Activity-Based Costing Systems

Activity-Based Costing Systems
9 Activity-Based Costing Systems

Learning Objective 1

Traditional Costing Systems
Traditional cost systems were created when manufacturing processes were labor intensive. A single company-wide overhead rate based on direct labor hours may be used to allocate overhead to products in these labor intensive processes.

In this example, overhead will be allocated to jobs using direct labor hours. If total overhead is $120, how much will be allocated to each job?

Overhead Rate = $120 ÷ 8 direct labor hours Overhead Rate = $15 per direct labor hour Job 1 = 2 hours × $15 per hour = $30 Job 2 = 6 hours × $15 per hour = $90

The company introduces automated machinery. Total overhead rises from $120 to $420, while the labor time needed for Job 2 falls from 6 hours to 1 hour. Now allocate the $420 overhead to the two jobs.

Overhead Rate = $420 ÷ 3 direct labor hours Overhead Rate = $140 per direct labor hour Job 1 = 2 hours × $140 per hour = $280 Job 2 = 1 hour × $140 per hour = $140

Is this a reasonable costing method? Automation benefited only Job 2, but most of the additional overhead cost was allocated to Job 1. Clearly, we need to look for another cost driver.

Activity-Based Costing (ABC)
A costing method that identifies the activities performed within the organization as it delivers its goods and services. Products Require Activities Activities Consume Resources People Manage Activities

A costing method that assigns costs to products, based on the number of activities the organization used in producing them. Process setups Direct labor hours Lot size Design time Machine hours Customer contact

Both manufacturing and nonmanufacturing costs may be assigned to products. ABC is a good supplement to our traditional cost system. A B C Allocation bases often differ from traditional costing systems. Used in internal decision making as well as in inventory valuation for external reporting.

ABC Compared with Traditional Costing
Activity-Based Costing Level of Complexity Cost of Implementation Level of Benefits Traditional Costing

ABC Compared with Traditional Costing
Activity-Based Costing Resource Costs Resource Costs Directly traced or allocated Directly traced or allocated Cost Pools: Plants or Departments Cost Pools: Activities or Activity Centers Predetermined overhead rate Cost driver rates for each activity Cost Objects Cost Objects

Activity Costs An Activity Cost Pool is a common way to collect costs that are related to a specific activity in the ABC system. $ $ $ $ $ $

Four Steps in the ABC Process
Identify and classify the activities related to the company’s products or services. Estimate the cost of each activity identified in . Calculate a cost-driver rate for each activity. Assign activity costs to products using the cost-driver rate.

 Identify and Classify Activities
UNIT-LEVEL ACTIVITIES Resources acquired and activities performed for individual units of product. BATCH-LEVEL ACTIVITIES Resources acquired and activities performed for a group or batch of similar products or services. PRODUCT-LEVEL ACTIVITIES Resources acquired and activities performed to produce and sell a specific product or service. CUSTOMER-LEVEL ACTIVITIES Resources acquired and activities performed to serve specific customers. FACILITY-LEVEL ACTIVITIES Resources acquired and activities performed to provide general capacity to produce goods or services.

 Identify and Classify Activities
TOP DOWN APPROACH ABC teams of people from top levels of management generate the activity dictionary. INTERVIEW OR PARTICIPATIVE APPROACH ABC teams include or interview operating employees. RECYCLING APPROACH Reuses documentation of processes used for other purposes.

 Estimate the Cost of Activities
The ABC teams should gather data on the costs of all the activities identified in Step 1. Examine accounting records for recorded cost information. Ask employees to indicate how much time they work on various activities.

 Calculate Cost-Driver Rates for Activities
Two pieces of information are required to compute the cost-driver rate: Activity Cost Activity Volume May Company has 4 employees in its Quality Control Department. Salaries and costs for the department total $360,000 per year. May produces 500,000 units of product a year. What is the cost-driver rate per unit? $360,000 ÷ 500,000 units = $.72 per unit

MAY has a customer service center where customers can call to ask questions. Customers pay a fixed fee for each call they make to the service center. It costs MAY $1,260,000 a year to operate the center. The center receives 120,000 calls per year. The center handles 1,000,000 minutes of calls. What is the appropriate cost driver: total minutes for all calls or number of calls? What is the cost-driver rate?

