Activity Based Costing Nancy R. Mangold Professor, Department of Accounting California State University, East Bay

Building Blocks of Costing Systems Direct Costs Indirect Costs Cost Object Cost Assignment n Cost object - anything for which a separate measurement of costs is desired.

Building Blocks of Costing Systems Direct Costs Indirect Costs Cost Object Cost Tracing Cost Assignment n Cost object - anything for which a separate measurement of costs is desired. n Direct costs of a cost object - costs that are related to the particular cost object and can be traced to it in an economically feasible (cost-effective) way.

Building Blocks of Costing Systems l Cost object - anything for which a separate measurement of costs is desired. l Direct costs of a cost object - costs that are related to the particular cost object and can be traced to it in an economically feasible (cost-effective) way. l Indirect costs of a cost object - costs that are related to the particular cost object but cannot be traced to it in an economically feasible way. Indirect costs are allocated to the cost object. Direct Costs Indirect Costs Cost Object Cost Tracing Cost Allocation Cost Assignment

Six-Step Approach to Costing éIdentify Cost Objects éIdentify Direct Costs éIdentify Indirect-Cost Pools éSelect Cost-Allocation Base for Each Indirect Cost Pool éDevelop the Rate Per Unit of the Cost- Allocation Base Used to Allocate Indirect Costs éAssign Costs to the Cost Objects

Traditional Costing Systems l Traditionally, job-order and process costing systems have assigned direct labor and direct materials costs to products l Indirect costs were accumulated as support department expenses. l These expenses were allocated to production departments in a simple proportion. Direct Costs Indirect Costs Cost Object Cost Tracing Cost Allocation Cost Assignment

Traditional Costing Systems l Indirect costs are grouped together into one cost pool - called Manufacturing Overhead l One allocation base is selected to allocate the Manufacturing overhead l Allocation base is usually volume based - labor hours, machine hours. l Per unit cost produced from traditional costing system is often not accurate Direct Costs Indirect Costs Cost Object Cost Tracing Cost Allocation Cost Assignment

The World is Changing... l Technology l Product Life Cycle l Product Complexity l Capital Intensiveness l Quality Requirements

Manufacturing Cost Structure is Changing... l Previously l Labor cost was the largest proportion of total product costs l Now l Overhead costs increase significantly due to the use of advanced manufacturing technology

Cost of Product Complexity is Changing... l Which factory has more scheduling costs? Set- up/change-over costs? Inventory carrying costs? Vendor negotiations? Engineering change orders? Plant A Plant B

The Impact of Plant B l Marketplace segmentation and technology advances have moved companies more toward a Plant B environment l Standard cost accounting systems have stayed as they were - designed to support a Plant A environment

Simple and Complex Factories Simple and Complex Factories l Plant A (a simple factory) has little need for a cost system to calculate the cost of its product. l Plant B (A complex factory) requires many resources to support a highly varied product mix. l Complex factories require a cost accounting system to trace expenses to its various products.

Simple and Complex Factories Simple and Complex Factories l Traditional cost systems will under-estimate the cost of resources required for specialty, low-volume products. l These systems will over-estimate the resource cost of high volume, standard products.

The Symptoms of Obsolete Cost System l Products difficult to produce are very profitable, even though they are not premium priced l Profit margin can not be easily explained l Some products that are not sold by competitors have high reported margins l The results of bids are difficult to explain

The Symptoms of Obsolete Cost System l The competition’s high-volume products are priced at apparently unrealistically low levels l Vendor bids for parts are considerably lower than expected l Customer ignore price increases, even when there is no corresponding increase in cost

The Design Flaws of Traditional Cost Accounting System l Only direct labor hours are used to allocate overhead from cost pools to the products –Direct labor costs are less than 10% of the total production cost, whereas overhead is more than 30% of total cost –Direct labor hours are not a good predictor of the indirect costs

The Design Flaws of Traditional Cost Accounting System l Only volume-related allocation bases (labor hours, machine hours and material dollars) are used to allocate overhead from cost pools to products –correct for volume -related activities –not for non-volume-related costs :setup, scheduling, inspection. –low -volume products may be undercosted –high-volume products are overcosted

The Design Flaws of Traditional Cost Accounting System l Cost pools are too large and contain machines that have very different overhead cost structures –Overhead costs charged to conventional machines too high –Overhead costs charged to automated machines too low

The Design Flaws of Traditional Cost Accounting System l The cost of marketing and delivering the product varies dramatically by distribution channel and yet the cost accounting system ignores marketing costs –marketing and distribution costs are treated as a period cost and written off

Traditional Cost Accounting Weaknesses l Overhead Allocated on Arbitrary Basis –Direct labor over-emphasized –True cost drivers not identified –Product profitability distorted

Traditional Cost Accounting Weaknesses l Cost accounting system supports financial accounting –Directed towards inventory valuation –Emphasis on time period, not product –Management information is secondary concern

Traditional Cost Accounting Weaknesses l Limited to production costs –Non-production expenses not linked to product –No life cycle data available –Cost of quality not reported

Activity Based Costing System l Identify activities performed in order to produce products or perform services l Determine how much the organization is spending on its resources l Trace the expenses of support resources to the activities using resource drivers l Identify the activity cost drivers l Trace activity cost to products based on individual products’ consumption of each activity l Evaluate activity effectiveness & efficiency

Steps For Activity Based Costing éIdentify Activities éIdentify Resources needed éIdentify Resource Drivers éTrace the Resources to Activities using resource drivers éIdentify Activity Cost Drivers éDevelop per unit activity cost rate éAssign activity costs to products based on the actual activities performed for the products

Benefits of ABC l More accurate product cost l Better cost control –continuous improvement of activities to reduce overhead costs l Improved decisions –more accurate product costing lead to better decisions on pricing, product mix, product design, marketing and distribution.

Survey of Activity-Based Costing Survey of Activity-Based Costing U.S. Companies l 36% of the business interviewed use ABC l Of the companies using ABC –25% use ABC to replace their existing cost accounting systems –the others use it for analyses outside their accounting system

Survey of Activity-Based Costing United Kingdom Companies 32% of the companies adopted ABC Canadian Companies 14% have implemented ABC 15% are considering changing to ABC

What Attracted U.S. and Canadian Firms to ABC l More accurate cost information for product pricing (61%) l More accurate profit analysis –By Product (61%) –By Customer (22%) –By Process (20%) –By Department (24%) l Improved performance measures (43%) l Improved insight into cost causation (37%)

Potential Areas for ABC Managing product (project, job, process) costs and product line profitability –ABC for manufacturing costs and manufacturing overhead (30% -50% of manufacturing costs)

Potential Areas for ABC Managing Corporate Overhead –ABC for Selling,, General and Administrative Expenses (25% - 30% of total revenue)

Potential Areas for ABC Managing Customers –ABC for Customer Profitability Analysis

Potential Areas for ABC Managing Marketing and Distribution Channels –ABC for Marketing and Distribution Channel Analysis

Activity-Based Management Use ABC information to have ABM l Operational ABM l Strategic ABM-Product Mix and Pricing l Strategic ABM for Customers l Strategic ABM for Suppliers l Strategic ABM for Product Development l ABC for Service Industries