Activity-Based Costing and Analysis

Activity-Based Costing and Analysis
Chapter 17 Activity-Based Costing and Analysis This chapter introduces the activity-based costing (ABC) system with the potential for greater accuracy of cost allocations. ABC provides managers with cost information for strategic decisions that is not readily available with other costing methods.

Conceptual Learning Objectives
C1: Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and activity-based costing method. C2: Explain cost flows for the plant wide overhead rate method. C3: Explain cost flows for the departmental overhead rate method. C4: Explain cost flows for activity-based costing. In this chapter, you will learn the following conceptual objectives: C1: Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and activity-based costing method. C2: Explain cost flows for the plant wide overhead rate method. C3: Explain cost flows for the departmental overhead rate method. C4: Explain cost flows for activity-based costing.

Analytical Learning Objectives
A1: Identify and assess advantages and disadvantages of the plantwide overhead rate method. A2: Identify and assess advantages and disadvantages of the departmental overhead rate method. A3: Identify and assess advantages and disadvantages of activity-based costing. In this chapter, you will learn the following analytical objectives: A1: Identify and assess advantages and disadvantages of the plantwide overhead rate method. A2: Identify and assess advantages and disadvantages of the departmental overhead rate method. A3: Identify and assess advantages and disadvantages of activity-based costing.

Procedural Learning Objectives
P1: Allocate overhead costs to products using the plantwide overhead rate method. P2: Allocate overhead costs to products using departmental overhead rate method. P3: Allocate overhead costs to products using activity-based costing. In this chapter, you will learn the following procedural objectives: P1: Allocate overhead costs to products using the plantwide overhead rate method. P2: Allocate overhead costs to products using departmental overhead rate method. P3: Allocate overhead costs to products using activity-based costing.

Assigning Overhead Costs
Direct Materials Indirect Factory Overhead Allocate Goods in Process Finished Goods Recall from Chapter 15 that factory overhead costs cannot be directly traced to products, and must be allocated. We learned that we must develop a predetermined overhead rate to allocate the factory overhead to the goods in process. Indirect Cost of Goods Sold Direct Labor

Overhead costs are not directly related to production volume, and therefore cannot be traced to units of product in the same way as direct materials and direct labor. Consequently, we must assign overhead costs using an allocation system. This chapter identifies three methods of overhead allocation.

Overhead can be assigned to production in one of three ways: Single plant-wide overhead rate Departmental overhead rates Activity-based costing Let’s take a look at the first method, plant wide overhead rate method

Plant Wide Overhead Rate Method
When overhead costs are closely related to volume-related measures this method is logical. 1. Total budgeted overhead costs are combined into one overhead cost pool. 2. Next, the cost pool is divided by the chosen allocation base, such as total direct labor hours, to arrive at a single plant wide allocation rate. 3. Finally, this rate is applied to assign costs to all products The target of the cost assignment or Cost Object is the unit of product.

Plant Wide Overhead Rate Method
C2 Plant Wide Overhead Rate Method Indirect Costs Overhead Cost Single Plant-Wide Overhead Rate Cost Allocation Base Product 1 Product 2 Product 3 For this method, the target of the cost assignment, or cost object, is the unit of product. The rate is determined using volume-related measures such as direct labor hours, direct labor cost dollars, or machine hours, which are readily available in most manufacturing settings. Under the single plant wide overhead rate method, total budgeted overhead costs are combined into one overhead cost pool. This cost pool is then divided by the chosen allocation base, such as total direct labor hours, to arrive at a single plant wide overhead rate. This rate then is applied to assign costs to all products based on the allocation base such as direct labor hours required to manufacture each product. Let’s look at the Exhibit 17.2 as an example. Cost Objects

Plant Wide Overhead Rate Method Illustration
Let’s look at an example. KartCo. Manufactures two models of go-karts, standard and custom. They use a plantwide rate and use direct labor hours as the allocation base To calculate total direct labor hours, multiply the number of product units by direct labor hours per unit per product. Kartco’s budgeted overhead cost consists of indirect labor costs of $4,000,000 and factory utilities of $800,000 for a total of $4,800,000. This number will also be needed to calculate the plant wide overhead rate.

Total budgeted overhead costs Total budgeted DLH = Plant wide overhead rate is equal to total budgeted overhead cost divided by total budgeted direct labor hours.

$4,800,000 100,000 DLH = Dividing $4,800,000 into 100,000 hours gives us plant overhead rate of $48 per DHL (direct labor hour). This plant wide overhead rate is then used to allocate overhead cost to products based on the number of direct labor hours required to produce each unit as follows. Overhead allocated to each product unit = Plant wide overhead rate X DHL per unit. = $48/DLH

Using the overhead rate of $48 per direct labor hour KartCo can determine the amount of factory overhead to allocate to each go-kart. The can then use this information to determine the total unit cost of each go-kart.

