Hilton Maher Selto

4 Activity-Based Costing Systems McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

4-3 yes Activity based costing allocates costs based on the discreet tasks (activities) that drive those costs. Is it important to know how the work of the organization is done? Is it important to know how the work of the organization is done? Do we need costs to provide incentives for Improvements? Do we need costs to provide incentives for Improvements? Activity-Based Costing

4-4 4 Steps  Identify and classify the activities related to the company’s products or services.  Estimate the costs associated with each activity.  Calculate a cost-driver rate for each activity.  Assign activity costs to products using the cost-driver rate. 4 Steps  Identify and classify the activities related to the company’s products or services.  Estimate the costs associated with each activity.  Calculate a cost-driver rate for each activity.  Assign activity costs to products using the cost-driver rate. 4 Steps in the ABC Process

4-5 UNIT-LEVEL ACTIVITES The work efforts that transform resources into individual products and resources UNIT-LEVEL ACTIVITES The work efforts that transform resources into individual products and resources CUSTOMER- LEVEL ACTIVITES Performed to meet the needs of specific customers CUSTOMER- LEVEL ACTIVITES Performed to meet the needs of specific customers BATCH-LEVEL ACTIVITES Manufacturing or service technology that affect multiple units of activity equally and simultaneously BATCH-LEVEL ACTIVITES Manufacturing or service technology that affect multiple units of activity equally and simultaneously PRODUCT - LEVEL ACTIVITES Support specific products or service lines PRODUCT - LEVEL ACTIVITES Support specific products or service lines FACILITY-LEVEL ACTIVITIES Support all of the organizations processes FACILITY-LEVEL ACTIVITIES Support all of the organizations processes Step 1: Identify and Classify Activities

4-6 INTERVIEW OR PARTICIPATIVE APPROACH ABC teams include or interview operating employees. INTERVIEW OR PARTICIPATIVE APPROACH ABC teams include or interview operating employees. RECYCLING APPROACH Reuses documentation of processes used for other purposes. RECYCLING APPROACH Reuses documentation of processes used for other purposes. Step 1: Identify and Classify Activities TOP DOWN APPROACH ABC teams of middle- management or above develop the activity dictionary. TOP DOWN APPROACH ABC teams of middle- management or above develop the activity dictionary.

4-7 An appropriate cost driver base should: Have a cause-effect relationship with the activity and the use of resources (costs). Have a cause-effect relationship with the activity and the use of resources (costs). Be feasible to measure Predict or explain activities’ use of resources (cost) with reasonable accuracy Be based on the practical capacity of the resources to support activities Step 1: Identify and Classify Activities

4-8 The ABC teams should gather date on the costs of all the activities identified in Step 1. Step 2: Estimate the Cost of Activities Examine accounting records for recorded cost information. Ask employees to provide information on the time they work on various activities.

4-9 Step 2: Estimate the Cost of Activities When estimating the cost of an activity, only the costs associated with the product should be used (practical capacity). The cost of “unused capacity” should not be applied to products. EXAMPLE Suppose we rent a 1,000 square foot warehouse for $1,000 per month. Only 800 sq. ft. are used to store Product A. The rest of the warehouse is “unused”. How much rent cost should be allocated to Product A? EXAMPLE Suppose we rent a 1,000 square foot warehouse for $1,000 per month. Only 800 sq. ft. are used to store Product A. The rest of the warehouse is “unused”. How much rent cost should be allocated to Product A?

4-10 Step 2: Estimate the Cost of Activities 20%, or $200 should be assigned to “unused capacity” 80%, or $800 should be assigned to Product A

4-11 EXAMPLE #1 XCo has 4 employees in its Quality Control Dept. Salaries and costs for the department total $360,000 per year. XCo produces 500,000 units of product a year. What is the appropriate activity, # of employees or units of product? What is the cost-driver rate? EXAMPLE #1 XCo has 4 employees in its Quality Control Dept. Salaries and costs for the department total $360,000 per year. XCo produces 500,000 units of product a year. What is the appropriate activity, # of employees or units of product? What is the cost-driver rate? EXAMPLE #1 The proper activity in this case is the # of units produced. The cost-driver rate would be: $360,000 ÷500,000 units = $.72 per unit EXAMPLE #1 The proper activity in this case is the # of units produced. The cost-driver rate would be: $360,000 ÷500,000 units = $.72 per unit Step 3: Compute the Cost- Driver Rates Two pieces of information are required to compute the cost-driver rate: Activity Cost Activity Volume Two pieces of information are required to compute the cost-driver rate: Activity Cost Activity Volume

4-12 EXAMPLE #2 XCo has a customer service center where customers can call to ask questions. Customers pay a fixed fee for each call they make to the service center. In addition, other XCo departments also use the service center. It costs XCo $1,260,000 a year to operate the center. The center receives 120,000 calls per year. The center handles 1,000,000 minutes of calls. What is the appropriate cost driver; total minutes per call or number of calls? What is the cost-driver rate? EXAMPLE #2 XCo has a customer service center where customers can call to ask questions. Customers pay a fixed fee for each call they make to the service center. In addition, other XCo departments also use the service center. It costs XCo $1,260,000 a year to operate the center. The center receives 120,000 calls per year. The center handles 1,000,000 minutes of calls. What is the appropriate cost driver; total minutes per call or number of calls? What is the cost-driver rate? EXAMPLE #2 Since customers are charged “per call”, the proper activity in this case is the # of calls handled by the center. The cost-driver rate would be: $1,260,000 ÷120,000 units = $10.50 per call EXAMPLE #2 Since customers are charged “per call”, the proper activity in this case is the # of calls handled by the center. The cost-driver rate would be: $1,260,000 ÷120,000 units = $10.50 per call Step 3: Compute the Cost- Driver Rates

4-13 Step 4: Assign Activity Costs to Products 1. Identify all the activities related to a given product or service. 2. Determine how many units of each activity are used per unit of product. 3. Assign costs to products using the cost- driver rates for each activity

4-14 Step 4: Assign Activity Costs to Products Example: Yazz, Inc. produces 130,000 units of Product A and 400,000 units for Product B. Using the following cost information, how much overhead should be allocated to Product A?

4-15 Step 4: Assign Activity Costs to Products

4-16 Product and Customer Profitability Companies will often look at the profitability for individual products or customers. Information required for each product or customer includes: Revenue, costs that can be traced, costs that can not be traced. Companies will often look at the profitability for individual products or customers. Information required for each product or customer includes: Revenue, costs that can be traced, costs that can not be traced. Exh. 4.7

4-17 When Should a Company Use ABC? ABC is often considered as an option when one or more of the following conditions exist: Indirect costs are significant in proportion to direct costs and use only one or two cost-drivers. Goods are complex, requiring many inputs and processes. Simple, high-volume products perform more poorly than complex, low-volume products. Different departments believe costs are assigned inaccurately. The company loses bids it thought were low, and wins bids it thought were high. Operations have changed significantly, but the costing system has not changed. ABC is often considered as an option when one or more of the following conditions exist: Indirect costs are significant in proportion to direct costs and use only one or two cost-drivers. Goods are complex, requiring many inputs and processes. Simple, high-volume products perform more poorly than complex, low-volume products. Different departments believe costs are assigned inaccurately. The company loses bids it thought were low, and wins bids it thought were high. Operations have changed significantly, but the costing system has not changed.

4-18 Why Companies Use ABC

4-19 End of Chapter 4