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Symptoms of an Outdated Functional Cost System (continued) The company has a highly profitable niche all to itself.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 Allocation Plant-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 methods more 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 Ê Identify activities that consume resources and assign costs to those activities Ë 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) ¹ Assign costs to products Multiply the cost driver rate times the volume (amount) of cost driver units consumed by product

4 Steps of ABC - Example Identify 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 ABC Step 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 drivenPages typed Machine setups Flight hoursComputer timeNumber of surgeries Rework OrdersCustomers servedQuality 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 cost Estimated activity driver Step 4: Assign costs to products Cost driver rate x volume (amount) consumed by product = Costs assigned

Belring, Inc.– Activity Usage CordlessRegularTotal Units produced per year10,000100,000110,000 Prime costs$78,000$738,000$816,000 Direct labor hours10,00090,000100,000 Machine hours5,00045,00050,000 Production runs Number of moves603090

Belring, Inc. – Additional OH Cost Data ActivityActivity Cost Setups$120,000 Material handling60,000 Machining100,000 Testing 80,000 Total$360,000 =======

Belring, Inc. – Activity Rates Activity rates are computed below: Setup rate:$120,000/30 =$4,000 per run Material-handling rate:$60,000/90 = $ 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 Costing Unit Cost Computation CordlessRegular Prime costs$ 78,000$ 738,000 Overhead costs: Setups80,00040,000 Material handling40,00020,000 Machining10,00090,000 Testing 8,000 72,000 Total mfg. costs$216,000$ 960,000 Units produced  10,000  100,000 Unit cost$ 21.60$ 9.60=====

ABC - Not an Easy Process Conversion to ABC takes a lot of time and resources General 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