Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-Based Costing: A Tool to Aid Decision Making Chapter Eight

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity Based Costing (ABC) ABC is designed to provide more accurate ways of assigning indirect and support service costs to activities, processes, products, customers ABC is a good supplement to our traditional cost system I agree!

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin ABC differs from traditional costing Both manufacturing and non manufacturing costs are allocated Use of several cost pools Different kinds of allocation base Allocation through capacity vs activity

Copyright © 2006, The McGraw-Hill Companies, Inc.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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Designing 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Manufacturing companies typically combine their activities into five classifications. Unit-LevelActivityBatch-LevelActivityProduct-LevelActivityCustomer-LevelActivity Organization- sustaining Activity

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Activities should only be combined within a level if they are highly correlated. When combining activities, they should be grouped together only at the appropriate level.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Activity Cost Pool An Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system. $ $ $ $ $ $

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Simple count of the number of times an activity occurs. Transaction driver A measure of the amount of time needed for an activity. Duration driver Two types of activity measures:

Copyright © 2006, The McGraw-Hill Companies, Inc.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:

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Identify and Define Activities and Activity Cost Pools Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product Designs - assigned all costs of resources consumed by designing products. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations – assigned all costs associated with maintaining relations with customers. Other – assigned all overhead costs that are not associated with the other cost pools. Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product Designs - assigned all costs of resources consumed by designing products. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations – assigned all costs associated with maintaining relations with customers. Other – assigned all overhead costs that are not associated with the other cost pools.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   When Possible, Directly Trace Overhead Costs to Activities and Cost Objects

Copyright © 2006, The McGraw-Hill Companies, Inc.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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000   Assign Costs to Activity Cost Pools

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000   Assign Costs to Activity Cost Pools

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Assign Costs to Activity Cost Pools

Copyright © 2006, The McGraw-Hill Companies, Inc.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,  200 new designs,  20,000 machine-hours,  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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Calculate Activity Rates

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Traced 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

Copyright © 2006, The McGraw-Hill Companies, Inc.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

Copyright © 2006, The McGraw-Hill Companies, Inc.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 $/Order $/Design $/Customer Unallocated

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer – Windward Yachts. Standard Stanchions (no design required) units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours. 3. Selling price is $34 each. 4. Direct materials total $2, Direct labor totals $1, Shipping costs total $180. Custom Compass Housing (requires new design) 1. One order during the year. 2. Each housing required 4 machine-hours. 3. Selling price is $650 each. 4. Direct materials total $ Direct labor totals $ Shipping costs total $25.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Prepare Management Reports

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin   Prepare Management Reports Customer Profitability Analysis

Copyright © 2006, The McGraw-Hill Companies, Inc.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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Differences Between ABC and Traditional Product Costs Product margins are different for four reasons:  Traditional costing assigns design costs to both products based on machine hours. ABC assigns product design costs to a product only if product design work is required.  Traditional costing assigns customer order costs, a batch- level cost, using a unit-level allocation base, machine hours. ABC assigns these batch-level costs using a batch-level activity measure.  Traditional costing assigns only manufacturing costs to products. ABC also assigns nonmanufacturing costs to products.  Traditional costing assigns all manufacturing costs to products. The ABC system does not assign organization- sustaining manufacturing costs to the products.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Differences Between ABC and Traditional Product Costs When batch-level and product-level costs are present, ABC will usually shift costs from high volume products, produced in large batches, to low volume products produced in small batches. This cost shifting will usually have its greatest impact on the per unit cost of the low volume products.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin So What???? Diverse product line  various models and variants The difference will be felt for specialty and customized products Cumulative products + profitability - WHALE CURVE- After assigning service and Support departments by ABC

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity Based Management Upon analysis of product costs thru ABC  Re-price products  Substitute products  Redesign products  Improve processes and operations strategy  Technology investment  Eliminate products

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Customer Profitability Analysis High Cost to Serve  Order custom products  Small order quantity  Unpredictable orders  Customized delivery  Large amount of pre-sales efforts  Large amount of post- sales efforts  Pay slow High Cost to Serve  Order std. products  High order quantity  Predictable orders  Std. delivery  No pre-sales efforts  No post-sales efforts  Pay on time

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin End of Chapter 8