Shahadat Hosan Faculty ( Part-time), MBA Program Manarat International University Activity Based Costing: A Tool to Aid Decision Making

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Activity Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” costs. ABC is a good supplement to our traditional cost system I agree!

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Overhead rates may be based on activity at capacity. Overhead rates may be based on activity at capacity. Activity Based Costing (ABC) Both manufacturing and nonmanufacturing costs may be assigned to products. Both manufacturing and nonmanufacturing costs may be assigned to products. Some manufacturing costs may be excluded from product costs. Some manufacturing costs may be excluded from product costs. A number of cost pools each allocated to a product or cost object. A number of cost pools each allocated to a product or cost object. Allocation bases often differ from traditional costing systems. Allocation bases often differ from traditional costing systems.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin How Costs are Treated Under Activity-Based Costing Level of Complexity Overhead Allocation Plantwide PlantwideOverheadRate OverheadRate DepartmentalOverheadRatesDepartmentalOverheadRates Activity Based Costing Costing

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Plantwide Overhead Rate direct labor as Companies tended to use direct labor as the overhead allocation base. There was a belief that direct labor and overhead costs were highly correlated.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Departmental Overhead Rates Finishing Department Shipping Department Painting Department Many companies have a system in which each department has its own overhead rate.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Department1Department1Department2Department2Department3Department3 Cost pools IndirectLaborIndirectLaborIndirectMaterialsIndirectMaterialsOtherOverheadOtherOverhead Stage One: Costs assigned to pools Departmental Overhead Rates

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Department1Department1Department2Department2Department3Department3 Cost pools IndirectLaborIndirectLaborIndirectMaterialsIndirectMaterialsOtherOverheadOtherOverhead Stage One: Costs assigned to pools Departmental Overhead Rates Products Products Stage Two: Costs applied to products

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Department1Department1Department2Department2Department3Department3 Cost pools IndirectLaborIndirectLaborIndirectMaterialsIndirectMaterialsOtherOverheadOtherOverhead Stage One: Costs assigned to pools Departmental Overhead Rates Products Products Stage Two: Costs applied to products Departmental Allocation Bases Direct Labor Hours Machine Hours Raw Materials Cost

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Designing an ABC System Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers) ActivitiesActivities Consumption of Resources Consumption CostCost

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Designing of an ABC System Steps for Implementing ABC  Identify and define activities and activity cost pools.  Trace costs to activities and cost objects.  Assign costs to activity cost pools.  Calculate activity rates.  Assign costs to cost objects.  Prepare management reports.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools A part of the production process for which management wants a separate reporting of the costs of the activity involved. Unit-LevelActivityBatch-LevelActivityProduct-LevelActivityCustomer-LevelActivity Organization- sustaining Activity

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Activity Cost Pool Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system. $ $ $ $ $ $

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Assign Costs to Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity cost pools is determined. ** Not included because they are directly traced to customer orders.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool... 1,000 customer orders 1,000 customer orders 200 new designs 200 new designs 20,000 machine-hours 20,000 machine-hours 100 customer relations activities 100 customer relations activities Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Calculate Activity Rates ÷

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin TracedTracedTracedTracedTracedTraced Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Overhead Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers OrderSizeOrderSizeCustomerOrdersCustomerOrdersProductDesignProductDesignCustomerRelationsCustomerRelationsOtherOther Overhead Costs First-Stage Allocation

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Activity-Based Costing at Classic Brass Direct Materials Direct Materials Direct Labor Direct Labor Shipping Costs Shipping Costs Cost Objects: Products, Customer Orders, Customers Cost Objects: Products, Customer Orders, Customers OrderSizeOrderSizeCustomerOrdersCustomerOrdersProductDesignProductDesignCustomerRelationsCustomerRelationsOtherOther Overhead Costs First-Stage Allocation Second-Stage Allocations $/MH$/MH$/Order$/Order$/Design$/Design$/Customer$/Customer UnallocatedUnallocated

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Prepare Management Reports

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin   Prepare Management Reports Customer Profitability Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Product Margins Traditional Cost Accounting System Predetermined manufacturing overhead rate $1,000,000 20,000 MH = $50/MH= 400 units x 0.5 MH/unit x $50/MH = $10,000

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Difference Between ABC and Traditional Product Costs Batch-level or product- level costs will ordinarily shift overhead costs from high-volume products produced in large batches to low-volume products produced in small batches. Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organization- sustaining costs and the costs of idle capacity are not assigned to products.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Targeting Process Improvement Activity-based costing can be used to identify areas that would benefit from process improvements. The theory of constraints approach is a powerful tool for targeting the area in an organization whose improvement will yield the greatest benefits.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because... 1.External reports are less detailed than internal reports. 2.It may be difficult to make changes to the company’s accounting system. 3.ABC does not conform to GAAP. 4.Auditors may be suspect of the subjective allocation process based on interviews with employees.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Limitations of ABC ABC systems are a major project requiring substantial resources. The benefits of increased accuracy must outweigh these additional costs. ABC produces numbers, like product margins, that are at odds with numbers produced by traditional costing system. Some managers find it difficult to adjust to this change. ABC data can be misinterpreted and must be used with care when making decisions.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Thank You