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Activity-Based CostingActivity-Based Costing

Key ConceptsKey Concepts

CostsCosts

Life cycleFirstOperating & MaintenanceDisposalSunkFutureOpportunityDirectIndirectOverheadFixedVariable

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Cost Structure for ManufacturingCost Structure for Manufacturing

Direct materialDirect labor Sum is prime costsIndirect materialIndirect labor Factory overheadFixed and miscellaneous Sum is cost of goods

madeGeneral and administrativeSelling Sum is cost of good soldProfit Sum is selling price

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Cost EstimatingCost Estimating

What cost components must be estimated?First component ~ equipment, delivery, installation

insurance, trainingElements – Direct labor and materials, maintenance

What approach to cost estimation will be applied?Bottom-up, design-to-cost or top-down

How accurate should estimates be?ROMs ~ 20% of actual costs, Detail 5%

What estimation techniques will be used?Unit, cost indices, learning curves, capacity, analogy

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Cost EstimationCost Estimation

Cost component estimates

Cost Estimates

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Required price Bottom-Up

Top-Down DTCRequired price

Unit MethodUnit Method

CT = U x N

Cost of operating a car (43 cents / mile)Cost to bury fiber cable ($30K / mile)Cost to construct a parking space in parking garage $4500Cost to construct Interstate highway ($6.2 M /mile)Cost of house construction ($225 /ft2)

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Total Cost EstimateTotal Cost Estimate

Resource Amount, N Unit Cost Factor U

Cost Estimate U x N

Materials 3000 tons $45.90 per ton $137,700

Machinery, tooling 1500 hours $120 per hour 180,000

Labor, casting 3000 hours $ 55 per hour 165,000

Labor, Finishing 1200 hours $ 45 per hour 54,000

Labor, indirect 400 hours $ 75 per hour 30,000

Total cost estimate $566,700

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Cost IndexesCost Indexes

Cost index is a ratio of the cost of something today to its cost sometime in the past.

CPI ~ Consumer Price Index

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Cost CapacityCost Capacity

C2 = C1 (Q2 / Q1)x (It /I0)

The total cost for a digester with a flow rate of ½ MGD was $1.7M in 2000. Estimate the cost for a flow rate of 2 MGD. The cost index in 2000 of 131 is now 225 and the exponent x = 0.14 for the range flow 0.2 to 40 MGD.

C2 = 1,700,000 * (2/0.5)0.14 (225/131)

= $3,546,178.Component Size Range ExponentActivated sludge plant 1-100 MGD 0.84Aerobic digester 0.2-40 MGD 0.14…. … …

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Cost Estimating RelationshipsCost Estimating Relationships

Factor Method (Hans J. Lang)CT = h x CE

Total cost = factor times cost of major equipment where h is usually used as 4.

Delivered equipment cost is $1.55M imply a total cost of4 * $1.55M = $6.2M

Factor method can be broken down into direct and indirect costs. h = 1 + => CT = [CE(1 + )](1 + fd)

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1

n

ii

f

1

n

ii

f

Learning CurveLearning CurveTN = T1 Nb where N is unit number, T1 is cost or time for first

item, TN is the cost or time for the Nth unit and b is the slope of the learning curve in decimal.

b = (Log learning-rate 2) = Ln L / Ln 2 Unit Hours Cumulative (sim-lc 100 10 90) 1 100.00 100.00

2 90.00 190.00 3 84.62 274.62 4 81.00 355.62 5 78.30 433.92 6 76.16 510.08 7 74.39 584.47 8 72.90 657.37 9 71.61 728.98 10 70.47 799.45

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Learning Curve ExampleLearning Curve ExampleTo build 25 FEMA test units took 200 hours for the first one. The direct and indirect labor costs average $50.hour and 80% learning curve is assumed. Estimate the total labor cost for the 25 units. (sim-lc 200 25 80) Unit Hours Cumulative Unit Hours Cumulative 1 200.00 200.00 16 81.92 1784.03 2 160.00 360.00 17 80.34 1864.36 3 140.42 500.42 18 78.87 1943.24 4 128.00 628.42 19 77.51 2020.75 5 119.13 747.55 20 76.24 2096.99 6 112.34 859.88 21 75.05 2172.04 7 106.90 966.78 22 73.94 2245.98 8 102.40 1069.18 23 72.89 2318.87 9 98.59 1167.77 24 71.90 2390.76

