Activity based costing a tool to aid decision making
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Activity-Based Costing: A Tool to Aid Decision Making. Chapter 7. 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. ABC is a

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Activity based costing a tool to aid decision making

Activity-Based Costing: A Tool to Aid Decision Making

Chapter 7


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.

ABC is a

good supplement to our traditional cost system

Activity–Based Costing (ABC)

I agree!


An brief overview

An Brief Overview


Learning objective 1

Learning Objective 1

Understand activity-based costing and how it differs from a traditional costing system.


How costs are treated under activity based costing

How Costs are Treated UnderActivity–Based Costing

ABC differs from traditional cost accounting in three ways.

Manufacturingcosts

Nonmanufacturingcosts

Traditionalproduct costing

ABCproduct costing

 ABC assigns both types of costs to products.


How costs are treated under activity based costing1

How Costs are Treated UnderActivity–Based Costing

ABC differs from traditional cost accounting in three ways.

Manufacturingcosts

Nonmanufacturingcosts

Most, butnot all

Some

All

Traditionalproduct costing

ABCproduct costing

  • ABC does not assign all manufacturing costs to products.


How costs are treated under activity based costing2

How Costs are Treated UnderActivity–Based Costing

ABC differs from traditional cost accounting in three ways.

Activity–Based

Costing

Departmental

Overhead

Rates

Level of complexity

Plantwide

Overhead

Rate

Number of cost pools

  • ABC uses more cost pools.


How costs are treated under activity based costing3

How Costs are Treated UnderActivity–Based Costing

ABC differs from traditional cost accounting in three ways.

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 allocateall overhead costs to products.

  • ABC uses more cost pools.


How costs are treated under activity based costing4

How Costs are Treated UnderActivity–Based Costing

An event that causes the consumption of overhead resources.

Activity

A “cost bucket” in which costs related to a single activity measure are accumulated.

Activity Cost Pool

$

$

$

$

$

$


How costs are treated under activity based costing5

The term cost driver is also used to refer to an activity measure.

Activity Measure

An allocation basein an activity-basedcosting system.

How Costs are Treated UnderActivity–Based Costing


How costs are treated under activity based costing6

Transactiondriver

Durationdriver

Simple countof the number oftimes an activityoccurs.

A measureof the amountof time neededfor an activity.

How Costs are Treated UnderActivity–Based Costing

Two common types of activity measures:


How costs are treated under activity based costing7

How Costs are Treated UnderActivity–Based Costing

ABC definesfive levels of activitythat largely do not relateto the volume of unitsproduced.

Traditional cost systems usually rely on volumemeasures such as direct labor hours and/or machinehours to allocate all overhead costs to products.


How costs are treated under activity based costing8

Unit-Level

Activity

Batch-Level

Activity

Manufacturingcompanies typically combinetheir activities into fiveclassifications.

Product-Level

Activity

Customer-Level

Activity

Organization-sustaining

Activity

How Costs are Treated UnderActivity–Based Costing


Characteristics of successful abc implementations

Strong topmanagement support

Link to evaluationsand rewards

Cross-functionalinvolvement

Characteristics of Successful ABC Implementations


Baxter battery an abc example

Baxter Battery – An ABC Example

Manufacturing overhead is allocated to products usinga single plantwide overhead rate based on machine hours.


Define activities activity cost pools and activity measures

 Define Activities, Activity Cost Pools, and Activity Measures

At Baxter Battery, the ABC team, selected the followingactivity cost pools and activity measures:


Define activities activity cost pools and activity measures1

 Define Activities, Activity Cost Pools, and Activity Measures

  • Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.

  • Design Changes- assigned all costs of resources consumed by customer requested design changes.

  • 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 organization-sustaining costs and unused capacity costs


Learning objective 2

Learning Objective 2

Assign costs to cost pools using a first-stage allocation.


