1. Module 19
Activity-Based Costing, Customer Profitability, and Activity-Based Management
© Cambridge Business Publishers, 2018

2. 1
Explain the changes in the modern production environment that have affected cost structures.
© Cambridge Business Publishers, 2018

3. Changing Cost Environment
Fundamental shift from labor-intensive to automated assembly
More time is spent by employees
On scheduling
Setting up
Maintaining
Moving materials to and from equipment
Employees keep equipment running efficiently
RESULT
Increase in manufacturing overhead costs
© Cambridge Business Publishers, 2018

4. Changing Production Cost Structure
Many companies’ cost structures are moving to a lower proportion of variable costs and a higher proportion of fixed costs.
© Cambridge Business Publishers, 2018

5. 2
Outline the concept of activity-based costing (ABC) and how it is applied.
© Cambridge Business Publishers, 2018

6. Activity-Based Costing (ABC)
Involves determining the cost of activities and tracing their costs to a cost object on the basis of the cost object’s use of units of activity
Underlying premises
Activities drive costs
Costs should be assigned to products/services in proportion to the volume of activities they consume
© Cambridge Business Publishers, 2018

7. Cost Object A product or service provided to a customer
Can be a customer
A revenue-producing event for which management wants to know the cost
© Cambridge Business Publishers, 2018

8. Activity-Based Costing (ABC)
Activities performed to fill customer needs consume resources that cost money.
Served by
Customers
Consume
Activities
Have
Resources
Costs
The cost of resources consumed by activities should be assigned to cost objects on the basis of the units of activity consumed by the cost object.
Assigned to
Costs of Resources
Reassigned to*
Activity Pools
Cost Objects
* Based on units of activity utilized by the cost objective
© Cambridge Business Publishers, 2018

9. ABC Product Costing Model
Consists of two stages:
Assignment of manufacturing overhead resource costs to activity cost pools for the key activities identified.
Costs can be indirect labor, insurance, maintenance, depreciation, utilities, etc.
Stage 1:
Assignment of costs from activity cost pools to cost objects
Stage 2:
Direct costs are assigned directly to the final cost objects and are, thus, excluded from the activity cost pools.
© Cambridge Business Publishers, 2018

10. ABC Product Costing Model
Operationalizing the two-stage model requires the following:
Identifying activities
Assigning cost to activities
Determining the basis (activity cost driver) for
assigning the cost of activities to cost object.
Determining the cost per unit of activity
Reassigning costs from the activity to the cost object on the basis of the cost object’s volume of consumption of activities
Most CRITICAL Step
© Cambridge Business Publishers, 2018

11. ABC Product Costing Model
© Cambridge Business Publishers, 2018

12. Identifying Activities Example
Expert Ironworks produces custom heavy duty shelving. Filling customer orders requires acquiring raw materials, manufacturing, and shipping as follows:
© Cambridge Business Publishers, 2018

13. Assigning Costs to Activities Example
Placing Purchase Orders
Receiving Materials
Salaries
Purchasing agents ($7,800 × 3 agents)
$23,400
Receiving room employees ($2,400 × 2 employees)
$ 4,800
Supervisor
($5,000 × 3/5 purchasing)
3,000
($5,000 × 2/5 receiving)
2,000
Other costs
($4,500 × 25% purchasing)
1,125
($4,500 × 75% receiving) -
3,375
Total
$27,525
$10,175
Supervisors spend 20% of their time with each employee in
purchasing and receiving.
Other costs related to space of which 25% is occupied by purchasing
and 75% by receiving.
© Cambridge Business Publishers, 2018

14. Refining Into Three Activities
Placing Purchase Orders
Verifying Purchase Orders
Unload
Unpack
Inspect
Total
Costs
Salaries
Purchasing agents ($7,800 × 3 agents)
$23,400
Receiving room employees ($2,400 × 2 emp.)
($2,400 × 2 employees × 15% verifying) $
($2,400 × 2 employees × 85% unload, etc.)
$4,080
Supervisor
($5,000 × 3/5 purchasing)
3,000
($5,000 × 2/5 receiving x 30% verifying)
600
($5,000 × 2/5 receiving x 70% verifying)
1,400
Other costs
($4,500 × 25% purchasing)
1,125
($4,500 × 75% receiving) -
3,375
$27,525
$ 1,320
$ 8,855
$37,700
Interviews determined how
receiving room employees spent their time:
15% verifying purchase orders
85% unloading, unpacking, and inspecting.
Supervisors were found to spend their time:
30% of receiving time was verifying issues
70% spent on unloading, unpacking, and inspecting issues.
© Cambridge Business Publishers, 2018

