Activity Based Costing: A Tool to Aid Decision Making

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Activity Based CostingA Tool to Aid Decision
Making
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Activity Based Costing (ABC)
Both manufacturing and nonmanufacturing costs may
be assigned to products.
A number of cost pools each allocated to a
product or cost object.
Some manufacturing costs may be excluded from
product costs.
Overhead rates may be based on activity at
capacity.
Allocation bases often differ from traditional
costing systems.
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How Costs are Treated Under Activity-Based Costing
Activity Based Costing
Departmental Overhead Rates
Level of Complexity
Plantwide Overhead Rate
Overhead Allocation
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Cost of Idle Capacity

• Traditional Cost Accounting
• The predetermined overhead rate is based on
  budgeted activity. This results in applying
  overhead costs of unused, or idle, capacity.

• Activity BasedCosting
• Products are charged for the costs of capacity
  they use not for the costs of capacity they
  dont use.

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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.
  Organization-sustaining costs and the costs of
  idle capacity are not assigned to products.

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Designing an ABC System
Cost Objects (e.g., products and customers)
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Designing of an ABC System

• Steps for Implementing ABC
• Identify and define activities and activity cost
  pools.
• Trace costs to activities and cost objects.
• Assign costs to activity cost pools.
• Calculate activity rates.
• Assign costs to cost objects.

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?Identify and Define Activities and Activity Cost
Pools
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?Identify and Define Activities and Activity Cost
Pools

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

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Activity-Based Costing at Classic Brass
Direct Materials
Direct Labor
Shipping Costs
Overhead Costs
First-Stage Allocation
Activity 1
Activity 2
Activity 3
Activity 4
Other
Cost Objects Products, Customer Orders, Customers
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?Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of
resource consumption across activity cost pools
is determined.
Not included because they are directly traced
to customer orders.
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?Assign Costs to Activity Cost Pools
Indirect factory wages
500,000 Percent consumed by customer orders
25 125,000
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?Assign Costs to Activity Cost Pools
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?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.
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?Calculate Activity Rates

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Activity-Based Costing at Classic Brass
Direct Materials
Direct Labor
Shipping Costs
Overhead Costs
Cost Objects Products, Customer Orders, Customers
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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
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?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.
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?Assigning Costs to Cost Objects
The customer-level cost is assigned to customers
directly it is not assigned to products.
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Limitations of ABC
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 systems are a major project requiring
substantial resources. The benefits of increased
accuracy must outweigh these additional costs.
ABC data can be misinterpreted and must be used
with care when making decisions.