Assign overhead costs to activity cost pools

 Assign Overhead Costs to Activity Cost Pools


Assign overhead costs to activity cost pools1

 Assign Overhead Costs to Activity Cost Pools

Direct materials, direct labor, and shipping are excludedbecause Baxter Battery’s existing cost system can directlytrace these costs to products or customer orders.


Assign overhead costs to activity cost pools2

 Assign Overhead Costs to Activity Cost Pools

At Baxter Battery the following distribution of resource consumption across activity cost pools is determined.


Assign overhead costs to activity cost pools3

 Assign Overhead Costs to Activity Cost Pools

Indirect factory wages $6,000,000

Percent consumed by customer orders 30%

$1,800,000


Assign overhead costs to activity cost pools4

 Assign Overhead Costs to Activity Cost Pools

Factory equipment depreciation $3,500,000

Percent consumed by customer orders 20%

$ 700,000


Assign overhead costs to activity cost pools5

 Assign Overhead Costs to Activity Cost Pools


Learning objective 3

Learning Objective 3

Compute activityrates for cost pools.


Calculate activity rates

 Calculate Activity Rates

The ABC team determines that Baxter Battery will have these total activities for each activity cost pool . . .

  • 10,000 customer orders,

  • 4,000 design changes,

  • 800,000 machine-hours,

  • 2,000 customers served.

Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.


Calculate activity rates1

 Calculate Activity Rates


Activity based costing at baxter battery

Traced

Traced

Traced

Activity–Based Costing at Baxter Battery

Direct

Materials

Direct

Labor

Shipping

Costs

Overhead Costs

Cost Objects:

Products, Customer Orders, Customers


Activity based costing at baxter battery1

Activity–Based Costing at Baxter Battery

Direct

Materials

Direct

Labor

Shipping

Costs

Overhead Costs

First-Stage Allocation

CustomerOrders

OrderSize

Customer

Relations

Other

Design

Changes

Cost Objects:

Products, Customer Orders, Customers


Activity based costing at baxter battery2

Activity–Based Costing at Baxter Battery

Direct

Materials

Direct

Labor

Shipping

Costs

Overhead Costs

First-Stage Allocation

CustomerOrders

OrderSize

Customer

Relations

Other

Design

Changes

Second-Stage Allocations

$/Order

$/Change

$/MH

$/Customer

Cost Objects:

Products, Customer Orders, Customers

Unallocated


Learning objective 4

Learning Objective 4

Assign costs to a cost object using a second-stage allocation.


Assigning overhead to products

 Assigning Overhead to Products

Baxter Battery Information

  • SureStart

  • Requires no new design resources.

  • 800,000 batteries ordered with 4,000 separate orders.

  • Each SureStart requires 36 minutes of machinetime for a total of 480,000 machine-hours.

  • LongLife

  • Requires new design resources.

  • 400,000 batteries ordered with 6,000 separate orders.

  • 4,000 custom designs prepared.

  • Each LongLife requires 48 minutes of machinetime for a total of 320,000 machine-hours.


Assigning overhead to products1

 Assigning Overhead to Products


Assigning overhead to customers

Assigning Overhead to Customers

Let’s take a look at how Baxter Battery’s system works for just one of the 2,000 customers – Acme Auto Parts who placed a total of twelve orders. Note that the four orders for LongLifes required a design change.

  • Orders

  • Eight orders for 60 SureStarts per order.

  • Four orders for 50 LongLifes per order.

  • Machine-hours

  • The 480 SureStarts required 288 machine-hours.

  • The 200 LongLifes required 160 machine hours.


Assigning overhead to customers1

Assigning Overhead to Customers


Learning objective 5

Learning Objective 5

Use activity-based costing to compute product and customer margins.


Prepare management reports

 Prepare Management Reports

Product Margin Calculations

The first step in computing product margins is togather each product’s sales and direct cost data.


Prepare management reports1

 Prepare Management Reports

Product Margin Calculations

The second step in computing product margins is toincorporate the previously computed activity-basedcost assignments pertaining to each product.


