activity based costing and traditional costing system

Activity-BasedCosting SystemsLearning Objective 1

Traditional Costing Systems

Traditional cost systems were created whenmanufacturing processes were labor intensive.

Traditional cost systems were created whenmanufacturing processes were labor intensive.

A single company-wide overhead ratebased on direct labor hours may be

used to allocate overhead to productsin these labor intensive processes.

A single company-wide overhead ratebased on direct labor hours may be

used to allocate overhead to productsin these labor intensive processes.

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?

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?


Job 1 Job 2

Labor Hours 2 6

Job 1 Job 2

Labor Hours 2 6

Overhead Allocation

30$ 90$

Overhead Rate = $120 ÷ 8 direct labor hoursOverhead Rate = $15 per direct labor hour

Job 1 = 2 hours × $15 per hour = $30Job 2 = 6 hours × $15 per hour = $90


The company introducesautomated machinery. Totaloverhead rises from $120 to

$420, while the labor timeneeded for Job 2 falls from

6 hours to 1 hour. Nowallocate the $420 overhead

to the two jobs.


Job 1 Job 2

Labor Hours 2 1

Overhead Allocation

280$ 140$

Overhead Rate = $420 ÷ 3 direct labor hoursOverhead Rate = $140 per direct labor hour

Job 1 = 2 hours × $140 per hour = $280Job 2 = 1 hour × $140 per hour = $140


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.

Job 1 Job 2

Labor Hours 2 1

Overhead Allocation

280$ 140$


Learning Objective 2

ProductsRequire

Activities

ActivitiesConsume

Resources

PeopleManage

Activities

Activity-Based Costing (ABC)

A costing method that identifies the activities performed within the organization as it delivers

its goods and services.

A costing method that identifies the activities performed within the organization as it delivers

its goods and services.

Directlabor hours

Machinehours

Processsetups

Designtime

Lot size

Customercontact


A costing method that assigns costs to products, based on the number of activities the

organization used in producing them.

A costing method that assigns costs to products, based on the number of activities the

organization used in producing them.

Used in internaldecision making as wellas in inventory valuation for external reporting.

Used in internaldecision making as wellas in inventory valuation for external reporting.


Both manufacturingand nonmanufacturing

costs may be assigned toproducts.

Both manufacturingand nonmanufacturing

costs may be assigned toproducts.

Allocation bases often differ from

traditional costingsystems.

Allocation bases often differ from

traditional costingsystems.

AB C

ABC is a goodsupplement

to our traditionalcost system.

ABC is a goodsupplement

to our traditionalcost system.

Level of C

omplexity

Cost of I

mplem

entatio

n

Level of B

enefits

TraditionalCosting

TraditionalCosting

Activity-BasedCosting

Activity-BasedCosting

ABC Compared with Traditional Costing

Resource CostsResource Costs

Cost Pools:Cost Pools:Plants or Plants or

DepartmentsDepartments

Cost ObjectsCost Objects

Traditional Costing

Resource CostsResource Costs

Cost Pools:Cost Pools:Activities orActivities or

Activity CentersActivity Centers

Cost ObjectsCost Objects

Activity-Based Costing

Directly tracedor allocated

Directly tracedor allocated

Predeterminedoverhead

rate

Cost driverrates foreach activity

ABC Compared with Traditional Costing

An Activity Cost Activity Cost PoolPool is a

common way to collect costs

that are related to a specific

activity in the ABC system.

$

$

$ $

$$

Activity Costs


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.




Assign activity costs to products using the cost-driver rate.

Four Steps in the ABC Process

Identify and Classify Activities

UNIT-LEVEL ACTIVITIESResources acquired and activities performed for individual units of product.

CUSTOMER-LEVEL ACTIVITIESResources acquired and activities performed to serve specific customers.

BATCH-LEVEL ACTIVITIES Resources acquired and activities performed for a group or batch of similar

products or services.

PRODUCT-LEVEL ACTIVITIESResources acquired and activities performed to produce and sell a

specific product or service.

