1. Activity-Based Costing Systems4
Activity-Based Costing Systems

2. Learning Objective 1

3. 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.

4. Traditional Costing Systems
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?

5. Traditional Costing Systems
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

6. Traditional Costing Systems
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.

7. Traditional Costing Systems
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

8. Traditional Costing Systems
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.

9. Learning Objective 2

10. 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

11. Activity-Based Costing (ABC)
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

12. Activity-Based Costing (ABC)
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.

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

14. 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

15. Activity-Based Costing (ABC)
Activity Costs
An Activity Cost Pool is a common way to collect costs that are related to a specific activity in the ABC system. $ $ $ $ $ $

16. 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.

17. Learning Objective 3

18.  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.

19.  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.

20. Learning Objective 4

21.  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.

22.  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

23.  Calculate Cost-Driver Rates for Activities
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?

24.  Calculate Cost-Driver Rates for Activities
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

25.  Calculate Cost-Driver Rates for Activities
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

26. 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?

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

28. Learning Objective 5

29.  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.

30.  Assign Activity Costs to Products
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?

31.  Assign Activity Costs to Products

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

33. Activity-Based Costing Example
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

34. Activity-Based Costing Example
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.

35. Activity-Based Costing Example
$ × 1.50
Traditional Costing
$975,000 ÷ ($975,000 +$3,900,000) × $500,000

36. Activity-Based Costing Example
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.

37. Activity-Based Costing Example
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.

38. Activity-Based Costing Example
Management has identified the following five activities and costs in the production of its two products:
Total conversion cost

39. Activity-Based Costing Example
The following transaction data has been complied by management of Bilson:

40. Activity-Based Costing Example
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

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

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

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

44. Activity-Based Costing Example
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.

45. Activity-Based Costing Example
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.

46. Activity-Based Costing Example
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.

47. Activity-Based Costing Example
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?

48. Activity-Based Costing Example
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

49. Activity-Based Costing Example
No change in sales price
ABC Costing
Let’s compare product income using traditional and ABC costing.

50. ABC Costing Traditional Costing
4-50
ABC Costing
Traditional Costing

51. Learning Objective 6

52. 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.

53. 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.

54. 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.

55. 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.

56. Learning Objective 7

57. 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.

58. 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.

59. 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.

60. End of Chapter 4