Since customers are charged “per call”, the proper activity in this case is the number of calls handled by the center. The cost-driver rate would be: $1,260,000 ÷ 120,000 units = $10.50 per call

Cause and effect relationship between activity and costs Measurable Appropriate cost-driver base Based on resource’s practical capacity to support activities Predict or explain an activity’s use of resources

Practical Capacity Note
When estimating the cost of an activity, only the costs associated with the product should be used (practical capacity). The cost of “unused capacity” should not be applied to products. EXAMPLE Suppose we rent a 1,000 square foot warehouse for $1,000 per month. Only 800 sq. ft. are used to store Product A. The rest of the warehouse is “unused”. How much rent cost should be allocated to Product A?

Practical Capacity Note
80%, or $800 should be assigned to Product A 20%, or $200 should be assigned to “unused capacity”

 Assign Activity Costs to Products
1. Identify all the activities related to a given product or service. 2. Determine how many units of each activity are used per unit of product. 3. Assign costs to products using the cost-driver rates for each activity.

Example: Yazz, Inc. produces 130,000 units of Product A and 400,000 units for Product B. Using the following cost information, how much overhead should be allocated to Product A?

Activity-Based Costing Example
Let’s look at an example from the Bilson Company.

Bilson, Inc. manufactures and sells 5,000 units of Product A (deluxe model), and 25,000 units of Product B (standard model) each year. Product A requires 3.0 direct labor hours (DLH) and Product B requires 2.5 DLH to produce. Employing a traditional costing system, Bilson assigns overhead cost to products using direct labor hours. The predetermined overhead rate is: Mfg. overhead cost Direct labor hours = $1,550,000 77,500 $20/DLH

Bilson’s unit product costs using traditional costing are: Bilson marks its products up by 50 percent and allocates its $500,000 customer service costs based on revenue.

$ × 1.50 Traditional Costing $975,000 ÷ ($975,000 +$3,900,000) × $500,000

Sales of Product A have increased steadily since introduction, but company income has declined. Management at Bilson is unhappy with the traditional costing system and they have decided to try activity-based costing. In addition, management has observed that the cost of direct labor is relatively stable. Since labor does not behave like a unit-level cost, labor will be combined with overhead and the total conversion cost will be assigned using ABC.

The total conversion cost is: Traditional overhead $1,550,000 Labor (77,500 $10) ,000 Total $2,325,000 In addition, management has observed that the cost of direct labor is relatively stable. Since labor does not behave like a unit-level cost, labor will be combined with overhead and the total conversion cost will be assigned using ABC.

Management has identified the following five activities and costs in the production of its two products: Total conversion cost

The following transaction data has been complied by management of Bilson:

These data can be used to develop predetermined cost-driver rates for each of the five activities: $ 800,000 ÷ 5,000 Machine setups = $ per setup

The activity-based overhead rates we just calculated can be used to assign conversion costs to Bilson’s two products.

Let’s compute the product cost for A and B using our ABC overhead rates: These amounts did not change as a result of using ABC.

Now compare the unit product costs using the traditional costing system and our ABC system. Remember, we used one overhead rate based on direct labor hours.

Now compare the unit product costs using the traditional costing system and our ABC system. Adopting activity-based costing usually results in a shift of batch-level and product-level overhead costs from high-volume standard products to low-volume, more complex products.

Now compare the unit product costs using the traditional costing system and our ABC system. Can you see how different allocation methods might lead to making different management decisions?

Based on these results Bilson also decides to use ABC to assign its $500,000 customer service costs. The applicable activity is number of customer consultations. Customers buying Product A, the deluxe model, require more consultations than those buying Product B, the standard model. Cost per consultation = $500,000 ÷ 125,000 consultations = $4.00

No change in sales price ABC Costing Let’s compare product income using traditional and ABC costing.

ABC Costing Traditional Costing

Product Profitability
Should Bilson drop Product A? Should Bilson increase the price of Product A? Should Bilson reduce the price of Product B? Now that we have measured product costs accurately, we see how profitable each product really is.

