Activity Based Costing: A Tool to Aid Decision Making

UAA ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

Chapter

Cost Measurement Cost Accumulation Cost Assignment

Direct Materials Direct Labor Mfg. Overhead Work-inProcess Finished Goods Cost-of Goods Sold

Goal: Accurately costed products.

Actual Costing System Normal Costing System Standard Costing System

Actual DM Actual DL Actual MOH

Actual DM Measuring Actual DL Estimated MOH Costs

Standard DM Standard DL Standard MOH

Cost Accounting Systems

Product Costs Job-Order Costing Process Costing

Total/Unit Cost

Assigning Manufacturing Costs

Functional Based Costing

Activity Based Costing

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 manufacturing and nonmanufacturing costs may be assigned to products. Some manufacturing costs may be excluded from product costs. Allocation bases often differ from traditional costing systems. Overhead rates may be based on activity at capacity. A number of cost pools each allocated to a product or cost object.

How Costs are Treated Under Activity-Based Costing

Activity Based Costing Departmental Overhead Rates Plantwide Overhead Rate

Overhead Allocation

Functional Based (Traditional) Costing

Departmental Overhead Rates

Indirect Labor Indirect Materials Other Overhead

Stage One: Costs assigned to pools

Cost pools
Stage Two: Costs applied to products

Department 1
Direct Labor Hours

Department 2
Machine Hours

Department 3
Raw Materials Cost

Products
Departmental Allocation Bases

Peanut-butter costing describes a cost approach that uniformly assigns (spreads or smooths out) the cost of resources to cost objects.

Functional-Based Management Model

Cost View

Resources

Operational View

Efficiency Analysis

Functions

Performance Analysis

Products

The problem with this approach is that individual products, services, etc., may use those resources in a nonuniform way.

The end result is that some products will be overcosted while others will be undercosted.

Refining a Cost System

Reclassify

indirect costs as direct

costs.
Define

more cost pools.

Identify
Use

cost drivers.

Activity-Based Costing.

Activity-Based Management Model

Cost View

Resources

Operational View

Driver Analysis

Activities

Performance Analysis

Products & Customers

Designing an ABC System

Cost Objects (e.g., products and customers)

Activities

Consumption of Resources

Cost

Designing an ABC System

1. Identify and define activities and activity cost pools. 2. Whenever possible, directly trace costs to activities and cost objects. 3. Assign costs to activity cost pools. 4. Calculate activity rates.

Designing an ABC System

5. Assign costs to cost objects using the activity rates and activity measures. 6. Prepare management reports.

Identify and Define Activities and Activity Cost Pools

Step #1:Identify and Define Activities and Activity Cost Pools

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

$$ $ $$$

Activity Levels (Step #1)

Batch Level Product Level

Activity Levels
Unit Level Customer Level Organization-Sustaining Level

Step #1: Identify and Define Step #1 For Classic Brass Activities and Activity Cost Pools
At Classic Brass, the ABC team, 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

Step #1:Identify and Define Activities and Activity Cost Pools

Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product Designs - assigned all costs of resources consumed by designing products. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced.

Step #1:Identify and Define Activities and Activity Cost Pools

Customer Relations assigned all costs associated with maintaining relations with customers. Other assigned all overhead costs that are not associated with the other cost pools.

Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects.

The overhead costs at Classic Brass

Exhibit 8-2

Assign Costs to Activity Cost Pools

The overhead costs at Classic Brass

Exhibit 8-2

Assign Costs to Activity Cost Pools

At Classic Brass the following distribution of resource consumption across activity cost pools is determined.
Activity Cost Pools Customer Product Order Orders Design Size Production 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.

