4 ActivityBased Costing Systems Mc GrawHillIrwin Copyright 2008

4 Activity-Based Costing Systems Mc. Graw-Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

2 Learning Objective 1

3 Traditional Costing Systems Traditional cost systems were created when manufacturing processes were labor intensive. A single company-wide overhead rate based on direct labor hours may be used to allocate overhead to products in these labor intensive processes.

4 Traditional Costing Systems In this example, overhead will be allocated to jobs using direct labor hours. If total overhead is $120, how much will be allocated to each job?

5 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

6 Traditional Costing Systems The company introduces automated machinery. Total overhead rises from $120 to $420, while the labor time needed for Job 2 falls from 6 hours to 1 hour. Now allocate the $420 overhead to the two jobs.

7 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

8 Traditional Costing Systems Is this a reasonable costing method? Automation benefited only Job 2, but most of the additional overhead cost was allocated to Job 1. Clearly, we need to look for another cost driver.

9 Learning Objective 2

10 Activity-Based Costing (ABC) A costing method that identifies the activities performed within the organization as it delivers its goods and services. Products Require Activities Consume Resources People Manage Activities

11 Activity-Based Costing (ABC) A costing method that assigns costs to products, based on the number of activities the organization used in producing them. Lot size Design time Direct labor hours Machine hours Process setups Customer contact

12 Activity-Based Costing (ABC) Both manufacturing and nonmanufacturing costs may be assigned to products. A B Allocation bases often differ from traditional costing systems. ABC is a good supplement to our traditional cost system. C Used in internal decision making as well as in inventory valuation for external reporting.

13 ABC Compared with Traditional Costing Activity-Based Costing Traditional Costing ty n i x tio e pl nta m e its o f m C e f le en o p B l e Im f v f lo e o L t e v s e o L C

14 ABC Compared with Traditional Costing Resource Costs Directly traced or allocated Cost Pools: Plants or Departments Predetermined overhead rate Cost Objects Activity-Based Costing Resource Costs Directly traced or allocated Cost Pools: Activities or Activity Centers Cost driver rates for each activity Cost Objects

15 Activity-Based Costing (ABC) An Activity Cost Pool is a common way to collect costs that are related to a specific activity in the ABC system. Activity Costs $$ $ $

16 Four Steps in the ABC Process Identify and classify the activities related to the company’s 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.

17 Learning Objective 3

18 Identify and Classify Activities UNIT-LEVEL ACTIVITIES Resources acquired and activities performed for individual units of product. BATCH-LEVEL ACTIVITIES Resources acquired and activities performed for a group or batch of similar products or services. PRODUCT-LEVEL ACTIVITIES Resources acquired and activities performed to produce and sell a specific product or service. CUSTOMER-LEVEL ACTIVITIES 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.

19 Identify and Classify Activities TOP DOWN APPROACH ABC teams of people from top levels of management generate the activity dictionary. RECYCLING APPROACH Reuses documentation of processes used for other purposes. INTERVIEW OR PARTICIPATIVE APPROACH ABC teams include or interview operating employees.

20 Learning Objective 4

21 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 time they work on various activities.

22 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

23 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 minutes of calls. What is the appropriate cost driver: total minutes for all calls or number of calls? What is the cost-driver rate?

24 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

25 Calculate Cost-Driver Rates for Activities Cause and effect relationship between activity and costs Based on resource’s practical capacity to support activities Measurable Appropriate cost-driver base Predict or explain an activity’s use of resources

26 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?

27 Practical Capacity Note 80%, or $800 should be assigned to Product A 20%, or $200 should be assigned to “unused capacity”

28 Learning Objective 5

29 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 costdriver rates for each activity.

30 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?

