1. Activity Based Costing: A Tool to Aid Decision Making 3/24/04
Chapter 8
Activity Based Costing: A Tool to Aid Decision Making 3/24/04

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

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

4. Plantwide Overhead Rate
Companies tended to use direct labor as
the overhead allocation base. There was a belief that direct labor and overhead costs were highly correlated. Automation
changed all that.

5. Plant-wide Overhead Rate
POHR = Total Manufacturing Overhead
Allocation Base
Allocation Base usually Direct Labor
Is used for all products manufactured
Is applied only to those products that incur or use the allocation base, such as direct labor

6. Departmental Overhead Rates
Finishing Department
Many companies have a system in which each department has its own overhead rate.
Painting Department
Shipping Department

7. Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools

8. Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools
Stage Two:
Costs applied
to products
Products

9. Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools
Direct
Labor
Hours
Machine
Hours
Raw
Materials
Cost
Stage Two:
Costs applied
to products
Products
Departmental Allocation Bases

10. 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. Idle capacity
Is charged as a period
Cost.

11. Designing of an ABC System
Steps for Implementing ABC
Identify and define activities and activity cost pools.
Trace costs to those activities and cost objects.
Assign all other traceable costs to activity cost pools. Non-traceable costs lumped.
Calculate activity rates.
Assign costs to cost objects(products, customers).
Prepare management reports.

12. 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
(machining)
Batch-Level
(customer order)
Product-Level
(product design)
Customer-Level
(customer relations)
Organization- sustaining
Activity (lumped)

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

14. 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.

15. 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. I.e., machine shop costs
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.

16. Whenever Possible, Directly Trace all Overhead Costs to Activities and Cost Objects

17. 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.

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

19. Assign Costs to Activity Cost Pools
Factory equipment depreciation $300,000
Percent consumed by customer orders %
$ 60,000

20. Assign Costs to Activity Cost Pools

21. 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.

22. Calculate Activity Rates÷

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

24. 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
Cost Objects:
Products, Customers

25. 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, Customers
Unallocated

26. 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)
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.

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

28. Prepare Management Reports

29. Prepare Management Reports
Customer Profitability Analysis

30. 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 =

31. Comparison of ABC and Traditional Overhead Product Costs
Product Standard Custom
ABC Trad ABC Trad
Overhead
Shipping
Cust Order
Design
Order size
OH assigned

32. Contrasting ABC and Traditional Costing
See TM 8-16
Calculate cost per unit for both Stanchions and Custom Compass Housing
Note the shift in overhead costs from the high volume Stanchions to the low volume Custom Compass Housings

33. 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.

34. 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.

35. Benefits of ABC
More cost pools = more accurate costs on a per unit basis
Cost are assigned using relevant versus arbitrary drivers
Makes overhead costs more manageable (traceable)
Shifts costs from high volume to low volume products as appropriate

36. Limitations of ABC
Too many organization sustaining costs can limit the benefits of ABC
There are high costs associated with ABC implementation
High time commitments and discipline required in making necessary cost changes

37. ABC Review Problem See pages 340 – 342
Step 1: Allocate overhead costs to activity pools
Step 2: Calculate activity rates by dividing each pool cost by activity
Step 3: Use activity rates to assign overhead costs to products based on activities per product

38. End of Chapter 8