Prepare management reports2

 Prepare Management Reports

Product Margin Calculations

The third step in computing productmarginsis to deduct each product’sdirect and indirect costs from sales.


Prepare management reports3

 Prepare Management Reports

Product Margin Calculations

The product margins can be reconciled withthe company’s net operating income as follows:


Prepare management reports4

 Prepare Management Reports

Customer Margin (Profitability) Analysis The first step in computing Acme Auto Parts’ customer margin is to gather its sales and direct cost data.


Prepare management reports5

 Prepare Management Reports

Customer Margin (Profitability) Analysis The second step is to incorporate Acme Auto Parts’ previously computed activity-based cost assignments.


Prepare management reports6

 Prepare Management Reports

Customer Margin (Profitability) Analysis The third step is to compute Acme Auto Parts’ customer margin of $384 by deducting all its direct and indirect costs from its sales.


Product margins computed using the traditional cost system

Product Margins Computed Using the Traditional Cost System

The first step in computing product margins is togather each product’s sales and direct cost data.


Product margins computed using the traditional cost system1

Plantwide manufacturing

overhead rate

$14,000,000

800,000 MH

=

= $17.50 per machine-hour

Product Margins Computed Using the Traditional Cost System

The second step in computing product marginsis to compute the plantwide overhead rate.


Product margins computed using the traditional cost system2

480,000 hours × $17.50 per hour = $8,400,000

Product Margins Computed Using the Traditional Cost System

The third step in computing product margins isallocate manufacturing overhead to each product.


Product margins computed using the traditional cost system3

Product Margins Computed Using the Traditional Cost System

The fourth step is to actuallycompute the product margins.


Differences between abc and traditional product costs

Differences Between ABC and Traditional Product Costs

The traditional costsystem overcosts theSureStarts and reports a lower productmargin for this product.

The traditional costsystem undercosts theLongLifes and reportsa higher productmargin for this product.


Differences between abc and traditional product costs1

Differences Between ABC and Traditional Product Costs

There are three reasons why thereported product margins for the twocosting systems differ from one another.

Traditional costing allocates all manufacturing overhead to products. ABC costing only assigns manufacturing overhead costs consumed by products to those products.


Differences between abc and traditional product costs2

Differences Between ABC and Traditional Product Costs

There are three reasons why thereported product margins for the twocosting systems differ from one another.

 Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. ABC costing also uses non-volume related allocation bases.


Differences between abc and traditional product costs3

Differences Between ABC and Traditional Product Costs

There are three reasons why thereported product margins for the twocosting systems differ from one another.

 Traditional costing disregards selling and administrative expenses because they are assumed to be period expenses. ABC costing directly traces shipping costs to products and includes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned to products.


Activity based costing and customer profitability analysis

Activity-based Costing and Customer Profitability Analysis

  • Analyze profitability of different customer groups

    • e.g. retail customers vs corporate customers

    • Examine different activities by resource consumption and relevant cost drivers

    • Sum up the allocated costs in each activity based on customer group

  • Other factors to consider:

    • Growth potential

    • Customer loyalty and industry’s barrier of entry

    • Customer lifetime value


Activity based management targeting process improvement

Activity-based Management: 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 1is a powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on where to focus improvement efforts.

Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations.


Activity based costing and external reporting

Activity-Based Costing and External Reporting

Most companies do not use ABCfor external reporting because . . .

  • External reports are less detailed than internal reports.

  • It may be difficult to make changes to the company’s accounting system.

  • ABC does not conform to GAAP.

  • Auditors may be suspect of the subjective allocation process based on interviews with employees.


Abc limitations

ABC Limitations

Substantial resourcesrequired to implementand maintain.

Resistance tounfamiliar numbersand reports.

Desire to fullyallocate all coststo products.

Potentialmisinterpretation ofunfamiliar numbers.

Does not conform toGAAP. Two costingsystems may be needed.


