Module#4

Activity-Based
Costing and
Management

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 “ABC”
COSTING
DEFINITION
“Cost attribution to
cost units on the basis
of benefit received
from indirect activities
e.g. Ordering, setting
up, assuring quality.”

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 PROF. KAPLAN AND COOPER
“The collection of financial and operational
performance information tracing the
significant activities of firm to product costs.”
 INTRODUCTION
• Difficult to calculate the cost of products or
services with precise accuracy
• Pricing is based on what the market will
bear, competitor’s more
• ABC tries to help in determine the
cost/correctly
• ABC evolved between the 1960’s and the
1980 to produce more accurate product
costs
 COOPER 1990
• Unit level activities – indirect rate
consumables inspection and testing of every
item produced
• Batch level activities – manufacturing
support activities
• Product level activities – new product line
and its maintenance, designing advertising
cost
• Facilities level activities – cannot be related
to a particular product line- maintaining
building, salaries, advertising
 TRADITIONAL ABSORPTION
COSTING
• TOTAL COST – Variable and Fixed
• Absorption overhead
• Plant-wide
• Department wide
 WHERE ABC IS MOST
SUITABLE
• Production overheads are high in relation to
direct cost
• There is a great diversity in the product
range
• Products use very different amounts of the
overhead resources
• Consumption of overhead resources is not
primarily driven by volume
 OBJECTIVES
• To improve the accuracy of product cost by carefully
changing the type and number of factors used to assign
costs
• To use this information to improve product mix and pricing
decision
• Identify value added activities in transaction
• Find out ways to eliminate non value added activities
• To allocate overheads on the basis of activities
• To validate the success of the quality drivers
• To ensure accurate product costing for decision making
• To focus on the high cost activities
• To identify the opportunities for improvement and reduction
of costs
 STEPS IN ABC SYSTEM
• Process specification – identify different stage in
production process
• Identify main activities
• Identify non value added activities
• Identification of activity cost pools- the point of focus
for the cost relating to a particularly activity
• Selection of activity cost drivers
• Tracing of cost with cost object
• Staff training – the cooperation of workforce is
critical - create ABC awareness
• Reviews and follow ups – periodic review and follow
ups
 BRAAS COMPANY
“ABC is not a magic bullet, but it is a tool to
help you understand your business better”
 COST POOLS
• Machine related setups
• Purchasing material handling
• Quality assurance – inspections
• Packing Shipping
• Engineering design
• facilitations
 COST DRIVERS
• Machine hours – no. of step ups
• No of purchase orders, material requisitions
• No of inspections
• No of orders dispatched
• Engineering hours
 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:

Mode I Mode II Mode III

Production:
Units 10,000 20,000 4,000
Runs 1 run of 10,000 4 runs of 10 runs of
units 5,000 units 400 units

Mode I Mode I I Mode I I I

Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
Total $ 209.00 $ 302.00 $ 126.00

Mode I Mode I I Mode I I I

Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor (hr/board) 3 4 2
S etup time (hr/run) 10 10 10
Machine time (hr/board) 1 1.25 2

Manufacturing overhead is determined as follows 5-13

 Traditional, Volume-Based
Product-Costing System
Mode I Mode II Mode III
Units produced 10,000 20,000 4,000
Direct labor (hr/unit) 3 4 2
Total hours 30,000 80,000 8,000

Total hours required 118,000

Budgeted manufacturing overhead $3,894,000

= $33 per hour
Budgeted direct-labor hours 118,000

Mode I Mode II Mode III

Direct labor (hr/unit) 3 4 2
Overhead rate per hour $ 33 $ 33 $ 33
Overhead per unit $ 99 $ 132 $ 66

5-14
 Traditional, Volume-Based
Product-Costing System
With these product costs, Aerotech established
target selling prices (Cost × 125%).
Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
Total $ 209.00 $ 302.00 $ 126.00

Mode I Mode II Mode III

Cost per unit $ 209.00 $ 302.00 $ 126.00
Target selling price 261.25 377.50 157.50

209.00 x 1.25
5-15
 Activity Based Costing System
(ABC)
ABC systems follow a two-stage procedure
to assign overhead costs to products.
Stage One
Identify significant activities and assign overhead costs
to each activity in proportion to resources used.
Stage Two
Identify cost drivers appropriate to each activity and
allocate overhead to the products.

5-16
 STAGE ONE

Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600

5-17
 STAGE TWO
Calculate Budgeted Machinery Costs = $1,212,600
the pool Budgeted Machine Hours 43,000
rate = $28.20/hour

Mode I: Mode II:

$28.20 per hr. $28.20 per hr.
1 hr. per unit 1.25 hr. per unit
Cost $28.20 per unit $35.25 per unit

Assignment
Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit

5-18
 STAGE ONE
Total budgeted setup cost
Calculation of $20 per hour
total setup cost 10 hr. per setup
$200 cost per setup
15 production runs
$ 3,000 Total

Activity
cost Setup Cost Pool
pool Total budgeted cost = $3,000

5-19
 STAGE TWO
Calculate Budgeted Setup Costs = $3,000
the pool Planned Production Runs 15 runs
rate = $200 per run