31 Assign Activity Costs to Products

32 Activity-Based Costing Example Let’s look at an example from the Bilson Company.

33 Activity-Based Costing Example l Bilson, Inc. manufactures and sells 5, 000 units of Product A (deluxe model), and 25, 000 units of Product B (standard model) each year. l Product A requires 3. 0 direct labor hours (DLH) and Product B requires 2. 5 DLH to produce. l Employing a traditional costing system, Bilson assigns overhead cost to products using direct labor hours. l The predetermined overhead rate is: Mfg. overhead cost Direct labor hours = $1, 550, 000 77, 500 = $20/DLH

34 Activity-Based Costing Example Bilson’s unit product costs using traditional costing are: Bilson marks its products up by 50 percent and allocates its $500, 000 customer service costs based on revenue.

35 Activity-Based Costing Example $130. 00 × 1. 50 Traditional Costing $975, 000 ÷ ($975, 000 +$3, 900, 000) × $500, 000

36 Activity-Based Costing Example Sales of Product A have increased steadily since introduction, but company income has declined. Management at Bilson is unhappy with the traditional costing system and they have decided to try activity-based costing. In addition, management has observed that the cost of direct labor is relatively stable. Since labor does not behave like a unit-level cost, labor will be combined with overhead and the total conversion cost will be assigned using ABC.

37 Activity-Based Costing Example The total conversion cost is: Traditional overhead Labor (77, 500 hours @ $10) Total In addition, management has observed that the cost of direct labor is relatively stable. Since labor does not behave like a unit-level cost, labor will be combined with overhead and the total conversion cost will be assigned using ABC. $1, 550, 000 775, 000 $2, 325, 000

38 Activity-Based Costing Example Management has identified the following five activities and costs in the production of its two products: Total conversion cost

39 Activity-Based Costing Example The following transaction data has been complied by management of Bilson:

40 Activity-Based Costing Example These data can be used to develop predetermined cost-driver rates for each of the five activities: $ 800, 000 ÷ 5, 000 Machine setups = $160. 00 per setup

41 Activity-Based Costing Example The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilson’s two products.

42 Activity-Based Costing Example The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilson’s two products.

43 Activity-Based Costing Example The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilson’s two products.

44 Activity-Based Costing Example Let’s compute the product cost for A and B using our ABC overhead rates: These amounts did not change as a result of using ABC.

45 Activity-Based Costing Example Now compare the unit product costs using the traditional costing system and our ABC system. Remember, we used one overhead rate based on direct labor hours.

46 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 standard products to low-volume, more complex products.

47 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?

48 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 is number of customer consultations. Customers buying Product A, the deluxe model, require more consultations than those buying Product B, the standard model. Cost per consultation = $500, 000 ÷ 125, 000 consultations = $4. 00

49 Activity-Based Costing Example No change in sales price ABC Costing Let’s compare product income using traditional and ABC costing.

4 -50 50 ABC Costing Traditional Costing

51 Learning Objective 6

52 Product Profitability Should Bilson drop Product A? Should Bilson increase the price of Product A? Now that we have measured product costs accurately, we see how profitable each product really is. Should Bilson reduce the price of Product B?

53 l l Product Profitability 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. Decreasing the price would increase volume, possibly resulting in more income.

54 Customer Profitability What are the costs and benefits of serving specific customers? Service calls Buy/sell orders Order changes Activity-based analysis can be used to track the costs of serving customers and those customers’ contribution to company profits.

55 Estimating Costs of New Products l l Apply ABC analysis of present product lines to proposed new products. This is valid as long as the activities involved with the new products are similar to those for the present products.

56 Learning Objective 7

57 ABC in Service and Merchandising Companies The process is exactly the same as for manufacturing! Identify and classify the activities related to the company’s 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 relevant cost-driver rates.

58 ABC– Benefits and Limitations More accurate and informative product costs lead to better pricing decisions. The activities driving costs are more accurately measured. Ž Managers gain easier access to the relevant costs. An ABC system is very expensive to develop and implement, and very time-consuming to maintain.

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

60 End of Chapter 4