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Activity-Based Costing
A Tool to Aid Decision Making
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Activity Based Costing (ABC)
ABC is designed to provide managers with
cost information for strategic and other
decisions that potentially affect capacity and
therefore affect fixed as well as variable costs.
It is ordinarily used as a supplement to, rather than as a replacement
for, the company’s usual costing system.
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How Costs are Treated UnderActivity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Manufacturingcosts
Non-manufacturingcosts
ABC assigns both types of costs to products. For example, ABC systems can assign sales commissions, shipping costs,
and warranty repair costs to specific products.
Traditionalproduct costing
ABCproduct costing
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How Costs are Treated UnderActivity–Based Costing
ABC does not assign all manufacturing costs to products. This is because ABC only assigns a cost to a product if decisions
concerning that product will cause changes in the cost.
Manufacturingcosts
Non-manufacturingcosts
“Best practice” ABC differs from traditional costing in five ways.
Traditionalproduct costing
ABCproduct costing
All Most, butnot all
Som
e
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How Costs are Treated UnderActivity–Based Costing
Plantwide Overhead
Rate
DepartmentalOverhead
Rates
Activity–BasedCosting
Number of cost pools
Leve
l of
com
plex
ity
ABC uses more cost pools.
ABC uses more cost pools than traditional cost systems that often use a single plant wide overhead pool or just one overhead pool
per department. Since more than one activity is often performed within each
department.
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How Costs are Treated UnderActivity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
ABC uses more allocation bases.Traditional Costing
Num
ber o
fA
lloca
tion
Bas
es
ABC
Bases usuallyrely only on
volumemeasures.
Volumemeasuresplus other
bases.
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How Costs are Treated UnderActivity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
The most commonly used allocation basein traditional costing is direct labor hours.
Direct labor hours workwell when overheadincreases as direct
labor hours increase.
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How Costs are Treated UnderActivity–Based Costing
Problems: In many processes, overhead is increasing while direct labor is decreasing. Variety and complexity of products is increasing.
The most commonly used allocation basein traditional costing is direct labor hours.
“Best practice” ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
How Costs are Treated UnderActivity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
All overheadcosts are not related
to volume measures likedirect labor
hours.
ABC usesvolume as well as
other allocation bases notrelated to the volume
of production.
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How Costs are Treated UnderActivity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Traditional Costing The predetermined overhead rate is based on budgeted activity.
This results in applying all overhead costs
including unused, or idle capacity costs to
products.
ABC Products are charged
for the costs of capacity they use – not
for the costs of capacity they don’t
use. Unused capacity costs are treated as
period expenses.
ABC bases level of activity on capacity.
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Characteristics of SuccessfulABC Implementations
Strong topmanagement support
Cross-functionalinvolvement
Link to evaluationsand rewards
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Designing an ABC System
Cost ObjectsCost Objects(e.g., products(e.g., productsand customers)and customers)
ActivitiesActivities
ConsumptionConsumptionof Resourcesof Resources
CostCost
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Designing an ABC System
Steps for Implementing ABCIdentify 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.
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Identify and Define Activitiesand Activity Cost Pools
ManufacturingManufacturingcompanies typically combinecompanies typically combine
their activities into fivetheir activities into fiveclassifications.classifications.
Unit-LevelUnit-LevelActivityActivity
Batch-Level Batch-Level ActivityActivity
Product-LevelProduct-LevelActivityActivity
Customer-LevelCustomer-LevelActivityActivityOrganization-Organization-
sustainingsustainingActivityActivity
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1. Unit-level activities are performed each time a unit is produced. 2. Batch-level activities are performed each time a batch is
handled or processed, regardless of how many units are in the batch. e.g. inspection, setting up equipment and shipping customer orders.
3. Product-level activities relate to specific products and must be carried out regardless of how many batches are run or units produced and sold. For example, designing or advertising a product.
4. Customer-level activities relate to specific customers and are not tied to any specific product. For example, sales calls and catalog mailings.
5. Organization-sustaining activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices.
Identify and Define Activitiesand Activity Cost Pools--Explanation
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Identify and Define Activitiesand Activity Cost Pools
Activities should only be
combined within a levelif they are highly
correlated.
When combiningactivities, they should be grouped together only at
the appropriatelevel.
Batch-level Activities should not be combined with unit-level
activities, and so on
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Identify and Define Activitiesand Activity Cost Pools
An Activity Cost Activity Cost PoolPool is a “bucket” in
which costs are accumulated that relate to a single
activity measure in the ABC system.
$
$
$ $
$$
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Identify and Define Activitiesand Activity Cost Pools
Simple countof the number oftimes an activity
occurs.
Transactiondriver
A measureof the amountof time neededfor an activity.
Durationdriver
Two types of activity measures:
When All Activity takes the same time
Different amount of time required to perform Activities
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Identify and Define Activitiesand Activity Cost Pools
At Classic Brass, the ABC team, selected the followingactivity cost pools and activity measures:
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Identify and Define Activitiesand 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.
• 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.
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When Possible, Directly Trace OverheadCosts to Activities and Cost Objects
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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.
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Assign Costs to Activity Cost Pools
• The indirect factory workers allocated twenty-five percent of their time to the customer orders activity, forty percent of their time to the product design activity, twenty percent of their time to the order size activity, ten percent of their time to customer relations, and five percent of their
time to the “other” activity.
