0 CHAPTER 6 Activity-Based Costing © 2009 Cengage Learning

1 1 Introduction Overhead costs have soared to 60 percent or more of total product costs in heavily automated manufacturing environments. As overhead costs increase and make up a larger portion of the total costs of products, accuracy in overhead application has become much more important.

2 2 Activity-Based Costing In this chapter we introduce a different approach to overhead allocation using Activity-Based Cost Drivers as opposed to Volume-Based Cost Drivers

3 3 Categories of Overhead Costs Unit-level costs are incurred each time a unit is produced. Examples:  Supplies for factory  Depreciation on factory machinery  Energy costs for factory machinery  Repairs and maintenance of factory machinery

4 4 Categories of Overhead Costs Batch-level costs are incurred each time a batch of goods is produced. Examples:  Salaries related to purchasing and receiving  Salaries related to moving material  Quality control costs  Depreciation of setup equipment

5 5 Categories of Overhead Costs Product-level costs are incurred as needed to support the production of each different type of product. Examples:  Salaries of engineers  Depreciation of engineering equipment  Product development costs (testing)  Quality control costs

6 6 Categories of Overhead Costs Facility-level costs simply sustain a facility’s general manufacturing process. Examples:  Depreciation or rent of a factory building  Salary of a plant manager  Insurance, taxes, etc.  Training

7 7 Activities and Cost Drivers: Unit Level Activity Machining Maintenance of machines Potential Cost Driver Machine hours, labor hours or number of units produced Machine hours

8 8 Activities and Cost Drivers: Product Level Activity Product Testing Supervision Potential Cost Driver Number of change orders, number of tests, hours of testing time Number of supervision hours

9 9 Activities and Cost Drivers: Batch Level Activity Purchasing Receiving Machine setups Customer orders Potential Cost Driver Number of purchase orders or number of parts Amount of material or number of receipts Number of setups Number of orders, number of customers

10 Activities and Cost Drivers: Facility Level Activity Plant Occupancy Potential Cost Driver Square footage, number of employees, labor hours, machine hours

11 Unit-level costs are incurred each time a unit is produced. Batch-level costs are incurred each time a batch of goods is produced. Product-level costs are incurred as needed to support the production of each type of product. Facility-level costs simply sustain a facility’s general manufacturing process. Unit-, Batch-, Product-, and Facility- Level Costs Key Concept

12 The key feature of an Activity-Based Costing system is allocating overhead costs based on activities that drive costs rather than on the volume or number of units produced. Activity-Based Costing Key Concept

13 Traditional Overhead Allocation and ABC - An Example Modular-Home Builder Builds 2 basic models and a fast- delivery Cottage TopSail Construction

14 Estimated Manufacturing Overhead Costs for 2008

15 Costs per Unit Using Volume-Based OH Allocation

16 Stage 1: Identification of Activities

17 Stage 2: Identification of Cost Drivers & Allocation of Costs Activity Inspections Purchasing Supervision Delivery & setup Cost Driver Number of inspections Number of purchase orders Hours of supervisor time Setup time (days)

18 Estimated Cost Driver Activity

19 Calculation of Predetermined Activity Rates

20 Cost of Units Based on Activity- Based Costing

21 Cost Comparisons between Traditional and ABC Costing

22 Price Comparison between Traditional and ABC Costing

23 Activity-Based Costing Volume-based costing systems often result in over-costing high volume products and under-costing low- volume products. This cross subsidy is eliminated by the use of ABC. Key Concept

24 ABC Systems in Service Industries Although ABC was developed for use primarily by manufacturing companies, it has gained widespread acceptance in the service sector.

25 ABC Systems in Service Industries Problems  Type of work performed in service industries tends to be non-repetitive  Activities differ for each customer or service  Services have proportionately more facility-level costs

26 ABC Systems and Nonmanufacturing Activities ABC is used to determine the cost of providing a selling or administrative service.  Example: The U.S. Post Office used ABC to help determine the costs and benefits of allowing customers to pay using debit and credit cards.

27 Benefits of Activity-Based Costing  Using ABC in the budgeting process provides more accurate estimates of resources  Provides more accurate cost information for day-to-day decision making  Costs that appeared to be indirect using volume-based costing systems are now traced to specific activities using cost drivers

28 Limitations of Activity-Based Costing  High measurement costs  The higher the potential for cost distortions, the more likely the company will benefit from ABC  Distortions result from diverse products Diverse products: products that consume resources in different proportions

29 Backflush Costing Companies using JIT generally have little or no inventory or finished goods.  All manufacturing costs are flushed directly into cost of goods sold  If the company has small amounts of inventory on hand at the end of the period, manufacturing costs are backflushed into the appropriate materials inventory, WIP inventory or finished goods inventory