1. Chapter 4
Product Costing for Management Decisions: Activity-Based Costing and Activity-Based Management

2. Topics to be Discussed Introduction Activity-Based Costing
Choosing Cost Drivers to Motivate Behavior

3. Introduction
Overhead costs have soared to 60 percent or more of total product costs in heavily automated manufacturing environments.
As overhead costs increase and make up a larger portion of the total costs of products, accuracy in overhead application has become much more important.

4. Activity-Based Costing
Overhead Allocation Methods
Using Volume-Based Cost Drivers
Using Activity-Based Cost Drivers

5. Types of Overhead Costs
Unit-level costs are incurred each time a unit is produced. Examples:
Supplies for factory
Depreciation on factory machinery
Energy costs for factory machinery
Repairs and maintenance of factory machinery

6. Types of Overhead Costs
Batch-level costs are incurred each time a batch of goods is produced. Examples:
Salaries related to purchasing and receiving
Salaries related to moving material
Quality control costs
Depreciation of setup equipment

7. Types of Overhead Costs
Product-level costs are incurred as needed to support the production of each different type of product. Examples:
Salaries of engineers
Depreciation of engineering equipment
Product development costs (testing)
Quality control costs

8. Types of Overhead Costs
Facility-level costs simply sustain a facility’s general manufacturing process. Examples:
Depreciation of factory building or rent
Salary of plant manager
Insurance, taxes, etc.
Training

9. Activity-Based Costing (ABC)
Key Concept
Overhead costs are assigned to products in an ABC system in two stages:
Stage 1: Activities are identified and overhead costs are traced to each activity
Stage 2: Cost drivers are determined for each activity and costs are assigned to products

10. Activities and Cost Drivers: Unit Level
Activity
Machining
Maintenance of machines
Potential Cost Driver
Machine hours, labor hours or number of units
Machine hours

11. Activities and Cost Drivers: Batch Level
Activity
Purchasing
Receiving
Machine setups
Customer orders
Potential Cost Driver
Number of purchase orders or number of parts
Amount of material or number of receipts
Number of setups
Number of orders, number of customers

12. Activities and Cost Drivers: Product Level
Activity
Product Testing
Supervision
Potential Cost Driver
Number of change orders, number of tests, hours of testing time
Number of supervision hours

13. Activities and Cost Drivers: Facility Level
Activity
Plant Occupancy
Potential Cost Driver
Square footage, number of employees, labor hours, machine hours

14. Choosing Cost Drivers to Motivate Behavior
Cost drivers should generally be chosen based on a cause-and-effect relationship between the driver and the specific cost being considered.
However, cost drivers may have motivational effects that must be considered as well. Example: Taking customers’ orders by phone.

15. Choosing Cost Drivers to Motivate Behavior
Step 2: Identify Objectives
Minimize cost, thus spending as little time on the phone as possible or increase sales, thus spending more time on the call to make the sale

16. Choosing Cost Drivers to Motivate Behavior
Step 3: Identify and Analyze Available Options
If less time is spent per call, perhaps employees will answer more calls or by not cutting a call short, perhaps customers will be more satisfied and more sales will occur.

17. Traditional Overhead Allocation and ABC - An Example
Beach Housing Contractor
Builds standard houses and custom houses

18. Estimated Overhead Costs for 2002
Overhead Item
Indirect Materials
Construction Supervisors
Office Staff
Part-time Workers
Office Expenses
Tools
Trucks and Other Equipment
Rent on Construction Trailers
Total
Estimated Cost
$180,000
130,000
30,000
48,000
15,000
40,000
12,000
$485,000

19. Stage 1: Identification of Activities
Activity
Inspections
Purchasing
Supervision
Material delivery & handling
Processing change orders
Total
Estimated Cost
$50,000
30,000
100,000
225,000
80,000
$485,000

20. Stage 2: Identification of Cost Drivers & Allocation of Costs
Activity
Inspections
Purchasing
Supervision
Material delivery & handling
Change orders
Cost Driver
Number of inspections
Number of purchase orders
Hours of supervisor time
Number of deliveries
Number of change orders

21. Estimated Cost Driver Activity
Number of Houses
Number of inspections
Number of purchase orders
Supervision hours
Number of deliveries
Number of change orders
Direct Labor Hours
Standard Houses
(20)
400
600
2,500
200
48,000
Custom Houses
(10)
1,000
600
1,500
300
40,000
Totals
1,400
1,200
4,000
500
88,000

22. Traditional Volume Based Costing
Activity
Total Overhead
Cost / Cost Driver
$485,000 / 88,000
= POR
= $5,51/DLH

23. Activity-Based Costing
Inspections
Purchasing
Supervision
Material delivery & handling
Processing change orders
Total Overhead
Cost
$50,000
30,000
100,000
225,000
80,000
$485,000 /
Cost Driver = PDR
1400 = $35.71/inspection
1200 = $25/order
4000 = $25/hour
1200 = $187.50/delivery
500 = $160/order

