ACTIVITY BASED COSTING
Learning Objectives
Discuss the importance of unit costs
Describe the functional-based costing approach
Explain why functional-based costing approaches may produce distorted costs
Explain how an activity-based costing system works
Provide a detailed description of how activities can be grouped into homogeneous sets to reduce the number of activity rates.
Describe the role of activity-based costing for organizations with only one product, homogeneous products, or a JIT structure.
Learning Objectives (continued)
Costing Review The unit cost is the total cost associated with the
units produced divided by the number of units produced
A functional-based costing system assigns costs using only unit level drivers (those tied directly to production such as machine hours or units produced)
A predetermined overhead rate is calculated and used to allocate expenses
An activity-based costing system isolates costs by activities (such as taking orders, shipping, etc.) that are not necessarily related to unit-level drivers
Signs that a functional based costing system is providing inaccurate data
The outcome of bids is difficult to explain.
Competitors’ prices appear unrealistically low.
Products that are difficult to produce show high profits.
Operational managers want to drop products that appear profitable.
Symptoms of an Outdated FunctionalCost System (continued)
The company has a highly profitable niche all to itself.
Customers do not complain about price increases.
Some departments are using their own accounting system.
What Gave Rise to ABC? In the early 1980’s:
Direct labor becoming a smaller percentage of total manufacturing cost
Cost (overhead) allocations based on direct labor became increasingly inaccurate
Traditional cost accounting systems valued inventory for external reporting purposes
Increasing pressures on product costing
Types of AllocationPlant-wide Allocation simplest method entire plant = cost pool note: the term plant is used, but doesn’t have
to be a plant; can be hospital, school, store etc.
Departmental Allocation a separate cost pool for each department
Activity Centers a cost pool for each part of a company that
performs some easily described activity
Which Allocation Method to Use?
Decision based on cost-benefit Plant-wide methods cost the least but provide
the least information Maintaining cost pools by activity center
costs the most but provides the most information
Do the benefits justify the costs? Is the data needed attainable? What is the cost of collecting data? What is the cost of processing more data?
Factors That Impair Accuracy of Functional Rates
Non-unit- related OH costs Activities that are not performed each
time a unit of product is produced Machine Setups (occur for each batch) Costs increase for each additional setup, not
an additional unit of product
Product Diversity Different products consume overhead
activities in different proportions Labor intensive products vs. machine
intensive
Benefits of an ABC System
ABC provides: more detailed measures of costs than plant-wide or departmental allocation methodsmore accurate product costs for marketing decisions pricing; products to keep; products to discontinue
better information to production managers costs of each activity identifies previously unknown cost drivers
vehicle to promote teamwork among accounting, production, marketing, management
4 Steps of Activity-Based-Costing
Identify activities that consume resources and assign costs to those activities
Identify cost driver(s) associated with each
activity cost driver = factor that causes or “drives” an
activity’s costs
Compute a cost rate per unit (of cost driver) Assign costs to products
Multiply the cost driver rate times the volume (amount) of cost driver units consumed by product
4 Steps of ABC - ExampleIdentify activities & assign costs to those activities Purchasing materials Accounting costs related to purchasing
Identify cost driver(s) associated with each activity Number of orders
Compute a cost rate per unit (of cost driver) Processing costs per purchase order
Assign costs to products Costs/purchase order x # of orders for October
More About the 4 Steps of ABCStep 1:
Identify activities and assign costs to those activities Most interesting and challenging step Requires people understand all of the
activities required to make the product Managers attempt to identify those
activities that have the greatest impact on costs
More on the 4 Steps of ABC Cont’d
Step 2:
Identify cost driver(s) associated with
each activity Examples of cost drivers
Miles driven Pages typed Machine setupsFlight hoursComputer time Number of surgeriesRework Orders Customers served Quality inspections
How to Decide Which Driver to Use?
Causal Relation Choose cost driver that causes costs Not always feasible as indirect costs are
generally not causally linked to a cost object
Benefits Received Choose cost driver so that costs are assigned in
proportion to the benefits received
Reasonableness Costs that can not be linked based on causality
or benefits received
More on the 4 Steps of ABC (Cont)Step 3: Compute a cost rate per unit (of
cost driver)
Predetermined indirect cost (driver) rate:Estimated indirect costEstimated activity driver
Step 4: Assign costs to products Cost driver rate x volume (amount)
consumed by product = Costs assigned
Belring, Inc. – Activity UsageCordless Regular Total
Units produced per year10,000 100,000 110,000
Prime costs $78,000 $738,000 $816,000
Direct labor hours 10,000 90,000 100,000
Machine hours 5,000 45,000 50,000
Production runs 20 10 30
Number of moves 60 30 90
Belring, Inc. – Additional OH Cost Data
Activity Activity CostSetups $120,000Material handling 60,000Machining 100,000Testing 80,000
Total $360,000
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Belring, Inc. – Activity Rates
Activity rates are computed below:
Setup rate: $120,000/30 =$4,000 per run
Material-handling rate: $60,000/90 = $666.67 per move
Machining rate: $100,000/50,000 = $2 per MH
Testing rate: $80,000/100,000 = $0.80 per DLH
Belring, Inc. – Activity-Based CostingUnit Cost Computation
Cordless Regular
Prime costs $ 78,000 $ 738,000
Overhead costs:
Setups 80,000 40,000
Material handling 40,000 20,000
Machining 10,000 90,000
Testing 8,000 72,000
Total mfg. costs $216,000 $ 960,000
Units produced 10,000 100,000
Unit cost $ 21.60 $ 9.60
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ABC - Not an Easy ProcessConversion to ABC takes a lot of time and resourcesGeneral process: Interview employees Collect data
on time, activities, resources, activity attributes Build initial model of ABC system Cost-out the activities Test model Prepare analysis; Report to management;
Implementation
Just-in-time Manufacturing
Having only as much as you need only when you need it eliminate waste by not keeping excess moves costs to suppliers allows for easier product costing
because there is less to cost and the costs that are present are easier to trace to products