1. Activity Based Costing
November 12, 2015
Activity Based Costing
Chapter 3: Systems Design: Activity Based Costing.
Overhead costs cannot be easily traced to products. Using a plantwide predetermined overhead rate as described in chapter 2 is simple, but using such a rate may inaccurately assign costs to products. Activity-based costing is an alternative that attempts to accurately assign overhead costs to products for financial reporting and other purposes.

2. Activity Based Costing
Shortcomings of Simple Job Order Costing
What is Activity Based Costing?
How is it Superior?
How is it Applied?
Journal Entries

3. Ratio Analysis
Gross margin
Operating margin
Net income margin

4. Assigning Overhead Costs to Products
When cost systems were developed in the 1800s, the emphasis was on simplicity because:
1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil.
2.   Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.
When cost systems were developed in the 1800s, the emphasis was on simplicity because:
Cost and activity data had to be collected by hand and all calculations were done with paper and pencil.
Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

5. Plantwide Overhead Rate
Plantwide Overhead Rate A single overhead rate used throughout an entire factory.
Direct labor has often been used as the allocation base for overhead because:
1.    Direct labor information was already being recorded.
2.    Direct labor was a large component of product costs.
3. Managers believed direct labor and overhead costs were highly correlated.
In the interest of simplicity, companies often established a single overhead pool for an entire factory that used direct labor as the allocation base. Direct labor was the obvious choice because:
Direct labor information was already being recorded.
Direct labor was a large component of product costs.
Managers believed direct labor and overhead costs were highly correlated.

6. Shortcomings of Simple Job Order Costing
Plant-wide allocation of costs may be a reasonable methodology for single product facilities
Companies produce a multitude of products out of the same plant
These different products tend to consume different amounts of overhead
Additionally in many businesses, overhead is increasing as a proportion of overall cost and consequently its allocation becomes more meaningful
In these circumstances, a simple plant wide allocation is not granular enough to capture good product cost information

7. What is Activity Based Costing (ABC)?
Activity Based Costing is a methodology for allocating costs based on:
Each of the activities associated with producing a product, and
The level of overhead that each of these require
There are a number of allocation bases for assigning costs to products
We end up with a more accurate understanding of Product Cost
Better basis for manufacturing and pricing decisions

8. Activity-Based Costing (ABC)
An event that causes the consumption of overhead resources
Examples of Activities
Part I
An activity in activity-based costing is an event that causes the consumption of overhead resources.
Part II
Examples of activities include:
a.     Setting up machines
b.     Admitting patients to a hospital
c.     Billing customers
d.     Opening an account at a bank
Setting up machines
Admitting hospital patients
Billing customers
Opening a bank account

9. Activity-Based Costing (ABC)
Activity Cost Pool
A “cost bucket” in which costs related to a particular activity are accumulated.
Activity Measure
Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs.
Part I
An activity cost pool can be thought of as a “cost bucket” in which costs related to a particular activity are accumulated.
Part II
An activity measure expresses how much of the activity is carried out and it is used as the allocation base for applying overhead costs to products and services. Activity measures may or may not be related to volume.
Part III
An activity rate is a predetermined overhead rate in an activity-based costing system. Each activity cost pool has its own activity rate that is used to apply overhead costs to cost objects.
Activity Rate
A predetermined overhead rate for each activity cost pool.

10. Activity-Based Costing (ABC)
For each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2.
A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product.
Part I
Taking each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2.
Part II
A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product.

11. Designing an Activity-Based Costing System
The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs.
Part I
In most companies, hundreds or even thousands of different activities cause overhead costs. The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs.
Part II
Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources.
Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources.

12. Graphic Example of Activity-Based Costing
Various Manufacturing Overhead Costs
Labor Related Pool
Machine Related Pool
Setup Pool
Production Order Pool
General Factory Pool
Parts Admin. Pool
First-Stage Cost Assignment
Unit-Level Activity
Batch-Level Activity
Facility-Level Activity
Product-Level Activity
Products
$/DLH
$/MH
$/Setup
$/Order
$/Part Type
Second-Stage Allocations
In the second stage, the costs in the activity cost pools are allocated to products, using activity rates and activity measures. For example, if the total cost in the production order cost pool was $450,000 and the company expected to process 1,200 orders, the activity rate would be $375 per order. Each order would be charged $375 for production order costs. Notice, the example shown on the slide includes two unit-level activities, two batch-level activities, one product-level activity, and one facility-level activity.

13. Applying Activity Based Costing
Applying ABC requires:
Detailed understanding of the organization
Overhead departments, functions and activities
Manufacturing departments, functions and activities
Detailed costing for all
Judgment
Selecting which costs to map to which products
What allocation base to use
The impact of these decisions can be material and therefore managers must understand the underlying information to trouble-shoot

14. Designing an Activity-Based Costing System
Select a few activities which capture most of the overhead
Group the related activities; eg materials handling
Interview company managers to understand which overhead costs they believe are most costly and most critical to efficient production
Interview marketing and sales people to understand which products are most sensitive to pricing
Establish which cost objects to focus upon in more detail
Design the system from cost-down and product-up
Ensure all costs are captured
Part I
In most companies, hundreds or even thousands of different activities cause overhead costs. The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs.
Part II
Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources.

