
provide
managers with
cost information
for strategic and
other decisions
that potentially
affect capacity
and therefore
fixed costs.

ABC is a
good supplement
to our traditional
cost system

I agree!

Activity Based Costing

(ABC)
Both
Both manufacturing
manufacturing
and
and nonmanufacturing
nonmanufacturing
costs
costs may
may be
be
assigned
assigned to
to
products.
products.

AAnumber
number
of
of cost
cost pools
pools each
each
allocated
allocated to
to aa product
product
or
or cost
cost object.
object.
Some
Some manufacturing
manufacturing
costs
costs may
may be
be excluded
excluded
from
from product
product
costs.
costs.

Allocation
Allocation bases
bases often
often
differ
differ from
from
traditional
traditional costing
costing
systems.
systems.

Overhead
Overhead rates
rates may
may
be
be based
based on
on activity
activity
at
at capacity.
capacity.

Traditional, Volume-Based
Product-Costing System
Aerotech produces three complex
printed circuit boards referred to as
Mode I, Mode II, and Mode III.
The following information is obtained
from company records:

Production:
Units
Runs

Mode I

Mode II

Mode III

10,000
1 of 10,000

20,000
4 of 5,000

4,000
10 of 400

Traditional, Volume-Based
Product-Costing System
Additional information includes:
Mode I
Direct materials
$
50.00
Direct labor (hr/board)
3
Setup time (hr/run)
10
Machine time (hr/board)
1

Mode II
$
90.00
4
10
1.25

Mode III
$ 20.00
2
10
2

Manufacturing overhead is determined as follows

Traditional, Volume-Based
Product-Costing System

Budgeted manufacturing overhead

Budgeted direct-labor hours

$3,894,000
118,000

= $33 per hour

Traditional, Volume-Based
Product-Costing System
With these product costs, Aerotech established
target selling prices (Cost 125%).

209.00 x 1.25

Traditional, Volume-Based
Product-Costing System
Aerotech
Aerotech wishes
wishes to
to see
see what
what target
target
selling
selling prices
prices would
would be
be suggested
suggested
when
when using
using activity-based
activity-based costing.
costing.

Lets see how ABC works.

Activity Based Costing

System (ABC)
ABC systems
follow a twostage
procedure to
assign
overhead
costs to
products.

Assigning
overhead to
products is a
difficult process.

I agree!

Activity Based Costing

System (ABC)
ABC systems
follow a twostage procedure
to assign
overhead costs
to products.
Stage
Stage One
One
Identify
Identify significant
significant
activities
activities and
and assign
assign overhead
overhead
costs
costs to
to each
each activity
activity in
in
proportion
proportion to
to resources
resources used.
used.

Lets begin
by identifying
our major
activities.

Activity Based Costing

System (ABC)
ABC systems
follow a twostage procedure
to assign
overhead costs
to products.
Stage
Stage Two
Two
Identify
Identify cost
cost drivers
drivers
appropriate
appropriate to
to each
each activity
activity
and
and allocate
allocate overhead
overhead to
to
the
the products.
products.

Overhead assigned to
activities are called
activity cost pools.

Activity Cost
Pools
Activity Cost
Activity Cost
Pool is a
bucket in
which costs are
accumulated
that relate to a
single activity
measure in the
ABC system.

$$
$
$ $
$

Homogeneous Activity Cost

Pools
A homogeneous cost pool is a grouping of
overhead costs in which each cost component
is consumed in roughly the same proportion
by each product line.

A homogeneous cost pool

uses a single cost driver.

Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of
Correlation

Behavioral
Effects
Cost of
Measurement

Overhead Costs
Activity
must be
done on
each unit
produced.

Total budgeted cost = $3,894,000

Activity
Cost
Pools

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Activity
performed
on each
batch
produced.

Activities needed to support

an entire product line

Identification
Identification
of
of Activity
Activity
Cost
Cost Pools
Pools

Facility
Level
Facility
cost pool
$507,400

Activity required in order

for the production
process to occur.

