1. ACTIVITY BASED SYSTEMS William M Baker

2. Overview When cost accounting was first created, and until the 1930s, management accounting dominated all accounting data. That changed with the creation of the SEC. Recent changes (e.g., JIT) made it clear that new management accounting was necessary (without interrupting financial accounting).

3. Where Does ABC Fit? Direct Costing Job Order Costing Standard Costing Actual Costing Full Costing Normal Costing Backflush Costing Joint Product Costing Variable Costing Absorption Costing Product Costing Quality Costing Process Costing Operation Costing Life-Cycle Costing Peanut Butter Costing

4. Traditional Cost Accounting The traditional approach to overhead cost allocation: –Choose one allocation base: Usually, direct labor cost or direct labor hours Sometimes, using machine hours Use the chosen allocation base to apply overhead cost to products.

5. Criticisms of Traditional Approach One allocation base cannot properly reflect all cost relationships. The importance of direct labor cost is extinct (at best). Overhead costs are now large enough that overhead allocation is anything but trivial.

6. The Principles Of ABC It is NOT the making of products that directly affects costs. Activities directly affect costs. As activities are created or changed, costs are created or changed.

7. The Two-Stage (ABC) Approach The traditional approach is to allocate costs to products. The ABC approach is to allocate (or trace) costs to activities, and then allocate the activities (and their costs) to products. The bases for allocating activities (and their costs) to products are called cost drivers. The activities themselves may be called cost drivers.

8. The ABC Approach To Overhead Cost Allocation Allocate (usually directly traceable) costs to activities. For each activity, choose an allocation base that reflects the activity.

9. Allocation Base (Cost Driver) Examples Allocate the costs of a production run using production run time. Allocate set-up costs using set-up time. Allocate materials handling costs using materials requisitions.

10. The ABC Approach To Overhead Cost Allocation Allocate (usually directly traceable) costs to activities. For each activity, choose an allocation base that reflects the activity. Using an appropriate base for each activity, ALLOCATE ACTIVITIES, AND THEIR COSTS, TO PRODUCTS.

11. Daniel Company Daniel Company manufactures a product that comes in both a deluxe model and a regular model. The deluxe model is fairly new; since its introduction, profits have steadily declined. Daniel assigns overhead (in a traditional way) on the basis of direct labor hours.

12. Daniel Company For 2002, the company estimated that it would incur $900,000 in overhead and produce 5,000 units of the deluxe model and 40,000 units of the regular model. The deluxe model requires two hours of direct labor time, and the regular model requires one hour. The deluxe model costs $40 for materials and $14 for direct labor. The regular model costs $25 for materials and $7 for direct labor.

13. Requirements (1) How much does each model cost (per unit)? (2) Cost-per-unit information is often used in setting product prices. This is true at Daniel Company. Assuming they charge a 35% markup on cost, determine the list price for each model.

14. Traditional Solution The cost of a unit of product is calculated by summing the cost of materials, labor, and the (assigned) overhead. Using a traditional approach, the following solution is obtained: The overhead rate is $18 per direct labor hour –$900,000 / ((5,000X2) + (40,000X1))

15. Traditional Solution Deluxe ModelRegular Model Direct Materials$40.00$25.00 Direct Labor14.007.00 Overhead (@18)36.0018.00 Cost Per Unit$90.00$50.00 35% Markup31.5017.50 List Price$121.50$67.50

16. ABC Solution Process Daniel Company decides to switch to ABC. After much research and discussion, all of Daniel Company’s overhead costs were traced to four activities. –(Note that the overhead costs did not change; they still total $900,000).

17. Allocate Costs To Activities ActivityCost (1) Requisitions for Materials$204,000 (2) Machine Assembly182,000 (3) Reworking Inferior-Quality Units379,000 (4) Loading, Handling, and Shipping135,000 Total$900,000

18. Choosing Cost Drivers Daniel must choose allocation bases to reflect incurrence of each activity (and to allocate costs). Then, Daniel must obtain cost driver measures for each product.

19. Cost Drivers ActivityCost Driver (1) Requisitions for materials Number of Requisitions (2) Machine AssemblyNumber of Machine Hours (3) Reworking Inferior- Quality Units Number of Rework Orders (4) Loading, Shipping, and Handling Number of Shipments

20. Cost Driver Allocation Measures Cost DriverDeluxeRegular Number of Requisitions200400 Number of Machine Hours20,00015,000 Number of Rework Orders1,000 Number of Shipments250650

21. Per Driver Allocation Costs Cost per Requisition $204,000 600 $340.00 Cost per Machine Hour $182,000 35,000 $5.20 Cost per Rework Order $379,000 2,000 $189.50 Cost per Shipment $135,000 900 $150.00

22. Allocation of Costs to Products Cost DriverTotal CostsDeluxeRegular Requisitions$204,000$68,000$136,000 Machine Hours$182,000$104,000$78,000 Re-Works$379,000$189,500 Shipments$135,000$37,500$97,500 Total$900,000$399,000$501,000

23. Overhead Cost Per Unit DeluxeRegular Total Overhead Costs$399,000$501,000 Number of Units5,00040,000 Overhead Cost Per Unit$79.800$12.525

24. ABC Solution Deluxe ModelRegular Model Direct Materials$40.000$25.000 Direct Labor14.0007.000 Overhead (@18)79.80012.525 Cost Per Unit$133.800$44.525 “Old” Cost$90.000$50.000 Current Price$121.500$67.500

25. ACTIVITY BASED COSTING DOES NOT MAKE ACCOUNTING MORE ACCURATE

26. …But There Are Benefits Foremost, managers learn what activities are really costing them money. Managers learn the relationships among activities. Managers see the effects of changes in cost drivers on costs, and learn to control them.

27. The Ultimate Benefit Managers talk about ADDING VALUE. Activities are separated into value-added and non-value added categories. –Eliminate non-value-added activities. –Make value-added activities more efficient and more effective. This is Activity Based Management, and it now extends well beyond overhead costs.

28. Who Might Use ABC Or ABM? Companies where overhead costs are a large percentage of total manufacturing costs Companies where operations personnel and managers do not trust the cost system Companies with many cost drivers Companies with many products Companies with the necessary technology