15. Applying Activity-Based Costing
List all Cost Objects; i.e., products to be costed
List all Overhead Departments / Costs
Identify Activity Cost Pools that production of each product requires
E.g., maintaining machines. Other examples?
Establish which overhead costs are consumed for the activity
E.g., Maintenance Mechanics Department
Measure the activity
Calculate the cost
E.g., the overall cost of the Mechanics Department
Select the Allocation Bases and Activity Rate
Simply the POHR, except for each activity
E.g., Cost of Maintenance Mechanics / Estimated hours of machine operation
Part I
An activity cost pool can be thought of as a “cost bucket” in which costs related to a particular activity are accumulated.
Part II
An activity measure expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs to products and services. Activity measures may or may not be related to volume.
Part III
An activity rate is a predetermined overhead rate in an activity-based costing system. Each activity cost pool has its own activity rate that is used to apply overhead costs to cost objects.

16. Graphic Example of Activity-Based Costing
Various Manufacturing Overhead Costs
Labor Related Pool
Machine Related Pool
Setup Pool
Production Order Pool
General Factory Pool
Parts Admin. Pool
First-Stage Cost Assignment
Where cost correlations and overhead support required are similar, it is practical to consolidate the Activity Pools
Information systems are strong and can support extraordinary complexity
However, at a certain point the complexity becomes overly cumbersome interpret
Using activity based costing, the manufacturing overhead costs are allocated to products using a two-stage process. In the first stage, overhead costs are assigned to the six activity cost pools shown on the slide. For example, the production order cost pool may include the salaries of engineers who modify products for individual orders and the costs of scheduling and monitoring orders. In the examples and assignments in this book, the first-stage cost assignments have already been completed.

17. Hierarchy of Activities
A common framework for combining activities in manufacturing companies is as follows:
Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment is a unit-level activity.
Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities.
Product-level activities relate to specific products and must be carried out, regardless of how many batches are run or units produced and sold. For example, designing or advertising a product are product-level activities.
Facility-level activities are carried out regardless of which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are facility level activities.

18. Graphic Example of Activity-Based Costing
Various Manufacturing Overhead Costs
Labor Related Pool
Machine Related Pool
Setup Pool
Production Order Pool
General Factory Pool
Parts Admin. Pool
First-Stage Cost Assignment
Unit-Level Activity
Batch-Level Activity
Facility-Level Activity
Product-Level Activity
Products
$/DLH
$/MH
$/Setup
$/Order
$/Part Type
Second-Stage Allocations
In the second stage, the costs in the activity cost pools are allocated to products, using activity rates and activity measures. For example, if the total cost in the production order cost pool was $450,000 and the company expected to process 1,200 orders, the activity rate would be $375 per order. Each order would be charged $375 for production order costs. Notice, the example shown on the slide includes two unit-level activities, two batch-level activities, one product-level activity, and one facility-level activity.

19. Using Activity-Based Costing
An electronics manufacture produces Cell Phones and Servers
It uses a DL hours bases Overhead allocation system
What are the product costs of each product?
Calculate the POHR
What are your observations?

20. Using Activity-Based Costing
What are the product costs of each product?
Calculate the POHR
What are your observations?

21. Using Activity-Based Costing
Note that Manufacturing Overhead as a percentage of product cost is more than 4 times higher for cell phones!

22. Computing Activity Rates
The company undertook to implement ABC
Established Cost Objects, Activity Pools, and Rates

23. Applying Overhead with ABC Rates

24. Methodology Results - A Comparison
Which methodology is more accurate? Why?
Cell phone costs decreased by 5% under ABC. Why?
What opportunities are there for the company?

25. Targeting Process Improvements
Activity Based Management
Using ABC output to identify areas of improvement
Reduce costs
Reduce production time, and
Reduce defects / improve quality
Identify high cost areas first
Benchmark against 3rd party data to identify weaknesses
What areas might we take a closer look at in the Electronics Manufacturer example?
The first step in any improvement program is to decide what to improve.
The Theory of Constraints approach discussed in the Prologue is one tool for targeting the highest impact improvement opportunities.
Activity-based management provides another approach. Activity-rates can be used to target areas where costs seem excessively high.
Benchmarking can also be used to compare activity cost information with world-class standards of performance achieved by other organizations.

26. ABC – Cost Flows and Journal Entries

27. ABC – Cost Flows and Journal Entries
Cost flows are the same for ABC as for Job-Order Costing, except ABC has more POHRs
Over and under allocations of Manufacturing Overhead are dealt with through COGS
As with Job-Order Costing
The first step in any improvement program is to decide what to improve.
The Theory of Constraints approach discussed in the Prologue is one tool for targeting the highest impact improvement opportunities.
Activity-based management provides another approach. Activity-rates can be used to target areas where costs seem excessively high.
Benchmarking can also be used to compare activity cost information with world-class standards of performance achieved by other organizations.

28. Ratio Analysis
Gross margin
Operating margin
Net income margin

29. SWOT Analysis - Introduction
Strengths
Weaknesses
Opportunities
Threats

30. Review Shortcomings of Simple Job Order Costing
What is Activity Based Costing?
When should it be Applied?
How is it Superior?
Journal Entries

31. Tutorial Case Studies Raw data functioning in working spreadsheets
Balance Sheet
Income Statement
Strong Presentation
Submit paper portfolios