1. IE 475 Advanced Manufacturing Costing Techniques
Lecture Notes #4
Activity Based Costing

2. Topic Learning Objectives
After completing this module, IE 475 students should be able to:
Understand the strategic role of activity-based costing (ABC)
Understand why traditional (i.e., volume-based) costing systems tend to overcost/undercost products or services
Describe ABC; the steps in developing an ABC system; and the benefits and limitations of an ABC system
Compute and contrast product costs using volume-based and ABC systems

3. Topic Learning Objectives (cont.)
After completing this module, IE 475 students should be able to (cont.):
Understand the objectives of an activity-based management system
Relate activity-based costing to strategic cost management
Understand the limitations of a traditional ABC system when implemented in a large-scale setting
Understand the main features of Time-Driven ABC
Understand the advantages of Time-Driven ABC and its reporting capabilities

4. Limitations of Traditional Costing Systems
Recent changes in manufacturing and business environments have made traditional (i.e., volume-based) costing systems unreliable and inaccurate
Examples

5. Limitations of Volume-Based Costing Systems
Volume-based costing is often inadequate because indirect costs do not always occur in proportion to output volume
Volume-based costing generally causes miscosting of outputs
It generally overcosts some products and undercosts others
Volume-based costing can create inappropriate incentives for managers
e.g., more volume equates to more overhead expense

6. Limitations of Volume-Based Costing Systems (cont.)
Strategies to allocate overhead in volume-based costing systems
Plant-wide allocation
Simple but omits allocation of service department costs
Departmental rate
Provides more detailed cost measures, particularly if the departments perform quite different activities

7. Volume-based Costing System Example: Single Plant-wide Overhead Rate
Dole Company has two divisions: Machining (highly automated) and Finishing (labor-intensive). The company uses a single plant-wide overhead rate based upon labor hours.
Annual Budget Data
Machining
Division
Finishing
Total
Budgeted overhead
400,000 $
200,000
600,000
Budgeted labor hours
10,000
50,000
60,000
Budgeted machine hours
20,000
4,000
24,000
Single Plant-wide Overhead Rate = =

8. Volume-based Costing System Example: Single Plant-wide Overhead Rate (cont.)
Dole spent the following hours in July to manufacture 2,000 units of each of its two products: Widget and Gidget.
Machining
Division
Finishing
TOTAL
Widget:
Labor hrs
500
4,000
4,500
Machine hrs
900
300
1,200
Gidget:
1,000
1,500
1,300

9. Volume-based Costing System Example: Single Plant-wide Overhead Rate (cont.)
Using the pre-determined plantwide overhead rate of $10 per direct labor hour, the firm calculates factory overhead costs for these two products as follows:
Total DLH
Overhead Rate/DLH
Total Overhead
Widget
4,500
$10
Gidget
1,500
Total
Widget Overhead
Cost per Unit = =
Gidget Overhead
Cost per Unit = =

10. Volume-based Costing System Example: Single Plant-wide Overhead Rate (cont.)
A plantwide overhead rate assumes that all products or services benefit from or consume overhead costs in proportion to the quantity of the chosen activity (driver) for applying overhead
In the previous example, the assumption is that each direct labor hour spent on Widget uses the same amount of overhead as each direct labor hour spent on Gidget

11. Volume-based Costing System Example: Departmental Overhead Rates
To obtain more accurate product costing, the company decided to use departmental overhead rates. The overhead in Machining is to be based on machine hours, and Finishing will use labor hours.
Machining Overhead Rate = =
Finishing Overhead Rate = =

12. Volume-based Costing System Example: Departmental Overhead Rates (cont
Using the new departmental overhead rates, the factory overhead cost assigned to the two products is:
Widget
Gidget
Machining Division
Finishing Division
Overhead applied
Units manufactured
Overhead / unit

13. Volume-based Costing System Example: Departmental Overhead Rates (cont
The following table summarizes the amounts of applied overhead in July with different overhead application rates:

14. Limitations of Volume-Based Costing Systems
A traditional volume-based overhead costing system, whether plantwide or departmental, often leads to inaccurate product costs
Especially for firms with complex manufacturing operations
Distortions of volume-based overhead cost systems increase as product diversity increases
Inaccurate cost information can lead to undesirable strategic results
Wrong product-line decisions
Unrealistic pricing
Ineffective resource allocations