Plant Wide Overhead Rate Method -Advantages
Information is readily available Easy to implement Often sufficient to meet external financial reporting needs

Plant Wide Overhead Rate Method -Disadvantages
Overhead costs may not bear any relationship with direct labor hours. Example: Technology Intensive vs. Labor Intensive production stages. Various types of products within the same company may not use overhead costs in the same proportion.

Departmental Overhead Rate Method
Many companies have several departments that produce various products and consumes overhead resources in a substantially different way. Example: Machining Dept => Machine Hours Assembly Dept => Labor Hours Departmental OH Rate is a better method to allocate of costs to departments when overhead resources are consumed in substantially different ways.

Two stages of allocating overhead rates: First stage: Overhead costs are determined separately for each production department. Cost Object is the ‘Department’. Second stage: An overhead rate is computed for each production department to allocate the overhead costs to products passing through that department. Cost Object is the ‘Product’.

C3 Departmental Overhead Rate Method Overhead Cost Indirect Costs First Stage Department A Department B Cost Objects Exhibit 17.4 shows that under the departmental overhead rate method, overhead costs are first determined separately for each production departments. Next, an overhead rate is computed for each production department to allocate the overhead costs of each product to products passing through that department. The departmental overhead rate method allows each department to have its own overhead rate and its own allocation base. Department A Overhead Rate Department B Overhead Rate Second Stage Allocation Base Cost Objects Product 3 Product 1 Product 2

Departmental Overhead Rate Method: First Stage
Overhead Cost $4,800,000 First Stage Let’s return to KartCo and calculate their departmental overhead rates. The first stage requires that KartCo assign its $4,800,000 overhead cost to its two production departments. KartCo determines from an analysis of its indirect labor and factory utilities that $4,200,000 of its overhead costs are traceable to its machining department and the remaining $600,000 are traceable to its assembly department. Machining Dept. $4,200,000 Assembly Dept. $600,000

Departmental Overhead Rate Method: Second Stage
Department B Overhead Rate Second Stage Product 1 Product 2 Product 3 The second stage demands that after overhead costs are assigned to its departments, each department determines an allocation base for its operations. For KartCo, the machining department uses machine hours (MH) as a base for allocating its overhead and the assembly department uses direct labor hours (DLH) as the base for allocating its overhead. Let’s look at Exhibit 17.5.

Here is the departmental information about KartCo. They will be using Machine Hours as the allocation base in Machining, and direct labor hours in Assembly.

Total departmental overhead costs Total unit number in departmental allocation base = Each department computes its own overhead rate using the following formula: Departmental Overhead Rate = Total departmental overhead cost / Total unit number; in department allocation base

Machining Department Overhead Rate = $4,200,000 70,000 MH $60/MH For KartCo, it’s departmental overhead rates are computed as follows. Machining department overhead rate = $4,200,000 / 70,000 MH = $60 per MH Assembly department overhead rate = $600,000 / 30,000 DLH = $20 per DLH Assembly Department Overhead Rate = $600,000 30,000 DLH $20/DLH

The final part of the second stage is to apply overhead costs to each product based on departmental overhead rates. For KartCo, since each standard go-kart requires 10 MH from the machining department and 5 DLH from the assembly department, the overhead cost allocated to each standard go-kart is $600 from machining department (10 MH X $60/MH) and $100 from the assembly department (5 DLH X $20/DLH). The same procedure is applied for its custom go-kart. Here we can see the overhead allocated per unit of each model of go-kart, and the total cost per unit. Note that the total unit cost for each model of go-kart is different than the cost determined using the plantwide rate

Advantages of Departmental Overhead Rate Method
More accurate overhead allocations More refined than the plant-wide overhead rate method

Disadvantages of Departmental Overhead Rate Method
Since different products within the department may differ in batch size and complexity, Departmental Overhead Rate method: Can distort product costs Assumes that products are similar in volume, complexity, batch size Assumes that departmental overhead costs are proportional to the allocation base

Activity-Based Costing (ABC) Method
Activity-Based Costing (ABC) Rates and method attempts to more accurately assign overhead costs by focusing on activities. The premise of ABC is that it takes activities to make products and provide services. These activities drive cost. For example, costs are incurred and resources are used when we perform activities: -Cutting Raw Materials; -Inspecting parts; -Processing Invoices

Activity is the basic principle underlying ABC method. Activity is a TASK, OPERATION, or PROCEDURE which causes costs to be incurred => Cost Driver. Example: Warehousing Products consumes resources (drives costs) such as: -Employee time for driving forklift; -Electricity to power forklift; -Wear & tear (depreciation) on a forklift. Training employees consumes resources (drives costs) such as: -Trainers’ salaries; -Training supplies

There are two basic stages to ABC: The first stage of ABC cost assignment is to Identify the activities (cost objects) involved in manufacturing products and match those activities with the costs that they cause (cost driver). To reduce the total number of activities that must be assigned costs, the homogeneous activities (those caused by the same factors such as cutting metal) are grouped into activity cost pool. The second stage of ABC is to compute an activity rate for each cost pool and use this rate to allocate overhead costs to products (cost objects).

