Chapter 8

Activity Based Costing:
A Tool to Aid Decision Making
11/16/04

Activity Based Costing (ABC)
ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore ³fixed´ costs.
McGraw-Hill/Irwin

ABC is a good supplement to our traditional cost system

I agree!

© The McGraw-Hill Companies, Inc., 2003

How Costs are Treated Under Activity-Based Costing
Activity Based Costing Departmental Overhead Rates Plantwide Overhead Rate

Overhead Allocation
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003

Plantwide Overhead Rate Companies tended to use direct labor as the overhead allocation base. There was a belief that direct labor and overhead costs were highly correlated. Automation changed all that.. Inc. McGraw-Hill/Irwin © The McGraw-Hill Companies. 2003 .

McGraw-Hill/Irwin © The McGraw-Hill Companies. Inc.. 2003 .Departmental Overhead Rates Finishing Department Painting Department Shipping Department Many companies have a system in which each department has its own overhead rate.

Departmental Overhead Rates Stage One: Costs assigned to pools Cost pools Indirect Labor Indirect Materials Other Overhead Department 1 Department 2 Department 3 McGraw-Hill/Irwin © The McGraw-Hill Companies. Inc. 2003 ..

Departmental Overhead Rates Stage One: Costs assigned to pools Cost pools Stage Two: Costs applied to products Indirect Labor Indirect Materials Other Overhead Department 1 Department 2 Department 3 Products McGraw-Hill/Irwin © The McGraw-Hill Companies.. Inc. 2003 .

Departmental Overhead Rates Stage One: Costs assigned to pools Cost pools Stage Two: Costs applied to products Indirect Labor Indirect Materials Other Overhead Department 1 Direct Labor Hours Department 2 Machine Hours Department 3 Raw Materials Cost Products Departmental Allocation Bases McGraw-Hill/Irwin © The McGraw-Hill Companies. 2003 .. Inc.

Inc.Cost of Idle Capacity Traditional Cost Accounting The predetermined overhead rate is based on budgeted activity. capacity. 2003 . This results in applying overhead costs of unused.. or idle. Activity Based Costing Products are charged for the costs of capacity they use ± not for the costs of capacity they don¶t use. McGraw-Hill/Irwin © The McGraw-Hill Companies.

Prepare management reports. NonCalculate activity rates. Assign costs to cost objects.. trace costs directly to activities and cost objects (products). Where possible. Non-traceable costs lumped. Assign all other traceable costs to activity cost pools. McGraw-Hill/Irwin © The McGraw-Hill Companies. 2003 .Designing of an ABC System Steps for Implementing ABC Identify and define major activities and activity cost pools. Inc.

2003 .Identify and Define Activities and Activity Cost Pools UnitUnit-Level Activity (machining) BatchBatch-Level Activity (customer order) A part of the production process for which management wants a separate reporting of the costs of the activity involved.. Inc. ProductProduct-Level Activity (product design) McGraw-Hill/Irwin OrganizationOrganizationsustaining Activity (lumped) CustomerCustomer-Level Activity (customer relations) © The McGraw-Hill Companies.

Identify and Define Activities and Activity Cost Pools At Classic Brass. 2003 .. selected the following activity cost pools and activity measures: Activity Cost Pools at Classic Brass Activity Cost Pool Customer orders Product design Order size Customer relations Other Activity Measure Number of customer orders Number of product designs Machine-hours Number of active customers Not applicable McGraw-Hill/Irwin © The McGraw-Hill Companies. the ABC team. Inc.

Identify and Define Activities and Activity Cost Pools Activity Cost ool is a ³bucket´ in which OH costs are accumulated that relate to a single activity measure in the ABC system.. McGraw-Hill/Irwin $$ $ $ $ $ © The McGraw-Hill Companies. Inc. 2003 .

assigned all costs of resources consumed as a consequence of the number of units produced. McGraw-Hill/Irwin © The McGraw-Hill Companies. machined) Customer Relations ± assigned all costs associated with maintaining relations with customers.. 2003 . Inc.assigned all costs of resources that are consumed by taking and processing customer orders. Order Size . Other ± assigned all overhead costs that are not associated with the other cost pools. (in this case.Identify and Define Activities and Activity Cost Pools Customer Orders . Product Designs .assigned all costs of resources consumed by designing products.

Directly Trace Overhead Costs to Activities and Cost Objects ( a Pr er ea ac r ssa a ass c rass a ac r ) c De ar e rec ac r wa es $ Fac r eq e e rec a es Fac r ease Fac r S c s s race c s er r ers Ge era s ra e De ar e s ra e wa es a sa ar es ce eq e e rec a s ra e ease arke De ar e arke wa es a sa ar es Se ex e ses T a er ea c s s McGraw-Hill/Irwin 500 000 300 000 120 000 80 000 $ 1 000 000 40 000 400 000 50 000 60 000 250 000 50 000 $ 510 000 300 000 1 850 000 © The McGraw-Hill Companies. Inc..Whenever Possible. 2003 .

