Activity Based Costing (ABC)

Traditional Cost Accounting (TCA) 2 products: A & B Product A: 1 hour of direct labor Direct labor cost = $20/hr * 1 hr = $20 Demand: 100 Product B: 2 hours of direct labor Direct labor cost = $20/hr * 2 hrs = $40 Demand: 950

TCA Total overhead: $100,000 Total direct labor: 2,000 hrs Unit overhead: $100,000/2,000 hrs = $50/hr Product A: 1 hr of direct labor Product B: 2 hrs of direct labor TCA overhead allocation: Product A: $50/unit Product B: $100/unit

When to use ABC Overhead is high Products are diverse: complexity, volume, amount of direct labor Cost of errors are high Competition is stiff

ABC Basic Premise Cost objects consume activities Activities consume resources The consumption of resources is what drives costs

ABC Steps Identify activities Determine cost for each activity Determine cost drivers Collect activity data Calculate product cost

ABC Illustration 1. Identify activities Set-up Machining Receiving Packing Engineering

ABC Illustration 2. Determine activity cost Set-up $10,000 Machining $40,000 Receiving $10,000 Packing $10,000 Engineering $30,000

ABC Illustration 3. Determine cost drivers Set-up Number of Setups Machining Machining Hours Receiving Number of Receipts Packing Number of Deliveries Engineering Engineering Hours

ABC Illustration 4. Activity Data Activity Cost A $ B Set-up $10,000 1 $2,500 3 $7,500 Machining $40,000 100 $2,000 1900 $38,000 Receiving Packing Engineering $30,000 500 $15,000 $100,000 $24,500 $75,500

ABC Illustration Overhead for product A: Overhead for product B: 5. Product cost calculation Overhead for product A: $24,500/100 = $245 Overhead for product B: $75,500/950 = $79.47

Product Cost: TCA vs. ABC Product A TCA ABC Direct labor $20.00 Overhead $50.00 $245.00 $70.00 $265.00 Product B $40.00 $100.00 $79.47 $140.00 $119.47