15. Cost per Unit of Activity
Each activity results in a different rate
Rates are used to apply costs to cost objectives
Cost per unit of activity cost driver =
Cost of activity
Units of cost driver
© Cambridge Business Publishers, 2018

16. Cost per Unit of Activity
Each activity results in a different rate
Rates are used to apply costs to cost objects
Assume direct materials totaling $120, are to be acquired during the month.
Monthly Costs:
Placing
Purchase
Orders
Verifying Purchase Orders
Unloading Unpacking Inspecting
Total cost of activity
$27,525
$ 1,320
$ 8,855
Units of cost driver:
Number of purchase orders ÷ ÷
Number of dollars of materials —
120,000
Cost per unit of activity $ $ $
© Cambridge Business Publishers, 2018

17. Assigning Activity Costs to Cost Objectives
Assigning costs to one purchase which has a materials cost of $1,600.
Costs for Purchase Order 1 :
Direct materials costs
$ 1,600
Activity costs:
Placing purchase order $
Verifying purchase order
4.40
Unloading/unpacking/inspecting
($0.074 × $1,600)
118.40
Costs assigned to cost objective
$214.55
© Cambridge Business Publishers, 2018

18. Activities & Their Relationship to Purchase Orders
Purchasing Department $37,700
Resource Costs
Purchase Order 1 $214.55
Other purchase orders $37,485.45
Cost Objects
Placing purchase orders $27,525
Verifying purchase orders $1,320
Unloading/ Unpacking/ Inspecting $8,855
Activity Cost Pool
© Cambridge Business Publishers, 2018

19. Assigning Costs to a Job Example
The following activity costs were determined in the Machining and Finishing Departments:
Machining Dept: Setup $160
Conversion $ 32 per machine hour
Finishing Dept: Polishing $33 per labor hour
Packing $ 5 per pound
If Job 554 requires 21 machine hours in the machining department and 32 labor hours in the finishing department, and weighs 230 pounds, what is the total activity cost assigned to Job 554?
© Cambridge Business Publishers, 2018

20. Assigning Costs to a Job Example
Activity Costs assigned to Job 554:
Machining Department:
Setup
$ 160
Conversion ($32 × 21 machine hours)
672
Finishing Department:
Polish ($33 x 32 labor hours)
1,056
Pack ($5 x 230 pounds)
1,150
Total activity cost assigned to Job 554
$3,038
Direct materials and direct labor must be directly traced to determine the total coast of Job 554.
© Cambridge Business Publishers, 2018

21. 3
Perform product costing using both traditional and activity-based costing methods.
© Cambridge Business Publishers, 2018

22. Traditional Product Costing
Plantwide overhead allocations are used often where production of only one product occurs.
Departmental rates produce a more accurate allocation of overhead costs than plantwide rates.
Although product costs determined with department rates may not be as precise as those determined with ABC, they are used because of relative simplicity.
© Cambridge Business Publishers, 2018

23. Traditional Product Costing Example
Jump Start produces two energy drinks in 800 gallon batches in two departments--mixing and bottling. A total of 60 batches are estimated to be produced with 2,400 machine hours and estimated total manufacturing overhead of $156,000.
Data for the products follows:
Explosion
Eruption
Machine hours required per batch
Total machine hours
18 hours
1,080 hours
22 hours
1,320 hours
Direct materials cost
$260 per batch
$380 per batch
Total direct labor cost per batch
$80
$100
Total direct labor hours
240 hours
300 hours
Direct labor hours per batch
4 hours
5 hours
© Cambridge Business Publishers, 2018

24. Traditional Product Costing Example
Additional data:
Machine Hours for 60 Batches
Departments
Explosion
Eruption
Total
Mixing
400
600
1,000
Bottling
680
720
1,400
Totals
1,080
1,320
2,400
Overhead rate: $156,000 ÷ 2,400 = $65 per machine hour
Machine hours—Explosion: 1,080 ÷ 60 = 18 hours per batch
—Eruption: 1,320 ÷ 60 = 22 hours per batch
Unit Cost of Each Batch:
Explosion
Eruption
Direct materials cost $ $
Direct labor cost 80
100
Overhead cost:
Explosion: 18 hours × $65
1,170
Eruption: 22 hours × $65
1,430
Unit cost per batch
$ 1,510
$ 1,910
© Cambridge Business Publishers, 2018

