Activity-Based Costing and Activity-Based Management CHAPTER 5 Activity-Based Costing and Activity-Based Management In this chapter, we will discuss a different method that can be used to allocate overhead and other types of expenses. As you’ll see, the difference is the way the cost accountant views the cost pool, or pools, to be allocated. In simple costing, the overhead is spread to cost objects based on one or sometimes a few simple, alleged “causes”. With ABC, it is based on the underlying activities which generate the expenses. Generally, it results in a much more accurate cost.

Chapter 5 Learning Objectives Explain how broad averaging undercosts and overcosts products or services Present three guidelines for refining a costing system Distinguish between simple and activity- based costing systems Describe a four-part cost hierarchy Cost products or services using activity- based costing Your learning objectives in this chapter are intended to get you familiar with an alternative way to allocate overhead costs. As you’ll see, the alternative uses activities rather than just various bases to spread the overhead costs to the products.

Chapter 5 Learning Objectives, cont’d Evaluate the costs and benefits of implementing activity-based costing systems Explain how managers use activity-based costing systems in activity-based management Compare activity-based costing systems and department costing systems You may recall that department costing also uses multiple bases, however that procedure is still rooted in an allocation system that uses a basis that may or may not correspond to how the resources are used.

Background Recall that plant overhead is applied to production in a rational systematic manner, using some type of averaging. There are a variety of methods to accomplish this goal. These methods often involve trade-offs between simplicity and realism. Simple Methods Complex Methods Can be inaccurate Usually more accurate When companies tend to produce only one or a limited number of products, a broad average can be an effective way to allocate costs. However, as the breadth of products offered increases and their use of resources becomes diverse, that system is often no longer accurate. The departmental method is a bit of an improvement but still uses a relatively broad average.

Plantwide & Department OVERHEAD CALCULATIONS Plantwide Overhead Rate: Total Estimated Overhead* /Total Estimated Base** *Obtain total of all overhead costs to be allocated. ** Determine best “base” – direct labor hours, machine hours, etc. This rate is used to allocate overhead costs to all products. Dept Overhead Rate: Similar concept except overhead cost pools and selected base are obtained by department. Recall that the formula to calculate a plant wide overhead rate uses the total estimated overhead in the numerator and the total estimated base that will be used as the denominator. That base might be direct labor hours, direct labor dollars, machine hours or something else. The result will be a dollar amount per single unit of the base. For example, if our total overhead estimate is $750,000 and our total estimated base is 15,000 direct labor hours, we will allocate $50.00 of overhead per each direct labor hour. A departmental overhead rate works similarly but would take the $750,000 of overhead separately by department.

Example of plantwide & department overhead calculations For our example, let’s say we have Department A and Department B with overhead costs of $300,000 and $450,000, respectively. We might also use different bases for each department. In our example, we will use DLH for Department A and Machine Hours for Dept B. In our example, we have two departments with overhead costs of $300,000 and $450,000, respectively.

Example, cont’d Dept A Dept B O/H $300,000 $450,000 DLH 8000 7000 MH 750 1200 Overhead allocation in Department A would be $300,000 / 8000 (DLH) or $37.50 per DLH Overhead allocation in Department B would be $450,000 / 1200 (MH) or $375.00 per MH Continuing our example, we see on this slide the Direct Labor and Machine Hours used in each department. Using the information to calculation departmental overhead, Department A is $37.50 per DLH and Department B is $375.00 per MH.

Example, cont’d Contrast this with a single Plantwide Rate which would be calculated as follows: Based on DLH: $750,000 / 15,000 or $50.00/DLH Based on MH: $750,000 / 1,950 or $384.62/MH From this simple comparison we see that a product using more Dept A resources would be severely overcosted, especially if we were basing the single rate on Machine Hours and a product using more Dept B resources would be severely undercosted if we used DLH as the base for the single rate. Comparing those departmental rates to one plantwide rate, we see that the allocation of costs is more accurate using departmental rates. This concept of more detailed cost allocation is extended even further with ABC costing, as we’ll soon learn.

Broad Averaging Historically, firms produced a limited variety of goods and at the same time, their indirect costs were relatively small. Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of how they are actually incurred. Generally known as “Peanut-butter costing” (perhaps because it is spread evenly??) The end-result: Products using fewer resources are overcosted and products using more resources are undercosted. As a result of the change in product offerings, which almost certainly will change a company’s manufacturing costs, this type of broad averaging is no longer as accurate as companies need their costing to be. The short and long term effect of this over or undercosting can be significant.

