1/30/20161rd Activity-Based Costing Key Concepts

Costs Life cycle First Operating & Maintenance Disposal Sunk Future Opportunity Direct Indirect Overhead Fixed Variable 1/30/2016rd2

Cost Structure for Manufacturing Direct material Direct laborSum is prime costs Indirect material Indirect laborFactory overhead Fixed and miscellaneousSum is cost of goods made General and administrative SellingSum is cost of good sold ProfitSum is selling price 1/30/2016rd3

Cost Estimating What cost components must be estimated? First component ~ equipment, delivery, installation insurance, training Elements – Direct labor and materials, maintenance What approach to cost estimation will be applied? Bottom-up, design-to-cost or top-down How accurate should estimates be? ROMs ~  20% of actual costs, Detail  5% What estimation techniques will be used? Unit, cost indices, learning curves, capacity, analogy 1/30/2016rd4

Cost Estimation Cost component estimates Cost Estimates 1/30/2016rd5 Required price Bottom-Up Top-Down DTC Required price

Unit Method C T = U x N Cost of operating a car (43 cents / mile) Cost to bury fiber cable ($30K / mile) Cost to construct a parking space in parking garage $4500 Cost to construct Interstate highway ($6.2 M /mile) Cost of house construction ($225 /ft 2 ) 1/30/2016rd6

Total Cost Estimate ResourceAmount, NUnit Cost Factor U Cost Estimate U x N Materials3000 tons$45.90 per ton$137,700 Machinery, tooling1500 hours$120 per hour180,000 Labor, casting3000 hours$ 55 per hour165,000 Labor, Finishing1200 hours$ 45 per hour54,000 Labor, indirect400 hours$ 75 per hour30,000 Total cost estimate$566,700 1/30/2016rd7

Cost Indexes Cost index is a ratio of the cost of something today to its cost sometime in the past. CPI ~ Consumer Price Index 1/30/2016rd8

Cost Capacity C 2 = C 1 (Q 2 / Q 1 ) x (I t /I 0 ) The total cost for a digester with a flow rate of ½ MGD was $1.7M in Estimate the cost for a flow rate of 2 MGD. The cost index in 2000 of 131 is now 225 and the exponent x = 0.14 for the range flow 0.2 to 40 MGD. C 2 = 1,700,000 * (2/0.5) 0.14 (225/131) = $3,546,178. ComponentSize RangeExponent Activated sludge plant1-100 MGD 0.84 Aerobic digester MGD 0.14 …. … … 1/30/2016rd9

Cost Estimating Relationships Factor Method (Hans J. Lang) C T = h x C E Total cost = factor times cost of major equipment where h is usually used as 4. Delivered equipment cost is $1.55M imply a total cost of 4 * $1.55M = $6.2M Factor method can be broken down into direct and indirect costs. h = 1 + => C T = [C E (1 + )](1 + f d ) 1/30/2016rd10

Learning Curve T N = T 1 N b where N is unit number, T 1 is cost or time for first item, T N is the cost or time for the N th unit and b is the slope of the learning curve in decimal. b = (Log learning-rate 2) = Ln L / Ln 2 Unit Hours Cumulative (sim-lc ) /30/2016rd11

Learning Curve Example To build 25 FEMA test units took 200 hours for the first one. The direct and indirect labor costs average $50.hour and 80% learning curve is assumed. Estimate the total labor cost for the 25 units. (sim-lc )  Unit Hours Cumulative Unit Hours Cumulative TC = * 50 = $123, /30/2016rd12

Indirect Cost (Overhead) Traditional Overhead = Estimated total indirect cost Estimated basis level Allocation Basis Indirect Cost Category Direct labor hoursMachine shop, human resources, supervision Direct labor costMachine shop, supervision, accounting Machine hoursUtilities, IT network servers Cost of materialsPurchasing, receiving, inspection Space occupiedTaxes, utilities, bldg maintenance Amount consumedUtilities, food services Number of itemsPurchasing, receiving, inspection Number of accessesSoftware Number of inspectionsQuality assurance 1/30/2016rd13

Blanket Rate Example Blanket indirect cost rate = total expected indirect costs total estimated materials costs Automated vs. non-automated could cause discrepancy with low value items mixed with high value items resulting in over-accumulating of indirect costs for -lower value items. 1/30/2016rd14

Economic Value Added (EVA) EVA ~ adding value to the shareholders looks at the difference between net operating profit and the cost of capital. 1/30/2016rd15

Activity Based Cost (ABC) Accounting Rate sensitive to value added is a production hour rate method. Using more than one basis led to the ABC method. Factory costs are the sum of the costs of goods. Automation advances result in decreased direct hours. Once 35% to 45% of final cost due to labor; now 5 to 15% Indirect cost comprise as much as 35% to 45% of total cost 1/30/2016rd16

1/30/2016rd17 Four Key Concepts Activity accounting ~ decomposes into a cause-and-effect rationale of how activities results in outputs Cost Drivers ~ an event that affects cost/performance of a group of related activities. Number of machine hours, engineering change notices, purchase orders Direct traceability ~ attributing costs to products or processes that consume resources Non-value-added costs ABC identify and place a cost on the activities performed so that management can determine desired changes

