bmfp 4512 chapter-3 tutorial (activity based costing)

TUTORIAL TUTORIAL --ABCABC

Ir. Haery Ir. Haery SihombingSihombing/IP/IPPensyarah PelawatFakulti Kejuruteraan PembuatanUniversiti Teknologi Malaysia Melaka

TOTAL COST for a COST OBJECTTOTAL COST for a COST OBJECT

Direct Cost Direct Cost (Labor Material)(Labor Material)Overhead CostOverhead Cost

++Total Object CostTotal Object Cost

EXAMPLE: 1

TRADITIONAL COST ACCOUNTINGTRADITIONAL COST ACCOUNTING

Arbitrarily allocates to the cost objectsArbitrarily allocates to the cost objects

Total CompanyTotal Company’’s overhead is allocated s overhead is allocated o the products based on volume based o the products based on volume based measure (measure (e.g. labor hours, machine hourse.g. labor hours, machine hours))

Assumption: relation between Assumption: relation between overhead and the volume based overhead and the volume based measuremeasure

Product A :Product A :1 hours of direct labor1 hours of direct labor

(direct labor cost 1 *RM20/hour(direct labor cost 1 *RM20/hour=RM =RM 20.00/20.00/hours)hours)

Demand = 100Demand = 100


Product B:Product B:2 hours of direct labor2 hours of direct labor

(direct labor cost 2 *RM20/ hour (direct labor cost 2 *RM20/ hour =RM =RM 40.0040.00/hours)/hours)

Demand = 950Demand = 950

•Two products: Product AProduct A and Product BProduct B

TOTAL OVERHEAD = RM 100,000.00TOTAL OVERHEAD = RM 100,000.00TOTAL DIRECT LABOR = 2,000 HoursTOTAL DIRECT LABOR = 2,000 Hours

RM 100,000/2000 Hours = RM 50/ HoursRM 100,000/2000 Hours = RM 50/ Hours

Product A :Product A : 1 hours of direct labor1 hours of direct laborProduct B :Product B : 2 hours of direct labor2 hours of direct laborTCA Overhead Allocation : TCA Overhead Allocation : AA = RM = RM 50/unit50/unit

BB = RM = RM 100/unit100/unit


ACTIVITY BASED COSTINGACTIVITY BASED COSTING

More Accurate Cost Management MethodologyMore Accurate Cost Management MethodologyFocuses on indirect costs (overhead)Focuses on indirect costs (overhead)Traces rather than allocates each expense Traces rather than allocates each expense category to the particular cost objectcategory to the particular cost objectMakes Makes ““indirectindirect”” expense expense ““directdirect””

ABC Basic PremiseABC Basic Premise

Cost objects consume activitiesCost objects consume activitiesActivities consume resourcesActivities consume resourcesThis consumption of resources is what This consumption of resources is what driver costsdriver costsUnderstanding this relationship is critical Understanding this relationship is critical to successfully managing overheadto successfully managing overhead

When To Use ABCWhen To Use ABC

Overhead is highOverhead is highProducts are diverse: complexity, Products are diverse: complexity, volume, amount of direct laborvolume, amount of direct laborCost of errors are highCost of errors are highCompetition is stiffCompetition is stiff

ABC StepsABC Steps

Identifies activitiesIdentifies activitiesDetermine cost for each activityDetermine cost for each activityDetermine cost driversDetermine cost driversCollect activity dataCollect activity dataCalculate product costCalculate product cost

ABC IllustrationABC Illustration

SetSet--upupMachiningMachiningReceivingReceivingPackingPackingEngineeringEngineering

1. INDENTIFY ACTIVITIES1. INDENTIFY ACTIVITIES



2. DETERMINE ACTIVITY COST2. DETERMINE ACTIVITY COST

= RM 10,000= RM 10,000= RM 40,000= RM 40,000= RM 10,000= RM 10,000= RM 10,000= RM 10,000= RM 30,000= RM 30,000


3. DETERMINE COT DRIVERS3. DETERMINE COT DRIVERS


= Number of Setups= Number of Setups= Machining Hours= Machining Hours= Number of Receipt= Number of Receipt= Number of Deliveries= Number of Deliveries= Engineering Hours= Engineering Hours