Over and Undercosting-defined Overcosting—a product consumes a low level of resources but is allocated high costs per unit. Undercosting—a product consumes a high level of resources but is allocated low costs per unit. It is perhaps obvious to you that if we are spreading out or allocating costs using broad averages, almost certainly some products will be overcosted and others will be undercosted. The definitions here are merely the acknowledgement that some products will be allocated too much cost, versus what they actually use, and others too little.

Cross-subsidization If one product is undercosted then at least one other product must be overcosted. The overcosted product absorbs too much cost, making it seem less profitable than it really is. The undercosted product is left with too little cost, making it seem more profitable than it really is. Cross-subsidization causes problems for businesses. The greater the degree, the bigger the problems are likely to be. The manufacturing overhead costs that are allocated are included as part of the product cost; therefore, they are included when looking at the profitability of a particular product. Some products will show higher profitability than they should and others will look like “duds” when they may actually be contributing to a firm’s profitability. The results can be disastrous. Let’s use our previous example to see how that would calculate out. Recall our situation from slide #6: A departmental overhead rate would take the $750,000 of overhead separately by department. For our example, let’s say we have Department A and Department B with overhead costs of $300,000 and $450,000, respectively. We might also use different bases for each department. In our example, we will use DLH for Department A and Machine Hours for Dept B. Dept A Dept B O/H $300,000 $450,000 DLH 8000 7000 MH 750 1200 Overhead allocation in Department A would be $300,000 / 8000 (DLH) or $37.50 per DLH Overhead allocation in Department B would be $450,000 / 1200 (MH) or $375.00 per MH Contrast this with a single Plantwide Rate which would be calculated as follows: Based on DLH: $750,000 / 15,000 or $50.00 per DLH Based on MH: $750,000 / 1,950 or $384.62 per MH Let’s say that Job 457 for Product XYZ incurs 1000 DLH in Dept A and 1000 DLH in Dept B; 50 MH in Dept A and 75 MH in Dept B. Overhead would be as follows for this job: Dept A/DLH Dept B/MH Total Departmental Single P/W Rate Departmental Rate: 1,000 * $37.50 $37,500 75 * $375.00 $28,125 Total $65,625 Plantwide Rate based on DLH: 2000 * $50.00 $100,000 Plantwide Rate based on MH: 125 * $384.62 $48,077.50

Cross-subsidization, cont’d CONSIDER THIS: If you were using cost to determine price, what affect would this have? If you were looking at product profitability to determine marketing focus, what result? Let’s take a closer look using our previous example. Managers use product costs everyday to make decisions. If the cost is wrong, so will be your decision!

Cross-subsidization, example You recall that in our previous plantwide vs. departmental example, Dept A had a rate of $37.50/DLH; Dept B had a rate of $375/MH and the plantwide rate would be $50.00/DLH or $384.62/MH. Job 457 incurs 1,000 DLH in each department, 40 MH in Dept A and 75 MH in Dept B. Let’s compare the costs of the job based on different allocation methods. Using our example from earlier, let’s extend it for Job 457 and allocate based on the departmental rates as well as the two possible plantwide rates.

Cross-subsidization, example, cont’d- Allocating to Job 457 Explanation Dept A/DLH Dept B/MH Total Single Rate 1000*37.50 $37,500 75*375 $28,125 Total by Dept $65,625 PW/DLH 2000*$50 $100,000 PW/MH 125*$384.62 $48,077.50 Using the departmental rates, costs allocated to Job 457 are $65,625. Using a plantwide rate with Direct Labor hours, costs allocated to Job 457 are $100,000 Using a plantwide rate with Machine hours, costs allocated to Job 457 are $48,077.50 We learn from this example that using a single rate based on MH would undercost this product and using DLH would overcost this product. Of course, this assumes that DLH and MH are accurate choices for an allocation base in each department.