Product Profitability
The price of Product A, the deluxe model, should probably be increased. Customers who buy deluxe models may buy based on features instead of price. The price of Product B, the standard model, may be too high. Customers who buy standard models are price sensitive. Decreasing the price would increase volume, possibly resulting in more income.

Customer Profitability
Service calls What are the costs and benefits of serving specific customers? Buy/sell orders Order changes Activity-based analysis can be used to track the costs of serving customers and those customers’ contribution to company profits.

Estimating Costs of New Products
Apply ABC analysis of present product lines to proposed new products. This is valid as long as the activities involved with the new products are similar to those for the present products.

ABC in Service and Merchandising Companies
The process is exactly the same as for manufacturing! Identify and classify the activities related to the company’s products or services. Estimate the cost of each activity identified in . Calculate a cost-driver rate for each activity. Assign activity costs to products using the relevant cost-driver rates.

ABC– Benefits and Limitations
More accurate and informative product costs lead to better pricing decisions. The activities driving costs are more accurately measured. Managers gain easier access to the relevant costs. Benefits Major Limitation An ABC system is very expensive to develop and implement, and very time-consuming to maintain.

When Should a Company Use ABC?
Indirect costs are significant in proportion to direct costs. Goods are complex, requiring many inputs and processes. Complex, low-volume products are profitable while standard, high-volume products are not. Different departments believe costs are assigned inaccurately. The company loses bids it thought were low, and wins bids it thought were high. Operations have changed significantly, but the costing system has not changed. Introduction of new models result in higher sales, apparent profits per unit, but an overall income decline.

Activity Based Costing

Product Costs Direct labor Direct materials Factory Overhead Period Costs Administrative expense Sales expense Appear on the income statement when goods are sold, prior to that time they are stored on the balance sheet as inventory. Appear on the income statement in the period incurred.

Product Costs Direct labor Direct materials Factory Overhead Period Costs Administrative expense Sales expense Direct labor and direct materials are easy to trace to products. The problem comes with factory overhead.

Typically used one rate to allocate overhead to products. This rate was often based on direct labor dollars or direct labor hours. This made sense, as direct labor was a major cost driver in early manufacturing plants.

Problems with Traditional Costing Systems
Manufacturing processes and the products they produce are now more complex. This results in over-costing or under-costing. Complex products are not allocated an adequate amount of overhead costs. Simple products get too much.

Today’s Manufacturing Plants
Are more complex Are often automated Often make more than one product Use proportionately smaller amount of direct labor making direct labor a poor allocation base for factory overhead.

When the manufacturing process is more complex:
Then multiple allocation bases should be used to allocate overhead expense. In such situations, managers need to consider using activity based costing (ABC).

ABC Definitions Activity based costing is an approach for allocating overhead costs. An activity is an event that incurs costs. A cost driver is any factor or activity that has a direct cause and effect relationship with the resources consumed.

ABC Steps Overhead cost drivers are determined.
Activity cost pools are created. A activity cost pool is a pool of individual costs that all have the same cost driver. All overhead costs are then allocated to one of the activity cost pools.

ABC Steps: An overhead rate is then calculated for each cost pool using the following formula: Costs in activity cost pool/base The base is, of course, the cost driver Overhead costs are then allocated to each product according to how much of each base the product uses.

Let’s work an example . . . Assume that a company makes widgets
Management decides to install an ABC system

Overhead Cost Drivers are Determined:
Management decides that all overhead costs only have three cost drivers—sometimes called activities (obviously a simplification of the real world) Direct labor hours Machine hours Number of purchase orders

Which overhead costs do you think are driven by direct labor hours?
All overhead costs are then allocated to one of the activity cost pools. Direct Labor General Ledger Payroll taxes $1,000 Machine maintenance $500 Purchasing Dept. labor $4,000 Fringe benefits $2,000 Purchasing Dept. Supplies $250 Equipment depreciation $750 Electricity $1,250 Unemployment insurance $1,500 Machine Hours # of Purchase Orders Which overhead costs do you think are driven by direct labor hours?

