Chapter 8

Activity Based Costing:

A Tool to Aid Decision Making
3/24/04

Activity Based Costing (ABC)

ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore fixed costs.
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ABC is a good supplement to our traditional cost system

I agree!

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How Costs are Treated Under Activity-Based Costing

Activity Based Costing
Departmental Overhead Rates

Plantwide Overhead Rate

Overhead Allocation
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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. McGraw-Hill/Irwin

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Plant-wide Overhead Rate

POHR = Total Manufacturing Overhead Allocation Base Allocation Base usually Direct Labor Is used for all products manufactured Is applied only to those products that incur or use the allocation base, such as direct labor
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Departmental Overhead Rates

Finishing Department

Painting Department
Shipping Department

Many companies have a system in which each department has its own overhead rate.

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Departmental Overhead Rates

Stage One: Costs assigned to pools

Indirect Labor

Indirect Materials

Other Overhead

Cost pools

Department 1

Department 2

Department 3

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Departmental Overhead Rates

Stage One: Costs assigned to pools

Indirect Labor

Indirect Materials

Other Overhead

Cost pools
Stage Two: Costs applied to products

Department 1

Department 2

Department 3

Products

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Departmental Overhead Rates

Stage One: Costs assigned to pools

Indirect Labor

Indirect Materials

Other Overhead

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

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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 Based Costing

Products are charged for the costs of capacity they use not for the costs of capacity they dont use. Idle capacity Is charged as a period Cost.

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Designing of an ABC System

Steps for Implementing ABC
Identify and define activities and activity cost pools. Trace costs to those activities and cost objects. Assign all other traceable costs to activity cost pools. Non-traceable costs lumped. Calculate activity rates. Assign costs to cost objects(products, customers). Prepare management reports.

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Identify and Define Activities and Activity Cost Pools

Unit-Level Activity (machining) Batch-Level Activity (customer order)

A part of the production process for which management wants a separate reporting of the costs of the activity involved.

Product-Level Activity (product design)

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Organizationsustaining Activity (lumped)

Customer-Level Activity (customer relations)

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Identify and Define 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

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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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$$ $ $ $ $

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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. I.e., machine shop costs 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.
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Whenever Possible, Directly Trace all Overhead Costs to Activities and Cost Objects
Overhead Costs at Classic Brass (Manufacturing and NonManufacturing) Production Department Indirect factory wages $ Factory equipment depreciation Factory utilities Factory building lease 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
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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

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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.
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
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Customer Relations 10% 0% 0% 0%

Other 5% 20% 40% 100%

Total 100% 100% 100% 100%

25% 20% 0% 0%

40% 0% 10% 0%

20% 60% 50% 0%

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.

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Assign Costs to Activity Cost Pools

Overhead Costs at Classic Brass (Manufacturing and NonManufacturing) Production Department $ CostIndirect Pools factory wages Factory equipment depreciation Product Order Customer Factory utilities Design Sizelease Relations Factory building 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
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Assign Costs to Activity Cost Pools

Overhead Costs at Classic Brass (Manufacturing and NonManufacturing) Production Department $ CostIndirect Pools factory wages Factory equipment depreciation Product Order Customer Factory utilities Design Sizelease Relations Factory building 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
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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

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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

Computation of Activity Rates
Activity Cost Pools Customer orders Product design Order size Customer relations Other Total (a) Total Cost $ 315,000 257,000 380,000 367,500 490,500 $1,810,000 (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

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Activity-Based Costing at Classic Brass

Direct Materials Direct Labor Shipping Costs Overhead Costs

Traced

Traced

Traced

Cost Objects:
Products, 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

Cost Objects:
Products, 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, Customers
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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. The McGraw-Hill Companies, Inc., 2003

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Assigning Costs to Cost Objects

Overhead Cost for the Standard Stanchions
Activity Cost Pools Customer orders Product design Order size Customer relations (a) Activity Rate $ 315 1,285 19 3,675 VG 22 (b) Activity 2 0 200 N/A (a) (b) ABC Cost $ 630 3,800

The customer-level cost is assigned to customers directly; it is not assigned to products.

Overhead Cost for the Custom Housing

Activity Cost Pools Customer orders Product design Order size Customer relations (a) Activity Rate $ 315 1,285 19 3,675 (b) Activity 1 1 4 N/A (a) (b) ABC Cost $ 315 1,285 76

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Prepare Management Reports

Standard Stanchions Sales Cost: Direct materials Direct labor Shipping costs Customer orders Product design Order size Product margin $ $ 2,110 1,850 180 630 3,800 $ 13,600

8,570 5,030

Custom Compass Housing Sales Cost: Direct materials Direct labor Shipping costs Customer orders Product design Order size Product margin

$ $ 13 50 25 315 1,285 76

650

1,764 $ (1,114)

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Prepare Management Reports

Customer Profitability Analysis
Windward Yachts Product margins: Standard stanchion Custom compass housing Total product margin Less: Customer relations Customer margin

$ 5,030 (1,114) 3,916 3,675 $ 241

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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

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$1,000,000 20,000 MH

= $50/MH
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Comparison of ABC and Traditional Overhead Product Costs

Product Standard ABC Trad 10000 180 630 Custom ABC Trad 200 25 315 1285 76 1701
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Overhead Shipping Cust Order Design Order size 3800 OH assigned 4610
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Contrasting ABC and Traditional Costing

See TM 8-16 Calculate cost per unit for both Stanchions and Custom Compass Housing Note the shift in overhead costs from the high volume Stanchions to the low volume Custom Compass Housings

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Difference Between ABC and Traditional Product Costs

Batch-level or productlevel costs will ordinarily shift overhead costs from high-volume products produced in large batches to low-volume products produced in small batches.
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Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organizationsustaining costs and the costs of idle capacity are not assigned to products.
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Activity-Based Costing and External Reporting

Most companies do not use ABC for external reporting because . . .
1. External reports are less detailed than internal reports. 2. It may be difficult to make changes to the companys accounting system.

3. ABC does not conform to GAAP.

4. Auditors may be suspect of the subjective allocation process based on interviews with employees.

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Benefits of ABC
More cost pools = more accurate costs on a per unit basis Cost are assigned using relevant versus arbitrary drivers Makes overhead costs more manageable (traceable) Shifts costs from high volume to low volume products as appropriate
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Limitations of ABC
Too many organization sustaining costs can limit the benefits of ABC There are high costs associated with ABC implementation High time commitments and discipline required in making necessary cost changes
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ABC Review Problem

See pages 340 342 Step 1: Allocate overhead costs to activity pools Step 2: Calculate activity rates by dividing each pool cost by activity Step 3: Use activity rates to assign overhead costs to products based on activities per product
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End of Chapter 8

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