activity based costing lecture seven (7) issah hamdu faculty of business management &...

Activity Based Costing

LECTURE SEVEN (7)

Issah HamduFaculty of Business Management & Globalization

Tel: Ext 8978Email: issah@limkokwing.edu.my

(Feb – Jun 2010 Semester)

BACCT2101 • Cost Accounting

Traditional, Volume-Based Product-Costing System

• Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.

• The following information is obtained from company records:

• Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.

• The following information is obtained from company records:

Mode I Mode II Mode IIIProduction: Units 10,000 20,000 4,000 Runs 1 of 10,000 4 of 5,000 10 of 400

Traditional, Volume-Based Product-Costing System

Additional information includes:

Mode I Mode II Mode IIIDirect materials 50.00$ 90.00$ 20.00$ Direct labor (hr/board) 3 4 2 Setup time (hr/run) 10 10 10 Machine time (hr/board) 1 1.25 2

Manufacturing overhead is determined as follows

Traditional, Volume-Based Product-Costing System

Budgeted manufacturing overhead Budgeted manufacturing overhead $3,894,000 $3,894,000 Budgeted direct-labor hours 118,000Budgeted direct-labor hours 118,000 = $33 per hour= $33 per hour

Traditional, Volume-Based Product-Costing System

With these product costs, Aerotech established target selling prices (Cost × 125%).

209.00 x 1.25

Traditional, Volume-Based Product-Costing System

Aerotech wishes to see what target selling prices would be suggested

when using activity-based costing.

Aerotech wishes to see what target selling prices would be suggested

when using activity-based costing.

Let’s see how ABC works.Let’s see how ABC works.

Activity Based Costing System (ABC)

ABC systems follow a two-

stage procedure to

assign overhead costs

to products.

Assigningoverhead to products is a

difficult process. I agree!

Activity Based Costing System (ABC)

ABC systems follow a two-

stage procedure to

assign overhead costs

to products.

Let’s beginby identifying

our major activities.

Stage OneIdentify significant

activities and assign overheadcosts to each activity in

proportion to resources used.

Stage OneIdentify significant

activities and assign overheadcosts to each activity in

proportion to resources used.

Activity Based Costing System (ABC)

ABC systems follow a two-

stage procedure to

assign overhead costs

to products.

Overhead assigned to activities are

called “activity cost pools.”

Stage TwoIdentify cost drivers

appropriate to each activityand allocate overhead to

the products.

Stage TwoIdentify cost drivers

appropriate to each activityand allocate overhead to

the products.

Overhead CostsOverhead Costs

Total budgeted cost = $3,894,000Total budgeted cost = $3,894,000

ActivityActivityCostCostPoolsPools

MachineryMachinerycost poolcost pool

$1,212,600$1,212,600

SetupSetupcost poolcost pool$3,000$3,000

EngineeringEngineeringcost poolcost pool$700,000$700,000

FacilityFacilitycost poolcost pool$507,400$507,400

UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel

Identificationof ActivityCost Pools

Identificationof ActivityCost Pools

ActivityActivitymust bemust bedone ondone oneach uniteach unitproduced.produced.

ActivityActivityperformedperformed

on eachon eachbatchbatch

produced.produced.

Activities needed to supportActivities needed to supportan entire product linean entire product line

Activity required in orderActivity required in orderfor the productionfor the productionprocess to occur.process to occur.

Overhead CostsOverhead Costs

Total budgeted cost = $3,894,000Total budgeted cost = $3,894,000

ActivityActivityCostCostPoolsPools

MachineryMachinerycost poolcost pool

$1,212,600$1,212,600

SetupSetupcost poolcost pool$3,000$3,000

EngineeringEngineeringcost poolcost pool$700,000$700,000

FacilityFacilitycost poolcost pool$507,400$507,400

MoreCostPools

UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel

Identificationof ActivityCost Pools

Identificationof ActivityCost Pools

Receiving/InspectionReceiving/Inspectioncost pool cost pool $200,000$200,000

Material-HandlingMaterial-Handlingcost pool cost pool $600,000$600,000

Quality-AssuranceQuality-Assurancecost pool cost pool $421,000$421,000

Packaging/ShippingPackaging/Shippingcost pool cost pool $250,000$250,000

MachineryMachinerycost poolcost pool

$1,212,600$1,212,600

SetupSetupcost poolcost pool$3,000$3,000

EngineeringEngineeringcost poolcost pool$700,000$700,000

FacilityFacilitycost poolcost pool$507,400$507,400

UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel

Various overheadVarious overheadcosts relatedcosts relatedto to machinerymachinery

