activity based systems william m baker. overview when cost accounting was first created, and until...
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ACTIVITY BASED SYSTEMS
William M Baker
Overview
• When cost accounting was first created, and until the 1930s, management accounting dominated all accounting data.
• That changed with the creation of the SEC.
• Recent changes (e.g., JIT) made it clear that new management accounting was necessary (without interrupting financial accounting).
Where Does ABC Fit?
• Direct Costing• Job Order Costing• Standard Costing• Actual Costing• Full Costing• Normal Costing• Backflush Costing• Joint Product Costing
• Variable Costing• Absorption Costing• Product Costing• Quality Costing• Process Costing• Operation Costing• Life-Cycle Costing• Peanut Butter Costing
Traditional Cost Accounting
• The traditional approach to overhead cost allocation:– Choose one allocation base:
• Usually, direct labor cost or direct labor hours
• Sometimes, using machine hours
• Use the chosen allocation base to apply overhead cost to products.
Criticisms of Traditional Approach
• One allocation base cannot properly reflect all cost relationships.
• The importance of direct labor cost is extinct (at best).
• Overhead costs are now large enough that overhead allocation is anything but trivial.
The Principles Of ABC
• It is NOT the making of products that directly affects costs.
• Activities directly affect costs.
• As activities are created or changed, costs are created or changed.
The Two-Stage (ABC) Approach
• The traditional approach is to allocate costs to products.
• The ABC approach is to allocate (or trace) costs to activities, and then allocate the activities (and their costs) to products.
• The bases for allocating activities (and their costs) to products are called cost drivers.
• The activities themselves may be called cost drivers.
The ABC Approach To Overhead Cost Allocation
• Allocate (usually directly traceable) costs to activities.
• For each activity, choose an allocation base that reflects the activity.
Allocation Base (Cost Driver)Examples
• Allocate the costs of a production run using production run time.
• Allocate set-up costs using set-up time.
• Allocate materials handling costs using materials requisitions.
The ABC Approach To Overhead Cost Allocation
• Allocate (usually directly traceable) costs to activities.
• For each activity, choose an allocation base that reflects the activity.
• Using an appropriate base for each activity, ALLOCATE ACTIVITIES, AND THEIR COSTS, TO PRODUCTS.
Daniel Company
• Daniel Company manufactures a product that comes in both a deluxe model and a regular model. The deluxe model is fairly new; since its introduction, profits have steadily declined.
• Daniel assigns overhead (in a traditional way) on the basis of direct labor hours.
Daniel Company
• For 2002, the company estimated that it would incur $900,000 in overhead and produce 5,000 units of the deluxe model and 40,000 units of the regular model. The deluxe model requires two hours of direct labor time, and the regular model requires one hour. The deluxe model costs $40 for materials and $14 for direct labor. The regular model costs $25 for materials and $7 for direct labor.
Requirements
• (1) How much does each model cost (per unit)?
• (2) Cost-per-unit information is often used in setting product prices. This is true at Daniel Company. Assuming they charge a 35% markup on cost, determine the list price for each model.
Traditional Solution
• The cost of a unit of product is calculated by summing the cost of materials, labor, and the (assigned) overhead.
• Using a traditional approach, the following solution is obtained:
• The overhead rate is $18 per direct labor hour– $900,000 / ((5,000X2) + (40,000X1))
Traditional Solution
Deluxe Model Regular Model
Direct Materials $40.00 $25.00
Direct Labor 14.00 7.00
Overhead (@18) 36.00 18.00
Cost Per Unit $90.00 $50.00
35% Markup 31.50 17.50
List Price $121.50 $67.50
ABC Solution Process
• Daniel Company decides to switch to ABC.
• After much research and discussion, all of Daniel Company’s overhead costs were traced to four activities.– (Note that the overhead costs did not change;
they still total $900,000).
Allocate Costs To Activities
Activity Cost
(1) Requisitions for Materials $204,000
(2) Machine Assembly 182,000
(3) Reworking Inferior-Quality Units 379,000
(4) Loading, Handling, and Shipping 135,000
Total $900,000
Choosing Cost Drivers
• Daniel must choose allocation bases to reflect incurrence of each activity (and to allocate costs).
• Then, Daniel must obtain cost driver measures for each product.
Cost Drivers
Activity Cost Driver
(1) Requisitions for materials
Number of Requisitions
(2) Machine Assembly Number of Machine Hours
(3) Reworking Inferior-Quality Units
Number of Rework Orders
(4) Loading, Shipping, and Handling
Number of Shipments
Cost Driver Allocation Measures
Cost Driver Deluxe Regular
Number of Requisitions 200 400
Number of Machine Hours 20,000 15,000
Number of Rework Orders 1,000 1,000
Number of Shipments 250 650
Per Driver Allocation Costs
Cost per Requisition
$204,000
600
$340.00
Cost per Machine Hour
$182,000
35,000
$5.20
Cost per Rework Order
$379,000
2,000
$189.50
Cost per Shipment
$135,000
900
$150.00
Allocation of Costs to Products
Cost Driver Total Costs Deluxe Regular
Requisitions $204,000 $68,000 $136,000
Machine Hours $182,000 $104,000 $78,000
Re-Works $379,000 $189,500 $189,500
Shipments $135,000 $37,500 $97,500
Total $900,000 $399,000 $501,000
Overhead Cost Per Unit
Deluxe Regular
Total Overhead Costs $399,000 $501,000
Number of Units 5,000 40,000
Overhead Cost Per Unit $79.800 $12.525
ABC Solution
Deluxe Model Regular Model
Direct Materials $40.000 $25.000
Direct Labor 14.000 7.000
Overhead (@18) 79.800 12.525
Cost Per Unit $133.800 $44.525
“Old” Cost $90.000 $50.000
Current Price $121.500 $67.500
ACTIVITY BASED COSTING ACTIVITY BASED COSTING DOES NOT MAKE DOES NOT MAKE
ACCOUNTING MORE ACCOUNTING MORE ACCURATEACCURATE
…But There Are Benefits
• Foremost, managers learn what activities are really costing them money.
• Managers learn the relationships among activities.
• Managers see the effects of changes in cost drivers on costs, and learn to control them.
The Ultimate Benefit
• Managers talk about ADDING VALUE.• Activities are separated into value-added
and non-value added categories.– Eliminate non-value-added activities.– Make value-added activities more efficient and
more effective.
• This is Activity Based Management, and it now extends well beyond overhead costs.
Who Might Use ABC Or ABM?
• Companies where overhead costs are a large percentage of total manufacturing costs
• Companies where operations personnel and managers do not trust the cost system
• Companies with many cost drivers
• Companies with many products
• Companies with the necessary technology