Activity-Based Costing

Over- and Undercosting Overcosting – a product consumes a low level of resources (costs) but is allocated high costs per unit Undercosting – a product consumes a high level of resources (costs) but is allocated low costs per unit

Direct versus Indirect Costs Traditional Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Traditional Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. IndirectCosts

Activity An event that causes the consumption of overhead resources. Activity Cost Pool A “cost bucket” in which costs related to a particular activity measure are accumulated. $ $ $ $ $ $ How Costs are Treated Under Activity–Based Costing

Activity Measure An allocation base in an activity-based costing system. How Costs are Treated Under Activity–Based Costing The term cost driver is also used to refer to an activity measure.

Homogeneous Activity Cost Pools A homogeneous cost pool is a grouping of overhead costs in which each cost component is consumed in roughly the same proportion by each product line. A homogeneous cost pool uses a single cost driver.

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 common types of activity measures: How Costs are Treated Under Activity–Based Costing

Traditional Product-Costing System Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records: Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records:

Traditional Product-Costing System Additional information includes: Manufacturing overhead is determined as follows

Traditional Product-Costing System Budgeted manufacturing overhead $3,894,000 Budgeted direct-labor hours 118,000 = $33 per hour

Traditional Product-Costing System With these product costs, Aerotech established target selling prices (Cost × 125%) x 1.25

Traditional Product-Costing System Aerotech wishes to see what target selling prices would be suggested when using activity-based costing. Let’s see how ABC works.

Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Assigning overhead to products is a difficult process. I agree!

Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Let’s begin by identifying our major activities. Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used. Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.

Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Overhead assigned to activities are called “activity cost pools.” Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products. Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products.

Overhead Costs Total budgeted cost = $3,894,000 ActivityCostPools Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 Unit Level Batch Level Product- Sustaining Level Facility Level Identification of Activity Cost Pools Identification of Activity Cost Pools Activity must be done on each unit produced. Activityperformed on each batchproduced. Activities needed to support an entire product line Activities that support the organization as a whole.

Overhead Costs Total budgeted cost = $3,894,000 ActivityCostPools Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 More Cost Pools Unit Level Batch Level Product- Sustaining Level Facility Level Identification of Activity Cost Pools Identification of Activity Cost Pools

Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000 Machinery cost pool $1,212,600Setup $3,000Engineering $700,000Facility $507,400 Unit Level Batch Level Product- Sustaining Level Facility Level

Various overhead costs related to machinery Maintenance Depreciation Computer Support Lubrication Electricity Calibration Machinery Cost Pool Total budgeted cost = $1,212,600Activitycostpool STAGE ONE

Calculate the pool rate Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hour $28.20/hour CostAssignment STAGE TWO = =

Calculation of total setup cost Setup Cost Pool Total budgeted cost = $3,000Activitycostpool STAGE ONE

Calculate the pool rate Budgeted Setup Costs $3,000 Planned Production Runs 15 runs $200 per run $200 per run CostAssignment STAGE TWO = =

Various overhead costs related to engineering Engineering salaries Engineering supplies Engineering software Depreciation Engineering Cost Pool Total budgeted cost = $700,000Activitycostpool STAGE ONE

Allocate based on engineering transactions CostAssignment STAGE TWO Engineering Cost Pool Total budgeted cost = $700,000

Various overhead costs related to general operations Plant depr. Plant mgmt. Plant maint. Property taxes Insurance Security Facility Cost Pool Total budgeted cost = $507,400Activitycostpool STAGE ONE

Calculate the pool rate Budgeted Facilities Cost $507,400 Budgeted Direct-Labor Hours 118,000 $4.30/hour $4.30/hour CostAssignment STAGE TWO = =

Product Cost from ABC Here are the new product costs so far...

Additional ABC Information Percentages for the above information are as follows:

Other Overhead Costs

$14.82

Product Cost from ABC These are the new product costs when Aerotech uses ABC.

Product Diversity Both original and ABC target selling prices are based on (Cost × 125%). [$ × 1.25][$ × 1.25] The selling price of Mode I and II are reduced and the selling price for Mode III is increased.

Product Diversity Can you identify any problems Aerotech is likely to face as a result of this distortion? Traditional costing understates the cost of complex, low volume products.

Activity-Based Management A method of management that used ABC as an integral part in critical decision-making situations, including: –Pricing decisions –Cost reduction and process improvement decisions –Planning and managing activities