25. Departmental Rates Costing Example
Assign a portion of the total overhead to the production departments
Assign departmental costs to the products
Two Steps
Additional data:
Direct Labor Hours for 60 Batches
Departments
Explosion
Eruption
Total
Mixing
180
220
400
Bottling 60 80
140
Totals
240
300
540
Dept.
Overhead
Application Base
Mixing
Direct labor hours in mixing
Bottling
Machine hours in bottling
Machine Hours for 60 Batches
Departments
Explosion
Eruption
Total
Mixing
400
600
1,000
Bottling
680
720
1,400
Totals
1,080
1,320
2,400
Overhead
Per Department
Mixing
$40,000
Bottling
$116,000
© Cambridge Business Publishers, 2018

26. Departmental Rates Costing Example
Computation of departmental rates:
Overhead costs per activity
Mixing
Bottling
Department manufacturing overhead
$40,000
$116,000
Quantity of overhead application base
Total direct labor hours in mixing ÷
Total machine hours in bottling -
÷ 1,400
Overhead rates per department $ $
Per direct
labor hour
Per
machine hour
© Cambridge Business Publishers, 2018

27. Departmental Rates Costing Example
Additional data:
Mixing direct labor hours per batch:
Explosion: 180 ÷ 60 = 3.00 direct labor hours
Eruption: 220 ÷ 60 = 3.67 direct labor hours
Bottling machine hours per batch:
Explosion: 680 ÷ 60 = machine hours
Eruption: 720 ÷ 60 = machine hours
Total Cost per Batch:
Explosion
Eruption
Direct materials cost
$260
$ 380
Direct labor cost 80
100
Manufacturing overhead
Mixing: $100 × 3 direct labor hours
300
Mixing: $100 × 3.67 direct labor hour
367
Bottling: $82.86 × machine hours
939
Bottling: $82.86 × 12 machine hours -
994
Total costs per batch
$1,579
$1,841
© Cambridge Business Publishers, 2018

28. Applying Overhead with ABC Example
Additional data:
Overhead Activity
Total
Activity Cost
Activity Cost Driver
(Number of)
Activity Quantity
Unit Activity Rates
Direct department costs—mixing
$ 32,000
Labor hours
400
$80.00
Direct department costs—bottling
39,000
Machine hours
1,400
27.86
Common overhead costs
Support services
Receiving
17,000
Purchase orders
320
53.13
Inventory control
15,000
Batches produced 60
250.00
Engineering resources
Production setup
11,000
Production runs 18
611.11
Engineering and testing
16,000
Tests
40.00
Building and grounds
Maintenance, machines
12,000
Maintenance visits
150
80.00
Depreciation, machines
14,000
2,400
5.83
$156,000
© Cambridge Business Publishers, 2018

29. Applying Overhead with ABC Example
Explosion
Eruption
Overhead costs
Rate
Activity
Cost of Activity
Mixing
$ 80.00
220
$17,600
180
$14,400
Bottling
27.86
680
18,943
720
20,057
Receiving
53.13
240
12,750 80
4,250
Inventory control
250.00 30
7,500
Production setup
611.11 4
2,444 14
8,556
Engineering and testing
40.00
200
8,000
Maintenance, machines
80.00 70
5,600
6,400
Depreciation, machines
5.83
1,080
6,300
1,320
7,700
Total overhead product cost
$79,137
$76,863
Each activity rate is multiplied by the actual activity to determine the cost allocated to each product batch.
© Cambridge Business Publishers, 2018

30. Cost per Unit ABC Example
Explosion
Eruption
Total factory overhead product cost
$79,137
$76,863
Batches produced ÷
Factory overhead cost per batch
1,319
1,281
Direct material cost per batch
260
380
Direct labor cost per batch 80
100
Total batch product cost using ABC
$ 1,659
$ 1,761
There were 60 batches of product resulting in a cost of $1,659 for Explosion and $1,761 for Eruption.
ABC provides more accurate cost data for internal decision making.
© Cambridge Business Publishers, 2018

31. 4
Compare activity-based costing to traditional methods Assess implementation issues involved in activity-based costing systems.
© Cambridge Business Publishers, 2018

