Activity-Based Costing Lecture 5

Introduction Activities generate transactions. Transactions generate costs. ABC traces costs to activities.

Undercosting &Overcosting A product consumes a relatively high level of resources but is reported to have a relatively low total cost. Overcosting: A product consumes a relatively low level of resources but is reported to have a relatively high total cost.

Undercosting &Overcosting Irene, Roberta, and Nancy meet occasionally for lunch. Each one orders separate items: Irene’s order amounts to $14 Roberta consumed 30 Nancy’s order is 16 Total $60

Undercosting &Overcosting Assuming they divide the bill equally, what is the average cost per lunch? $60 ÷ 3 = $20 Actual Average Irene’s order amounts to $14 $20 O Roberta consumed 30 $20 U Nancy’s order is 16 $20 O Total $60 $60

Traditional costing system vs ABC costing system

Single Indirect Cost Pool Cole Corporation manufactures two types of lenses: a normal lens (NL) and a complex lens (CL). To cost products, Cole currently uses a single indirect-cost rate job costing system.

Single Indirect Cost Pool The cost objects are the total costs of manufacturing and distributing 80,000 units of normal lenses (NL) and 20,000 units of complex lenses (CL).

Single Indirect Cost Pool Normal Lenses (NL) Direct materials $1,520,000 Direct mfg. labor $800,000 Total direct costs $2,320,000 Direct cost per unit of NL: $2,320,000 ÷ 80,000 = $29

Single Indirect Cost Pool Complex Lenses (CL) Direct materials $ 920,000 Direct mfg. labor $260,000 Total direct costs $1,180,000 Direct cost per unit of CL: $1,180,000 ÷ 20,000 = $59

Single Indirect Cost Pool Indirect costs of $2,900,000 are grouped into a single overhead cost pool. 50,000 of DL hours are used as the cost-allocation base. What is the indirect cost rate? $2,900,000 ÷ 50,000 = $58 per DL hr

Single Indirect Cost Pool Cole uses 36,000 DL hr.s to make NL and 14,000 DL hr.s to make CL. How much indirect costs are allocated to each product? NL: 36,000 × $58 = $2,088,000 CL: 14,000 × $58 = $812,000

Single Indirect Cost Pool What is the total cost of NL? Direct costs $2,320,000 + Allocated costs $2,088,000 = $4,408,000 What is the cost per unit? $4,408,000 ÷ 80,000 = $55.10

Single Indirect Cost Pool What is the total cost of CL? Direct costs $1,180,000 + Allocated costs $812,000 = $1,992,000 What is the cost per unit? $1,992,000 ÷ 20,000 = $99.60

Single Indirect Cost Pool Normal lenses sell for $60 each and complex lenses for $142 each. Normal Complex Revenue $60.00 $142.00 Cost 55.10 99.60 Income $ 4.90 $ 42.40 Margin 8.2% 29.9%

Refining a Costing System Let us say that our competitor is selling NL lenses for $55. Maybe we are overcosting or undercosting our products? How do we refine a simple costing system?

Refining a Costing System Guidelines for refining a costing system: Direct-cost tracing – Classify as many of the total costs as direct costs as is economically feasible. Indirect-cost pools – Expand the number of cost pools until each of these pools is homogeneous. Cost-allocation basis – Identify the preferred cost-allocation base for each indirect-cost pool.

Activity-Based Costing ABC systems refine costing systems by focusing on activities as the fundamental cost object. ABC: calculates the costs of activities and assigns costs to cost objects on the basis of the activities undertaken to produce each product or service.

Cost Hierarchies A cost hierarchy is a categorization of costs into different cost pools on the basis of the different types of cost drivers (cost-allocation bases) or different degrees of difficulty in determining cause-and-effect relationships.

Output Unit-Level Costs... are resources sacrificed on activities performed on each individual unit of product or service. Energy Machine depreciation Repairs

Batch-Level Costs... are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. Example: Setup hours Procurement costs

Product-Sustaining... or service-sustaining, costs are resources sacrificed on activities undertaken to support individual products or services. Example: Design costs Engineering costs

Facility-Sustaining Costs... are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. Example: General administration costs Rent Building security

Cost Hierarchies ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: Output unit-level cost Batch level costs Product-sustaining costs Facility-sustaining costs

Seven steps of implementing Activity-Based Costing

1. Identify cost objects Step 1: Identify the chosen cost objects. The cost object is to calculate the total costs of designing, manufacturing, and distributing NL and CL.

2. Identify direct costs Step 2: Identify the direct costs of the product. Cole identifies direct materials costs and direct manufacturing labor as direct costs. Using Direct cost tracing new direct costs of Mold cleaning and maintenance costs of $360,000 are also identified.

2. Identify direct costs In the ABC costing system: Cleaning and maintenance costs of $360,000 are direct batch-level-costs. Because these costs consist of workers’ wages for cleaning molds after each batch of lenses is run.