15. Applicability of Volume-Based Costing Systems
Volume-based costing systems are appropriate generally when direct costs are the major cost of the product or service and the activities supporting its production are relatively simple, low-cost, and homogeneous across different product lines
Although often inadequate, volume-based costing may be a good strategic choice for some firms, e.g.,
Paper product manufacturers
Producers of agricultural products, and
Professional service firms

16. Activity-Based Costing Definition
Activity-Based Costing (ABC) is a costing approach that assigns resource costs to cost objects based on activities performed for the cost objects
ABC uses detailed information about the activities that make up indirect (support) costs so that outputs are charged only for resources consumed
Volume-based costing systems allocate cost
ABC costing traces the significant activities (and ultimately the cost)

17. Strategic Role of Activity-Based Costing
ABC is a method for determining accurate costs
Accurate cost information provides a competitive advantage
It helps a company or organization to develop and to execute its strategy by providing accurate information about the cost of
Products and services
Serving its customers
Dealing with its suppliers
Supporting business processes within the company

18. Strategic Role of Activity-Based Costing (cont.)
For firms following a cost leadership strategy, ABC helps in identifying key activities, cost drivers, and ways to improve processes to reduce cost
For firms following a differentiation strategy, ABC can help to:
Identify value-enhancement opportunities
Develop a customer strategy
Support a technological leadership strategy
Establish a pricing strategy

19. Activity-Based Costing Terminology
Action or an aggregation of actions performed within an organization
E.g., production setup, customer inquires, etc.
Resource
Economic element needed or consumed in performing activities
E.g., salaries and supplies, space, time

20. Activity-Based Costing Terminology (cont.)
A cost driver is either a resource consumption cost driver or an activity consumption cost driver
Resource consumption cost driver
Measures the amount of resources consumed by an activity, e.g., number of minutes used to fulfill a customer order
Activity consumption cost driver
Measures the amount of activity performed for a cost object, e.g., number of batches used to manufacture product Y

21. Activity-Based Costing Terminology (cont.)
Resource vs. Activity Consumption Cost Drivers
Source: Roztocki, N., Porter, J.D., Thomas, R.M., Needy, K.L. (2004). “A Procedure for Smooth Implementation of Activity Based Costing in Small Companies,” ASEM Engineering Management Journal, Vol. 16, No. 4, pp

22. Activity-Based Costing Two-Stage Cost Assignment
A two-stage cost assignment assigns factory overhead costs to activity centers or cost pools and then to costs objects
ABC systems differ from traditional volume-based costing systems in two ways:
Defines cost pools as activities or activity centers rather than production plant or department cost centers
The cost drivers used to assign activity costs to cost objects are based on an activity or activities performed for the cost objects

23. Two-Stage Cost Assignment: Traditional vs. ABC
Exhibit 5.1 The Volume-Based Two-Stage Procedure
Exhibit 5.2 The Activity-Based Two-Stage Procedure
Resources
Resources
Direct Materials
and Direct Labor
Indirect Costs
(Overhead)
Direct Materials
and Direct Labor
Indirect Costs
(Overhead)
First stage: Direct mat’s and labor assigned to cost objects
First stage: Direct mat’s and labor assigned to cost objects
Cost Pools: The plant or the departments in the plant
Cost Pools: The activities in the plant
First stage: overhead costs assigned to department directly or aggregated to plant level
First stage: overhead costs assigned to activities using resource consumption cost drivers
Cost Objects
Cost Objects
Second stage: Plant level or departmental costs assigned to cost objects using volume-based cost drivers
Second stage: Activity cost pools assigned to cost objects using activity consumption cost drivers

24. Steps in Designing an ABC System
There are three steps in the development of an ABC system:
Identify resource costs and activities (Stage One)
An activity analysis is performed to identify key activities and the way in which the activities consume resources
Assign resource costs to activities (Stage One)
Use resource consumption cost drivers based on cause-and-effect relationships, such as the number of labor hours, setups, moves, machine-hours, employees, or square feet to assign resource costs
The assignment is made through either direct tracing or estimation

25. Steps in Designing an Activity-Based Costing System
Assign activity costs to cost objects (Stage Two)
Use activity consumption cost drivers, such as purchase orders, receiving reports, parts stored, direct labor-hours, or manufacturing cycle time to assign activity costs

26. Activity-Based Costing Two-Stage Cost Assignment
Source: Roztocki, N., Porter, J.D., Thomas, R.M., Needy, K.L. (2004). “A Procedure for Smooth Implementation of Activity Based Costing in Small Companies,” ASEM Engineering Management Journal, Vol. 16, No. 4, pp

27. Applicability of Activity-Based Costing Systems
ABC should be implemented when
The cost of measuring the activities and their costs is reduced, perhaps because of computerized scheduling systems on the production floor
Stronger competition increases the cost of errors caused by erroneous pricing
Product diversity is high in volume, size, or complexity

28. Activity Analysis for ABC
This process includes gathering data from existing documents and records, as well as collecting additional data using questionnaires, observations, or interviews of key personnel
Sample questions include:
What work or activities do you do?
How much time do you spend performing these activities?
What resources are required to perform these activities?
What value does the activity have for the product, service, customer, or organization?