4. ACTIVITY DATA4. ACTIVITY DATA

75,50075,50024,50024,500

15,00015,00050050015,00015,00050050030,00030,000EngineeringEngineering7,5007,500332,5002,5001110,00010,000PackingPacking7,5007,500332,5002,5001110,00010,000ReceivingReceiving

38,00038,000190019002,0002,00010010040,00040,000MachiningMachining7,5007,500332,5002,5001110,00010,000SetSet--upup

RMRMPRODUCTPRODUCTBB

RMRMPRODUCTPRODUCTAA

Cost Cost (RM)(RM)

ACTIVITYACTIVITY

Overhead for Product A =Overhead for Product A =RM 24,500 : 100 = RM RM 24,500 : 100 = RM 245245

Overhead for Product B =Overhead for Product B =RM 75,000 : 950 = RM RM 75,000 : 950 = RM 79. 4779. 47


5. PRODUCT COST CALCULATION5. PRODUCT COST CALCULATION

PRODUCT COST TCA Vs. ABCPRODUCT COST TCA Vs. ABC

Overhead Overhead TCATCA RM RM 50,0050,00Overhead Overhead ABCABC RM RM 245,00245,00Direct Cost Direct Cost TCATCA RM RM 20,0020,00Direct Cost Direct Cost ABC ABC RM RM 20,0020,00TOTAL TOTAL TCATCA RM RM 70,0070,00TOTAL TOTAL ABCABC RM RM 265,00 265,00

Overhead Overhead TCA TCA RM RM 100,00100,00Overhead Overhead ABC ABC RM RM 79.4779.47Direct Cost Direct Cost TCATCA RM RM 40,0040,00Direct Cost Direct Cost ABC ABC RM RM 40,0040,00TOTAL TOTAL TCATCA RM RM 140,00140,00TOTAL TOTAL ABC ABC RM RM 119,47 119,47

Cost for Product A : Cost for Product A : Cost for Product B :Cost for Product B :

Undercosting & Undercosting & OvercostingOvercosting

Jose, Roberta, and Nancy orderseparate items for lunch.

Jose’s order amounts to $14Roberta consumed 30Nancy’s order is 16Total $60

What is the average cost per lunch?

EXAMPLE: 2

$60 ÷ 3 = $20

Jose and Nancyare overcosted.

Roberta isundercosted.

Undercosting & Undercosting & OvercostingOvercosting

Existing Single IndirectExisting Single Indirect-- Cost Pool SystemCost Pool System

Kole Corporation manufactures a normal lens(NL) and a complex lens (CL).

Kole currently uses a single indirect-cost ratejob costing system.

Cost objects: 80,000 (NL) and 20,000 (CL).

EXAMPLE: 3

Normal Lenses (NL)Direct materials $1,520,000Direct mfg. labor 800,000Total direct costs $2,320,000Direct cost per unit: $2,320,000 ÷ 80,000 = $29


Complex Lenses (CL)Direct materials $ 920,000Direct mfg. labor 260,000Total direct costs $1,180,000Direct cost per unit: $1,180,000 ÷ 20,000 = $59


All Indirect Costs$2,900,000

All Indirect Costs$2,900,000

50,000 DirectManufacturingLabor-Hours

50,000 DirectManufacturingLabor-Hours

INDIRECT-COSTPOLL

INDIRECTCOST-ALLOCATIONBASE

$58 per DirectManufacturing

Labor-Hour


Indirect Costs

Direct Costs

Indirect Costs

Direct Costs

COST OBJECT:NL AND CLLENSES

DIRECTCOSTS

DirectMaterialsDirect

MaterialsDirect

ManufacturingLabor

DirectManufacturing

Labor


Kole uses 36,000 direct manufacturinglabor-hours to make NL and 14,000 directmanufacturing labor-hours to make CL.How much indirect costs are allocated

to each product?