Overhead driver by direct labor hours
All overhead costs are then allocated to one of the activity cost pools. Direct Labor General Ledger Payroll taxes $1,000 Machine maintenance $500 Purchasing Dept. labor $4,000 Fringe benefits $2,000 Purchasing Dept. Supplies $250 Equipment depreciation $750 Electricity $1,250 Unemployment insurance $1,500 $1,000 2,000 1,500 $4,500 Machine Hours # of Purchase Orders Overhead driver by direct labor hours

All overhead costs are then allocated to one of the activity cost pools.
Direct Labor General Ledger Payroll taxes $1,000 Machine maintenance $500 Purchasing Dept. labor $4,000 Fringe benefits $2,000 Purchasing Dept. Supplies $250 Equipment depreciation $750 Electricity $1,250 Unemployment insurance $1,500 $1,000 2,000 1,500 $4,500 Machine Hours $ 500 750 1,250 $2,500 # of Purchase Orders Which overhead costs are driven by machine hours?

All overhead costs are then allocated to one of the activity cost pools.
Direct Labor General Ledger Payroll taxes $1,000 Machine maintenance $500 Purchasing Dept. labor $4,000 Fringe benefits $2,000 Purchasing Dept. Supplies $250 Equipment depreciation $750 Electricity $1,250 Unemployment insurance $1,500 $1,000 2,000 1,500 $4,500 Machine Hours $ 500 750 1,250 $2,500 # of Purchase Orders And finally, which overhead costs are driven by # of purchase orders? $4,000 250 $4,250

An overhead rate is then calculated for each cost pool:
Direct Labor Again the formulas is: Costs in Activity Cost Pool/Base = rate $1,000 2,000 1,500 $4,500 Assume the following bases: Direct labor hours = 1,000 Machine hours = 250 Purchase orders = 100 Machine Hours $ 500 750 1,250 $2,500 # of Purchase Orders The ABC rates are: $4,500/1,000 = $4.50 per direct labor hour $4,000 250 $4,250 $2,500/250 = $10 per machine hour $4,250/100 = $42.50 per purchase order

Overhead costs are then allocated to each product according to how much of each base the product uses. $4,500/1,000 = $4.50 per direct labor hour $2,500/250 = $10 per machine hour $4,250/100 = $42.50 per purchase order The ABC rates are: Lets assume the company makes two products, Widget A and Widget B: Let’s also assume that each product uses the following quantity of overhead cost drivers: Base Widget A Widget B Total Direct labor hours 400 600 1,000 Machine hours 100 150 250 Purchase orders 50 Notice that all base units are accounted for.

Now let’s allocate overhead to Widget A:
Base A Rate Allocated Direct labor hours 400 $ $ ,800.00 Just like we learned in Accounting 2020, we multiply the base used by the rate. In this case, 400 hours used to make Widget A is multiplied by the rate of $4.50. This gives total overhead applied for this activity cost pool of $1,800 to Widget A.

Continuing the calculation:
Let’s do the same thing for the other two rates, to get the total amount of overhead applied to Widget A: Widget A Base Rate Allocated Direct labor hours 400 $ $ ,800.00 Machine hours 100 $ $ ,000.00 Purchase orders 50 $ $ ,125.00 Total $ ,925.00

Now let’s allocate overhead to Widget B:
Let’s do the same thing for the other two rates, to get the total amount of overhead applied. Widget B Base Rate Allocated Direct labor hours 600 $ $ 2,700.00 Machine hours 150 $ $ 1,500.00 Purchase orders 50 $ $ 2,125.00 Total $ 6,325.00 The original overhead to be applied was $4,500 of direct labor driven overhead + $2,500 of machine hour driven overhead + $4,250 of purchase order driven overhead = $11,250 total overhead to apply. The actual overhead allocated was $4,925 for Widget A + $6,350 = $11,250 overhead applied.

Same Problems Traditional Method
Okay, so what if we had allocated the overhead in this company using traditional cost accounting allocation. Let’s assume the base is direct labor hours. What would be the amount allocated to each product?