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Indirect factory wages $500,000Indirect factory wages $500,000Percent consumed by customer orders 25%Percent consumed by customer orders 25%
$125,000$125,000
Assign Costs to Activity Cost Pools
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Factory equipment depreciation $300,000Factory equipment depreciation $300,000Percent consumed by customer orders 20%Percent consumed by customer orders 20%
$ 60,000$ 60,000
Assign Costs to Activity Cost Pools
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Assign Costs to Activity Cost Pools
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Calculate Activity Rates
The ABC team determines that Classic Brass will have these total activities for each activity cost
pool . . . 1,000 customer orders,1,000 customer orders, 200 new designs,200 new designs, 20,000 machine-hours,20,000 machine-hours, 100 customer relations activities.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.
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Calculate Activity Rates
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Traced Traced Traced
Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingCosts Overhead Costs
Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers
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Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingCosts
Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers
OrderOrderSizeSize
CustomerCustomerOrdersOrders
ProductProductDesignDesign
CustomerCustomerRelationsRelations OtherOther
Overhead Costs
First-Stage Allocation
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Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingCosts
Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers
OrderOrderSizeSize
CustomerCustomerOrdersOrders
ProductProductDesignDesign
CustomerCustomerRelationsRelations OtherOther
Overhead Costs
First-Stage Allocation
Second-Stage AllocationsSecond-Stage Allocations
$/MH $/Order $/Design $/Customer
Unallocated
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Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingCosts
Cost Objects:Cost Objects:Products, Customer Orders, CustomersProducts, Customer Orders, Customers
OrderOrderSizeSize
CustomerCustomerOrdersOrders
ProductProductDesignDesign
CustomerCustomerRelationsRelations OtherOther
Overhead Costs
First-Stage Allocation
Second-Stage AllocationsSecond-Stage Allocations
$19/MH $315/Order $257/Design $3675/Customer
Unallocated
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Assigning Costs to Cost Objects
Let’s take a look at how our system worksfor just one customer – Windward Yachts.
Standard Stanchions (no design required)1. 400 units ordered with 2 separate orders.1. 400 units ordered with 2 separate orders.2. Each stanchion required 0.5 machine-hours.2. Each stanchion required 0.5 machine-hours.3. Selling price is $34 each.3. Selling price is $34 each.4. Direct materials total $2,110.4. Direct materials total $2,110.5. Direct labor totals $1,850.5. Direct labor totals $1,850.6. Shipping costs total $180.6. Shipping costs total $180.
Custom Compass Housing (requires new design)1. One order during the year.1. One order during the year.2. Each housing required 4 machine-hours.2. Each housing required 4 machine-hours.3. Selling price is $650 each.3. Selling price is $650 each.4. Direct materials total $13.4. Direct materials total $13.5. Direct labor totals $50.5. Direct labor totals $50.6. Shipping costs total $25.6. Shipping costs total $25.
For each activity cost pool, the amount of activity consumed by the product (or customer) is multiplied by the activity rate to arrive at the amount of overhead cost applied to the product (or customer).
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Assigning Costs to Cost Objects
The customer-level cost is assigned to customers directly; it is not assigned to
products.
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Prepare Management Reports
Standard StanchionsSales 13,600$ Cost: Direct materials 2,110$ Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570
Product margin 5,030$
Custom Compass HousingSales 650$ Cost: Direct materials 13$ Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285 Order size 76 1,764
Product margin (1,114)$
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Prepare Management Reports
Customer Profitability Analysis
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Product Margins
Traditional Cost Accounting System
Predetermined manufacturingoverhead rate
$1,000,000 20,000 MH = $50/MH=
400 units x 0.5 MH/unit x $50/MH = $10,000400 units x 0.5 MH/unit x $50/MH = $10,000
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Differences Between ABC and Traditional Product Costs
Product margins are different for four reasons: Traditional costing assigns design costs to both products based on machine hours. ABC assigns product design costs to a product only if product design work is required. Traditional costing assigns customer order costs, a batch- level cost, using a unit-level allocation base, machine hours. ABC assigns these batch-level costs using a batch-level activity measure. Traditional costing assigns only manufacturing costs to products. ABC also assigns nonmanufacturing costs to products. Traditional costing assigns all manufacturing costs to products. The ABC system does not assign organization- sustaining manufacturing costs to the products.
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Differences Between ABC and Traditional Product Costs
When batch-level andproduct-level costs are present,
ABC will usually shift costs from highvolume products, produced in large batches,
to low volume products produced in small batches.
This cost shifting will usually have itsgreatest impact on the per
unit cost of the lowvolume products.
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Targeting Process Improvement
Activity-based management is used in conjunction with ABC to identify areas that would benefit
from process improvements.
While the theory of constraints approach discussed in Chapter 1 is a
powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on
where to focus improvement efforts.
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Activity-Based Costing and External Reporting
Most companies do not use ABCfor external reporting because . . .
1. External reports are less detailed than internal reports.
2. It may be difficult to make changes to the company’s accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation process based on interviews with employees.
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ABC Limitations
Substantial resourcesrequired to implement
and maintain.
Resistance tounfamiliar numbers
and reports.
Desire to fullyallocate all costs
to products.
Potentialmisinterpretation ofunfamiliar numbers.
Does not conform toGAAP. Two costing
systems may be needed.
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