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

500,000 300,000 120,000 Other $ 80,000

Total 1,000,000 40,000

400,000 50,000 60,000 250,000 50,000 $

510,000

300,000 1,850,000

Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

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 60,000

500,000 300,000 120,000 Other $ 80,000

Total 1,000,000 40,000

400,000 50,000 60,000 250,000 50,000 $

510,000

300,000 1,850,000

Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

Assign Costs to Activity Cost Pools

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 60,000 15,000 50,000 5,000 $ 315,000 $ 200,000 12,000 20,000 25,000 $ 257,000

Order Size $ 100,000 180,000 60,000 40,000 $ 380,000

Customer Relations $ 50,000 120,000 12,500 150,000 35,000 $ 367,500

Other $ 25,000 60,000 48,000 80,000 160,000 22,500 60,000 25,000 10,000 $ 490,500 $

Total 500,000 300,000 120,000 80,000 400,000 50,000 60,000 250,000 50,000 $ 1,810,000

Calculate the Activity Rates

Activity Cost Pools For Step #1: Identify and Define Classic Brass Activity Cost Pools Activities and
At Classic Brass, the ABC team, 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

Calculate Activity Rates

The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . .
1,000 customer orders 200 new designs 20,000 machine-hours 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.

Calculate Activity Rates

Computation of Activity Rates

Activity Cost Pools Customer orders Product design Order size Customer relations Other (a) Total Cost $ 315,000 257,000 380,000 367,500 490,500 (b) Total Activity 1,000 orders 200 designs 20,000 MHs 100 customer Not applicable (a) (b) Activity Rate $315 per order $1,285 per design $19 per MH $3,675 per customer Not applicable

Activity-Based Costing at Classic Brass

Direct Materials Direct Labor Shipping Costs Overhead Costs

Traced

Traced

Traced

Cost Objects:
Products, Customer Orders, Customers

Activity-Based Costing at Classic Brass

Direct Materials Direct Labor Shipping Costs Overhead Costs

First-Stage Allocation

Order Size

Customer Orders

Product Design

Customer Relations

Other

Cost Objects:
Products, Customer Orders, Customers

Activity-Based Costing at Classic Brass Activity-Based Costing at Classic Brass

Direct Materials Direct Labor Shipping Costs Overhead Costs

First-Stage Allocation

Order Size

Customer Orders

Product Design

Customer Relations

Other

Second-Stage Allocations
$/MH $/Order $/Design $/Customer

Cost Objects:
Products, Customer Orders, Customers

Unallocated

Assign Costs to Cost Objects

Assigning Costs to Cost Objects

Lets take a look at how our system works for just one customer Windward Yachts.
Standard Stanchions (no design required) 1. 400 units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours . 3. Selling price is $34 each. 4. Direct materials total $2,110. 5. Direct labor totals $1,850. 6. Shipping costs total $180. Custom Compass Housing (requires new design) 1. One order during the year. 2. Each housing required 4 machine-hours . 3. Selling price is $650 each. 4. Direct materials total $13. 5. Direct labor totals $50. 6. Shipping costs total $25.

Computation of Activity Rates

Activity Cost Pools Customer orders Product design Order size Customer relations Other (a) Total Cost $ 315,000 257,000 380,000 367,500 490,500 (b) Total Activity 1,000 orders 200 designs 20,000 MHs 100 customer Not applicable (a) (b) Activity Rate $315 per order $1,285 per design $19 per MH $3,675 per customer Not applicable

Standard Stanchions (no design required) 1. 400 units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours . 3. Selling price is $34 each. 4. Direct materials total $2,110. 5. Direct labor totals $1,850. 6. Shipping costs total $180.

Custom Compass Housing (requires new design) 1. One order during the year. 2. Each housing required 4 machine-hours . 3. Selling price is $650 each. 4. Direct materials total $13. 5. Direct labor totals $50. 6. Shipping costs total $25.

Computation of Activity Rates

Activity Cost Pools Customer orders Product design Order size Customer relations Other (a) Total Cost $ 315,000 257,000 380,000 367,500 490,500 (b) Total Activity 1,000 orders 200 designs 20,000 MHs 100 customer Not applicable (a) (b) Activity Rate $315 per order $1,285 per design $19 per MH $3,675 per customer Not applicable

Prepare Management Reports

Product Margins
Traditional Cost Accounting System
Sales Costs Direct materials Direct labor Manufacturing overhead Product margin Standard Stanchions $ 13,600 (2,110) (1,850) (10,000) (360) Compass Housing $ 650 (13) (50) (200) 387

400 units x 0.5 MH/unit x $50/MH = $10,000

Predetermined manufacturing = overhead rate

$1,000,000 20,000 MH

= $50/MH