FACILITY-LEVEL ACTIVITIESResources acquired and activities performed to provide general capacity to

produce goods or services.

INTERVIEW OR INTERVIEW OR PARTICIPATIVE PARTICIPATIVE

APPROACHAPPROACHABC teams include or

interview operating employees.

INTERVIEW OR INTERVIEW OR PARTICIPATIVE PARTICIPATIVE

APPROACHAPPROACHABC teams include or

interview operating employees.

RECYCLING RECYCLING APPROACHAPPROACH

Reuses documentation of processes used for

other purposes.

RECYCLING RECYCLING APPROACHAPPROACH

Reuses documentation of processes used for

other purposes.

TOP DOWN APPROACHTOP DOWN APPROACHABC teams of people from top levels of management

generate the activity dictionary.

TOP DOWN APPROACHTOP DOWN APPROACHABC teams of people from top levels of management

generate the activity dictionary.

Identify and Classify Activities

The ABC teams should gather data on the costs of all the activities identified in Step 1.

The ABC teams should gather data on the costs of all the activities identified in Step 1.

Estimate the Cost of Activities

Examine accounting records for

recorded cost information.

Examine accounting records for

recorded cost information.

Ask employees to indicate how

much timethey work on

various activities.

Ask employees to indicate how

much timethey work on

various activities.

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

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

Two pieces of information are

required to compute the cost-driver rate:

•Activity Cost

•Activity Volume

Two pieces of information are

required to compute the cost-driver rate:

•Activity Cost

•Activity Volume

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 1,000,000 minutes of calls.

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

What is the cost-driver rate?

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 1,000,000 minutes of calls.

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

What is the cost-driver rate?


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

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



Appropriatecost-driver

baseBased on resource’spractical capacity to

support activities

Cause and effectrelationship between

activity and costsMeasurable

Predict or explainan activity’s use

of resources

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.

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?

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?

20%, or $200 should 20%, or $200 should be assigned to be assigned to

“unused capacity”“unused capacity”

80%, or $800 80%, or $800 should be assigned should be assigned

to Product Ato Product A

Practical Capacity Note

Assign Activity Costs to Products

1. Identify all the activities related to a

given product or service.

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.

2. Determine how many

units of each activity are

used per unit of product.

3. Assign costs to products

using the cost-driver rates for each activity.

3. Assign costs to products

using the cost-driver rates for each activity.

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?

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?


Let’s look at anexample from theBilson Company.

Activity-Based Costing Example

Bilson, Inc. manufactures and sells 5,000 units of Product A (deluxe model), and 25,000 units of Product B (standard model) each year.

Product A requires 3.0 direct labor hours (DLH) and Product B requires 2.5 DLH to produce.

Employing a traditional costing system, Bilson assigns overhead cost to products using direct labor hours.

The predetermined overhead rate is:

Bilson, Inc. manufactures and sells 5,000 units of Product A (deluxe model), and 25,000 units of Product B (standard model) each year.

Product A requires 3.0 direct labor hours (DLH) and Product B requires 2.5 DLH to produce.

Employing a traditional costing system, Bilson assigns overhead cost to products using direct labor hours.

The predetermined overhead rate is: Mfg. overhead cost Direct labor hours

= $1,550,000 77,500

= $20/DLH


Bilson’s unit product costs using traditional costing are:

Product A Product BDirect material 40.00$ 29.00$ Direct labor 30.00 25.00 Manufacturing overhead 3.0 DLH × $20/DLH 60.00 2.5 DLH × $20/DLH 50.00 Total unit product cost 130.00$ 104.00$

Bilson marks its products up by 50 percent and allocatesits $500,000 customer service costs based on revenue.


Volume 5,000 25,000 Sales Price 195.00$ 156.00$

Sales Revenue 975,000$ 3,900,000$ Direct Material 40.00$ 200,000 29.00$ 725,000 Direct Labor 30.00 150,000 25.00 625,000 Overhead 60.00 300,000 50.00 1,250,000 Gross Margin 65.00$ 325,000$ 52.00$ 1,300,000$ Customer Service Costs 100,000 400,000 Product operating income 225,000$ 900,000$

Product A Product B

$975,000 ÷ ($975,000 +$3,900,000) × $500,000

Traditional Costing

$130.00 × 1.50


Sales of Product A have increased steadily since introduction,but company income has declined. Management at Bilson isunhappy with the traditional costing system and they have

decided to try activity-based costing.

