1 activity-based costing and activity-based management 2005.09

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Activity-Based Costing and

Activity-Based Management

2005.09

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Outline

1 Introduction2 Explain under-costing and over-costing of

products3 Present three guidelines for refining a costing

system4 Distinguish between the traditional and the ABC

approaches to designing a costing system5 Describe a four-part cost hierarchy

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6 Cost products or services using activity-based costing (ABC)

7 Use ABC systems for activity-based management

8 Evaluate the costs and benefits of implementing ABC costing systems

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Introduction

• Activities generate costs.

• ABC traces costs to activities.

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Explain under-costing and

over-costing of products

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Under-costing and Over-costing

• Product under-costing:

A product consumes a relatively high level of total resources but is reported to have a relatively low total cost.

• Product over-costing:

A product consumes a relatively low level of total resources but is reported to have a relatively high total cost.

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• Lisa, Rola, and Nancy meet occasionally for lunch.

• Each one orders separate items.

• Lisa order amounts to $140

Rola consumes 300 Nancy’s order is 160 Total

$600

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• Assuming they divide the bill equally, what is the average cost per lunch?

• $600 ÷ 3 = $200

• Lisa and Nancy are over-costed.

• Rola is under-costed.

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Existing Single Indirect-Cost Pool System

• Cole Corporation manufactures two types of lenses :

a normal lens (NL)

a complex lens (CL).

• To cost products, Cole currently uses a single indirect-cost rate costing system.

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• The cost objects are the total costs of manufacturing and distributing 80,000 normal lenses (NL) and 20,000 complex lenses (CL).

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Normal Lenses (NL) Direct materials $1,520,000 Direct labor 800,000 Total direct costs

$2,320,000

• Direct cost per unit:$2,320,000 ÷ 80,000 = $29

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• Complex Lenses (CL) Direct materials $ 920,000 Direct labor 260,000 Total direct costs $1,180,000

• Direct cost per unit:

$1,180,000 ÷ 20,000 = $59

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• Indirect costs of $2,900,000 are grouped into a single overhead cost pool.

• 50,000 of direct labor hours are used as the cost-allocation base.

• What is the indirect cost allocation rate?

• $2,900,000 ÷ 50,000 = $58 per direct labor hour

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• Cole uses 36,000 direct labor-hours to make NL and 14,000 direct labor-hours to make CL.

• How much indirect costs are allocated to each product?

• NL: 36,000 × $58 = $2,088,000• CL: 14,000 × $58 = $ 812,000

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• What is the total cost of normal lenses (NL)?

TC = Direct costs $2,320,000 +

Allocated costs $2,088,000 = $4,408,000

• What is the cost per unit?

$4,408,000 ÷ 80,000 = $55.10

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• What is the total cost of complex lenses (CL)?

TC = Direct costs $1,180,000 +

Allocated costs $812,000 = $1,992,000

• What is the cost per unit?

UC = 1,992,000 ÷ 20,000 = $99.60

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• Normal lenses sell for $60 each and complex lenses for $142 each.

• Normal Complex Revenue $60.00 $142.00 Cost 55.10 99.60 Income $ 4.90 $ 42.40Margin (Profits) 8.2% 29.9%

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Guidelines for Refining a Costing System

Three Guidelines for refining a costing system:• 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 driver: Identify the preferred cost-allocation

base (cost driver) for each indirect-cost pool.

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Refining a Costing System

• The sequence of steps to design, produce, and distribute lenses is as follows:

1 Design of products and process：The Design Department designs the molds and defines production processes needed (details of the manufacturing operations).

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Refining a Costing System

2 Manufacturing operations：Lenses are molded, finished, cleaned, and inspected.

3 Shipping and distribution：Finished lenses are packed and sent to the various customers.

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Distinguish between the traditional and the ABC approaches to designing

a costing system

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Activity-Based Costing System

• ABC systems refine costing systems by focusing on individual activities as the fundamental cost object.