10 95.30 1263.07 25 70.96 2461.72 TC = 2461.72 * 50 = $123,086 11 92.42 1355.50 12 89.87 1445.37 13 87.58 1532.95 14 85.52 1618.47 15 83.64 1702.11

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Indirect Cost (Overhead)Indirect Cost (Overhead)Traditional Overhead = Estimated total indirect cost

Estimated basis level

Allocation Basis Indirect Cost Category Direct labor hours Machine shop, human resources, supervisionDirect labor cost Machine shop, supervision, accountingMachine hours Utilities, IT network serversCost of materials Purchasing, receiving, inspectionSpace occupied Taxes, utilities, bldg maintenanceAmount consumed Utilities, food servicesNumber of items Purchasing, receiving, inspectionNumber of accesses SoftwareNumber of inspections Quality assurance

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Blanket RateBlanket Rate

Example

Blanket indirect cost rate = total expected indirect coststotal estimated materials

costs

Automated vs. non-automated could cause discrepancy with low value items mixed with high value items resulting in over-accumulating of indirect costs for -lower value items.

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Economic Value Added (EVA)Economic Value Added (EVA)

EVA ~ adding value to the shareholders looks at the difference between net operating profit

and the cost of capital.

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Activity Based Cost (ABC) Accounting Activity Based Cost (ABC) Accounting

Rate sensitive to value added is a production hour rate method.

Using more than one basis led to the ABC method.

Factory costs are the sum of the costs of goods.

Automation advances result in decreased direct hours.Once 35% to 45% of final cost due to labor; now 5 to 15%Indirect cost comprise as much as 35% to 45% of total cost

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Four Key ConceptsFour Key Concepts

Activity accounting ~ decomposes into a cause-and-effect rationale of how activities results in outputs

Cost Drivers ~ an event that affects cost/performance of a group of related activities. Number of machine hours, engineering change notices, purchase orders

Direct traceability ~ attributing costs to products or processes that consume resources

Non-value-added costs

ABC identify and place a cost on the activities performed so that management can determine desired changes

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ExampleExampleXYZ makes 2 models Qt = 50K each Model ADirect material cost $2,800,600Direct labor cost $ 350,000Direct labor hours 35,000 $7M Model BDirect material cost $ 1,500,000Direct labor cost $ 250,000Direct labor hours 25,000 $5M

Total Manufacturing overhead costs $12,000,000Traditional (volume-based absorption) costing systemCost rate = Total Overhead Costs / Total Direct Labor Hours

= 12M / 60K hours = $200 per direct labor hour

Allocated overhead 35K hours * $200 = $7M Model A => $10,150,600Allocated overhead 25K hours * $200 = $5M Model B => $6,750,000Total costs for 50K units $10,150,600/50K = $203 A and $135 B

… continued

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Activity-based Costing DataActivity-based Costing DataSix Main Activities for ManufacturingSix Main Activities for Manufacturing

Activity $ Costs Cost Driver Budgeted RateProduction $8M # of machine hrs 200K hoursEngineering 1M # ECO 40K orders Material Handling 1M # of material moves 60K movesReceiving 800K # of batches 500 batchesQuality Assure 800K # of inspections 20K inspectionsPack & Ship 400K # of products 100K products

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ABC Driver Rates for Models A & BABC Driver Rates for Models A & B

Activity Model A Model BProduction 50K hours 150K hoursEngineering 15K orders 25K ordersMaterial Handling 20K moves 40K movesReceiving 150 batches 350 batchesQuality Assurance 6K inspections 14K inspectionsPack & ship 50K products 50K products

EVA ExampleEVA Example

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Firm X Firm YCapital Invested $100 $200