NL: 36,000 × $58 = $2,088,000CL: 14,000 × $58 = $812,000

What is the total cost of normal lenses?Direct costs $2,320,000 +

Allocated costs $2,088,000 = $4,408,000What is the cost per unit?

$4,408,000 ÷ 80,000 = $55.10


What is the total cost of complex lenses?Direct costs $1,180,000 + Allocated costs

$812,000 = $1,992,000What is the cost per unit?

$1,992,000 ÷ 20,000 = $99.60


Normal lenses sell for $60 each andcomplex lenses for $142 each.

Normal ComplexRevenue $60.00 $142.00Cost 55.10 99.60Income $ 4.90 $ 42.40Margin 8.2% 29.9%


Refining a Costing SystemRefining a Costing System

Direct-cost tracing

Indirect-cost pools

Cost-allocation basis

Refining a Costing SystemRefining a Costing System

1. Design of Products and ProcessThe Design Department designs the molds and defines

processes needed (details of the manufacturing operations).

2. Manufacturing OperationsLenses are molded, finished, cleaned, and inspected.

3. Shipping and DistributionFinished lenses are packed and sent to the various customers.

ActivityActivity--Based Costing SystemBased Costing System

FundamentalCost Objects

Activities

Costs of Activities

Assignment to OtherCost Objects

Cost of:• Product• Service• Customer


A cross-functional team at KoleCorporation identified key activities:

Design products and processes.Set up molding machine.

Operate machines to manufacture lenses.Maintain and clean the molds.


Set up batches of finished lenses for shipment.Distribute lenses to customers.

Administer and manage all processes.


No. ofSetupHours

LensesNL

LensesCL

LensesOther

CostAllocationBase

ProductCostObjects

No. ofShipments

Parts-Square

feet

SetupDesign ShippingActivityIndirect CostPool


NL CLQuantity produced 80,000 20,000No. produced/batch 250 50Number of batches 320 400Setup time per batch 2 hours 5 hoursTotal setup-hours 640 2,000

Total setup costs are $409,200.


What is the setup cost per setup-hour?$409,200 ÷ 2,640 hours = $155

What is the setup cost perdirect manufacturing labor-hour?

$409,200 ÷ 50,000 = $8.184


Allocation using direct labor-hours:NL: $8.184 × 36,000 = $294,624CL: $8.184 × 14,000 = $114,576Total $409,200

Allocation using setup-hours:NL: $155 × 640 = $ 99,200CL: $155 × 2,000 = $310,000Total $409,200

Cost HierarchiesCost Hierarchies

A cost hierarchy is a categorizationof costs into different cost pools.

Cost drivers bases (cost-allocation bases)Degrees of difficulty in determining

cause-and-effect relationships

Cost HierarchiesCost Hierarchies

ABC systems commonly use afour-part cost hierarchy to

identify cost-allocation bases:1. Output unit-level costs2. Batch-level costs3. Product-sustaining costs4. Facility-sustaining costs

Output UnitOutput Unit--Level CostsLevel Costs

These are resources sacrificedon activities performed on each

individual unit of product or service.Energy

Machine depreciationRepairs

BatchBatch--Level CostsLevel Costs

These are resources sacrificed onactivities that are related to a groupof units of product(s) or service(s)rather than to each individual unit

of product or service.Setup-hours

Procurement costs

ProductProduct--Sustaining CostsSustaining Costs

These are often called service-sustainingcosts and are resources sacrificed on

activities undertaken to supportindividual products or services.

Design costsEngineering costs

FacilityFacility--Sustaining CostsSustaining Costs

These are resources sacrificed onactivities that cannot be traced to

individual products or services butsupport the organization as a whole.

General administration– rent – building security

ImplementingImplementingActivityActivity--Based CostingBased Costing

Identify cost objects.

NLCL

Identify the direct costsof the products.

Direct materialDirect labor

Mold cleaning andmaintenance

Step 1Step 1 Step 2Step 2


Cleaning and maintenance costs of$360,000 are direct batch-level costs.