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ABC:(1) calculates the costs of individual activities (2) assigns costs to cost objects (such as products

and services) on the basis of the activities undertaken (consumed) to produce each product or service.

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Activities Cost of Activities

Cost of Product, Service, or Customer

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• A cross-functional team at Cole Corporation identified 7 key activities:

– Design products and processes

– Set up molding machine

– Operate machines to manufacture lenses

– Maintain and clean the molds

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– Set up batches of finished lenses for shipment.

– Distribute lenses to customers.

– Administer and manage all processes.

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Molding machine setup data for NL and CL:

NL CL

• Total quantity produced 80,000 20,000

• No. produced per batch 250 50

• Number of batches 320 400

• Setup time per batch 2 hours 5 hours

• Total setup hours 640 2,000

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• Total setup costs are $409,200.

• What is the setup cost per setup hour?

A: $409,200 ÷ 2,640 hours = $155

• What is the setup cost per direct labor hour?

A: $409,200 ÷ 50,000 = $8.184 (p.13)

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• (ABC) Cost allocation using setup-hours:

• NL: $155 × 640 = $ 99,200 CL: $155 × 2,000 = $310,000

Total $409,200

• (TCS) Cost allocation using direct labor-hours:

NL: $8.184 × 36,000 = $294,624 (O. costing) CL: $8.184 × 14,000 = $114,576 (U. costing)

Total $409,200

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How should Cole Co. allocate setup costs?A: Setup costs should be allocated on the basis of setup hourssetup hours.

• Why?• There is a strong cause-and-effect

relationship between setup-related overhead costs and setup-hours, a resource-consuming costing model .

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A four-part cost hierarchy

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Cost Hierarchies

• A cost hierarchy is a categorization of costs into different cost pools on the basis of the different types of cost drivers (cost-allocation bases).

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Cost Hierarchies

• ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases (cost drivers):

1 Unit-level costs2 Batch-level costs3 Product-sustaining costs (or Customer-sustaining costs) 4 Facility-sustaining costs

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Unit-Level Costs

– are resources consumed by activities performed on each individual unit of product or service.

• Direct material • Direct labor• Energy• Machine depreciation

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Batch-Level Costs

– are resources consumed by activities that are related to a batch (group of units) of product rather than to each individual unit of product.

• Setup costs

• Procurement costs

• Material moving costs

• Inspection costs

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Product-Sustaining Costs

– are resources consumed by activities undertaken related to individual products or services.

• Design costs

• Design change costs

• Engineering costs

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Facility-Sustaining Costs

– are resources consumed by activities that cannot be traced to individual products but related to the organization as a whole.

• General administration costs

– Rent

– Building security

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Cost products or services

using activity-based costing (ABC)

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Implementing Activity-Based Costing

• Step 1: Identify the chosen cost objects.

The objective is to calculate the total costs of designing, manufacturing, and distributing NL and CL.

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• Step 2: Identify the direct costs of the product.

Cole identifies direct materials costs and direct labor costs as direct costs.

Mold cleaning and maintenance costs of $360,000 are also identified as direct costs of the lenses.

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• The existing cost system classifies mold cleaning and maintenance costs ($360,000) as part of the $2,900,000 indirect costs.

• Recall that indirect costs were allocated to products using direct labor-hours.

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• Mold cleaning and maintenance costs of $360,000 are batch-level-costs. Why?

• Because these costs consist of workers’ wages for cleaning molds after each batch of lenses is run.