An Example: Plastim This chart depicts the process involved in simple costing for our sample company Plastim which is currently using that costing system. Let’s go through the steps. Step 1: Identify the cost objects (recall in Chapter 4 our “cost objects” were jobs; here our cost objects are products): Quantity 60,000 S3 lenses and Quantity 15,000 CL5 lenses Step 2: Identify the direct costs depicted by the bottom two triangles identified as direct materials and direct manufacturing labor. Step 3: Select the Cost-Allocation Base to Use for Allocating the Indirect (Overhead) Costs to the cost objects: Plastim has elected to use Direct Manufacturing Labor Hours as the base and estimates 39,750 such hours Step 4: Identify the Indirect Costs Associated with each allocation base: If you have only one base, you’ll need only one cost pool for all the costs to be allocated. If you are using multiple bases, you’ll separate the costs to be allocated into a separate pool for each base. Plastim uses only one allocation base which necessitates having only one cost pool. The estimate of their indirect costs is $2,385,000. Step 5: Compute the Rate per Unit of Each Cost-Allocation Base: Remember the formula? Budgeted Total Costs in Indirect Cost Pool / Budgeted Total Quantity of the Cost Allocation Base. $2,385,000 / 39,750 = $60.00 per Direct Mfg Labor Hour Step 6: Compute the Indirect Cost Allocated to the Products: Our managers have indicated that the DLH budget for the 60,000 S3 lenses is 30,000 hours and 9,750 hours for the 15,000 CL5 lenses. That will allocate overhead as follows: S3 = 30,000 * $60 = $1,800,000 CL5 = 9,750 * $60 = $585,000 Step 7: Compute the total cost of the products by adding all Direct and Indirect Costs Assigned to the Product: Let’s go to the next screen to view this step. Exhibit 5-1 page 154.

Plastim and Simple Costing In this slide, we see the summary of the Direct and Indirect Costs for our Lenses. Of course, direct costs are traced to the objects while the indirect costs are allocated in the manner we just discussed. Exhibit 5-2 page 155.

Using the 5-Step Decision Making Process 1. Identify the Problems & Uncertainties. (Possible loss of Giovanni business) 2. Obtain Information.(Analyze and evaluate the design, manufacture, and distribution operations for the S3 lens.) 3. Make Predictions about the future. (obtain a better cost estimate for the S3) 4. Make Decisions by Choosing among alternatives. (should they bid and if yes, at what price) 5. Implement the Decision, Evaluate Performance and Learn. You may recall from Chapter 1 our discussion of the five-step decision-making process. Plastim’s path is clear: they need to determine if they can profitably offer the S3 to their customer at a lower price. They will do this by obtaining information on their current costing method and looking at refined costing methods. Is there a more accurate way of allocating costs to their products that may change their pricing strategy. Remember, you aren’t searching for a costing method that will allow you to bid for this business; you are searching for an improved costing system which may or may not have that result.

Plastim and ABC Illustrated Plastim appears to be facing each of the 3 primary reasons why refined costing systems are gaining in popularity. Those reasons are an increase in product diversity (if Plastim made ONLY the S3 lens, there would be no problem), an increase in indirect costs (with increased technology we tend to move away from direct costs to indirect costs) and increased competition (which Plastim is facing from Bandix.) Exhibit 5-3 page 162. The guidelines we follow to refine a costing system are: Trace as many direct costs as possible Expand the number of indirect-cost pools such that each homogeneous cost pool has the same or a similar cause-and effect (or benefits received) relationship with a single cost driver. This step is more difficult than it sounds. To accomplish it, you must analyze the indirect costs and answer the question: what actually happens here to incur those costs. Identify the cause of the indirect costs as the cost driver and use it as the allocation base for each identified cost pool. What we see here is the same processes, the same seven steps, from Exhibit 5-1 but expanded using one of the best tools we have to refine a cost system, which is Activity-Based costing, knows as ABC. ABC uses activities as the fundamental cost objects. For example, in your indirect cost pool, you may have expenses related to the purchasing department. Perhaps the purchasing department incurs expenses in relationship to the number of purchase orders created, or the number of line items received. That determination and the subsequent use of that “activity” as the cost driver is how ABC refines our cost systems. At Plastim, after much research and analysis, managers defined the activities we see here. But please note, this process of defining activities is often quite difficult. The identification of the activities that truly DRIVE the costs, the activities that should be separated or combined all present challenges in the process. An ABC system should have enough activities identified to properly allocate costs but not so many that the system becomes unwieldy. Next, Plastim will follow our 3 steps in refining a cost system: Trace as many direct costs as possible (they’ve reclassified Mold Cleaning and Maintenance from an indirect cost to a direct cost since it is economically feasible to trace these costs to a specific mold and lens.) They identify the 6 indirect cost pools (the determination of which dollars should go to which pool is called “first-stage allocation” which is covered in more detail in later chapters. Here, we’ll concentrate on the “second-stage allocation” which is the allocation of costs of each of the activities to products.) Determining the cost-allocation base for each activity requires that as closely as possible, we select the cost driver as the cost-allocation base. With that in mind, we can then calculate the allocation rate for each activity. As an example, in the Molding Machine Setup Activity, Plastim expects costs of $300,000 which will be allocated on Setup Hours. They estimate 2,000 setup hours giving us an allocation rate of $150 per setup hour.