2003 .. Activity Cost ools Customer roduct Order Orders Design Size roduction Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease Shipping costs ** General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses 25% 20% 0% 0% 40% 0% 10% 0% 20% 60% 50% 0% Customer Relations 10% 0% 0% 0% Other 5% 20% 40% 100% Total 100% 100% 100% 100% 15% 30% 0% 20% 10% 5% 0% 0% 10% 0% 10% 0% 0% 0% 0% 30% 25% 0% 60% 70% 40% 45% 100% 10% 20% 100% 100% 100% 100% 100% **Not included because they are directly traced to customer orders. McGraw-Hill/Irwin © The McGraw-Hill Companies. Inc.Assign Costs to Activity Cost Pools Exhibit 8-3 At Classic Brass the following distribution of resource consumption across activity cost pools is determined.

000 1.000 Total 1.850..000 50.000 500.000 60. Inc.000 50. 2003 .000 400.000 $ 510.000 300.000 300.000 250.000 Percent consumed by customer orders 25% $125.000 McGraw-Hill/Irwin © The McGraw-Hill Companies.000 Other $ 80.000.000 Indirect factory wages $500.000 120.Assign Costs to Activity Cost Pools Overhead Costs at Classic Brass (Manufacturing and NonManufacturing) Production Department $ CostIndirect factory wages Pools Factory equipment depreciation Product Order Customer Factory utilities Design Size Factory building lease Relations Shipping costs traced to customer orders General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total overhead costs Activity Customer Orders Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total $ 125.000 40.

000 McGraw-Hill/Irwin © The McGraw-Hill Companies.000.000 Other $ 80.000 Total 1.850.000 1.000 60..000 250.000 50.000 300. Inc.000 40.000 $ 510.000 50.000 500.Assign Costs to Activity Cost Pools Overhead Costs at Classic Brass (Manufacturing and NonManufacturing) Production Department $ CostIndirect factory wages Pools Factory equipment depreciation Product Order Customer Factory utilities Design Size Factory building lease Relations Shipping costs traced to customer orders General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total overhead costs Activity Customer Orders Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total $ 125.000 400.000 Factory equipment depreciation $300. 2003 .000 Percent consumed by customer orders 20% $ 60.000 60.000 300.000 120.

000 250..000 60.000 5.000 McGraw-Hill/Irwin © The McGraw-Hill Companies.000 400.000 80.000 $ 1.000 25. Inc.500 60.000 40.000 120.000 80. 2003 .000 $ 257.000 50.000 60.500 $ Total 500.000 $ 315.000 160.000 60.000 50.500 150.000 35.000 12.000 50.000 25.000 Customer Relations $ 50.000 $ 380.000 120.000 15.000 Order Size $ 100.810.000 $ 200.000 $ 490.000 180.000 $ 367.000 300.000 20.000 48.000 10.500 Other $ 25.000 12.000 22.000 60.Assign Costs to Activity Cost Pools Exhibit 8-4 Activity Cost Pools Customer Product Orders Design Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department Marketing wages and salaries Selling expenses Total $ 125.000 60.

000 machine-hours machine 100 customer relations activities Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels. Inc..  1. 2003 .000 customer orders  200 new designs  20. McGraw-Hill/Irwin © The McGraw-Hill Companies. . .Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool .

Calculate Activity Rates Exhibit 8-5 Computation of Activity Rates Activity Cost Pools Customer orders Product design Order size Customer relations Other (a) Total Cost $ 315.500 490. 2003 .000 (b) Total Activity 1..000 257.500 1.000 367.000 380. Inc.675 per customer Not applicable McGraw-Hill/Irwin © The McGraw-Hill Companies.000 orders 200 designs 20.000 MHs 100 customer Not applicable (a) ÷(b) Activity Rate $315 per order $1.810.285 per design $19 per MH $3.

Inc.. Customers McGraw-Hill/Irwin © The McGraw-Hill Companies. 2003 .Activity-Based Costing at Classic Brass Direct aterials Direct La or Shipping Costs verhead Costs Traced Traced Traced Cost Objects: Products.

. Customers McGraw-Hill/Irwin © The McGraw-Hill Companies. 2003 . Inc.Activity-Based Costing at Classic Brass Direct aterials Direct La or Shipping Costs verhead Costs FirstFirst-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Cost Objects: Products.