29. Benefits and Limitations of an ABC System
Better profitability measures due to more accurate costs
Identification of value-added vs. non-value-added activities and associated costs
Information for process improvement
Improved cost estimation
Helps identify and control the cost of unused capacity
Some costs may require allocations to departments and products based on arbitrary volume measures
Some costs that can be identified with specific products are omitted
Expensive and time-consuming to develop and implement
Possible managerial resistance to ABC results

30. Comparison of Volume-Based and Activity-Based Costing Systems
The following example (Haymarket BioTech, Inc.) contrasts Steps 2 and 3 of the traditional volume-based costing system using direct labor-hours as the cost driver with an activity-based costing system that uses both volume-based and non-volume based cost drivers

31. Comparison of Volume-Based and Activity-Based Costing Systems (cont.)
Haymarket BioTech, Inc. (HBT) produces and sells two secure communication systems, AW (Anywhere) and SZ (SecureZone). HBT has the following operating data for the two products: AW SZ
Production Volume
5,000
20,000
Selling Price
$400.00
$200.00
Unit Direct Materials and Labor
$80.00
Total Direct Labor Hours
25,000
75,000
Direct Labor Hours per Unit 5
3.75

32. Volume-Based Costing System
The traditional volume-based costing system that the firm uses assigns factory overhead (OH) based on direct labor-hours (DLH). The firm has a total budgeted overhead of $2,000,000. Since the firm budgeted 100,000 direct labor hours for the year, the overhead rate per direct labor hour is $20 per direct labor hour:
Total Overhead =
Total Direct Labor Hours =
Overhead rate per DLH =

33. Volume-Based Costing System (cont.)
Since the firm spent 25,000 direct labor hours to manufacture 5,000 units of AW, the factory overhead assigned to AW is $500,000 in total and $100 per unit:
Total OH assigned to AW =
Number of units of AW =
Factory Overhead per unit of AW =
The factory overhead for SZ is $1,500,000 in total and $75 per unit since the firm spent 75,000 direct labor hours to manufacture 20,000 units of SZ:
Total OH assigned to SZ =
Number of units of SZ =
Factory Overhead per unit of SZ =

34. Product Profitability Analysis Volume-Based Costing SystemAW SZ
Unit Selling Price
$400
$200
Unit Product Cost:
Direct Materials and Labor
$80
Factory Overhead
Cost per unit
Product Margin

35. Activity-Based Costing System
In an attempt to use an activity-based costing, HBT has identified the following activities, budgeted costs, and activity consumption cost drivers:

36. Activity-Based Costing System (cont.)
HBT also has gathered the following operating data pertaining to each of its products:
AC Cost Driver AW SZ
Total
Engineering Hours
5,000
7,500
12,500
Number of Setups
200
100
300
Machine Hours
50,000
100,000
150,000
Packing Orders
10,000
15,000

37. Activity-Based Costing System (cont.)
Using the gathered data, the cost driver rate for each activity consumption cost driver is calculated as follows:
(1)
AC Cost Driver
(2)
Budgeted Cost
(3)
Activity Consumption
(4) = (2)/(3)
Activity Rate
Engineering Hours
Number of Setups
Machine Hours
Packing Orders

38. Activity-Based Costing System (cont.)
Factory overhead costs are assigned to both products by these calculations:
AW = 5,000 units
(1)
AC Cost Driver
(2)
Activity Rate
(3)
Activities
(4) = (2)x(3)
Total OH Rate
(5)
OH per unit
Engineering Hours
$10
5,000
Number of Setups
$1,000
200
Machine Hours
50,000
Packing Orders $5