Abc action analysis

ABC Action Analysis

Appendix 7A


Learning objective 6

Learning Objective 6

(Appendix 7A)

Prepare an action analysis report using activity-based costing data and interpret the report.


Appendix 7a abc action analysis

Appendix 7A: ABC Action Analysis

  • Conventional ABC analysis does not identify potentially relevant costs. An action analysisreport helps because it:

    • Shows what costs have been assigned to a cost object.

    • Indicates how difficult it would be to adjust those costs in response to changes in the level of activity.


Appendix 7a abc action analysis1

Appendix 7A: ABC Action Analysis

Constructing an action analysis report begins with the first-stage allocation process. In addition to computing an overall activity rate for each activity cost pool, an activity rate is computed for each type of overhead cost that is consumed supporting a given activity.

Let’s revisit the stage-one allocationsfrom the Baxter Battery Company example that we discussed earlier.


Appendix 7a abc action analysis2

Appendix 7A: ABC Action Analysis

$1,800,000 ÷ 10,000 orders = $180 per order

Other entries in the table are computed similarly.


Activity based costing a tool to aid decision making

$180 per order × 4,000 orders = $720,000

Other entries in the table are computed similarly.


Activity based costing a tool to aid decision making

$180 per order × 6,000 orders = $1,080,000

Other entries in the table are computed similarly.


Appendix 7a abc action analysis3

Appendix 7A: ABC Action Analysis

  • Next, label each cost using an ease of adjustment code:

  • Green costs adjust more or less automatically to changes in activity level without any action by managers.

  • Yellow costs can be adjusted to changes in activity level, but it would require management action to realize the change in cost.

  • Red costs can be adjusted to changes in activity level only with a great deal of difficulty and with management intervention.


Appendix 7a abc action analysis4

Appendix 7A: ABC Action Analysis


Using a modified form of activity based costing to determine product costs for external reports

Using a Modified Form of Activity-Based Costing to Determine Product Costs for External Reports

Appendix 7B


Learning objective 7

Learning Objective 7

(Appendix 7B)

Use activity-based costing techniques to compute unit product costs for external reports.


Appendix 7b

Appendix 7B

A modified form of activity-basedcosting can be used to develop productcosts for external financial reports.

  • ABC product costs:

  • Include organization-sustaining costs and unused capacity costs.

  • Exclude nonmanufacturing costs even if they are caused by the products.


Appendix 7b1

Appendix 7B

Simmons’ Industries provides the following informationfor the company as a whole and for its only twoproducts—deluxe and standard hedge trimmers.


Appendix 7b2

Predeterminedoverhead rate

$1,800,000400,000 DLHs

=

= $4.50 per DLH

Appendix 7B

Assuming that Simmons’ traditional cost system relies on one predetermined plantwide overhead rate with direct labor-hours (DLHs) as the allocation base, then its plantwide overhead rate is computed as follows:


Appendix 7b3

2.0 DLH × $4.50 per DLH

1.0 DLH × $4.50 per DLH

Appendix 7B

Simmons’ traditional cost system wouldreport unit product costs as follows:


Appendix 7b4

Appendix 7B

The ABC project team at Simmons hasdeveloped the following basic information.


Appendix 7b5

Appendix 7B

We can calculate the following activity rates:

Using the new activity rates, let’s assign overheadto the two products based upon expected activity.


Appendix 7b6

Appendix 7B

Deluxe Product

Standard Product


Appendix 7b7

Appendix 7B

Activity-based unit product costs for both product lines


Appendix 7b8

$670,000 ÷ 200,000 units

$1,130,000 ÷ 100,000 units

Appendix 7B

Activity-based unit product costs for both product lines


Appendix 7b9

Appendix 7B

Comparing the two approaches

Note that the unit product cost of a Standard unitdecreased from $44.50 to $43.35 . . . . .

. . . . . while the unit cost of a Deluxe unit increased from $71.00 to $73.30.


End of chapter 7

End of Chapter 7


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