Sales of Product A have increased steadily since introduction,but company income has declined. Management at Bilson isunhappy with the traditional costing system and they have

decided to try activity-based costing.

In addition, management hasobserved that the cost of direct

labor is relatively stable.Since labor does not behavelike a unit-level cost, labor will

be combined with overhead andthe total conversion cost

will be assigned using ABC.






The total conversion cost is:Traditional overhead $1,550,000Labor (77,500 hours @ $10) 775,000 Total $2,325,000

The total conversion cost is:Traditional overhead $1,550,000Labor (77,500 hours @ $10) 775,000 Total $2,325,000










Activity Cost Machine setups 800,000$ Quality inspections 450,000 Production orders 225,000 Machine-hours worked 650,000 Material receipts 200,000 Total 2,325,000$

Management has identified the following five activities and costs in the production of its two products:

Total conversion cost


The following transaction data has been complied by management of Bilson:

Activity Total Product A Product B Machine setups 5,000 3,000 2,000 Quality inspections 9,000 6,000 3,000 Production orders 600 200 400 Machine-hours worked 50,000 15,000 35,000 Material receipts 800 150 650


These data can be used to develop predetermined cost-driver rates for each of the five activities:

Activity CostsTotal

TransactionsRate per

Transaction Machine setups 800,000$ 5,000 160.00$ per setup Quality inspections 450,000 9,000 50.00 per inspection Production orders 225,000 600 375.00 per order Machine-hours worked 650,000 50,000 13.00 per hour Material receipts 200,000 800 250.00 per receipt Total 2,325,000$

$ 800,000 ÷ 5,000 Machine setups = $160.00 per setup


Product AActivity ABC Rate Transactions Amount

Machine setups 160.00$ 3,000 480,000$ Quality inspections 50.00 6,000 300,000 Production orders 375.00 200 75,000 Machine-hours worked 13.00 15,000 195,000 Material receipts 250.00 150 37,500 Total overhead assigned 1,087,500$ Number of units produced ÷ 5,000 Conversion per unit $217.50

The activity-based overhead rates we just calculatedcan be used to assign conversion costs to Bilson’s

two products.



two products.Product B

Activity ABC Rate Transactions Amount Machine setups $160.00 2,000 320,000$ Quality inspections 50.00 3,000 150,000 Production orders 375.00 400 150,000 Machine-hours worked 13.00 35,000 455,000 Material receipts 250.00 650 162,500 Total overhead assigned 1,237,500$ Number of units produced ÷ 25,000 Conversion per unit 49.50$



two products.Product B

Activity ABC Rate Transactions Amount Machine setups $160.00 2,000 320,000$ Quality inspections 50.00 3,000 150,000 Production orders 375.00 400 150,000 Machine-hours worked 13.00 35,000 455,000 Material receipts 250.00 650 162,500 Total overhead assigned 1,237,500$ Number of units produced ÷ 25,000 Overhead per unit 49.50$

Total conversion assigned to Product A 1,087,500$ Total conversion assigned to Product B 1,237,500 Total overhead 2,325,000$


Let’s compute the product cost for A and B using our ABC overhead rates:

Activity Based Costing Product A Product B Direct materials 40.00$ 29.00$ Conversion 217.50 49.50 Total unit product cost 257.50$ 78.50$

These amounts did notchange as a result of

using ABC.


Now compare the unit product costs using the traditional costing system and our ABC system.

Costing Method Product A Product BActivity-based costing 257.50$ 78.50$ Traditional costing 130.00 104.00

Remember, we used one overheadrate based on direct labor hours.




Adopting activity-based costing usually resultsin a shift of batch-level and product-level

overhead costs from high-volume standardproducts to low-volume, more complex products.


