lecture 5 accting 255 mgt acc ii 2011

8/2/2019 Lecture 5 Accting 255 Mgt Acc II 2011

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Week 5 LectureActivity-Based

Costing

Chapter 7:

Activity-Based Costing (ABC)

and

Activity-Based Management

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Cost Allocation

Assigning indirect costs to costobjects

These costs are not traced

Indirect costs often comprise a largepercentage of total costs

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Purposes of Cost Allocation

1. To provide information for economicdecisions

2. To motivate managers/employees

3. To compute/justify costs

4. To measure income and assets

Traditional costing systems may not yield thecosts necessary to meet the four-purposes for

cost allocation (above)


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(c) 2009 Pearson Prentice Hall. All rights reserved.

Six-Function Value Chain

Costs necessary for decision-making maypull costs from some or all of the abovesix value chain functions

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5Criteria for Guiding

Cost-Allocation Decisions

1. Cause-and-effect: variables areidentified that cause resources to beconsumed

Most credible to operating managers

Integral part of activity based costing(ABC)

2. Benefits received: the beneficiariesof the outputs of the cost object arecharged with costs in proportion tothe benefits received

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6Criteria for Guiding

Cost-Allocation Decisions

3. Fairness (Equity): the basis for establishing aprice satisfactory to the customer

Cost allocation here is viewed as areasonable or fair means of

establishing selling price

4. Ability to bear: costs are allocated inproportion to the cost objects ability to bear

them:

Generally, larger or more profitableobjects receive proportionally more of theallocated costs


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Background

Recall that factory overhead is applied toproduction in a rational systematic mannerusing some type of averaging

There are a variety of methods to accomplishthis goal:These methods often involve trade-offs between

simplicity and realism

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Broad Averaging

Historically, firms produced a limitedvariety of goods while their indirect costswere relatively small

Allocating overhead costs was simple:

Use broad averages to allocate costsuniformly regardless of how they areactually incurred

Peanut butter costing

End-result:

overcosting and undercosting

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Over and Undercosting

Overcosting: a product consumes a lowlevel of resources but is allocated highcosts per unit

Undercosting: a product consumes a highlevel of resources but is allocated low costsper unit


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10Limitations of Traditional Costing Systems

Volume-BasedPlantwide

Rate

DepartmentalRate Activity

BasedCosting

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Plantwideallocation

is simple but doesnot consider other

activities

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A Departmental rateprovides more detailed cost

measures, particularly ifthe departments performquite different activities


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I need to know more about ABCbefore I make my decision. It lookslike my decision will be based on

a careful cost-benefit analysis

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In the past, the direct cost component (e.g.direct labour) constituted a high percentage of the

total product cost, whereas the indirect costcomponent constituted a small percentage:

Thus, the allocation of indirect costsaccording to the traditional approach (e.g.

direct work hours or machine hours) did not

cause significant distortion in the decision

about pricing of products

Weight of indirect costs in product costs in the past

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Recently, the weight of indirect costs has

increased, now reaching a crucial part of total

production costs:

So, the allocation of indirect costs according

to the traditional approach has caused

considerable distortion in the costing of

products

Weight of indirect costs in product costsat present time


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Problems with traditional cost allocation

Arbitrariness:usually no single correct base

Smell test:managers know instinctively that simple

allocations are deficient

Cost cross-subsidization:products that use proportionately more of

allocation basis bear unfair share. Subsidizeother products

Spiral Death: retained products must carry more excess

capacity costs and may be dropped due toreduced profitability

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17Reasons for increased demand for

improved cost allocation

Increased competition with declining margins:Emphasis on improved productivityNeed for more accurate measurements

Increased automation and service content:Overhead a larger percentage of total costs

Deregulation, globalization of competition, and rapid

technological change: Increase demand for precise, timely profitabilityinformation for strategic purposes

Computerized information systems:Reduces cost of more detailed cost allocation

Decentralization of profit responsibility:Requires accurate measurement of subunit profits

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Companies more likely to benefit from

ABC

produce multiple, heterogeneous products

highly decentralized

have diverse customers and markets

use a variety of distribution channels

have relatively stable production andmarket environment


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How Costs are Treated UnderActivityBased Costing

ABC differs from traditional cost accounting in three ways

Manufacturingcosts

Nonmanufacturing

costs

ABC assigns both types of costs to products

Traditionalproduct costing

ABCproduct costing

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ABC does not assign all manufacturing costs to products