2. Identify direct costs In the OLD costing system: The existing cost system classifies mold cleaning and maintenance costs as part of the indirect costs. and indirect costs were allocated to products using DL hr.s.

2. Identify direct costs Normal Lenses (NL) Description Cost Hierarchy Category Direct materials Unit-level $1,520,000 Direct mfg. labor Unit-level $800,000 Cleaning &Mainten. Batch-level $160,000 Total direct costs $2,480,000

2. Identify direct costs Complex Lenses (CL) Description Cost Hierarchy Category Direct materials Unit-level $920,000 Direct mfg.labor Unit-level $260,000 Cleaning &Mainten. Batch-level $200,000 Total direct costs $1,380,000

3. Select cost-allocation bases Step 3: Select the cost-allocation bases to use in allocating indirect costs to the products.

3. Select cost-allocation bases Six activities were identified as cost allocation basis. Design Molding machines setups Manufacturing operations Shipment set up Distribution Administration

4. Identify indirect costs Step 4: Identify the indirect costs associated with each cost-allocation base. Overhead costs incurred are assigned to activities, to the extent possible, on the basis of a cause-and-effect relationship. Let use the activity of Molding machines setups as an example: Total setup costs are $409,200.

5. Compute rate per unit Setup data for the normal lens and the complex lens: NL CL Quantity produced 80,000 20,000 No. produced per batch 250 50 Number of batch (80K/250) = 320 (20K/50) = 400 Setup time per batch 2 hours 5 hours Total setup hours 640 hr.s 2,000 hr.s

5. Compute rate per unit Step 5: Compute the rate per unit of each cost allocation base used to allocate indirect costs to the products. Setup hours: NL CL Total 640 2,000 2,640 hr.s $409,200 ÷ 2,640 hours = $155 per set up hour

ABC vs Traditional Total setup costs are $409,200. Cost per setup hour using ABC $409,200 ÷ 2,640 (640+2,000) hr.s = $155 / set up hr.s Cost per DL hour using Traditional costing $409,200 ÷ 50,000 (given) hours = $8.184 / DL hr.s

6. Compute indirect costs Step 6: Compute the indirect costs allocated to the products. Total cost of setup activity: NL: $155 × 640 hr.s = $ 99,200 CL: $155 × 2,000 hr.s = 310,000 Total $409,200

ABC vs Traditional Cost allocation using DL hr.s: NL: $8.184 × 36,000 = $294,624 CL: $8.184 × 14,000 = $114,576 Total $409,200 Cost allocation using setup-hours: NL: $155 × 640 = $ 99,200 CL: $155 × 2,000 = $310,000 Total $409,200

ABC vs Traditional Setup costs should be allocated on the basis of setup hours. Because there is a strong cause-and-effect relationship between setup-related overhead costs and setup-hours.

Steps 4, 5, and 6 will have to be repeated for each of the new allocation basis: Design Molding machines setups (the example) Manufacturing operations Shipment set up Distribution Administration

7. Compute product costs Step 7: Compute the costs of the products by adding all direct and indirect costs assigned to them. NL and CL would show costs related to three direct cost categories. Direct materials Direct manufacturing labor Cleaning and maintenance

7. Compute product costs NL & CL Total Direct costs Description Cost Hierarchy Category Direct materials Unit-level $2,440,000 Direct mfg. labor Unit-level $1,060,000 Cleaning &Mainten. Batch-level $360,000 Total direct costs $3,860,000

7. Compute product costs NL and CL would show costs related to six indirect cost pools. Design Molding machine setups Manufacturing operations Shipment setup Distribution Administration

7. Compute product costs What is the total cost of NL? Direct costs $2,480,000 + Allocated costs $1,040,000 = $3,520,000 What is the cost per unit? $3,520,000 ÷ 80,000 = $44.00 What is the cost per unit in OLD system? $4,408,000 ÷ 80,000 = $55.10 O

7. Compute product costs What is the total cost of CL? Direct costs $1,380,000 + Allocated costs $1,500,000 = $2,880,000 What is the cost per unit? $2,880,000 ÷ 20,000 = $144.00 What is the cost per unit in OLD system? $1,992,000 ÷ 20,000 = $99.60 U

ABC costing will assign indirect and direct costs in a more accurate way to our products and we will be able to compete better against our competitors.

Use ABC systems for activity-based management

Activity-Based Management ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits. Product pricing and mix decisions Cost reduction and process improvement decisions Design decisions

Product Pricing& Mix Decisions ABC gives management insight into the cost structures for making and selling diverse products. It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs.

Cost Reduction&Process Improv. Manufacturing and distribution personnel use ABC systems to focus on cost reduction efforts. Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base.

Design Decisions Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can work with their customers to evaluate the costs and prices of alternative design choices.

Evaluate the costs and benefits of implementing ABC costing systems

Limitations of ABC Systems The main limitations of ABC are the measurements necessary to implement the system. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.

Limitations of ABC Systems Activity-cost rates also need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand.

Please read Chapter 5 in your Horngren book Thank you for your time. Please read Chapter 5 in your Horngren book