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• Mold cleaning and maintenance costs of $360,000 under ABC system:

• $360,000 / 720 batches = $500 / batch• NL: 320 batches * $500 = $160,000• CL: 400 batches * $500 = $200,000

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• Allocation of mold cleaning and maintenance costs $360,000 under traditional costing system:

• $360,000 / 50,000 D.L.hours = $7.2 per D.L.hour

• NL: 36,000 hours * $7.2 = $259,200 vs. $160,000

• CL: 14,000 hours * $7.2 = $100,800 vs. $200,000

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• Mold cleaning and maintenance costs of $360,000

under two costing systems:

TCS ABC

• NL $259,200 $160,000 (O. costing)

• CL $100,800 $200,000 (U. costing)

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Normal Lenses (NL)

Description Cost Hierarchy Category Direct materials Unit-level $1,520,000 Direct labor Unit-level

800,000 Mold cleaning & maintenance Batch-level 160,000 Total direct costs

$2,480,000

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Complex Lenses (CL)

Description Cost Hierarchy Category Direct materials Unit-level $ 920,000 Direct labor Unit-level 260,000 Mold cleaning & maintenance Batch-level 200,000 Total direct costs $1,380,000

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• Step 3: Select the cost drivers (cost-allocation bases) to use in allocating activity costs to the products.

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Six activities were identified.

1 Design

2 Molding machines setups*

3 Manufacturing operations

4 Shipment

5 Distribution

6 Administration

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• Step 4: Identify the activity costs associated with each cost driver (cost-allocation

base).

• Overhead costs incurred are assigned to activities, to the extent possible, on the basis of a cause-and-effect relationship.

• Total molding machines setup costs are $409,200.

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• Step 5: Compute the rate per unit of each cost driver (cost allocation base) used

to allocate molding machines setup costs to the products.

• Setup hours: NL CL Total 640 2,000 2,640

• $409,200 ÷ 2,640 = $155 per setup hour.

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• Step 6: Compute the setup costs allocated to the products.

• NL: $155 × 640 hours = $ 99,200

• CL: $155 × 2,000 hours = 310,000

Total $409,200

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• Setup cost of $409,200

under traditional costing system:

• $409,200 / 50,000 D.L.hours = $8.18 D.L.hour

• NL: 36,000 hours * $8.18 = $294,600

• CL: 14,000 hours * $8.18 = $114,600

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• Setup cost of $409,200

ABC TCS

NL $ 99,200 $ 310,000 (O. costing)

CL $294,600 $114,600 (U. costing)

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• Step 7: Compute the costs of the products by adding all direct and indirect costs assigned to them.

• NL and CL would show three direct cost categories.

1 Direct material costs

2 Direct labor costs

3 Mold cleaning and maintenance costs

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• NL and CL would show six activity cost pools.

1 Design

2 Molding machine setups

3 Manufacturing operations

4 Shipment

5 Distribution

6 Administration

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Use ABC systems for

activity-based management

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Activity-Based Management

• ABM describes management decisions that use activity-based costing information to improve profits.

– Product mix and pricing decisions– Customer mix and pricing decisions– Cost reduction and process improvement

decisions– Design decisions

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Product Pricing and Mix Decisions

• ABC provides more accurate product cost information and gives management insight into the cost structures for making and selling diverse products.

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Cost Reduction and Process Improvement Decisions

• Value-added activities vs.

Non value-added activities

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Design Decisions

• Management can identify and evaluate new designs to improve operating performance by evaluating how product and process 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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Evaluate the costs and benefits of implementing

ABC costing systems

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ABC Systems Are Most Beneficial When...

– significant amounts of indirect costs are allocated using only one or two cost pools.

– all or most costs are identified as output unit-level costs.

– products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.

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– products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits.

– complex products appear to be very profitable and simple products appear to be losing money.

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– operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.

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Limitations of ABC Systems

• The main limitations of ABC are the measurements necessary to implement the system.

• ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.

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Limitations of ABC Systems

• Activity-cost rates also need to be updated regularly.

• Very detailed ABC systems are costly to operate and difficult to understand.

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ABC In Service And Merchandising Companies

• The general approach to ABC in the service and merchandising areas is very similar to the approach in manufacturing.

• Costs are divided into homogeneous cost pools and classified as unit-level, batch level, product, or service-sustaining and facility sustaining costs.

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END

Thank You

1 activity-based costing and activity-based management 2005.09

Documents

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total cost of complex

low total cost

high total cost

single overhead cost

total direct costs

total cost of normal

indirect cost allocation