1. Activity Based Costing: A Tool to Aid Decision Making
Chapter 8
Activity Based Costing: A Tool to Aid Decision Making

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” as well as “variable” costs.
ABC is a
good supplement to our traditional cost system
I agree!

3. Organizations using the system…
Organizations that use activity-based costing have two costing systems.
1) The official costing system used for preparing external financial reports.
2) Activity-based costing system used for internal decision making and managerial activities.

4. Therefore…
Activity based costing system is used as a supplement, rather than as a replacement for the company’s formal accounting system.

5. 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.

6. 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 suspect of the subjective allocation process based on interviews with employees.

7. 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.

8. Non manufacturing cost & activity-based costing
In traditional accounting, only manufacturing costs are assigned to products.
Selling & administrative expenses are treated as period expenses and are not assigned to products.

9. However, many of these non manufacturing costs are also part of the costs of producing, selling, distributing and servicing specific products.
Example: commissions paid to sales persons, shipping costs, warranty repair cost can be traced to individual products.

10. In activity based costing, products are assigned all of the overhead costs – non-manufacturing as well as manufacturing- that they can reasonably supposed to have caused.

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

12. Plantwide Overhead Rate
Traditionally, single overhead rate, called plant wide overhead rate was being used throughout an entire factory and that allocation base was direct labor hours or machine hours.
There was a belief that direct labor and overhead costs were highly correlated.

13. Conditions have changed now a days
Conditions have changed now a days. Many companies sell large variety of products and services that consume different over head resources.
Economy wise it was found that direct labor and overhead costs have been moving in opposite direction. As a percentage of total cost DL cost has been declining whereas overhead has been increasing.

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

15. The nature of the work performed in a department will determine the department’s allocation base.
For example: overhead costs in a machining department may be allocated on the basis of the machine hours incurred in that department.

16. Unfortunately, even departmental overhead rates will not correctly assign overhead costs in situations where a company has a range of products that differ in volume, batch size or complexity of production.

17. Activity based costing is designed to reflect these diverse factors more accurately.
So, activity is any event that causes the consumption of overhead resources. The costs of carrying out these activities are assigned to the products that cause the activities.

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

19. 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

20. 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

21. 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.

22. 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.

23. Designing an ABC System
First the initiative to implement activity-based costing must be strongly supported by top management.
Second, the design and implementation of an ABC system should be the responsibility of a cross-functional team rather than of the accounting department.
Third, the ABC data should be linked to how people are evaluated and rewarded.

24. The reason for insisting on strong top management support and multifunction team approach is rooted in the fact that it is difficult to implement changes in organizations unless those changes have full support of those who are affected.

25. Cost Objects
(e.g., products
and customers)
Activities
Consumption
of Resources
Cost

26. For example, a customer order for a brass cupholder requires the activity of preparing a production order.
Such an activity consumes resources.
A production order uses a sheet of paper and takes time to fill out.
And consumption of resources causes costs.

27. The greater the number of sheets used to fill out production orders and the greater the amount of time devoted to filling out such orders, the greater the cost.
Activity based costing attempts to trace through these relationships to identify how products and customers affect costs.

28. 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.
Prepare management reports.

29. Identify and Define Activities and Activity Cost Pools
The first major step in implementing an ABC system is to identify the activities that will form foundation for the system.
A common procedure is for the ABC implementation team to interview people who work in overhead departments and ask them to describe their major activities.

30. Generally, this will result in a long list of activities which poses a problem.
On one hand, the greater the number of activities tracked in the ABC system, the more accurate the costs are likely to be.
On the other hand, a complex system involving large number of activities is costly to design, implement, maintain and use.

31. An useful way to think about activities is to organize them into 5 general levels…
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

32. Unit level activities
These activities are performed each time a unit is produced. The costs of unit level activity should be proportional to the number of units produced.
Example: providing power to run processing equipment would be unit level activity as power tends to be consumed in proportion to the number of units produced.

33. Batch level activities
These activities are performed each time a batch is processed regardless of how many units are in the batch. Costs at this level depends on number of batches processed rather than number of units produced.
Example: Placing purchase orders, arranging for shipments to customers.

34. Product level activities
These activities relate to specific products and typically must be carried out regardless of how many batches or units produced or sold.
Example: designing a product, advertising a product, maintaining a product manager.

35. Customer level activities
These activities relate to specific customers and include activities.
Example: sales calls, catalogue mailings and general technical support that are not tied to any specific product.

36. Organization sustaining activity
These are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made.
Example: heating the factory, cleaning executive offices, providing a computer network, arranging loans, preparing annual reports to shareholders.

37. 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.

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

39. Customer Orders cost pool – will be assigned all costs of resources that are consumed by taking and processing customer orders.
This is a batch level activity since each order generates work that occurs regardless of whether the order is for one unit or 1000 units

40. Product Design cost pool – will be assigned all costs of resources consumed by designing products.
This is a product level activity since the amount of design work on a new product does not depend on the number of units ultimately ordered or batches ultimately run.

41. Order Size cost pool – will be assigned all costs of resources consumed as a consequence of the number of units produced.
It includes cost of miscellaneous factory supplies, power to run machines.
This is a unit level activity since each unit requires some of these resources.
The activity measure for this cost pool may be machine hours.

42. Customer Relations cost pools – will be assigned all costs associated with maintaining relations with customers.
It includes sales calls, cost of entertaining customers.
Activity measure for this cost pool is the number of customers the company has on its active customer list.
So this represents customer level activity.

43. Other cost pool – will be assigned all overhead costs that are not associated with the other cost pools.
These costs will mainly consist of organization sustaining cost and the cost of unused, idle capacity.
REMEMBER, this cost will not be assigned to products since they represent resources not consumed by products.

44. Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects
The second step in implementing an ABC system is to directly trace as many overheads as possible to the ultimate cost objects.
Cost objects at Classic Brass were products, customer orders and customers.

45. Company’s annual manufacturing cost & Selling/ Admin cost are listed here:

46. Assign Costs to Activity Cost Pools
Most overhead costs are classified in a company’s general ledger according to the departments in which they are incurred.
For example: salaries, supplies, rent incurred by the marketing department are charged to that department

47. Assign Costs to Activity Cost Pools
It is quite common for an overhead department to be involved in several of the activities that are tracked in the ABC system.
In such situations costs of the dept. are divided among activity cost pools via an allocation process called ‘first-stage allocation’.

48. Assign Costs to Activity Cost Pools
First stage allocation is based on the results on interviews with employees who have first hand knowledge of the activities.
They might be asked to estimate what percentage of their time is spent dealing with customer orders, product design.
In addition, dept. managers are also interviewed.
In this way, the following table has been established

49. Therefore, the following percentage distribution is set up
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.

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

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

52. Assign Costs to Activity Cost Pools

53. 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.

54. Calculate Activity Rates÷

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

56. 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, Customer Orders, Customers

57. 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

58. Now we will use activity rates to apply costs to products and customers.
This way we will continue with the second stage of allocation and follows the fifth step of implementing ABC system which is “Assign costs to Cost objects”.

59. 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.

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

61. Prepare Management Reports

62. Prepare Management Reports
Customer Profitability Analysis

63. 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 =

64. In traditional costing system, non manufacturing costs are not included in product margin.
Whereas in activity costing systems, all costs both manufacturing and non manufacturing costs that are related to products are assigned to it.

65. End of Chapter 8