ActivityBased Costing Systems

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• Activity-BasedCosting Systems

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Traditional Costing Systems
Traditional cost systems were created
whenmanufacturing processes were labor intensive.
A single company-wide overhead rate,based on
direct labor hours, may be used to allocate
overhead to productsin these labor intensive
processes.
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Traditional Costing Systems
Overhead is allocated to jobs using directlabor
hours. If overhead is 120, how muchoverhead is
allocated to each job?
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Traditional Costing Systems
Overhead Rate 120 8 direct labor
hours Overhead Rate 15 per direct labor
hour Job 1 2 hours 15 per hour
30 Job 2 6 hours 15 per hour 90
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Traditional Costing Systems
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Traditional Costing Systems
Overhead Rate 420 3 direct labor
hours Overhead Rate 140 per direct labor
hour Job 1 2 hours 140 per hour
280 Job 2 1 hour 140 per hour
140
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Traditional Costing Systems
Is this reasonable? Automation benefited Job 2,
but Job 1 isallocated more overhead. Clearly,
we needanother cost driver to allocate overhead.
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Activity-Based Costing (ABC)
A costing method that first assigns costs to
activities, then assigns costs to products based
on their use of the activities.
Directlabor hours
Processsetups
Lot size
Machinehours
Designtime
Customercontact
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Activity-Based Costing (ABC)
A costing method that first assigns costs to
activities, then assigns costs to products based
on their use of the activities.
Products Require Activities
Activities Consume Resources
People Manage Activities
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Activity-Based Costing (ABC)
Both manufacturing and nonmanufacturing costs may
be assigned to products.
ABC is a goodsupplement to our
traditionalcost system.
ABC is used primarilyfor decision making,
notfor inventory valuation for external
reporting.
Allocation bases often differ from traditional
costing systems.
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Activity-Based Costing (ABC)
Activity-Based Costing
Level of Complexity Cost of Implementation Level
of Benefits
TraditionalCosting
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Activity-Based Costing (ABC)
Traditional Costing
Activity-Based Costing
Resource Costs
Resource Costs
Directly tracedor allocated
Directly tracedor allocated
Cost Pools Plants or Departments
Cost Pools Activities or Activity Centers
Predeterminedoverheadrate
Cost driverrates foreach activity
Cost Objects
Cost Objects
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Activity-Based Costing (ABC)
Costs

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

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Four Steps in the ABC Process

• Identify and classify the activities related to
  the companys products or services.
• Estimate the cost of each activity identified in
  ?.
• Calculate a cost-driver rate for each activity.
• Assign activity costs to products using the
  cost-driver rate.

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? Identify and Classify Activities

• UNIT-LEVEL ACTIVITES
• Resources acquired and activities performed for
  individual units.

BATCH-LEVEL ACTIVITES Resources acquired and
activities performed for a group or batch of
similar products or services.
PRODUCT - LEVEL ACTIVITES Resources acquired and
activities performed to produce and sell a
specific product or service.
CUSTOMER- LEVEL ACTIVITES Resources acquired and
activities performed to serve specific customers.
FACILITY-LEVEL ACTIVITIES Resources acquired and
activities performed to provide general capacity
to produce goods or services.
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? Identify and Classify Activities
TOP DOWN APPROACH ABC teams of middle-management
or above develop the activity dictionary.
INTERVIEW OR PARTICIPATIVE APPROACH ABC teams
include or interview operating employees.
RECYCLING APPROACH Reuses documentation of
processes used for other purposes.
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? Estimate the Cost of Activities
The ABC teams should gather data on the costs of
all the activities identified in Step 1.
Examine accounting records for recorded cost
information.
Ask employees to indicate how much timethey
work on various activities.
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? Calculate Cost-Driver Rates for Activities

• Two pieces of information are required to compute
  the cost-driver rate
• Activity Cost
• Activity Volume

MAY Company has 4 employees in its Quality
Control Department. Salaries and costs for the
department total 360,000 per year. MAY produces
500,000 units of product a year. What is the
cost-driver rate per unit? 360,000 500,000
units .72 per unit
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? Calculate Cost-Driver Rates for Activities
MAY has a customer service center where customers
can call to ask questions. Customers pay a fixed
fee for each call they make to the service
center. It costs MAY 1,260,000 a year to operate
the center. The center receives 120,000 calls
per year. The center handles 1,000,000 minutes
of calls. What is the appropriate cost driver
total minutes for all calls or number of calls?
What is the cost-driver rate?
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? Calculate Cost-Driver Rates for Activities
Since customers are charged per call, the
proper activity in this case is the number of
calls handled by the center. The cost-driver rate
would be 1,260,000 120,000 units 10.50 per
call
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? Calculate Cost-Driver Rates for Activities
Appropriatecost-driverbase
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Practical Capacity Note
When estimating the cost of an activity, only the
costs associated with the product should be used
(practical capacity). The cost of unused
capacity should not be applied to products.
EXAMPLE Suppose we rent a 1,000 square foot
warehouse for 1,000 per month. Only 800 sq. ft.
are used to store Product A. The rest of the
warehouse is unused. How much rent cost
should be allocated to Product A?
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Practical Capacity Note
20, or 200 should be assigned to unused
capacity
80, or 800 should be assigned to Product A
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? Assign Activity Costs to Products
1. Identify all the activities related to a given
product or service.
2. Determine how many units of each activity are
used per unit of product.
3. Assign costs to products using the cost-driver
rates for each activity.
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? Assign Activity Costs to Products

• Example Yazz, Inc. produces 130,000 units of
  Product A and 400,000 units for Product B. Using
  the following cost information, how much overhead
  should be allocated to Product A?

