Chapter 5: Activity‐Based g(
)
Costing (ABC) and Management
ACG 6309
Dr. Chula King
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Student Learning Outcomes
• Compute product costs under a traditional, volume‐based product‐costing system
• Explain how an ABC system operates
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• Explain the concept of cost levels
• Compute product costs under an ABC system
• Explain why traditional, volume‐based costing systems tend to distort product costs
• Explain the three criteria for selecting cost drivers
• Explain the concept of activity‐based management.
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Traditional Volume Based Costing Systems
• Plant‐wide overhead Rate
• Direct labor often used as allocation base
– Information already recorded and readily available
– Large component of product costs
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– Belief that direct labor and overhead costs were highly correlated
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Relevance Today
• Different environments
– Large variety of products consuming differing amounts of overhead
– Direct labor costs have been shrinking while overhead costs have been increasing
– Increasing overhead costs no longer highly correlated with direct labor
– Cost reductions because of technology
– Reduced complexity of gathering diverse sources of data because of technology
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Activity‐Based Costing (ABC)
• Number of allocation bases used for assigning costs to products
– Cost objects
– Performing activities
Performing activities
– Resource consumption
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Activity‐Based Costing (ABC)
• Activity: Event causing the consumption of overhead resources
• Activity Cost Pool: A “cost bucket” that accumulates costs
accumulates costs
• Activity Measure: Used as the allocation base for applying overhead costs
• Activity Rate: Predetermined overhead rate for each activity cost pool.
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Activity Based Costing (ABC)
• Overhead costs are assigned using a two stage procedure
• Stage 1: Identification of significant activities and assignment of overhead costs to each and assignment of overhead costs to each
activity in proportion to resources used
• Stage 2: Identification of cost drivers appropriate for each activity and allocation of overhead to the product.
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Stage One Cost Pools (Cost Hierarchy)
• Unit level: performed for each unit of production, e.g., machining
• Batch level: performed for each batch of the p
product, e.g., setup, quality assurance, receiving
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• Product‐sustaining level –performed to support an entire product line, e.g., engineering
• Facility or general operations level: Required for entire manufacturing process to occur, e.g., plant management, plant maintenance, depreciation © Dr. Chula King
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Stage Two – Cost Drivers
• Each cost pool is assigned a cost driver
• Overhead costs are assigned by using the cost drivers and assessing the relative proportion of the activity consumed by the product
of the activity consumed by the product
• Pool rate is calculated – per unit cost of the cost driver and eventual cost for each product line
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Exhibit 5‐4
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For Example
• Edgeworth Box Corporation manufactures a variety of special packaging boxes used in the pharmaceutical industry. The company’s Dallas plant is semi
Dallas plant is semi‐automated
automated, but the but the
special nature of the boxes requires some manual labor. The controller has chosen activity cost pools, cost drivers and pool rates for the Dallas plant product‐costing system
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Edgeworth Box Corporation
Activity Cost Pool
Purchasing, storage and material handling
Engineering and product design
Machine setup costs
Machine depreciation and maintenance
Overhead Cost
Cost Driver
$ 200,000 Raw material costs
Budgeted Level for Cost Driver
Pool Rate
$1,000,000 20% of material cost
Hours in design 100,000 department
5,000 hrs.
$20 per hour
70,000 Production runs
1,000 runs
$70 per run
300,000 Machine hours
100,000 hrs. $3 per hour
Factory depreciation, taxes, insurance and utilities
200,000 Machine hours
100,000 hrs. $2 per hour
Other manufacturing overhead costs
150,000 Machine hours
100,000 hrs. $1.50 per hour
Total
$ 1,020,000 © Dr. Chula King
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Additional Information
20,000 Units of Box 10,000 units of Box C52
W29
Direct labor hours
42 hours
21 hours
Raw material cost
$40,000
Hours in design dept 10
$35,000
25
Production runs
2
4
Machine hours
24
20
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Determination of Total Overhead
Box C52
Purchasing, storage and $8,000 (20% x $40,000)
material handling
Box W29
$7,000 (20% x $35,000)
Engineering and product design
200 (10 hrs x $20/hr)
500 (25 hrs x $20/hr)
Machine setup costs
140 (2 runs x $70/run)
280 (4 runs x $70/run)
Machine depreciation and maintenance
72 (24 Mhr x $3/hr)
60 (20 Mhr x $3/hr)
Factory depreciation, taxes, insurance and utilities
48 (24 Mhr x $2/hr)
40 (20 Mhr x $2/hr)
Other manufacturing overhead costs
36 (24 Mhr x $1.50/hr)
30 (20 Mhr x $1.50/hr)
Total overhead $8,496
$7,910
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Overhead Cost per Box
• Box C52: 20,000 boxes
$8,496 ÷ 20,000 boxes = $0.4248/box
• Box W29: 10,000 boxes
$7,910 ÷ 10,000 boxes = $0.791/box
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Predetermined Overhead Rate Based on Direct Labor Hours
• Total budgeted overhead ÷ Total budgeted direct labor hours
• Total budgeted overhead = $1,020,000
• Total budgeted direct labor hours = 4,000
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000
• Predetermined overhead rate = $1,020,000 ÷
4,000 direct labor hours = $255/direct labor hour
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Total and per Unit Overhead Assigned to C52 and W29
• Box C52: 42 direct labor hours x $255/direct labor hour = $10,710
– $10,710 ÷ 20,000 boxes = $0.5355/box
• Box W29: 21 direct labor hours x $255/direct Box W29 21 direct labor hours x $255/direct
labor hour = $5,355 – $5,355 ÷ 10,000 boxes = $0.5355/box
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Comparison of per Unit Overhead Costs
C52
W29
Using ABC
$0.4948 $0.791
Using single rate
$0.5355 $0.5355
There are inherent inaccuracies built into the single, volume based overhead rate. The allocation using just direct labor hours does not reflect the relative usage of the other manufacturing support areas.
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Cost Drivers
• Characteristic of an event or activity that results in the incurrence of costs.
– Degree of correlation
– Cost of measurement
Cost of measurement
– Behavioral effects
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Activity‐Based Management (ABM)
• Refers to the use of activity‐based costing information to support organizational strategy, improve operations, and manage costs.
• Assigns resource cost to a company
Assigns resource cost to a company'ss cost cost
objects (i.e., the cost assignment viewpoint). With a process viewpoint, the emphasis now is on the activities themselves—what causes them, the events that trigger them, and the related linkages. © Dr. Chula King
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ABM Goals
• To identify and eliminate non‐value‐added activities: activities that are either unnecessary and dispensable, or necessary but inefficient
but inefficient
– Common examples of non‐value‐added activities include move, wait, and storage time
– These activities give rise to non‐value‐added costs, or costs that can be eliminated without deterioration of product quality, performance, or perceived value © Dr. Chula King
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Customer Profitability Analysis
• Uses activity‐based costing to determine the activities, costs, and profit associated with serving particular customers.
• Factors that influence customer profitability Factors that influence customer profitability
include order quantity, order frequency, special packaging and/or delivery needs, engineering design changes, sales visits/contacts, and, in general, customized services.
• Customers can often be educated in terms of buying habits, with the result being lower ll
f b h h
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d h
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The Next Step
• Exercises 5‐26, 5‐27, 5‐36*, 5‐38*, 5‐40*, 5‐41*, 5‐44*
*Open ended to foster class discussion
• Problems 5‐46, 5‐49, 5‐50, 5‐52, 5‐53, 5‐54
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