32. Limitations of ABC
Complete analysis requires consideration beyond manufacturing costs to include nonmanufacturing
Activity can be measured on practical capacity, actual capacity, or other estimate
Practical capacity preferred over actual capacity because
Does not hide the cost of idle capacity within product costs
Gives a truer cost of activities used to produce the product
© Cambridge Business Publishers, 2018

33. Comparing Overhead Cost Allocation Methods
Explosion
Eruption
Traditional plantwide rate
$1,510
$1,910
Traditional departmental rate
1,579
1,841
ABC
1,659
1,761
Traditional methods
Undercost Explosion
Overcost Erruption
ABC
Most accurate costing method
ABC views operations of the company as activities.
© Cambridge Business Publishers, 2018

34. ABC Implementation Issues
After switching to ABC, companies may find that only 10 to 15% of their products are profitable
Causes management to alter the product mix by minimizing unprofitable products which causes profits to increase
Implementation mirrors the complexity of the organization
Complete conversion to ABC requires auditors to accept the system when used for financial reporting
© Cambridge Business Publishers, 2018

35. Analyze customer profitability using activity-based costing.5
Analyze customer profitability using activity-based costing.
© Cambridge Business Publishers, 2018

36. ABC and Customer Profitability
ABC may be used for customer profitability analysis
Customer costs to be analyzed
Cost incurred to sell the goods or services
Cost incurred to provide service
Actions possible from analysis
Convert customers to profitability or increase profitability
Seek to terminate unprofitable customer relationships
© Cambridge Business Publishers, 2018

37. Customer Profitability Profile Graph
Once a company knows the amount of profits or losses generated by each customer, it can create a customer profitability profile.
© Cambridge Business Publishers, 2018

38. ABC Customer Profitability Analysis
Step 1: Identify the activities related to serving customers.
Step 2: Prepare a customer profitability analysis.
Step 3: Take proactive steps to increase profit.
© Cambridge Business Publishers, 2018

39. ABC Customer Profitability Analysis Example
Manning Building Supplies prepared the following list concerning its customer activities:
Activity
Activity Cost Driver
Cost per Unit of Driver Activity
Visits to customers
Visits
$400
Remote contact
Number of contacts 30
Processing and shipping
Customer orders
150
Repackaging
Number of requests
120
Billing and collection
Invoices 40
The largest customer, Haskell Construction, will be analyzed.
© Cambridge Business Publishers, 2018

40. ABC Customer Profitability Analysis Example
Customer cost information:
Activity
Activity Cost Driver
Cost per Unit of Activity
Visits to customers
Visits
$400
Remote contact
Number of contacts 30
Processing and shipping
Customer orders
150
Repackaging
Number of requests
120
Billing and collection
Invoices 40
Customer activity costs for Haskell Construction:
Activity Cost Driver Data
Cost per Unit of Driver Activity
Customer Activity Cost
Visits to customers 4
$400
$1,600
Remote contact 3 30 90
Processing and shipping 6
150
900
Repackaging 2
120
240
Billing and collection 5 40
200
Total customer activity cost
$3,030
© Cambridge Business Publishers, 2018

41. ABC Customer Profitability Analysis Example
Customer sales
$79,000.
Less cost of goods sold
62,000.
Gross profit on sales
17,000.
Less activity costs
(3,030)
Customer profitability
$13,970.
Customer profitability ratio: $13,970 / $79,000 = 17.7%
Customers found to generate lower profitability should be flagged and efforts made to correct the situation or terminate the customer.
© Cambridge Business Publishers, 2018

42. 6
Explain the difference between activity-based costing and activity-based management.
© Cambridge Business Publishers, 2018

43. Activity-Based Management
Identification and selection of activities to maximize the value of activities while minimizing their cost from the perspective of the final consumer
Helps focus managerial attention on what is most important among the activities performed to create value for customers
© Cambridge Business Publishers, 2018

44. Activity-Based Costing
The evolution of ABC within the context of a product life cycle.
Introduced in the 1980’s
Expanded functionality
4th Generation
© Cambridge Business Publishers, 2018

45. Activity-Based Costing
Integral part of business performance management solutions.
Profitability management
Performance measurement
Financial management
Sustainability
Human capital management
© Cambridge Business Publishers, 2018

46. Activity-Based Costing
In its current state, a single ABC model can support a number of needs including:
Other Analyses
Performance Measurement
Resource Planning
Historical Cost Measurement
© Cambridge Business Publishers, 2018