Inc. 2003 ..Activity-Based Costing at Classic Brass Direct aterials Direct La or Shipping Costs verhead Costs FirstFirst-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other SecondSecond-Stage Allocations $/MH $/Order $/Design $/Customer Cost Objects: Products. Customers McGraw-Hill/Irwin Unallocated © The McGraw-Hill Companies.

6.Assigning Costs to Cost Objects VG Let¶s take a look at how our system works for just one customer ± Windward Yachts. Standard Stanchions no design re uired 1. 2003 McGraw-Hill/Irwin . Each housing required 4 machine-hours . Direct labor totals $1. 2. Direct labor totals $50. © The McGraw-Hill Companies. Each stanchion required 0. Selling price is $650 each. 4. 5..5 machine-hours . 6. Inc. Direct materials total $2. 400 units ordered with 2 separate orders. 2. Custom Compass Housing re uires new design 1. 4. machine3. 5. Shipping costs total $25. machine3. Selling price is $34 each.850. Direct materials total $13. Shipping costs total $180. One order during the year.110.

it is not assigned to products.285 McGraw-Hill/Irwin © The McGraw-Hill Companies. 2003 . Inc.Assigning Costs to Cost Objects Ove ea t f r t e Sta (a) Act t t $ 315 1 285 19 3 675 ard Sta c (b) Act t 2 0 200 N/ s Act t t Cust e e s uct es P e s ze Cust e e at s (a) (b) ABC Cost $ 630 3 800 The customer-level customercost is assigned to customers directly.675 (b) Activity 1 1 N/ (a) (b) ABC Cost $ 315 1.285 19 3. Overhead Cost for the Custom Housing Activity tP l Customer orders roduct design rder size Customer relations (a) Activity Rate $ 315 1..

110 1. Inc..Prepare Management Reports Standard Stanchions Sales Cost: Direct materials Direct labor Shipping costs Customer orders Product design Order size Product margin $ $ 2.764 $ (1.030 Custom Compass Housing Sales Cost: Direct materials Direct labor Shipping costs Customer orders Product design Order size Product margin $ $ 13 50 25 315 1.850 180 630 3.285 76 650 1.800 $ 13.114) McGraw-Hill/Irwin © The McGraw-Hill Companies. 2003 .570 5.600 8.

030 (1..114) 3. 2003 . Inc.Prepare Management Reports Customer Profitability Analysis Windward Yachts Product margins: Standard stanchion Custom compass housing Total product margin Less: Customer relations Customer margin $ 5.675 $ 241 McGraw-Hill/Irwin © The McGraw-Hill Companies.916 3.

000 redetermined manufacturing = overhead rate McGraw-Hill/Irwin $1.000 20.000) (360) C H pass sing 0 (13) (50) (200) 387 $ 400 units x 0. 2003 .110) (1.5 MH/unit x $50/MH = $10. Inc.Product Margins Traditional Cost Accounting System Sal s C sts Direct aterials Direct labor Manufacturing overhead roduct argin Standard Stanchi ns 13.. 00 (2.000.000 MH = $50/MH © The McGraw-Hill Companies. 0) (10.

2003 .000 $200 Shipping $ 180 $ 25 Cust Order 630 315 Design 1. Inc.800 OH assigned $4.Comparison of ABC and Traditional Overhead Product Costs Standard Custom ABC Trad ABC Trad Overhead $10.610 $1..701 Product McGraw-Hill/Irwin © The McGraw-Hill Companies.285 76 Order size 3.

McGraw-Hill/Irwin Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. OrganizationOrganizationsustaining costs and the costs of idle capacity are not assigned to products.. 2003 . © The McGraw-Hill Companies. Inc.Difference Between ABC and Traditional Product Costs BatchBatch-level or productproductlevel costs will ordinarily shift overhead costs from highhigh-volume products produced in large batches to lowlow-volume products produced in small batches.

2003 .Benefits of ABC More cost pools = more accurate per unit costs Costs are assigned using relevant versus arbitrary drivers Makes overhead costs more manageable (traceable) Shifts costs from high to low volume products as appropriate Makes for better cost/pricing decisions McGraw-Hill/Irwin © The McGraw-Hill Companies.. Inc.

High time commitment and discipline required 4. .Activity-Based Costing and Reporting Limitations Most companies do not use ABC because . ABC does not conform to GAAP. . 1. Limited benefit if organization sustaining costs too high McGraw-Hill/Irwin © The McGraw-Hill Companies. 2003 . Inc.. High costs associated with ABC implementation 3. 2.

End of Chapter 8 McGraw-Hill/Irwin © The McGraw-Hill Companies. Inc. 2003 ..

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