Maintenance

Depreciation

Computer Support

Lubrication

Electricity

Calibration

Machinery Cost PoolMachinery Cost PoolTotal budgeted cost = $1,212,600

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

CalculateCalculatethe poolthe pool

raterate

Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hour$28.20/hour

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

=

=

Calculation ofCalculation oftotal total setup costsetup cost

Setup Cost PoolSetup Cost PoolTotal budgeted cost = $3,000

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

CalculateCalculatethe poolthe pool

raterate

Budgeted Setup Costs $3,000Planned Production Runs 15 runs $200 per run$200 per run

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

=

=

Various overheadVarious overheadcosts relatedcosts related

to to engineeringengineering

Engineering salaries

Engineering supplies

Engineering software

Depreciation

Engineering Cost PoolEngineering Cost PoolTotal budgeted cost = $700,000

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

Allocate basedAllocate basedon on engineeringengineering

transactionstransactions

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

Engineering Cost PoolEngineering Cost PoolTotal budgeted cost = $700,000

Various overheadVarious overheadcosts relatedcosts relatedto to generalgeneraloperationsoperations

Plant depr.

Plant mgmt.

Plant maint.

Property taxes

Insurance

Security

Facility Cost PoolFacility Cost PoolTotal budgeted cost = $507,400

ActivityActivitycostcostpoolpool

STAGE ONESTAGE ONE

CalculateCalculatethe poolthe pool

raterate

Budgeted Facilities Cost $507,400Budgeted Direct-Labor Hours 118,000 $4.30/hour$4.30/hour

CostCostAssignmentAssignment

STAGE TWOSTAGE TWO

=

=

Product Cost from ABCHere are the new product costs so far . . .

Other Overhead CostsBoard Overhead × % ÷ Units = Cost/UnitMode I 200,000$ × 6% ÷ 10,000 = 1.20$ Mode II 200,000 × 24% ÷ 20,000 = 2.40 Mode III 200,000 × 70% ÷ 4,000 = 35.00

Receiving and Inspection Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 600,000$ × 7% ÷ 10,000 = 4.20$ Mode II 600,000 × 30% ÷ 20,000 = 9.00 Mode III 600,000 × 63% ÷ 4,000 = 94.50

Material-Handling Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 421,000$ × 20% ÷ 10,000 = 8.42$ Mode II 421,000 × 40% ÷ 20,000 = 8.42 Mode III 421,000 × 40% ÷ 4,000 = 42.10

Quality-Assurance Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 250,000$ × 4% ÷ 10,000 = 1.00$ Mode II 250,000 × 30% ÷ 20,000 = 3.75 Mode III 250,000 × 66% ÷ 4,000 = 41.25

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 250,000$ × 4% ÷ 10,000 = 1.00$ Mode II 250,000 × 30% ÷ 20,000 = 3.75 Mode III 250,000 × 66% ÷ 4,000 = 41.25

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 421,000$ × 20% ÷ 10,000 = 8.42$ Mode II 421,000 × 40% ÷ 20,000 = 8.42 Mode III 421,000 × 40% ÷ 4,000 = 42.10

Quality-Assurance Cost Pool

Other Overhead CostsBoard Overhead × % ÷ Units = Cost/UnitMode I 200,000$ × 6% ÷ 10,000 = 1.20$ Mode II 200,000 × 24% ÷ 20,000 = 2.40 Mode III 200,000 × 70% ÷ 4,000 = 35.00

Receiving and Inspection Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 600,000$ × 7% ÷ 10,000 = 4.20$ Mode II 600,000 × 30% ÷ 20,000 = 9.00 Mode III 600,000 × 63% ÷ 4,000 = 94.50

Material-Handling Cost Pool

$14.82$14.82

Product Cost from ABCThese are the new product costs when

Aerotech uses ABC.

Product DiversityBoth original and ABC target selling prices

are based on (Cost × 125%).

[$209.00 × 1.25] [$183.44 × 1.25]

The selling price of Mode I and II are reducedThe selling price of Mode I and II are reducedand the selling price for Mode III is increased.and the selling price for Mode III is increased.

Product DiversityCan you identify any problems Aerotech is

likely to face as a result of this distortion?

Traditional costing understates the costTraditional costing understates the costof complex, low volume products.of complex, low volume products.

ABC: Some Key IssuesThe Past

– Small number of products which did not differ much in required manufacturing support.

– Labor was the dominant element in the cost structure.

The Past– Small number of

products which did not differ much in required manufacturing support.

