ACTIVITY BASED SYSTEMS

William M Baker

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).

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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))

Traditional Solution

Deluxe Model Regular Model

Direct Materials $40.00 $25.00

Direct Labor 14.00 7.00

Overhead (@18) 36.00 18.00

Cost Per Unit $90.00 $50.00

35% Markup 31.50 17.50

List Price $121.50 $67.50

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).

Allocate Costs To Activities

Activity Cost

(1) Requisitions for Materials $204,000

(2) Machine Assembly 182,000

(3) Reworking Inferior-Quality Units 379,000

(4) Loading, Handling, and Shipping 135,000

Total $900,000

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.

Cost Drivers

Activity Cost Driver

(1) Requisitions for materials

Number of Requisitions

(2) Machine Assembly Number of Machine Hours

(3) Reworking Inferior-Quality Units

Number of Rework Orders

(4) Loading, Shipping, and Handling

Number of Shipments

Cost Driver Allocation Measures

Cost Driver Deluxe Regular

Number of Requisitions 200 400

Number of Machine Hours 20,000 15,000

Number of Rework Orders 1,000 1,000

Number of Shipments 250 650

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

Allocation of Costs to Products

Cost Driver Total Costs Deluxe Regular

Requisitions $204,000 $68,000 $136,000

Machine Hours $182,000 $104,000 $78,000

Re-Works $379,000 $189,500 $189,500

Shipments $135,000 $37,500 $97,500

Total $900,000 $399,000 $501,000

Overhead Cost Per Unit

Deluxe Regular

Total Overhead Costs $399,000 $501,000

Number of Units 5,000 40,000

Overhead Cost Per Unit $79.800 $12.525

ABC Solution

Deluxe Model Regular Model

Direct Materials $40.000 $25.000

Direct Labor 14.000 7.000

Overhead (@18) 79.800 12.525

Cost Per Unit $133.800 $44.525

“Old” Cost $90.000 $50.000

Current Price $121.500 $67.500

ACTIVITY BASED COSTING ACTIVITY BASED COSTING DOES NOT MAKE DOES NOT MAKE

ACCOUNTING MORE ACCOUNTING MORE ACCURATEACCURATE

…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.

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.

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