Why?Because these costs consist of workers’

wages for cleaning molds after eachbatch of lenses is run.


NormalNormal Lenses (NL)Lenses (NL)Cost HierarchyCost Hierarchy

DescriptionDescription CategoryCategoryDirect materialsDirect materials UnitUnit--levellevel $1,520,000$1,520,000Direct mfg. laborDirect mfg. labor UnitUnit--levellevel 800,000800,000Cleaning and maint.Cleaning and maint.BatchBatch--levellevel 160,000160,000Total direct costsTotal direct costs $2,480,000$2,480,000


ComplexComplex Lenses (CL)Lenses (CL)Cost HierarchyCost Hierarchy

DescriptionDescription CategoryCategoryDirect materialsDirect materials UnitUnit--levellevel $ 920,000$ 920,000Direct mfg. laborDirect mfg. labor UnitUnit--levellevel 260,000260,000Cleaning and maint.Cleaning and maint.BatchBatch--levellevel 200,000200,000Total direct costsTotal direct costs $1,380,000$1,380,000


Select the cost-allocation bases to use forallocating indirect costs to the products.

(1) (2) (3)Activity Cost Hierarchy Total CostsDesign Product-sustaining $450,000Setups Batch-level $409,200Operations Unit-level $637,500

Step 3


Identify the indirect costs associatedwith each cost-allocation base.

Overhead costs incurred are assignedto activities, to the extent possible, on

the basis of a cause-and-effect relationship.

Step 4Step 4


Compute the rate per unit.(1) (5)NL CL Total

Setup-hours: 640 2,000 2,640

Step 5

$409,200 ÷ 2,640 = $155


Compute the indirect costs allocatedto the products.

NL: $155 × 640 = $ 99,200CL: $155 × 2,000 = 310,000Total $409,200

Step 6


Compute the costs of the products.NL and CL would show three

direct cost categories.

Step 7

1. Direct materials2. Direct manufacturing labor3. Cleaning and maintenance


NL and CL would show six indirect cost pools.1. Design2. Molding machine setups3. Manufacturing operations4. Shipment setup5. Distribution6. Administration

ABC and DepartmentABC and DepartmentIndirectIndirect--Cost RatesCost Rates

Many companies have evolved theircosting system from using a single

cost pool to using separate indirect-costrates for each department:

DesignManufacturing

Distribution

ABC and DepartmentABC and DepartmentIndirectIndirect--Cost RatesCost Rates

Why?Because the cost drivers of resources in eachdepartment or subdepartment differ from thesingle, company-wide, cost-allocation base.

ABC systems are a further refinement ofdepartment costing systems.

SUMMARY of ABC APPOACHSUMMARY of ABC APPOACH

ABC is more accurate cost management ABC is more accurate cost management system than Traditional Cost Accounting system than Traditional Cost Accounting (TCA)(TCA)Traditional Cost Accounting (TCA) is unable Traditional Cost Accounting (TCA) is unable to calculate the to calculate the ““truetrue”” of a productof a product

Benefits of ABC SystemsBenefits of ABC Systems

Significant amounts of indirect costs areallocated using only one or two cost pools.

All or most costs are identifiedas output unit-level costs.

Products make diverse demands onresources because of differences involume, process steps, batch size,

or complexity.


Products that a company is well-suited tomake and sell show small profits whileproducts for which a company is less

suited show large profits.Complex products appear to be very

profitable and simple productsappear to be losing money.


Operations staff have significantdisagreements with the accounting

staff about the costs of manufacturingand marketing products and services.

Limitations of ABC SystemsLimitations of ABC Systems

The main limitations of ABC are themeasurements necessary to

implement the system.ABC systems require managementto estimate costs of activity poolsand to identify and measure cost

drivers for these pools.

Limitations of ABC SystemsLimitations of ABC Systems

Activity-cost rates also need to beupdated regularly.

Very detailed ABC systems are costlyto operate and difficult to understand.

bmfp 4512 chapter-3 tutorial (activity based costing)

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