Activity Based Costing: A Tool to Aid Decision Making

Activity Based Costing (ABC) Both manufacturing and nonmanufacturing costs may be assigned to products. A number of cost pools each allocated to a product or cost object. Some manufacturing costs may be excluded from product costs. Allocation bases often differ from traditional costing systems. Overhead rates may be based on activity at capacity.

How Costs are Treated Under Activity-Based Costing Departmental Overhead Rates Level of Complexity Plantwide Overhead Rate Overhead Allocation

Cost of Idle Capacity Activity Based Costing Traditional Cost Accounting The predetermined overhead rate is based on budgeted activity. This results in applying overhead costs of unused, or idle, capacity. Activity Based Costing Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use.

Difference Between ABC and Traditional Product Costs Batch-level or product-level costs will ordinarily shift overhead costs from high-volume products produced in large batches to low-volume products produced in small batches. Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organization-sustaining costs and the costs of idle capacity are not assigned to products.

Designing an ABC System Cost Objects (e.g., products and customers) Activities Consumption of Resources Cost

Designing of an ABC System Steps for Implementing ABC Identify and define activities and activity cost pools. Trace costs to activities and cost objects. Assign costs to activity cost pools. Calculate activity rates. Assign costs to cost objects.

Identify and Define Activities and Activity Cost Pools A part of the production process for which management wants a separate reporting of the costs of the activity involved. Unit-Level Activity Batch-Level Product-Level Customer-Level Organization- sustaining

Identify and Define Activities and Activity Cost Pools $ Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system.

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Activity 1 Activity 2 Activity 3 Activity 4 Other Cost Objects: Products, Customer Orders, Customers

Assign Costs to Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity cost pools is determined. **Not included because they are directly traced to customer orders.

Assign Costs to Activity Cost Pools Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000

Assign Costs to Activity Cost Pools

Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . . 1,000 customer orders 200 new designs 20,000 machine-hours 100 customer relations activities Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

Calculate Activity Rates ÷

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Traced Cost Objects: Products, Customer Orders, Customers

Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Second-Stage Allocations $/MH $/Order $/Design $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated

Assigning Costs to Cost Objects Let’s take a look at how our system works for just one customer – Windward Yachts. Standard Stanchions (no design required) 1. 400 units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours . 3. Selling price is $34 each. 4. Direct materials total $2,110. 5. Direct labor totals $1,850. 6. Shipping costs total $180. Custom Compass Housing (requires new design) 1. One order during the year. 2. Each housing required 4 machine-hours . 3. Selling price is $650 each. 4. Direct materials total $13. 5. Direct labor totals $50. 6. Shipping costs total $25.

Assigning Costs to Cost Objects The customer-level cost is assigned to customers directly; it is not assigned to products.

Limitations of ABC ABC produces numbers, like product margins, that are at odds with numbers produced by traditional costing system. Some managers find it difficult to adjust to this change. ABC systems are a major project requiring substantial resources. The benefits of increased accuracy must outweigh these additional costs. ABC data can be misinterpreted and must be used with care when making decisions.