24. Standard House Cost Direct materials Direct labor Inspections
Purchasing
Supervision
Material H&D
Processing change orders
Total Costs
ABC
$75,000
60,000
714
750
3,125
5,625
1,600
$146,814
Vol-Based
$75,000
60,000
overhead
13,224
$148,224

25. Custom House Cost Direct materials Direct labor Inspections Purchasig
Supervision
Material H&D
Processing change orders
Total Costs
ABC
$112,500
100,000
3,571
1,500
3,750
11,250
4,800
$237,371
Vol-Based
$112,500
100,000
overhead
22,040
$234,540

26. ABC
Allocating overhead costs using and activity-based costing system results in greater allocations of overhead to the custom house because it consumes more of the purchasing, inspection, supervision, material handling, and processing change order activities than the standard house.

27. ABC
Key Concept
Volume-based costing systems often result in overcosting high-volume products and undercosting low-volume products.
This cross subsidy is eliminated by the use of ABC.

28. More ABC Topics ABC Systems in Service Industries
ABC and Selling Administrative Activities
ABC and JIT
Cost Flows and ABC
Benefits and Limitations of ABC
The ABM Life Cycle

29. ABC Systems in Service Industries
Although ABC was developed for use primarily be manufacturing companies, it has gained widespread acceptance in the service sector.

30. ABC Systems in Service Industries
Problems
Type of work tends to be non-repetitive
Activities differ greatly for each customer or service
Have proportionately more facility-level costs

31. ABC Systems and Administrative Activities
ABC is used to determine the cost of providing a selling or administrative service. Example: The U.S. Post Office used ABC to help determine the costs and benefits of allowing customers to pay using debit and credit cards.

32. ABC and Just in Time
Since factories are typically redesigned in a JIT environment so that all machinery and equipment needed to make a product is available in one area, overhead costs are more likely to be traced to products as unit-level, batch-level, or product-level costs.

33. Cost Flows and ABC
The flow of costs from raw materials to work in process to finished goods and cost of goods sold is not affected by the implementation of ABC.

34. Benefits of ABC
Using ABC in the budgeting process provides more accurate estimates of resources
Provides more accuracy of cost information for day-to-day decision making
Costs that appeared to be indirect using volume-based costing systems are now traced to specific activities using cost drivers

35. Limitations of ABC High measurement costs are significant limitations.
The higher the potential for cost distortions, the more likely the company will benefit from ABC. Distortions result from diverse products.
Diverse products: products that consume resources in different proportions

36. Diverse Products Pause and Reflect:
Are the standard houses and custom houses built by TopSail Construction diverse products?

37. Activity-Based Management Topics
Activity-Based Management and ABC
ABM and the Value Chain
Value-Added and Non-Value-Added Activities
Successful Implementation of ABC and ABM

38. Activity-Based Management Topics
Key Concept
Activity-based management focuses on managing activities to reduce costs and make better decisions.

39. ABM and the Value Chain
1. Research and Development: The creation and development of ideas that lead to new products and services
2. Design: The detailed development of the research and development ideas that results in new products and services
3. Production: The use of resources to produce a product or provide a service

40. ABM and the Value Chain
4. Marketing: Providing potential customers with information about the attributes of products or services available that results in customers purchasing the products or services
5. Distribution: The actual delivery of products or services to customers
6. Customer Service: Providing customers with needed support and service during and after the sale.

41. Value-Added and Non-Value-Added Activities
Non-value-added activities don’t add value to the finished product or service.
Storage of inventory
Moving of materials and parts from storage to the factory
Idle time of employees while waiting for work

42. Value-Added and Non-Value-Added Activities
Pause and Reflect:
Can you think of a situation in which you would consider quality inspections to increase the value of a product or service?

43. Successful Implementation of ABC and ABM
Utilize activity-based costing information to reduce costs, eliminate non-value-added activities, and manage more effectively required the cooperation of all functional areas of business organization and top management.

44. Successful Implementation of ABC and ABM
Perhaps nowhere else is cooperation among accountants, marketing managers, production managers, human resource managers, and finance managers more critical than in the implementation of activity-based costing and management systems.

45. Successful Implementation of ABC and ABM
Key Concept
The successful implementation of ABC and ABM requires a long-term commitment by top management and the cooperation of all functional areas of business organization.

46. The ABM Life Cycle Cost Focus (1-2 years)
Performance Focus (1-2 years)
Value-Added Focus (ongoing)

47. End of Chapter 4
How do I allocate all of this overhead?