Can you see how different allocationCan you see how different allocationmethods might lead to makingmethods might lead to making

different management decisions?different management decisions?




Based on these results Bilson also decides to use ABC to assignits $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.

Product A Product B TotalSales Volume 5,000 25,000 Consultations per Unit Sold 10 3 Total Consultations 50,000 75,000 125,000 Cost per Consultation 4.00$ 4.00$ Cost per Product 200,000$ 300,000$ 500,000

Cost per consultation = $500,000 ÷ 125,000 consultations = $4.00



Sales Revenue 975,000$ 3,900,000$ Direct Material 40.00$ 200,000 29.00$ 725,000 Conversion 217.50 1,087,500 49.50 1,237,500 Gross Margin (62.50)$ (312,500)$ 77.50$ 1,937,500$

Customer Service Costs 200,000 300,000 Product operating income (512,500)$ 1,637,500$

Product A Product B

ABC Costing

No change in sales price

Let’s compare product income using traditional and ABC costing.Let’s compare product income using traditional and ABC costing.


ABCCosting

TraditionalCosting


Sales Revenue 975,000$ 3,900,000$ Direct Material 40.00$ 200,000 29.00$ 725,000 Conversion 217.50 1,087,500 49.50 1,237,500 Gross Margin (62.50)$ (312,500)$ 77.50$ 1,937,500$ Customer Service Costs 200,000 300,000 Product operating income (512,500)$ 1,637,500$

Product A Product B


Sales Revenue 975,000$ 3,900,000$ Direct Material 40.00$ 200,000 29.00$ 725,000 Direct Labor 30.00 150,000 25.00 625,000 Overhead 60.00 300,000 50.00 1,250,000 Gross Margin 65.00$ 325,000$ 52.00$ 1,300,000$ Customer Service Costs 100,000 400,000 Product operating income 225,000$ 900,000$

Product A Product B

4-49

Should Bilsonincrease the price

of Product A?

Should Bilsonreduce the price

of Product B?

Should Bilsondrop Product A?

Product Profitability

Now that we havemeasured productcosts accurately,

we see how profitableeach product really is.

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. Decreasingthe price would increase volume,possibly resulting in more income.

Product Profitability

Customer Profitability

What are the costs and benefits of serving

specific customers?

Activity-based analysis canbe used to track the costsof serving customers and

those customers’ contribution to company profits.

Service calls

Buy/sell orders

Order changes

Estimating Costs of New Products

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.

ABC in Service and Merchandising Companies




Assign activity costs to products using the relevant cost-driver rates.

The process is exactly the same as for manufacturing!

More accurate and informative product costs lead to better pricing decisions.

The activities driving costs are more accurately measured.

Managers gain easier access to the relevant costs.

More accurate and informative product costs lead to better pricing decisions.

The activities driving costs are more accurately measured.

Managers gain easier access to the relevant costs.

An ABC system is very expensiveto develop and implement, and

very time-consuming to maintain.

An ABC system is very expensiveto develop and implement, and

very time-consuming to maintain.

ABC– Benefits and Limitations

When Should a Company Use ABC? Indirect costs are significant in proportion to direct costs.

Goods are complex, requiring many inputs and processes.

Complex, low-volume products are profitable while standard, high-volume products are not.

Different departments believe costs are assigned inaccurately.

The company loses bids it thought were low, and wins bids it thought were high.

Operations have changed significantly, but the costing system has not changed.

Introduction of new models result in higher sales, apparent profits per unit, but an overall income decline.

Indirect costs are significant in proportion to direct costs.

Goods are complex, requiring many inputs and processes.

Complex, low-volume products are profitable while standard, high-volume products are not.

Different departments believe costs are assigned inaccurately.

The company loses bids it thought were low, and wins bids it thought were high.

Operations have changed significantly, but the costing system has not changed.

Introduction of new models result in higher sales, apparent profits per unit, but an overall income decline.

The End

activity based costing and traditional costing system

Education

direct labor hourjob

costdriver rate

reasonable costing method

labor intensive processes

activity cost pool

additional overhead

specific activity

assign activity costs