ABC: Activity (Cost Driver) and Activity Cost Pool
8-30 ABC: Activity (Cost Driver) and Activity Cost Pool An event that causes the consumption of overhead resources. Activity Cost Driver Activity Cost Pool A “cost bucket” in which costs related to a particular activity measure are accumulated. $ Part I. An activity is any event causes the consumption of overhead resources. Part II. An activity cost pool is a “bucket” in which costs are accumulated that relate to a single activity measure in an ABC system.

Cost Flows Under Activity-Based Costing Method
Indirect Costs Overhead Cost First Stage Activity Cost Pool X Activity Cost Pool Y Activity Cost Pool Z Cost Objects Activity-based costing (ABC) attempts to more accurately assign overhead costs to the proper users of overhead by focusing on activities. Let’s look at two stages of activity based costing. The basic principle underlying activity based costing is that activities, which are tasks, operations, or procedures, are what cause costs to be incurred. A cost pool is a collection of costs that are related to the same or similar activity. Pooling costs to determine a pool rate for all costs incurred by the same activity reduces the number of cost assignments required. Second Stage Activity Overhead rate Activity Overhead rate Cost Allocation Base Activity Overhead rate Cost Objects Product 1 Product 2 Product 3

Applying Activity-Based Costing
4 steps: Identify activities and the costs they cause. Group similar activities into activity pools. Determine an activity rate for each activity cost pool. Allocate overhead costs to products using those activity rates. ABC differs from using multiple departmental rates in how overhead cost pools are identified and in how overhead cost in each pool is allocated. ABC accumulates costing overhead costs into activity pools and then allocates those costs to products using activity rates. This involves four steps: Identify activities and the costs they cause. Group similar activities into activity pools. Determine an activity rate for each activity cost pool. Allocate overhead costs to products using those activity rates.

Step one: Identify activities and cost pools.
Activities causing overhead cost are typically separated into four levels reflecting control: (1) Unit level activities are performed on each product unit, (2) Batch level activities are performed only on each batch or group of units, (3) Product level activities are performed on each product line independent of the number of units or batches, and (4) Facility level activities are performed to sustain facility capacity as a whole.

Levels of types of activities
Unit level Batch level Product level Step one is to identify activities. This is mainly done through discussions with employees in production departments and reviewing production activities. However, tracking too many activities makes the system cumbersome and costly to maintain. The aim of this first step is to understand actions performed in the organization that drive costs. Activities causing overhead cost in an organization are typically separated into four levels: Unit level activities Batch level activities Product level activities Facility level activities Facility level

Levels of activities Unit level Unit level activities are performed on
each product unit. Example: Providing electricity to power machinery in the machining department is needed to produce each unit of product.

Levels of Activities Batch level Batch level activities are performed
only on each batch or group of units. Example: Machine setup is needed only for each batch regardless of the units in that batch. Batch level activities are performed only on each batch or group of units; for example, machine setup is needed only for each batch regardless of the units in that batch, and customer order processing must be performed for each order regardless of the number of units ordered. Batch level costs do not vary with the number of units, but instead with the number of batches.

Levels of Activities Product level
Product level activities are performed on each product line and are not affected by either numbers of units or batches. Example: Product design is needed only for each product line . Product level costs do not vary with the number of units or batches produced. Product level activities are performed on each product line and are not affected by either numbers of units or batches; for example, product design is needed only for each product line. Product level costs do not vary with the number of units or batches produced.

Facility Level Activities
Facility level activities are performed to sustain facility capacity as a whole and are not caused by any specific product. Example: Rent or factory maintenance costs are incurred no matter what is produced. Factory level costs do not vary with what is manufactured, how many batches are produced, or the output quality. Facility level activities are performed to sustain facility capacity as a whole and are not caused by any specific product; for example, factory maintenance costs are incurred to keep the plant clean and safe no matter what is being produced, and so is paying rent on a factory building. Facility level costs do not vary with what is manufactured, how many batches are produced, or the output quantity.

Step Two: Trace Overhead Costs to Cost Pools
Activity Cost Pool X Activity Cost Pool Y Activity Cost Pool Z Step 2 in applying ABC is to assign overhead costs pools. Overhead costs are commonly accumulated by each department in a traditional accounting system. Some of these overhead costs are traced directly to a specific activity cost pool.