Overhead Costs
Total budgeted cost = $3,894,000

Activity
Cost
Pools
Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

More
Cost
Pools

Identification
Identification
of
of Activity
Activity
Cost
Cost Pools
Pools

Facility
Level
Facility
cost pool
$507,400

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Receiving/Inspection
cost pool $200,000
Material-Handling
cost pool $600,000
Quality-Assurance
cost pool $421,000
Packaging/Shipping
cost pool $250,000

Facility
Level
Facility
cost pool
$507,400

STAGE ONE
Various overhead
costs related
to machinery

Activity
cost
pool

Maintenance

Lubrication

Depreciation

Electricity

Computer Support

Calibration

Machinery Cost Pool

Total budgeted cost = $1,212,600

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

Budgeted Machinery Costs = $1,212,600

Budgeted Machine Hours
43,000
= $28.20/hour

STAGE ONE
Calculation of
total setup cost

Activity
cost
pool

Setup Cost Pool

Total budgeted cost = $3,000

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

Budgeted Setup Costs

Planned Production Runs

= $3,000
15 runs
= $200 per run

STAGE ONE
Various overhead
costs related
to engineering

Activity
cost
pool

Engineering salaries

Engineering software

Engineering supplies

Depreciation

Engineering Cost Pool

Total budgeted cost = $700,000

STAGE TWO
Allocate based
on engineering
transactions

Cost
Assignment

Engineering Cost Pool

Total budgeted cost = $700,000

STAGE ONE
Various overhead
costs related
to general
operations

Activity
cost
pool

Plant depr.

Property taxes

Plant mgmt.

Insurance

Plant maint.

Security

Facility Cost Pool

Total budgeted cost = $507,400

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

Budgeted Facilities Cost

= $507,400
Budgeted Direct-Labor Hours
118,000
= $4.30/hour

Product Cost from ABC

Here are the new product costs so far . . .

Other Overhead Costs

Receiving and Inspection Cost Pool

Board
Overhead
Mode I
$ 200,000
Mode II
200,000
Mode III
200,000

%
6%
24%
70%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.20
=
2.40
=
35.00

Material-Handling Cost Pool

Board
Overhead
Mode I
$ 600,000
Mode II
600,000
Mode III
600,000

%
7%
30%
63%

Units
10,000
20,000
4,000

= Cost/Unit
= $
4.20
=
9.00
=
94.50

Quality-Assurance Cost Pool

Board
Overhead
Mode I
$ 421,000
Mode II
421,000
Mode III
421,000

%
20%
40%
40%

Units
10,000
20,000
4,000

= Cost/Unit
= $
8.42
=
8.42
=
42.10

Packaging and Shipping Cost Pool

Board
Overhead
Mode I
$ 250,000
Mode II
250,000
Mode III
250,000

%
4%
30%
66%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.00
=
3.75
=
41.25

Other Overhead Costs

Receiving and Inspection Cost Pool

Board
Overhead
Mode I
$ 200,000
Mode II
200,000
Mode III
200,000

%
6%
24%
70%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.20
=
2.40
=
35.00

Material-Handling Cost Pool

Board
Overhead
Mode I
$ 600,000
Mode II
600,000
Mode III
600,000

$14.82

%
7%
30%
63%

Units
10,000
20,000
4,000

= Cost/Unit
= $
4.20
=
9.00
=
94.50

Quality-Assurance Cost Pool

Board
Overhead
Mode I
$ 421,000
Mode II
421,000
Mode III
421,000

%
20%
40%
40%

Units
10,000
20,000
4,000

= Cost/Unit
= $
8.42
=
8.42
=
42.10

Packaging and Shipping Cost Pool

Board
Overhead
Mode I
$ 250,000
Mode II
250,000
Mode III
250,000

%
4%
30%
66%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.00
=
3.75
=
41.25

Product Cost from ABC

These are the new product costs when
Aerotech uses ABC.

Product Diversity
Both original and ABC target selling
prices are based on (Cost 125%).