Mode I: (1 Run) Mode II: (4 Runs)

$200 per run $200 per run
10,000 units per run 5,000 units per run
Cost = $.02 per unit = $.04 per unit
Assignment
Mode III: (10 Runs)
$200 per run
400 units per run
= $.50 per unit

5-20
 STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool
pool Total budgeted cost = $700,000

5-21
 STAGE TWO
Allocate based Engineering Cost Pool
on engineering Total budgeted cost = $700,000
transactions

Mode I: Mode II:

25% × $700,000 45% × $700,000
10,000 units 20,000 units
Cost = $17.50 per unit = $15.75 per unit
Assignment
Mode III:
30% × $700,000
4,000 units
= $52.50 per unit

5-22
 STAGE ONE
Various overhead Plant depr. Property taxes
costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507,400

5-23
 STAGE TWO
Calculate Budgeted Facilities Cost = $507,400
the pool Budgeted Direct-Labor Hours 118,000
rate = $4.30/hour

Mode I: Mode II:

$4.30 per hr. $4.30 per hr.
× 3 hr. per unit × 4 hr. per unit
Cost $12.90 per unit $17.20 per unit
Assignment
Mode III:
$4.30 per hr.
× 2 hr. per unit
$8.60 per unit

5-24
 Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Material-Handling Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
$14.82 Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Quality-Assurance Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25
5-25
 Product Cost from ABC
These are the new product costs when
Aerotech uses ABC.
Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Machinery 28.20 35.25 56.40
Setup 0.02 0.04 0.50
Engineering 17.50 15.75 52.50
Facilities 12.90 17.20 8.60
Other 14.82 23.57 212.85
Total $ 183.44 $ 261.81 $ 390.85

5-26
 Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 125%).

Mode I Mode II Mode III

Traditional costing $ 209.00 $ 302.00 $ 126.00
ABC costing 183.44 261.81 390.85

Original target selling price 261.25 377.50 157.50

ABC target selling price 229.30 327.26 488.56

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]

5-27
 Illustration # 1
Ontario, Inc, manufacturers two products,
Standard and Enhanced, and applies
overhead on the basis of direct labor hours
Anticipated overhead and direct-labor time for
the upcoming accounting periods are
$800,000 and 25,000, respectively.
Information about the company's products
follows

5-28
 Illustration # 1
Standard
Estimated production volume, 3,000 units
Direct-material cost, $25 per unit
Direct labor per unit, 3 hours at$12 per hour
Enhanced:
Estimated production volume, 4,000 units
Direct-material cost, $40 per unit
Direct labor per unit, 4 hours at $12 per hour

5-29
 Illustration # 1
Ontario's overhead of $800,000 can be
identified with three major activities: order
processing ($150,000), machine processing
($560,000), and product inspection
($90,000).
These activities are driven by number of
orders processed, machine hours worked,
and inspection hours, respectively. Data
relevant to these activities follows.

5-30
 Illustration # 1)
Order Machine Inspection
Processed hours Hours
worked

Standard 300 18,000 2,000

Enhanced 200 22,000 8,000
____ ______ ______
Total 500 40,000 10,000
5-31
 Illustration # 1)
Top management is very concerned about
declining profitability despite a healthy
increase in sales volume. The decrease in
income is especially puzzling because the
company recently undertook a massive
plant renovation during which new, highly
automated machinery was installed-
machinery that was expected to produce
significant efficiencies.

5-32
 Illustration # 1)
Required:
1. Assuming use of direct-labor hours to apply overhead to production,
compute the unit manufacturing costs of the Standard and Enhanced
products if the expected manufacturing volume is attained.
2. Assuming use of activity -based costing, compute the unit
manufacturing costs of the Standard and Enhanced products if the
expected manufacturing volume is attained.
3. Ontario's selling prices are based heavily on cost.
 By using direct-labor hours as an application base, which product is over costed
and which product is under costed? Calculate the amount of the cost distortion for
each product.
 Is it possible that over costing and under costing (i.e., cost distortion) and the
subsequent determination of selling prices are contributing to the company profit
woes? Explain.

5-33
 Solution # 1)
1)
Budgeted over
head 800,000 32/ Direct
Overhead rated = = =
Budgeted D. labor hrs
Labor hrs 25,000

Unity
manufacturing cost:
Standard Enhanced

Direct material 25 40

Direct labor (3 x 12) 36 (4 x 12) 48

FoH (3 x 32) 96 ( 4 x 32) 128

157 216
5-34
 Solution
b)Activity Based costing
Activity Per unit Activity cost Standard Enhanced
Order processing (150,000 /500) = 300 90,000 60,000
Machine processing (560,000/40,000) = 14 252,000 308,000
Product inspection (90,000/10,000) = 9 18,000 72,000
360,000 440,000

Standard:-
360,000
Per unit cost = 3,000 = 120 per unit cost

Enhanced:-
440,000
Per unit cost = 4,000 = 110 per unit cost

Standard Enhanced
Direct material 25 40
Direct labor 36 48
FoH 120 110
181 198
5-35
 Solution

c)
Standard Enhanced

Labor hr based 156 217

Activity based 181 198

Under-costed 181 Over-costed 18

5-36