Manufacturingcosts

Nonmanufacturing

costs

Traditionalproduct costing

ABCproduct costing

All

Som

e


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PlantwideOverhead

Rate

DepartmentalOverhead

Rates

ActivityBasedCosting

Number of cost pools

Levelofcomplexity

ABC uses more cost pools



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ABC uses more cost pools

Each ABC cost pool has itsown unique measure of activity


Traditional cost systems usually relyon volume measures such as direct laborhours and/or machine hours to allocate

all overhead costs to products

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Activity-Based Costing

ABC is a costingapproach thatassigns costs toproducts or servicesbased on theirconsumption of theresource caused bythe activities

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Single Plantwide Overhead Rate

Dole Company has two factories Alpha and Beta. Alphais a highly automated factory while Beta is a labor-

intensive factory. The company uses a single plantwideoverhead rate based upon labor hours

Annual Budget Data

Alpha

Division

Beta

Division Total

Budgeted overhead 400,000$ 200,000$ 600,000$

Budgeted labor hours 10,000 50,000 60,000

Budgeted machine hours 20,000 40,000 60,000

Single PlantwideOverhead Rate

$600,00060,000

= $10 per labor hour=


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Single Plantwide Overhead Rate

During the first month of operations the company has thefollowing information for it two products Widget and Gidget

Alpha

Division

Beta

Division

Widget:

Labor hours 500 4,000

Machine hours 800 200

Gidget:

Labor hours 500 1,000

Machine hours 1,200 400

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Single Plant-wide Overhead Rate

Using the plantwide rate, factory overhead is applied to thetwo products as shown below.

Widget Gidget

Alpha Division:

$10 x 500 5,000$

$10 x 500 5,000$Beta Division:

$10 x 4,000 40,000

$10 x 1,000 10,000

Ove rhe ad a ppl ie d 45,000$ 15,000$

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Departmental Overhead Rates

To obtain more accurate product costing the companydecided to use departmental overhead rates. The overhead

in Alpha is to based on machine hours, and Beta will uselabor hours.

Alphas Departmental

Overhead Rate$400,000

20,000= $20 per machine hour=

Betas Departmental

Overhead Rate

$200,000

50,000

= $4 per labor hour=


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Departmental Overhead Rates

Using the new departmental overhead rates, overhead

would be allocated to the two products as shown below:Widget Gidget

Alpha Disision:

$20 x 800 16,000$

$20 x 1,200 24,000$

Beta Division:

$4 x 4,000 16,000

$4 x 1,000 4,000

Overhead applied 32,000$ 28,000$

Applied overhead will be $13,000 lower for Widget and$13,000 higher for Gidget as a result of using departmental

rates rather than a plantwide rate

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First stage

Second stage

Traditional

Resource Costs

Cost Pools:Plants or

Departments

Cost Objects

First stage

Second stage

Activity-Based

Resource Costs

Cost Objects

Cost Pools:Activities or

Activity Centers

Two-Stage Allocation Procedures

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Summary

Activity 1 Activity 2 Activity 5Activity 3 Activity 4Indirect

Cost pool

Activity

Cost

Driver 1

Activity

Cost

Driver 2

Activity

Cost

Driver 3

Activity

Cost

Driver 4

Activity

Cost

Driver 5

Allocation

Rate 1

Allocation

Rate 2

Allocation

Rate 3

Allocation

Rate 4

Allocation

Rate 5

COST OBJECT

DIRECT

LABOUR

DIRECT

MATERIALS

Activity 1Total # Driver 1





DIRECT

Up-stream

Down streamProcurement costs

Transaction processing costs

Indirect

Cost

Allocation

Base

DirectCosts

Resource Indirect Cost Pool


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31Steps in Designing an

ABC System

Identify resource costs andactivities

Assign resource costs to activities

Assign activity costs to cost objects

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Cost Hierarchies

ABC uses a four-level cost structure todetermine how far down the productioncycle costs should be pushed:

Unit-level (output-level)

Batch-level

Product-sustaining-level

Facility-sustaining-level

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33Activity-based hierarchy of costs and

activities

Unit-level activity An activity that isperformed for each unit of production(direct materials, direct labor hours,inserting a component)

Batch-level activity An activity that isperformed for each batch of products ratherthan for each unit of production (machinesetup, purchase ordering, productionscheduling)