Plastim and ABC Rate Calculation This slide provides quite similar information to the slide we just left but it is in a spreadsheet format and includes the cost hierarchy category as well as a more detailed explanation of the cause and effect relationship between the allocation base and the activity cost. The budgeted indirect cost (allocation) rates are the same for each activity as we observed in the prior screen. A cost hierarchy categorizes various activity cost pools on the basis of the different types of cost drivers, cost-allocation bases, or different degrees of difficulty in determining cause-and effect (or benefits received) relationships. Generally, ABC uses four levels in the cost hierarcy: Output unit-level costs (related to the individual units of a product or service); Batch-level costs (related to a group of units); Product (or service)-sustaining costs (related to support a particular product or service without regard to the number of units or batches); and, Facility-sustaining costs (related to costs of activities that cannot be traced to individual products or services). These are the identifications that you see in column B. Exhibit 5-4 page 163.

Plastim and ABC Product Costs Once the activities have been identified, the cost drivers named and the activity allocation rate determined, we can recalculate the cost per unit based on the refined cost system rather than the simple costing system. Comparing our cost calculation here with that of slide 10, we note several differences: There are now three categories of direct costs instead of two because we were able to reclassify Direct mold cleaning and maintenance costs from indirect to direct. There are now 6 indirect cost pools instead of 1, each of which is allocated on that carefully selected base which has been identified as the cost driver. Total costs DO NOT CHANGE; only the process by which they are assigned to each product changes. Let’s analyze the difference in unit cost using the simple method and the ABC method. (see next slide) Exhibit 5-5 page 165.

Plastim: Simple and ABC Compared The comparison shows that we had been overcosting the S3 lens by $8.77 and undercosting the CL5 lens by $35.07. What impact do you think this will have on the Bandix/Giovanni situation with the S3 bidding? Exhibit 5-6 page 166.

Conclusions Each method is mathematically correct. Each method is acceptable. Each method yields a different cost figure, which will lead to different gross margin calculations which may lead to differences in other decisions such as pricing. Only overhead is involved. Total costs for the entire firm remain the same—they are just allocated differently to the cost objects within the firm. Selection of the appropriate method and drivers should be based on experience, industry practices, as well as a cost-benefit analysis of each option under consideration. ABC is an alternate way to allocate costs. It is generally considered to be more accurate and more costly to implement. A company should consider refining their cost system when evidence begins to suggest that their existing system is flawed. For Plastim, that occurred when they were in danger of losing business due to their higher price. Because a number of critical decisions, such as pricing, whether or not one product should be “pushed” over another, whether or not a product should be dropped, etc. will be made using cost information, best efforts should be used to arrive at a cost that is fair and reasonable for each product. The goal isn’t to attain a cost that serves the current purposes. This is an imprecise science and differences of opinion are likely to occur.

ABC vs. Simple Costing Schemes ABC is generally perceived to produce superior costing figures due to the use of multiple drivers across multiple levels. ABC is only as good as the drivers selected, and their actual relationship to costs. Poorly chosen drivers will produce inaccurate costs, even with ABC. Using ABC does not guarantee more accurate costs! As we’ve seen, implementing a refined cost system is not an easy task and it requires considerable resources of the company. Badly done, it is possible to have exhausted those resources without an improvement in the company’s costing.

Signals that Suggest that ABC Implementation Could Help a Firm: Significant amounts of indirect costs are allocated using only one or two cost pools. All or most indirect costs are identified as output unit- level costs. Products make diverse demands on resources because of volume, process steps, batch size or complexity. Products that a company is well-suited to make show small profits whereas products that a company is less suited to make show large profits. Here are some situations that suggest a refined cost system could be helpful to a firm. Let’s discuss a few of these. Signal number one means that we are following a “broad averaging” method; almost certainly unfairly allocating the costs among our products unless our products are quite similar in terms of resources used. Signal number two means that the overhead is primarily at the unit-level which means that a single allocation rate will ignore differences in resource use. Signal number five means that managers who know the product believe that the costs are inaccurate. Pay attention to this! Ask why they think so and research!

