4 ActivityBased Costing Systems Mc GrawHillIrwin The Mc

4 Activity-Based Costing Systems Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

2 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. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

3 Traditional Costing Systems Overhead is allocated to jobs using direct labor hours. If overhead is $120, how much overhead is allocated to each job? Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

4 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 Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

5 Traditional Costing Systems Automation increases overhead from $120 to $420 and reduces the Job 2 labor hours from 6 to 1. Allocate the $420 overhead to the two jobs using direct labor. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

6 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 Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

7 Traditional Costing Systems Is this reasonable? Automation benefited Job 2, but Job 1 is allocated more overhead. Clearly, we need another cost driver to allocate overhead. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

8 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. Lot size Des ign time Mc. Graw-Hill/Irwin t Direc rs u o h r labo Mac hine hou rs s Proces setups Cust omer cont act The Mc. Graw-Hill Companies, Inc. 2006

9 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 Consume Resources People Manage Activities Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

10 Activity-Based Costing (ABC) Both manufacturing and nonmanufacturing costs may be assigned to products. ABC is a good supplement to our traditional cost system. A Allocation bases often differ from traditional costing systems. Mc. Graw-Hill/Irwin B C ABC is used primarily for decision making, not for inventory valuation for external reporting. The Mc. Graw-Hill Companies, Inc. 2006

11 Activity-Based Costing (ABC) Activity-Based Costing Traditional Costing Mc. Graw-Hill/Irwin 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 The Mc. Graw-Hill Companies, Inc. 2006

12 Activity-Based Costing (ABC) Traditional Costing Resource Costs Directly traced or allocated Cost Pools: Plants or Departments Predetermined overhead rate Cost Objects Mc. Graw-Hill/Irwin Activity-Based Costing Resource Costs Directly traced or allocated Cost Pools: Activities or Activity Centers Cost driver rates for each activity Cost Objects The Mc. Graw-Hill Companies, Inc. 2006

13 Activity-Based Costing (ABC) An Activity Cost Pool is a “container” in which costs are accumulated that relate to a single activity in the ABC system. Mc. Graw-Hill/Irwin Costs $$ $ $ The Mc. Graw-Hill Companies, Inc. 2006

14 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. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

15 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. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

16 Identify and Classify Activities TOP DOWN APPROACH ABC teams of middlemanagement or above develop the activity dictionary. RECYCLING APPROACH Reuses documentation of processes used for other purposes. Mc. Graw-Hill/Irwin INTERVIEW OR PARTICIPATIVE APPROACH ABC teams include or interview operating employees. The Mc. Graw-Hill Companies, Inc. 2006

17 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. Mc. Graw-Hill/Irwin Ask employees to indicate how much time they work on various activities. The Mc. Graw-Hill Companies, Inc. 2006

18 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 Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

19 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? Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

20 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 Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

21 Calculate Cost-Driver Rates for Activities Cause and effect relationship between activity and costs Based on resource’s practical capacity to support activities Mc. Graw-Hill/Irwin Measurable Appropriate cost-driver base Predict or explain an activity’s use of resources The Mc. Graw-Hill Companies, Inc. 2006

22 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. Mc. Graw-Hill/Irwin 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? The Mc. Graw-Hill Companies, Inc. 2006

23 Practical Capacity Note 80%, or $800 should be assigned to Product A Mc. Graw-Hill/Irwin 20%, or $200 should be assigned to “unused capacity” The Mc. Graw-Hill Companies, Inc. 2006

24 Assign Activity Costs to Products 1. Identify all the activities related to a given product or service. Mc. Graw-Hill/Irwin 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. The Mc. Graw-Hill Companies, Inc. 2006

25 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? Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

26 Assign Activity Costs to Products Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

27 Activity-Based Costing Example Let’s look at an example from the Bilson Company. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

28 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 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 Mc. Graw-Hill/Irwin = $1, 550, 000 77, 500 = $20/DLH The Mc. Graw-Hill Companies, Inc. 2006

29 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. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

30 Activity-Based Costing Example $130. 00 × 1. 50 Traditional Costing $975, 000 ÷ ($975, 000 +$3, 900, 000) × $500, 000 Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

31 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. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

32 Activity-Based Costing Example The total conversion cost is: Traditional overhead Labor (77, 500 hours @ $10) Total $1, 550, 000 775, 000 $2, 325, 000 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. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

33 Activity-Based Costing Example Management has identified the following five activities and costs in the production of its two products: Total conversion cost Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

34 Activity-Based Costing Example The following transaction data has been complied by management of Bilson: Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

35 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 Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

36 Activity-Based Costing Example The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilson’s two products. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

37 Activity-Based Costing Example The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilson’s two products. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

38 Activity-Based Costing Example The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilson’s two products. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

39 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. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

40 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. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

41 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. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

42 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? Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

43 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 Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

44 Activity-Based Costing Example No change in sales price ABC Costing Let’s compare product income using traditional and ABC costing. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

45 ABC Costing Traditional Costing Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

46 Activity-Based Costing Example Should Bilson drop Product A? Should Bilson increase the price of Product A? Mc. Graw-Hill/Irwin Should Bilson reduce the price of Product B? The Mc. Graw-Hill Companies, Inc. 2006

47 l l 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. Decreasing the price would increase volume, possibly resulting in more income. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

48 ABC– Benefits and Limitations More accurate and informative product costs lead to better decisions. More accurate measurements of the activities driving costs. Ž Provides managers with easier access to relevant costs. An ABC system is very expensive to develop and implement; it is also very time-consuming. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

49 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. Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006

50 End of Chapter 4 Mc. Graw-Hill/Irwin The Mc. Graw-Hill Companies, Inc. 2006