Activity-Based Costing: A Tool to Aid Decision Making Chapter Eight

Learning Objectives After studying this chapter, you should be able to: 1. Describe activity-based costing and how it differs from a traditional costing system. 2. Assign costs to cost pools using a first-stage allocation. 3. Compute activity rates for cost pools. 4. Assign costs to a cost object using a second-stage allocation.

Learning Objectives After studying this chapter, you should be able to: Prepare a report showing activity-based costing product margins from an activity view. Compare product costs computed using traditional and activity-based costing methods. 7. (Appendix 8A) Prepare an action analysis report using activity-based costing data and interpret the report.

Activity Based Costing (ABC) ABC is a good supplement to our traditional cost system ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect fixed as well as variable costs. I agree!  

How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Manufacturing costs Nonmanufacturing costs Traditional product costing ABC product costing  ABC assigns both types of costs to products.

How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Manufacturing costs Nonmanufacturing costs Most, but not all Some All Traditional product costing ABC product costing ABC does not assign all manufacturing costs to products.

How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Activity–Based Costing Level of complexity Departmental Overhead Rates Plantwide Overhead Rate Number of cost pools ABC uses more cost pools.

How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Volume measures plus other bases. Bases usually rely solely on volume measures. Number of Allocation Bases Traditional Costing ABC ABC uses more allocation bases.

How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. The most commonly used allocation base in traditional costing is direct labour hours. Direct labour hours work well when overhead increases as direct labour hours increase. ABC uses more allocation bases.

How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. The most commonly used allocation base in traditional costing is direct labour hours. Problems: In many processes, overhead is increasing while direct labour is decreasing. Variety and complexity of products is increasing. ABC uses more allocation bases.

How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. ABC uses volume as well as other allocation bases not related to the volume of production. All overhead costs are not related to volume measures like direct labour hours. ABC uses more allocation bases.

How Costs are Treated Under Activity–Based Costing “Best practice” ABC differs from traditional costing in five ways. Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses. ABC bases level of activity on capacity.

Characteristics of Successful ABC Implementations Strong top management support Link to evaluations and rewards Cross-functional involvement

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

Designing 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. Prepare management reports.

Identify and Define Activities and Activity Cost Pools Manufacturing companies typically combine their activities into five classifications. Unit-Level Activity Batch-Level Product-Level Customer-Level Organization- sustaining

Identify and Define Activities and Activity Cost Pools Activities should only be combined within a level if they are highly correlated. When combining activities, they should be grouped together only at the appropriate level.

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

Identify and Define Activities and Activity Cost Pools Two types of activity measures: Simple count of the number of times an activity occurs. Transaction driver A measure of the amount of time needed for an activity. Duration driver

Identify and Define Activities and Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

Identify and Define Activities and Activity Cost Pools Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product Designs - assigned all costs of resources consumed by designing products. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations – assigned all costs associated with maintaining relations with customers. Other – assigned all overhead costs that are not associated with the other cost pools.

When Possible, Directly Trace Overhead Costs to Activities and Cost Objects

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 Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000

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 Labour Shipping Costs Overhead Costs Traced Cost Objects: Products, Customer Orders, Customers

Activity-Based Costing at Classic Brass Direct Materials Direct Labour Shipping Costs Overhead Costs First-Stage Allocation Order Size Customer Orders Product Design Customer Relations Other Cost Objects: Products, Customer Orders, Customers

Activity-Based Costing at Classic Brass Direct Materials Direct Labour 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 labour 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 labour 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.

Prepare Management Reports

Prepare Management Reports Customer Profitability Analysis

Predetermined manufacturing Product Margins Traditional Cost Accounting System 400 units x 0.5 MH/unit x $50/MH = $10,000 Predetermined manufacturing overhead rate $1,000,000 20,000 MH = $50/MH =

Differences Between ABC and Traditional Product Costs Product margins are different for four reasons: Traditional costing assigns design costs to both products based on machine hours. ABC assigns product design costs to a product only if product design work is required. Traditional costing assigns customer order costs, a batch- level cost, using a unit-level allocation base, machine hours. ABC assigns these batch-level costs using a batch-level activity measure. Traditional costing assigns only manufacturing costs to products. ABC also assigns nonmanufacturing costs to products. Traditional costing assigns all manufacturing costs to products. The ABC system does not assign organization- sustaining manufacturing costs to the products.