1/30/2016rd18Example XYZ makes 2 models Qt = 50K eachModel A Direct material cost $2,800,600 Direct labor cost$ 350,000 Direct labor hours 35,000  $7M Model B Direct material cost$ 1,500,000 Direct labor cost$ 250,000 Direct labor hours 25,000  $5M Total Manufacturing overhead costs$12,000,000 Traditional (volume-based absorption) costing system Cost rate = Total Overhead Costs / Total Direct Labor Hours = 12M / 60K hours = $200 per direct labor hour Allocated overhead 35K hours * $200 = $7M Model A => $10,150,600 Allocated overhead 25K hours * $200 = $5M Model B => $6,750,000 Total costs for 50K units $10,150,600/50K = $203 A and $135 B … continued 

1/30/2016rd19 Activity-based Costing Data Six Main Activities for Manufacturing Activity $ Costs Cost Driver Budgeted Rate Production $8M # of machine hrs 200K hours Engineering 1M # ECO 40K orders Material Handling 1M # of material moves 60K moves Receiving 800K # of batches 500 batches Quality Assure 800K # of inspections 20K inspections Pack & Ship 400K # of products 100K products

1/30/2016rd20 ABC Driver Rates for Models A & B Activity Model A Model B Production 50K hours150K hours Engineering 15K orders 25K orders Material Handling 20K moves 40K moves Receiving 150 batches 350 batches Quality Assurance 6K inspections 14K inspections Pack & ship 50K products 50K products

EVA Example 1/30/2016rd21 Firm XFirm Y Capital Invested$100$200 Annual Operating Profit$ 25$ 35 Taxes (40%)$ 10$ 35 NOPAT* (profit after tax)$ 15$ 21 Cost Capital (12%)$ 12$ 24 EVA +$3 -$3 Return on Assets (ROA)15% = 15/ % = 21/200 Cost of Capital12% Difference+3%-1.5% EVA = Difference x Assets+$3 = 0.03*100-$3 = *200 *NOPAT Net Operating Profit After Taxes

1/30/2016rd22 ABC for XYZ Applied Activity RateModel AModel B Production $40/machine hr $2M $6M Engineering $25/ECO $375K $625K Material Hand $16.67/move $333,400 $666,600 Receiving $1,600/batch$240,000$560,000 QA $40/inspection$240,000$560,000 Pack & Ship $4 / product$200,000$200,000 Total Overhead Costs $3,388,400 $8,611,600 Direct material cost $2,800,600 $1.5M Direct labor costs$350,000 $250K Total costs $6,539K $10,361,600 Cost per unit$130.78$ Cost per unit (traditional)$203$135 $12M = $3,388,400 + $8,611,600 Example: Production consumes 50K + 150K = 200K machine hours. $8M/200K = $40/machine hr.

Activity-based Costing vs. Traditional (Volume-based absorption VBC) Model AModel B Traditional costing$203.00$ Activity-based costing$130.78$ /30/2016rd23 Model A is less expensive to make than Model B. Traditional based cost estimates on Model A being responsible for more overhead costs than B using direct labor hours as its base. In reality Model B incurs more overhead because of difference in number of transactions.

ABC Example A firm with 4 plants used traditional methods for business travel. See table below. Last year $500K in travel expenses were distributed at a rate of $500K/29,100 = $17.18 / employee. A switch to ABC was considered. 1/30/2016rd24 CityEmployeesAllocation Paris12,500$214,777 Florence 8,600147,766 Hamburg 4,20072,165 Athens 3, ,100$500,000

Travel Voucher Basis Plant12345Total Paris Florence Hamburg Athens140 Total /30/2016rd25 PlantABC AllocationTraditional Allocation Paris$75,000$214,777 Florence140,000147,766 Hamburg145,00072,165 Athens140,00065, ,000, 500 = $1000/voucher

Problem If the processing cost decreases by a constant 4% every time the output is doubled, the slope parameter of the learning curve is closest to: a)-0.009b) c) 0.991d) (Log )  /30/2016rd26

Problem The cost of a robot is $80K and the cost for one with twice the capacity is $120K. The value of the exponent in the cost-capacity equation is closest to a)0.51 b) 0.58c) 0.62d) 0.69 C 2 = C 1 (Q 2 / Q 1 ) x (I t /I 0 ) 120 = 80*2 x x = /30/2016rd27

Problem Delivered equipment costs $650K with direct cost factor 1.82 and indirect cost factor The total plant cost estimate is approximately a)$2,034,500b) $1,734,500 c)$1,384,500d) $1,183,000 TC = ( ) * 650K = $2,034,500 1/30/2016rd28

Problem Police want to allocate indirect cost for speed monitoring of 3 toll roads. An allocation basis that may not be reasonable is a)Miles of toll road monitored b)Average number of cars patrolling per hours c)Amount of car traffic per section of toll road d) Cost to operate a car. 1/30/2016rd29

Problem First one took 24.5 seconds to paint with a 95% learning rate. How long to paint the 10 th one? a)20.7 secondsb) 0.46 seconds c)2.75 seconds d) 15.5 seconds T 10 = 24.5 * 10 (Log ) = sec. 1/30/2016rd30

Problem Cost of capital is 12%. Consider the two firms below. Which seems better? Firm B, but Firm A is better. 1/30/2016rd31 Firm AFirm B Equity$100$200 Annual Operating Profit$25$35 Taxes (40%)$10$14 Net income$15$21 Cost of Capital (12%)$12$24 EVA (economic value added)$3-$3