Chapter 5 Activity-based Cost · PDF fileChapter 5 Activity-based Cost Systems 1 ... machines...
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Chapter 5Activity-based Cost Systems
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See also: Kaplan/Atkinson 3rd ed. Ch.4Cooper/Kaplan: Cost and Effect,
Harvard Business School Press 1998
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Example of misleading traditional cost system
� Cole Corporation manufactures two types of lensesfor automobile rear lights out of plastic material
– a normal lens (NL) and a complex lens (CL).� lenses are molded using machines� redesigned according to the requirements of the cus tomers
(model changes)
To cost products, Cole currently uses a single
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� To cost products, Cole currently uses a single indirect-cost rate job costing system.
� The cost objects are the total costs of manufacturi ng and distributing 80,000 normal lenses (NL) and 20,000 complex lenses (CL).
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Application to two products
Normal Lenses (NL) Complex Lenses (CL)� Direct materials $1,520,000 $ 920,000� Direct mfg. labor 800,000 260,000
Total direct costs $2,320,000 $1,180,000
Direct cost per unit: $2,320,000 ÷ 80,000 $1,180,000 ÷ 20,000= $29 = $59
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= $29 = $59� total direct labor hrs. 36,000 14,000
� Indirect costs $2,900,000 � direct manufacturing labor hrs. 50,000 � Indirect cost rate = $2,900,000 ÷ 50,000
= $58
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Product cost
Normal Lenses (NL) Complex Lenses (CL)
� Direct costs $2,320,000 $1,180,000 + Allocated costs (= 36,000 × $58) (=14,000 × $58)
$2,088,000 $ 812,000= $4,408,000 $1,992,000cost per unit $4,408,000 ÷ 80,000 $1,992,000 ÷ 20,000
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cost per unit $4,408,000 ÷ 80,000 $1,992,000 ÷ 20,000
= $ 55.10 = $ 99.60Selling price: $ 60 $142Margin $ 4.90 $ 42.40Margin %age 8.2% 29.9%
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Refining a Costing System
Guidelines � Direct-cost tracing – Classify as many of the total costs
as direct costs as is economically feasible.� Indirect-cost pools – Expand the number of cost pools
until each of these pools is homogeneous.� Cost-allocation basis – Identify the preferred cost -
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� Cost-allocation basis – Identify the preferred cost -allocation base for each indirect-cost pool.
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Activity-Based Costing System
� ABC systems refine costing systems by focusing on individual activities as the fundamental cost object.
� ABC calculates the costs of individual activities a nd assigns costs to cost objects such as products and services on the basis of the activities undertaken to produce each product or service.
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produce each product or service.
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Activity-based Costing: the fundamental idea:
Resource: Indirect labor
Inspectincomingmaterials
Activity:Move
materialsMaintainmachines
Set upmachines
Preparetooling
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materials
Activitycost driver:
Cost driverrate:
Product,Customer:
××××
# receipts
××××
# moves
××××
# maint. hrs.
××××
# setup hrs.
××××
# setups
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General Procedure
� Determine the set of activities j performed in each department (cost center)
� determine a Cost Driver for each activity j measuring the causal relationship between � resource consumption of the activity and its� utilization by products or customers
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� assign (budgeted) resource costs to activities j� each activity is assigned a cost pool Cj
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General Procedure (cont’d)
� determine the total level xj of budgeted utilization of the activity
� determine the cost driver rate =
� Determine (actual) usage xjl of cost driver j by each user l
Cjxj
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� Activity-based cost assignment to user l:
xjl Cjxj
Σj
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Key step: Assigning resource costs to activities
� Resource costs per activity is an important piece o f information to management
� This is usually done by interviews with department managers on� activities performed� the proportion of working time usually spent on eac h
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� the proportion of working time usually spent on eac h activity
� no excessive precision required
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Activity-Based Costing System
� A cross-functional team at Cole Corporation identified key activities :� Design products and processes� Set up molding machine� Operate machines to mold lenses� Maintain the machines
Set up batches of finished lenses for shipment.
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� Set up batches of finished lenses for shipment.� Distribute lenses to customers.� Administer and manage all processes at Cole.
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Setup data for the normal lens and the complex len s
NL CL� Quantity produced 80,000 20,000� No. produced/batch 250 50� Number of batches 320 400� Setup time per batch 2 hrs 5 hrs� Total setup hours 640 2,000
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� Total setup costs are $409,200 (Cost pool)� Setup cost per hour: $409,200 ÷ 2,640 hrs
= $155 (cost driver rate)
� Cost allocation using setup-hours: $155 × 640 $155 × 2,000
= $ 99,200 = $310,000
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Cost allocation using direct manufacturing labor-hours
� Setup cost per direct manufacturing labor hour$409,200 ÷ 50,000 = $8.184 (cost driver rate)
� NL: CL: $8.184 × 36,000 $8.184 × 14,000
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$8.184 × 36,000 $8.184 × 14,000 = $294,624 = $114,576
Compared to:$ 99,200 $310,000
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Budgeted Resources �
expense activity level
Driver rate
Committed C1j xj = capacity C1j / xj Flexible C2j xj
(expected) C2j / xj
Separate cost driver rates for committed and flexible cost
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(expected) total C1j + C2j
C1j C2j
xj xj+
C1j + C2j
xj + xj
≠ in general
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Cost Hierarchies
� ABC systems commonly use a four-level cost hierarchy to identify cost-allocation bases:
1 Output unit-level cost2 Batch level costs3 Product-sustaining costs4 Facility -sustaining costs
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4 Facility -sustaining costs
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Functions of activities
� Unit level activities
� batch level activities
� product -sustaining • customer sustaining
(sales volume-related)
(related to # of batchesof saleable output)
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� product -sustaining • customer sustaining
(activities enabling theproduction of saleableoutput)
(activities enabling tosell products to individualcustomers or markets)
(Costs that may be assigned only to broader output categories)
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Cost hierarchy� Output Unit-Level Costs
� resources sacrificed on activities performed on eac h individual unit of product or service.