Differences Between ABC and Traditional Product Costs When batch-level and product-level costs are present, ABC will usually shift costs from high volume products, produced in large batches, to low volume products produced in small batches. This cost shifting will usually have its greatest impact on the per unit cost of the low volume products.

Targeting Process Improvement Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements. While the theory of constraints approach discussed in Chapter 1 is a powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on where to focus improvement efforts.

Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because . . . External reports are less detailed than internal reports. It may be difficult to make changes to the company’s accounting system. ABC does not conform to GAAP. Auditors may be suspect of the subjective allocation process based on interviews with employees.

ABC Limitations Substantial resources required to implement and maintain. Resistance to unfamiliar numbers and reports. Desire to fully allocate all costs to products. Potential misinterpretation of unfamiliar numbers. Does not conform to GAAP. Two costing systems may be needed.

Activity-Based Costing Review Problem Activity-Based Costing

Review Problem Ferris Corporation makes a single product – a fire-resistant commercial filing cabinet – that it sells to office furniture distributors. The company has a simple ABC system that it uses for internal decision making. The company has two overhead departments, for which the costs are listed below:

Review Problem The company’s ABC system has the following activity cost pools and activity measures:

Review Problem Costs assigned to the Other activity cost pool have no activity measure; they consist of the costs of unused capacity and organization-sustaining costs – neither of which are assigned to products, orders, or customers. Ferris Corporation distributes the costs of manufacturing overhead and selling and administrative overhead to the activity cost pools based on employee interviews, the results of which are reported on the next slide:

Review Problem

Review Problem Perform the first-stage allocation of overhead costs to the activity cost pools as in Exhibit 8-5. Compute activity rates for the activity cost pools as in Exhibit 8-6. OfficeMart is one of Ferris Corporation’s customers, Last year, OfficeMart ordered filing cabinets four different times. OfficeMart ordered a total of 80 filing cabinets during the year. Construct a table as in Exhibit 8-9 showing the overhead costs of these 80 units and four orders.

Review Problem The selling price of a filing cabinet is $595. The cost of direct materials is $180 per filing cabinet, and direct labour is $50 per filing cabinet. What is the product margin on the 80 fling cabinets ordered by OfficeMart? How profitable is OfficeMart as a customer? See Exhibit 8-10 for an example of how to complete this report.

Appendix 8A: ABC Action Analysis Conventional ABC analysis does not identify potentially relevant costs. An action analysis report helps because it: Shows what costs have been assigned to a cost object. Indicates how difficult it would be to adjust those costs in response to changes in the level of activity.

Appendix 8A: ABC Action Analysis Constructing an action analysis report begins with the first-stage allocation process. In addition to computing an overall activity rate for each activity cost pool, an activity rate is computed for each type of overhead cost that is consumed supporting a given activity. Let’s revisit the stage-one allocations from the Classic Brass example that we discussed earlier.

Appendix 8A: ABC Action Analysis $125,000 ÷ 1,000 orders = $125 per order Other entries in the table are computed similarly.

Appendix 8A: ABC Action Analysis $125 per order × 2 orders = $250 Other entries in the table are computed similarly.

Appendix 8A: ABC Action Analysis $125 per order × 1 orders = $125 Other entries in the table are computed similarly.

Appendix 8A: ABC Action Analysis Next, label each cost using an ease of adjustment code: Green costs adjust more or less automatically to changes in activity level without any action by managers. Yellow costs can be adjusted to changes in activity level, but it would require management action to realize the change in cost. Red costs can be adjusted to changes in activity level only with a great deal difficulty and with management intervention.

Appendix 8A: ABC Action Analysis

End of Chapter 8