Behavioral Issues in Implementing ABC Gain the support of top management and create a sense of urgency. Create a guiding coalition of managers throughout the value chain for the ABC effort. Educate and train employees in ABC as a basis for employee empowermen.t Seek small short-run success as proof that the ABC implementation is yielding results. Recognize that ABC is not perfect. (better costs but complex system) A move to a more refined cost system is not achieved solely within the Cost Accounting or Accounting Department. It is a firm-wide effort and should be acknowledged as such. The five issues discussed here will help to ensure that the implementation is successful. Often, the process of implementing ABC generates open and honest discussions of possible improvements that could be made within the firm.

Activity-Based Management A method of management that uses ABC as an integral part in critical decision- making situations, including: Pricing and product-mix decisions Cost reduction and process improvement decisions Design decisions Planning and managing activities ABC is really the first step. Once the revised information, the updated cost of products, has been calculated, the next step is for that information to be used for the firm’s decision making. Activity Based Management (ABM) is a method of management decision making that uses ABC information to improve customer satisfaction and the firm’s profitability. We are defining ABM broadly to include decisions about pricing, product mix, cost reduction, process improvement and product and process design.

ABC and Service/Merchandising Firms ABC implementation is widespread in a variety of applications outside manufacturing, including: Health Care Banking Telecommunications Retailing Transportation ABC isn’t only for manufacturing firms but can be successfully implemented in service or merchandising firms as well. Such firms have overhead that needs to be allocated and that overhead can be organized into the activities that drive the costs in a manner just like we observed for a manufacturing company.

Food for Thought! You are the owner/manager of a dance studio and are considering offering a beginner’s jazz dance class for a reduced rate. You believe that once your students start “jazz-dancing”, they’ll be hooked and will continue with the classes at your regular prices. You aren’t sure how to price the discounted beginner’s class and have gathered the following information: Direct cost per class: $95.00 Indirect studio costs/annual: $140,000 Anticipated # of classes (all): 20/week; 50 weeks Anticipated # of jazz intro classes: 5/week; 50 weeks Anticipated # of students for jazz class: 20 Note to instructor: This exercise can be used in class in groups to get your students thinking about the topics just covered or online for a discussion topic to start an exchange of ideas. Let’s put ourselves now in the position of a business manager struggling with some costing issues. We are the owner/manager of a dance studio who wants to create an intro-jazz dance class with reduced pricing. We have gathered information here on the studio costs and offerings and on the next screen, details regarding the indirect costs. Our example in this slide provides this information: You are the owner/manager of a dance studio and are considering offering a beginner’s jazz dance class for a reduced rate. You believe that once your students start “jazz-dancing”, they’ll be hooked and will continue with the classes at your regular prices. You aren’t sure how to price the discounted beginner’s class and have gathered the following information: Direct cost per class: $95.00 Indirect studio costs/annual: $140,000 Anticipated # of classes (all): 20/week; 50 weeks Anticipated # of jazz intro classes: 5/week; 50 weeks Anticipated # of students for jazz class: 20

Food for Thought, cont’d You were able to determine that the indirect costs ($140,000) consisted of the following: Studio Rental $70,000 Your salary $40,000 Utilities $ 5,000 Office Staff $12,000 Instructor Benefits $ 6,000 Cleaning services $ 6,000 Refreshments $ 1,000 On this screen, we learn more about the details of the indirect costs. You were able to determine that the indirect costs ($140,000) consisted of the following: Studio Rental $70,000 Your salary $40,000 Utilities $ 5,000 Office Staff $12,000 Instructor Benefits $ 6,000 Cleaning services $ 6,000 Refreshments $ 1,000 With this information, if you were the studio owner/manager, what calculations would you make to help determine an appropriate price for the intro class? What cost system would you use and why? What price would you charge?

TERMS to learn TERMS to LEARN Page Number Reference Activity Page 158 Activity Based Costing (ABC) Activity Based Management (ABM) Page 169 Batch-Level Costs Page 161 Cost Hierarchy Facility-Sustaining Costs Output Unit-Level Costs Product-Cost Cross-subsidization Page 152

TERMS to learn, Page 2 TERMS to LEARN Page Number Reference Product Overcosting Page 152 Product-Sustaining Costs Page 161 Product Undercosting Refined Costing System Page 157 Service-Sustaining Costs