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34Activity-based hierarchy of costs

and activities

Product-sustaining activity An activitythat is performed to support the productionof a given product (product design, partsadministration, issuance of engineeringchange orders, expediting)

Facility-sustaining activity An activity thatis performed to sustain the production ofproducts in general (security, safety, rent,maintenance, plant management)

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Materials purchasing

Direct labor support

Machine operation

Setup

Production orderMaterials handling

Parts administration

General and admin-

istrative

Identify these

activities as:

(1) Unit,

(2) Batch,

(3) Product, or

(4) Facility

Sample Activity Drivers at a Manufacturing Firm

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Sample Activity Drivers at a Manufacturing Firm

Materials purchasing

Direct labor support

Machine operation

Setup

Production order

Materials handling

Parts administration

General & administrative

UnitUnitUnitBatchBatchBatchProductFacility


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Steps in Designing an

Activity-Based Costing System

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Typical Resource Drivers

Meters for utilities

Number of employees for payroll-relatedactivities

Number of setups for the machine setup

activity Number of moves for the material handling

activity

Machine hours for machine power runningactivities

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Steps in Designing an

Activity-Based Costing System


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Activity Driver

Materials purchasing Material costDirect labor support Direct labor cost

Machine operation Machine hours

Setup Setup hours

Production orders Number of orders

Material handling Number of loads

Part administration Number of parts

General and administrative Amount of value-added

Activity Drivers at a Manufacturing Firm

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Expensive to developand implement

Time-consuming

Activity-Based Costing

It provides moreaccurate andinformative productcosts

It provides managerswith easier access torelevant costs

Benefits Limitations

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42Lecture example: Traditional Cost vs. ABC

Wombat company has identified the following overhead activities, costs and cost

drivers for the coming year:

Activity Expected

cost

Cost driver Activity

capacity

Setup costs $60 000 Number of setups 300

Ordering costs 45 000 Number of orders 4 500

Machine costs 90 000 Machine hours 18 000

Receiving 25 000 Number of parts 50 000

The following two jobs were completed during the year:

Job 600 Job 700

Direct material $750 $850

Direct labour (50 hours per job) $600 $600

Units completed 100 50

Number of setups 1 1

Number of orders 4 2

Machine hours 20 30

Parts used 20 40

The company's normal activity is 4000 direct labour hours (DLH).


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Traditional (volume-based) costing approach

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44Activity-based costing approach

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Conclusions

Each method is mathematically correct

Each method is acceptable (?)

Each method yields a different cost figure,which will lead to different gross margincalculations

Only overhead is involved:Total costs for the entire firm remain the

same (they are just allocated to differentcost objects within the firm)

Selection of the appropriate method andcost drivers should be based onexperience, and a cost-benefit analysis ofeach option under consideration


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A Cautionary Tale

A number of critical decisions can

be made using this information:Should one product be pushed over

another?

Should one product be dropped?

Accounting for overhead costs is animprecise science:

Best efforts should be put forward toarrive at a cost that is fair andreasonable

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Rationale for selecting a more refined

costing system:

Increase in product diversity:

Growing demand for customised productshas led to product diversity (i.e. productsdemand a different level of resources)

Increase in indirect costs:Due to modern technology

Advances in information technology:Makes it easier to assign/estimate costs to

products

Competition in foreign markets:

Need for more accurate cost information

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ABC vs. Simple Costing Schemes

ABC is generally perceived to producesuperior costing figures due to the use ofmultiple cost drivers across multiplelevels

But remember, ABC is only as good as thecost drivers selected and their actualrelationship to costs:

Poorly chosen cost drivers will produceinaccurate costs, even with ABC!


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Signals that suggest that ABC

implementation could help a

firm:

Significant overhead costs allocated using oneor two cost pools

Most or all overhead is considered unit-level

Products that consume different amounts ofresources

Products that a firm should successfully makeand sell consistently show small profits

Operations staff disagreeing with accountingover manufacturing and marketing costs

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50ABC and Service / Merchandising

Firms

ABC implementation is widespread ina variety of applications outsidemanufacturing, including:

Health Care

BankingTelecommunications

Retailing

Transportation

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Activity-Based Management

A method of management that uses ABC asan integral part in critical decision-makingsituations, including:

Pricing and product-mix decisions

Cost reduction and process improvementdecisions

Design decisions

Planning and managing activities

lecture 5 accting 255 mgt acc ii 2011

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