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? Assign Activity Costs to Products
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Activity-Based Costing Example
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Activity-Based Costing Example

• Bilson, Inc. manufactures and sells 5,000 units
  of Product A (deluxe model), and 25,000 units of
  Product B (standard model) each year.
• Product A requires 3.0 DLH and Product B requires
  2.5 DLH to produce.
• Employing a traditional costing system, Bilson
  assigns overhead cost to products using direct
  labor hours.
• The predetermined overhead rate is

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Activity-Based Costing Example

• Bilsons unit product costs using traditional
  costing are

Bilson marks its products up by 50 percent and
allocatesits 500,000 customer service costs
based on revenue.
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Activity-Based Costing Example
Traditional Costing
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Activity-Based Costing Example
Sales of Product A have increased steadily since
introduction,but company income has declined.
Management at Bilson isunhappy with the
traditional costing system and they havedecided
to try activity-based costing.
In addition, management hasobserved that the
cost of directlabor is relatively stable.Since
labor does not behavelike a unit-level cost,
labor willbe combined with overhead andthe
total conversion costwill be assigned using ABC.
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Activity-Based Costing Example
In addition, management hasobserved that the
cost of directlabor is relatively stable.Since
labor does not behavelike a unit-level cost,
labor willbe combined with overhead andthe
total conversion costwill be assigned using ABC.
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Activity-Based Costing Example
Management has identified the following five
activities and costs in the production of its
two products
Total conversion cost
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Activity-Based Costing Example

• The following transaction data has been complied
  by management of Bilson

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Activity-Based Costing Example

• These data can be used to develop predetermined
  cost-driver rates for each of the five activities

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Activity-Based Costing Example

• The activity-based overhead rates we just
  calculatedcan be used to assign conversion costs
  to Bilsonstwo products.

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Activity-Based Costing Example

• The activity-based overhead rates we just
  calculatedcan be used to assign conversion costs
  to Bilsonstwo products.

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Activity-Based Costing Example

• The activity-based overhead rates we just
  calculatedcan be used to assign conversion costs
  to Bilsonstwo products.

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Activity-Based Costing Example

• Lets compute the product cost for A and B using
  our ABC overhead rates

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Activity-Based Costing Example

• Now compare the unit product costs using the
  traditional costing system and our ABC system.

Remember, we used one overheadrate based on
direct labor hours.
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Activity-Based Costing Example

• Now compare the unit product costs using the
  traditional costing system and our ABC system.

Adopting activity-based costing usually
results in a shift of batch-level and
product-level overhead costs from high-volume
standardproducts to low-volume, more complex
products.
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Activity-Based Costing Example

• Now compare the unit product costs using the
  traditional costing system and our ABC system.

Can you see how different allocation methods
might lead to making different management
decisions?
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Activity-Based Costing Example
Based on these results Bilson also decides to use
ABC to assign Its 500,000 customer service
costs. The applicable activity isnumber of
customer consultations. Customers buying Product
A,the deluxe model, require more consultations
than those buyingProduct B, the standard model.
Cost per consultation 500,000 125,000
consultations 4.00
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Activity-Based Costing Example
ABC Costing
Lets compare product income using traditional
and ABC costing.
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ABCCosting
TraditionalCosting
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Activity-Based Costing Example
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Activity-Based Costing Example

• The price of Product A, the deluxe model, should
  probably be increased. Customers who buy deluxe
  models may buy based on features instead of
  price.
• The price of Product B, the standard model, may
  be too high. Customers who buy standard models
  are price sensitive. Decreasingthe price would
  increase volume,possibly resulting in more
  income.

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ABC Benefits and Limitations

• More accurate and informative product costs lead
  to better decisions.
• More accurate measurements of the activities
  driving costs.
• Provides managers with easier access to relevant
  costs.

Benefits
Major Limitation
An ABC system is very expensiveto develop and
implement it isalso very time-consuming.
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When Should a Company Use ABC?

• Indirect costs are significant in proportion to
  direct costs.
• Goods are complex, requiring many inputs and
  processes.
• Complex, low-volume products are profitable while
  standard, high-volume products are not.
• Different departments believe costs are assigned
  inaccurately.
• The company loses bids it thought were low, and
  wins bids it thought were high.
• Operations have changed significantly, but the
  costing system has not changed.
• Introduction of new models result in higher
  sales, apparent profits per unit, but an overall
  income decline.

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End of Chapter 4