– Labor was the dominant element in the cost structure.

The Present– Numerous products

with more and complicated production requirements.

– Labor is becoming an ever smaller part component of total production costs.

The Present– Numerous products

with more and complicated production requirements.

– Labor is becoming an ever smaller part component of total production costs.

Cost DriversA characteristic of an event or activity that

results in the incurrence of costs. In selecting a cost driver, we must consider . . .

Degree ofDegree ofCorrelationCorrelation

Cost ofCost ofMeasurementMeasurement

BehavioralBehavioralEffectsEffects

Homogeneous Activity Cost PoolsA homogeneous cost pool is a grouping of

overhead costs in which each cost component is consumed in roughly the same proportion by each product line.

A homogeneous cost poolA homogeneous cost pooluses a single cost driver.uses a single cost driver.

Transaction Costing

ActivitiesActivities PaperworkPaperwork

UsuallyUsually

Result InResult In

TransactionTransactionprocessingprocessingprovides aprovides a

readilyreadilymeasurablemeasurable

gauge ofgauge ofdepartmentaldepartmental

activity.activity.

TransactionTransactionprocessingprocessingprovides aprovides a

readilyreadilymeasurablemeasurable

gauge ofgauge ofdepartmentaldepartmental

activity.activity.

StoryboardingA procedure used to develop a

detailed process flow chart, which visually represents activities and the

relationships among activities.Step

1Step

1Step

2Step

2Step

3Step

3Step

4Step

4

These are the steps wefollow to build amemory board.

These are the steps wefollow to build amemory board.

Direct versus Indirect CostsVolume-Based Costing

All production costs All production costs except direct except direct

materials and direct materials and direct labor are lumped labor are lumped together in one together in one

overhead cost pool.overhead cost pool.

Volume-Based Costing

All production costs All production costs except direct except direct

materials and direct materials and direct labor are lumped labor are lumped together in one together in one

overhead cost pool.overhead cost pool.

Activity-Based Costing

An effort is made to An effort is made to account for as account for as many costs as many costs as

possible as direct possible as direct costs of production.costs of production.

Activity-Based Costing

An effort is made to An effort is made to account for as account for as many costs as many costs as

possible as direct possible as direct costs of production.costs of production.

IndirectIndirectCostsCosts

Indicators of Need for ABC

Line managers do notbelieve the product

costs reports

Line managers do notbelieve the product

costs reports

Marketing does notuse costs reports for

pricing decisions

Marketing does notuse costs reports for

pricing decisions

Product-line profitmargins are hard

to explain

Product-line profitmargins are hard

to explain

Sales are increasing,but profits are declining.

Sales are increasing,but profits are declining.

Some products thathave reported high

profit margins are notsold by competitors

Some products thathave reported high

profit margins are notsold by competitors

Direct labor is asmall percentage

of total costs

Direct labor is asmall percentage

of total costs

Optimal Product-Costing SystemHighHigh

HighHigh

LowLow

LowLow

CostCost

InformationInformationSystemSystemAccuracyAccuracyOptimalOptimal

systemsystem

Total CostTotal Cost

Design, implementationDesign, implementationand maintenance costsand maintenance costs

Cost ofCost ofinferiorinferior

decisionsdecisionsresultingresulting

fromfrominaccurateinaccurate

information.information.

Cost Management Systems

– Measure the cost of resources consumed.– Identify and eliminate non-value-added

costs.– Determine the efficiency and effectiveness

of all major activities.– Identify and evaluate new activities that can

improve future performance.

ObjectivesObjectives

Non-Value-Added CostsSuppose our production process looks like this:

StorageStorageTimeTime

WaitingWaitingTimeTime

ProcessProcessTimeTime

MoveMoveTimeTime

InspectionInspectionTimeTime

VAVA NVANVANVANVANVANVANVANVA

VA VA = Valued-added activity= Valued-added activityNVA NVA = Non-value-added activity= Non-value-added activity

Non-Value-Added Costs

VA VA = Valued-added activity= Valued-added activityNVA NVA = Non-value-added activity= Non-value-added activity

Our goal is to reduce or eliminate the non-value-added activities.

StorageStorageTimeTime

WaitingWaitingTimeTime

ProcessProcessTimeTime

MoveMoveTimeTime

InspectionInspectionTimeTime

VAVA NVANVANVANVANVANVANVANVA

ABC in the Service Industry

ImplementationImplementationProblemsProblems

ImplementationImplementationProblemsProblems

High proportion offacility-level costs

Activities tend tobe nonrepetitive

human tasks.