Annual Operating Profit $ 25 $ 35

Taxes (40%) $ 10 $ 35

NOPAT* (profit after tax) $ 15 $ 21

Cost Capital (12%) $ 12 $ 24EVA +$3 -$3

Return on Assets (ROA) 15% = 15/100 10.5% = 21/200

Cost of Capital 12% 12%

Difference +3% -1.5%

EVA = Difference x Assets +$3 = 0.03*100 -$3 = -0.015*200

*NOPAT Net Operating Profit After Taxes

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ABC for XYZABC for XYZ Applied Activity Rate Model A Model B

Production $40/machine hr $2M $6MEngineering $25/ECO $375K $625KMaterial Hand $16.67/move $333,400 $666,600Receiving $1,600/batch $240,000 $560,000QA $40/inspection $240,000 $560,000Pack & Ship $4 / product $200,000 $200,000Total Overhead Costs $3,388,400 $8,611,600Direct material cost $2,800,600 $1.5M Direct labor costs $350,000 $250KTotal costs $6,539K $10,361,600 Cost per unit $130.78 $207.23Cost per unit (traditional) $203 $135

$12M = $3,388,400 + $8,611,600Example: Production consumes 50K + 150K = 200K machine hours. $8M/200K = $40/machine hr.

Activity-based Costing vs. TraditionalActivity-based Costing vs. Traditional(Volume-based absorption VBC)(Volume-based absorption VBC)

Model A Model BTraditional costing $203.00 $135.00Activity-based costing $130.78 $207.24

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Model A is less expensive to make than Model B.

Traditional based cost estimates on Model A being responsible for more overhead costs than B using direct labor hours as its base. In reality Model B incurs more overhead because of difference in number of transactions.

ABC ExampleABC Example

A firm with 4 plants used traditional methods for business travel. See table below. Last year $500K in travel expenses were distributed at a rate of $500K/29,100 = $17.18 / employee. A switch to ABC was considered.

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City Employees AllocationParis 12,500 $214,777

Florence 8,600 147,766

Hamburg 4,200 72,165

Athens 3,800 65.292

29,100 $500,000

Travel Voucher BasisTravel Voucher BasisPlant 1 2 3 4 5 TotalParis 50 25 75

Florence 80 30 30 140

Hamburg 100 25 20 145

Athens 140 140

Total 230 50 30 20 170 500

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Plant ABC Allocation Traditional AllocationParis $75,000 $214,777

Florence 140,000 147,766

Hamburg 145,000 72,165

Athens 140,000 65,292

500,000, 500 = $1000/voucher

ProblemProblem

If the processing cost decreases by a constant 4% every time the output is doubled, the slope parameter of the learning curve is closest to:

a)-0.009 b) -0.059 c) 0.991 d) -1.699

(Log 0.96 2) -0.058894

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ProblemProblem

The cost of a robot is $80K and the cost for one with twice the capacity is $120K. The value of the exponent in the cost-capacity equation is closest to

a)0.51 b) 0.58 c) 0.62 d) 0.69

C2 = C1 (Q2 / Q1)x (It /I0)

120 = 80*2x

x = 0.58496

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ProblemProblem

Delivered equipment costs $650K with direct cost factor 1.82 and indirect cost factor 0.31. The total plant cost estimate is approximately

a)$2,034,500b) $1,734,500

c)$1,384,500 d) $1,183,000

TC = (1 + 1.82 + 0.31) * 650K = $2,034,500

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ProblemProblem

Police want to allocate indirect cost for speed monitoring of 3 toll roads. An allocation basis that may not be reasonable is

a)Miles of toll road monitoredb)Average number of cars patrolling per hoursc)Amount of car traffic per section of toll roadd) Cost to operate a car.

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ProblemProblem

First one took 24.5 seconds to paint with a 95% learning rate. How long to paint the 10th one?

a)20.7 seconds b) 0.46 secondsc)2.75 seconds d) 15.5 seconds

T10 = 24.5 * 10 (Log 0.95 2)

= 20.66 sec.

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ProblemProblem

Cost of capital is 12%. Consider the two firms below.Which seems better? Firm B, but Firm A is better.

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Firm A Firm BEquity $100 $200

Annual Operating Profit $25 $35

Taxes (40%) $10 $14

Net income $15 $21

Cost of Capital (12%) $12 $24

EVA (economic value added) $3 -$3