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
[$209.00 1.25]

[$183.44 1.25]

Product Diversity
Can you identify any problems Aerotech is
likely to face as a result of this distortion?

Traditional costing understates the cost

of complex, low volume products.

Difference Between ABC

and Traditional Product
Costs
Batch-level or
product-level costs
will ordinarily shift
overhead costs
from high-volume
products produced
in large batches to
low-volume
products produced
in small batches.

Under ABC both

manufacturing and
nonmanufacturing
costs may be
assigned to products.
Organizationsustaining costs and
the costs of idle
capacity are not
assigned to products.

ABC: Some Key Issues

The
The Past
Past
Small
Small number
number of
of
products
products which
which did
did
not
not differ
differ much
much in
in
required
required
manufacturing
manufacturing
support.
support.
Labor
Labor was
was the
the
dominant
dominant element
element
in
in the
the cost
cost
structure.
structure.

The
The Present
Present
Numerous
Numerous products
products
with
with more
more and
and
complicated
complicated
production
production
requirements.
requirements.
Labor
Labor is
is becoming
becoming
an
an ever
ever smaller
smaller
part
part component
component of
of
total
total production
production
costs.
costs.

Direct versus Indirect

Costs

Volume-Based
Volume-Based Costing
Costing
All
All production
production costs
costs
except
except direct
direct
materials
materials and
and direct
direct
labor
labor are
are lumped
lumped
together
together in
in one
one
overhead
overhead cost
cost pool.
pool.

Activity-Based
Activity-Based
Costing
Costing
An
An effort
effort is
is made
made to
to
account
account for
for as
as
many
many costs
costs as
as
possible
possible as
as direct
direct
costs
costs of
of production.
production.

Indirect
Costs

Indicators of Need for

ABC
Direct
Direct labor
labor is
is aa
small
small percentage
percentage
of
of total
total costs
costs

Product-line
Product-line profit
profit
margins
margins are
are hard
hard
to
to explain
explain

Sales
Sales are
are increasing,
increasing,
but
but profits
profits are
are declining.
declining.

Line
Line managers
managers do
do not
not
believe
believe the
the product
product
costs
costs reports
reports

Marketing
Marketing does
does not
not
use
use costs
costs reports
reports for
for
pricing
pricing decisions
decisions

Some
Some products
products that
that
have
have reported
reported high
high
profit
profit margins
margins are
are not
not
sold
sold by
by competitors
competitors

Cost Management
Systems
Objectives

Measure the cost of resources consumed.

Identify and eliminate non-value-added costs.
Determine the efficiency and effectiveness of
all major activities.
Identify and evaluate new activities that can
improve future performance.

Targeting Process
Improvement
Activity-based costing can be
used to identify areas that would
benefit from process
improvements.

The theory of constraints

approach is a powerful tool for
targeting the area in an
organization whose improvement
will yield the greatest benefits.

Non-Value-Added Costs
Suppose our production process looks like this:

Storage Waiting Process

TimeNVA TimeNVA Time VA
VA
NVA

= Valued-added activity
= Non-value-added activity

Move Inspection
TimeNVA TimeNVA

Non-Value-Added Costs
Our goal is to reduce or eliminate the non-value-added activities.

Storage Waiting Process

TimeNVA TimeNVA Time VA
VA
NVA

= Valued-added activity
= Non-value-added activity

Move Inspection
TimeNVA TimeNVA

ABC in the Service

Industry

Activities tend to
be nonrepetitive
human tasks.

Implementation
Implementation
Problems
Problems
High proportion of
facility-level costs

Activity-Based Costing and

External Reporting
Most companies do not use ABC for 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.

Limitations of ABC
ABC systems are a
major project requiring
substantial resources.
The benefits of
increased accuracy
must outweigh these
additional costs.

ABC produces
numbers, like product
margins, that are at
odds with numbers
produced by traditional
costing system. Some
managers find it
difficult to adjust to this
change.

ABC data can be misinterpreted and must

be used with care when making decisions.

End of Chapter 5

This is
real value-added
time!