• Energy• Machine depreciation• Repairs
� Batch-Level Costs� resources sacrificed on activities that are related to a group of units of product(s)
or service(s) rather than to each individual unit of product or service.• Setup hours
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• Setup hours• Procurement costs
� Product-Sustaining or service-sustaining costs� resources sacrificed on activities supporting indivi dual products or services.
• Design costs• Engineering costs
� Facility-Sustaining Costs� resources sacrificed on activities that cannot be t raced to individual products or
services but support the organization as a whole• General administration• Rent• Building security
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Types of activity cost drivers
� Number of transactions� duration of transaction
� if time consumed varies among individual instances of the activity
Accountingcost
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individual instances of the activity
� intensity or direct charging� number of staff of different wage groups
assigned to an activity per time unit� resources actually used for the
individual instance of an activity
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Appropriate number of cost drivers
� Small cost pools do not alter unit costs much� if additional information has to be acquired on a c ost
driver consider the information cost and compare it to the benefit of the better decision
� do not add a cost driver which is an approximate linear combination of cost drivers already used
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linear combination of cost drivers already used� existing cost pools should share in the cost that w ould be
assigned to that pool according to the weights of t he linear combination
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Implementing Activity-Based Costing
Step 1: Identify the chosen cost objects.� The objective is to calculate the total costs of de signing,
assembling, and distributing S and C.
Step 2: Identify the direct costs of the product.� Cole identifies direct materials costs and direct m anufacturing
labor as direct costs.� Cleaning and maintenance costs of $360,000 are also identified
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� Cleaning and maintenance costs of $360,000 are also identified as direct costs of the lenses.
• Cleaning and maintenance costs of $360,000 are direct batch-level-costs.
• Why? Because these costs consist of workers’ wages for maintenance of machines after each batch of phones is run.
� The old cost system classified cleaning and maintenance costs as part of the $2,900,000 indirect costs.
� Recall that indirect costs were allocated to products using direct manufacturing labor-hours.
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Implementing Activity-Based Costing
(“,000” omitted)Description Cost Hierarchy (S) (C)
Category
Direct materials Unit-level $1,520 920Direct mfg. labor Unit -level 800 260
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labor Unit -level 800 260Cleaning & Maintenance Batch-level 160 200Total direct costs $2,480 1,380
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Implementing Activity-Based Costing
Step 3: Select the cost-allocation bases to use in allocating indirect costs to the products.
Activities identified Cost drivers H-level1 Design design hours 32 Machine setups # of setups 2
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2 Machine setups # of setups 23 Manufacturing operations units 14 Shipment set up # of orders 25 Distribution # of orders 26 Administration 4
(allocated as percentage to costs assigned accordin g to activity-based method)
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Implementing Activity-Based Costing
Step 4: Identify the indirect costs associated with each co st-allocation base.� Overhead costs incurred are assigned to activities, to the extent
possible, on the basis of a cause-and-effect relati onship.� Total setup costs are $409,200.
Step 5: Compute the rate per unit of each cost allocation b ase used to allocate indirect costs to the products.
Setup hours: S C Total
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� Setup hours: S C Total640 2,000 2,640
� $409,200 ÷ 2,640 = $155
Step 6: Compute the indirect costs allocated to the product s.� Total cost of setup activity:
S: $155 × 640 = $ 99,200C: $155 × 2,000 = 310,000Total $409,200
Other activities treated analogously
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Implementing Activity-Based Costing
� Step 7: Compute the costs of the products by adding all direct and indirect costs assigned to them.S and C would show three direct cost categories.1 Direct materials2 Direct manufacturing labor3 Cleaning and maintenanceS and C would show six indirect cost pools.
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S and C would show six indirect cost pools.1 Design2 Machine setups3 Manufacturing operations4 Shipment setup5 Distribution6 Administration
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Primary purposes of Activity-based Cost Systems
� Analysis of decisions on the structure and design of productive system� more transparency of the factors causing costs� phasing out non-value-added activities� sporadic stand-alone analyses, not integrated in on -line
accounting system
not used for management control purposes
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� not used for management control purposes� otherwise management will have an incentive to choo se cost
drivers strategically
� Decision facilitating for Activity-based Management (ABM)
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Activity-Based Management
� ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits.– Product pricing and mix decisions– Cost reduction and process improvement
decisions
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decisions– Design decisions
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ABM decisions
� Product Pricing and Mix Decisions� ABC gives management insight into the cost structur es for
making and selling diverse products.� provides more accurate product cost information and more
detailed information on costs of activities and the drivers of those costs.
� Cost Reduction and Process Improvement Decisions� Manufacturing and distribution personnel use ABC sy stems
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� Manufacturing and distribution personnel use ABC sy stems to focus on cost reduction efforts.
� Managers set cost-reduction targets in terms of red ucing the cost per unit of the cost-allocation base.
� Design Decisions� Management can identify and evaluate new designs to
improve performance by evaluating how product and p rocess designs affect activities and costs.
� Companies can work with their customers to evaluate the costs and prices of alternative design choices.
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Critique
� ABC systems are full cost systems: they average costs over products according to cost driver utilization: every individual unit carries the same cost per unit of driver utilized
� For change management decisions an incremental costing approach is more adequate, when the size of the cost pool will not change proportionally with t he
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the cost pool will not change proportionally with t he cost driver (non-linearities in the cost function) due to� fixed costs� economies of scale � economies of scope