Systems Design: Activity Based Costing April 9-12, 2010 Systems Design: 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.

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

Shortcomings of Simple Job Order Costing Plant-wide allocation of costs may be a reasonable methodology for single product facilities Increasingly, companies produce a multitude of products out of the same plant These different products tend to consume different amounts of overhead Additionally 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

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.

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

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

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.

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.

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.

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.

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.

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

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

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

Applying Overhead with ABC Rates

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?

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.

ABC – Cost Flows and Journal Entries

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.

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

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