Calculation General Ledger Payroll taxes $1,000 Machine maintenance
$500 Purchasing Dept. labor $4,000 Fringe benefits $2,000 Purchasing Dept. Supplies $250 Equipment depreciation $750 Electricity $1,250 Unemployment insurance $1,500 This the total overhead we were given, the total amount is $11,250 as explained on the previous slide. Total direct labor hours are 1,000, also given earlier. Base Widget A Widget B Total Direct labor hours 400 600 1,000 Machine hours 100 150 250 Purchase orders 40 60

Calculation The rate would be: Applying overhead using this rate:
OH Rate = Overhead/Direct Labor Hours $11,250/1,000 = $11.25 per hour. Applying overhead using this rate: Widget A: 400 hours x $11.25 = $4,500 Widget B: 600 hours x $11.25 = $6,750 Total overhead applied = $11,250

Comparison Which is more accurate? ABC Costing!
Widget A Widget B Total Traditional Method $4,500 $6,750 $11,250 Activity Based Costing $4,925 $6,325 Difference -$425 $425 -0- Which is more accurate? ABC Costing! Note these are total costs. To get per-unit costs we would divide by the number of units produced.

When do we use ABC costing?
When one or more of the following conditions are present: Product lines differ in volume and manufacturing complexity. Product lines are numerous and diverse, and they require different degrees of support services. Overhead costs constitute a significant portion of total costs.

When do we use ABC costing?
The manufacturing process or number of products has changed significantly—for example, from labor intensive to capital intensive automation. Production or marketing managers are ignoring data provided by the existing system and are instead using “bootleg” costing data or other alternative data when pricing or making other product decisions.

Additional Uses of ABC Activity Based Management (ABM)
Extends the use of ABC from product costing to a comprehensive management tool that focuses on reducing costs and improving processes and decision making.

ABM ABM classifies all activities as value-added or non-value-added.
Value-added activities increase the worth of a product or service to the customer. Example: Addition of a sun roof to an automobile. Non-value added activities don’t. Example: The cost of moving or storing the product prior to sale.

The Objective of ABM . . . To reduce or eliminate non-value related activities (and therefore costs). Attention to ABM is a part of continuous improvement of operations and activities.

Possible Cost Drivers Machine hours Direct labor hours
Number of setups Number of products Number of purchase orders Number of employees Number of square feet

Common Classification System
Unit-level activities. Activities performed for each unit of production. Batch-level activities. Activities performed for each of bath of products. Product-level activities. Activities performed in support of an entire product line. Facility-level activities. Activities required to sustain an entire production process.

Common Classification System
This system provides a structured way of thinking about relationship between activities and the resources they consume.

Facility Sustaining Activities
Have no good cost driver May or may not be allocated to products depending upon the purpose for which the information is to be used Examples Housekeeping Factory yard maintenance

Manufacturing Systems
Traditional “Just-in-Case.” Inventories of raw materials are maintained just in case some items are of poor quality or key suppliers don’t delivery on time. Push approach manufacturing. Materials are pushed through the manufacturing process. Based on standard costs. Once a standard is reached improvement ceases.

Manufacturing Systems
Progressive “Just in Time.” Raw materials arrive just in time for use in production. Finished goods are manufactured just in time to meet customer needs. Pull approach manufacturing. Raw materials are not put into the process until the next department requests them. Continuous quality improvement.

Three important elements must exist for JIT systems to work:
Dependable suppliers who can delivery on short notice. Multiskilled workforce who can work in work cells or work stations. One worker may operate several kinds of machines. Total quality management. Objective is no defects.

Objectives of JIT Reduction or elimination of inventories
Enhanced production quality Reduction or elimination of rework costs Production cost savings from improved flow of goods through the process.

TERIMA KASIH

Tugas Mengapa metode akuntansi biaya tradisional sudah tidak tepat untuk digunakan pada perusahaan yg berproduksi dengan teknologi tinggi? Apa yang dimaksud dengan ABC, dan mengapa lebih cocok digunakan sebagai penentu HPP? Apa yg dimaksud dengan activity, activity cost, resource, resource cost, cost driver, cost object, activity pool Sebut keunggulan dan kelemahan ABC Sebutkan hirarki biaya dalam ABC Jelaska dengan yg dimaksud teori kendala Jelaskan langkah-langkah menyusun ABC

Activity-Based Costing Systems

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