Four Cost Pools for KartCo: -Craftsmanship -Setup -Design Modification -Plant Services

Recall that a premise of ABC is that operations are a series of activities that cause costs to be incurred. Instead of combining costs from different activities into one plant wide pool or multiple departmental pools, ABC focuses on activities as the cost object in the first step of cost assignment. We are then able to trace costs to a cost object and then combine activities that are used by products in similar ways to reduce the number of cost allocations. KartCo has total overhead cost of $4,800,000 consisting of $4,000,000 indirect labor costs and $800,000 factory utilities costs, see exhibit Details gathered by Kartco about its overhead costs are shown in Exhibit Column totals for indirect labor and factory utilities correspond to amounts in Exhibit ABC provides more detail about the activities and the costs they cause than is provided from traditional costing methods.

Step Two: Assigning Overhead to Activity Cost Pools
After review and analysis of its activities, KartCo management assigns its overhead costs into four activity cost pools as shown in exhibit To form cost pools we look for costs that are caused by the same activities within each activity level. For Kartco, there is only one activity driver within each control, but that is not always the case. It is common to see several different activity drivers within each level of control. We pool only those costs that are related to the same driver. Exhibit shows that $600,000 of its overhead costs are assigned to the craftsmanship cost pool, $2,000,000 to the set-up cost pool, $1,200,000 to the design modification cost pool, and $1,000,000 to the plant services cost pool. This reduces the potential number of overhead rates from six (one for each of its six activities) to four (one for each pool). For Kartco, the craftsmanship pool reflects unit level costs, the set-up pool reflects batch level costs, the design modification pool reflects product level costs, and the plant services reflect facility level costs.

Step Three: Determine Activity Rate
Cost Pool X Activity Cost Pool Y Activity Cost Pool Z Activity Overhead rate Activity Overhead rate Activity Overhead rate Step 3 is to compute the activity rates used to assign overhead costs to final cost objects such as products. Step 3 is to compute the activity rates used to assign overhead costs to final cost objects such as products.

Proper determination of activity rates depends on: and Proper identification of the factor that drives the cost Proper measures of activities Proper determination of activity rates depends on: Proper identification of the factor that drives the cost in each activity cost pool and proper measures of activities. A Cost Driver is that activity causing the costs in the pool to be incurred. An Activity Driver is a measure of activity level, and is determined for use as the allocation base.

Total cost in activity pool Measure of the activity Activity rate = For example: Set-up cost pool activity rate = $2,000,000 / 200 batches = $10,000 per batch Craftsmanship cost pool activity rate = $600,000/30,000 DLH = $20 per DLH

Step Four: Assign Overhead Costs to Cost Objects
Activity Overhead rate Activity Overhead rate Activity Overhead rate Product 1 Product 2 Product 3 Step 4 is to assign overhead costs in each activity cost pool to final cost objects using activity rates. Step 4 is to assign overhead costs in each activity cost pool to final cost objects using activity rates. To accomplish this, overhead costs in each activity cost pool are allocated to product lines and then divided by the number of units of that product line to arrive at overhead cost per product unit.

To illustrate, the overhead costs in the craftsmanship pool are allocated to standard go-karts as follows: Overhead allocated to standard go-kart = Activities consumed X Activity rate = 25,000 DLH x $20 / DLH = $500,000 To illustrate, the $500,000 of overhead costs in the craftsmanship pool is allocated to standard go-karts as follows: Overhead allocated to standard go-kart = Activities consumed X Activity rate =25,000 DLH x $20 =$500,000

Overhead costs allocated to standard and custom go-karts under ABC for Kartco are summarized in Exhibit This exhibit uses the activity rates from exhibit to assign costs to standard go-karts and custom go-karts. We know that standard go-karts require 25,000 direct labor hours and the activity rate for craftsmanship is $20 per direct labor hour. Multiplying the number of direct labor hours by the activity rate yields the craftsmanship costs assigned to standard go-karts. Custom go-karts consumed 5,000 direct labor hours, so we assign $100,000 (5,000 $20/DLH) to that product line. Similarly, we assign set-up costs, design modification costs, and plant services costs based on the quantity of activities related to costs consumed to produce each type of go-kart.

The unit overhead costs is computed by dividing total overhead cost allocated to the product lines by the number of product units. Kartco’s overhead cost per unit for it’s standard and custom go-karts is computed and shown in Exhibit

Comparison of Overhead Allocations by Method
Does the method of overhead allocation really make a difference? Overhead allocation to the standard go-karts is much less under ABC than under either of the volume-based costing methods. One reason for this difference is the large design modification costs that were spread over all go-karts under both the plantwide and departmental rate methods even though standard go-karts require no engineering modification.

Advantages and Disadvantages of Activity-Based Costing
More accurate overhead cost allocation More effective overhead cost control Focus on relevant factors Better management of activities Disadvantages: Costs to implement and maintain Uncertainty with decisions still remains

End of Chapter 17

Activity-Based Costing and Analysis

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