39. Activity-Based Costing System (cont.)
Factory overhead costs are assigned to both products by these calculations:
SZ = 20,000 units
(1)
AC Cost Driver
(2)
Activity Rate
(3)
Activities
(4) = (2)x(3)
Total OH Rate
(5)
OH per unit
Engineering Hours
$10
7,500
Number of Setups
$1,000
100
Machine Hours
100,000
Packing Orders $5
10,000

40. Product Profitability Analysis Activity-Based Costing SystemAW SZ
Unit Selling Price
$400.00
$200.00
Unit Product Cost:
Direct Materials and Labor
$80.00
Factory Overhead:
Engineering Hours
Number of Setups
Machine Hours
Packing Orders
Cost per unit
Product Margin

41. Comparison of Alternative Costing Approaches

42. Comparison of Volume-based and ABC: Conclusions
One major limitation of a traditional volume-based costing system is that it tends to undercost complex low-volume products and overcost high-volume products
Referred to as cross-subsidization
Distorted or inaccurate product costing can lead to inappropriate inventory valuations, unrealistic pricing, ineffective resource allocations, misplaced strategic focus, misidentified CSFs, and lost competitive advantage
The ABC system presents a more accurate measurement of product costs by tracing overhead consumption

43. Time-Driven ABC1
Overcomes the time and cost demands of creating and maintaining large-scale ABC systems
Provides managers with a far more flexible cost model to capture the complexities of their operations
Relies on informed managerial estimates rather than on employee surveys
1 Kaplan, R.S. and Anderson, S.R. (2004). Time-Driven Activity-Based Costing. Harvard Business Review, Vol. 82, Issue 11, pp

44. Traditional ABC and Large-Scale Implementations
Large-scale implementations require lots of data collection
A bank’s brokerage operation required 70,000 employees at 100 locations to submit monthly reports of their time allocation
The ABC system needed 14 full-time employees to do data-collection, processing and reporting
Large-scale ABC systems are updated infrequently due to the time and costs required to re-interview and re-survey employees
Under these conditions, estimates of costs of processes, products and customers soon become inaccurate

45. Traditional ABC and Complex Operations
Consider the activity “ship order to customer”
Example
Hendee Enterprises’ ABC system took three days to calculate costs for its 40 departments, 150 activities, 10,000 orders, and 45,000 line items

46. Estimating Time in Traditional ABC Systems
Time spent by employees on activities is collected via interviews and/or surveys
People invariably report percentages that add up to 100
Few report idle or unused time
Cost driver rates are calculated assuming resources are working at full capacity
Thus, estimated cost-driver rates are usually much too high

47. Approach of Time-Driven ABC
Managers directly estimate resource demands imposed by each transaction, product, or customer
For each group of resources, only two parameters are required
Provides more accurate cost-driver rates by allowing unit times to be estimated even for complex, specialized transactions

48. Estimate #1: Cost per Time Unit of Capacity
Estimated by managers as a percentage of the theoretical capacity
~ 85% for machines; ~ 80% for people
Could also review past activity levels
Period with largest volume of activity handled w/o excessive delays, poor quality, overtime or stressed employees
Do not be overly sensitive to small errors
Objective  within 5% to 10% of actual number
Process of running the model will eventually reveal big errors

49. Estimate #2: Unit Times of Activities
Obtained through employee interviews or by direct observation
In large organizations, surveying may be helpful
However, question is not about the % of time an employee spends doing an activity (e.g., processing orders) but how long it takes to complete one unit of that activity (e.g., time to process one order)
Cost-driver rates can now be calculated by multiplying the two estimates

50. Time Equations to Capture Complexity
Traditional ABC assumption:
“All transactions of a particular type are the same and require the same amount of time to process”
Time-driven ABC models reflect how order and activity characteristics cause processing times to vary
Key insights:
Managers can usually identify which variables make transactions complicated
These variables are typically already recorded in a company’s information system

51. Time Equations to Capture Complexity: Example
Traditional ABC model
Three separate activities in the inside sales department at Hunter Corporation
Customer setup, order entry and order expediting
Time-driven ABC
Single departmental process  Inside sales order entry
5 min to enter basic order info
+3 min for each line item
+10 min if order needs to be expedited
+15 min if new customer

52. Advantages of Time-Driven ABC
Enables managers to report costs on an on-going basis
Reveals both the cost of a business’ activities and the time spent on them
Reports highlight the difference b/w capacity supplied (both quantity and cost) and the capacity used
Managers can easily update cost-driver rates
Model is updated on the basis of events rather than on the calendar (quarterly or annually)
Provides more accurate reflection of current conditions

53. Time-Driven ABC Reporting