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Activity-Based Costing: A Tool to Aid Decision Making






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Activity-Based Costing: A Tool to Aid Decision Making. Chapter 8. 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
Activity-Based Costing: A Tool to Aid Decision Making

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Activity based costing a tool to aid decision making l.jpgSlide 1

Activity-Based Costing: A Tool to Aid Decision Making

Chapter 8

Activity based costing abc l.jpgSlide 2

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!

Learning objective 1 l.jpgSlide 3

Learning Objective 1

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

How costs are treated under activity based costing l.jpgSlide 4

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.

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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.

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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.

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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.

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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 costing9 l.jpgSlide 9

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 costing10 l.jpgSlide 10

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:

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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 costing12 l.jpgSlide 12

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 l.jpgSlide 13

Strong topmanagement support

Link to evaluationsand rewards

Cross-functionalinvolvement

Characteristics of Successful ABC Implementations

Baxter battery an abc example l.jpgSlide 14

Baxter Battery – An ABC Example

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

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 Define Activities, Activity Cost Pools, and Activity Measures

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

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 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

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Learning Objective 2

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

Assign overhead costs to activity cost pools l.jpgSlide 18

 Assign Overhead Costs to Activity Cost Pools

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 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.

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 Assign Overhead Costs to Activity Cost Pools

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

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 Assign Overhead Costs to Activity Cost Pools

Indirect factory wages $6,000,000

Percent consumed by customer orders 30%

$1,800,000

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 Assign Overhead Costs to Activity Cost Pools

Factory equipment depreciation $3,500,000

Percent consumed by customer orders 20%

$ 700,000

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 Assign Overhead Costs to Activity Cost Pools

Learning objective 3 l.jpgSlide 24

Learning Objective 3

Compute activityrates for cost pools.

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 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.

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 Calculate Activity Rates

Activity based costing at baxter battery l.jpgSlide 27

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 battery28 l.jpgSlide 28

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 battery29 l.jpgSlide 29

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 l.jpgSlide 30

Learning Objective 4

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

Assigning overhead to products l.jpgSlide 31

 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 products32 l.jpgSlide 32

 Assigning Overhead to Products

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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.

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Assigning Overhead to Customers

Learning objective 5 l.jpgSlide 35

Learning Objective 5

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

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 Prepare Management Reports

Product Margin Calculations

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

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 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.

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 Prepare Management Reports

Product Margin Calculations

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

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 Prepare Management Reports

Product Margin Calculations

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

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 Prepare Management Reports

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

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 Prepare Management Reports

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

Prepare management reports42 l.jpgSlide 42

 Prepare Management Reports

Customer Margin 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 l.jpgSlide 43

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 system44 l.jpgSlide 44

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 system45 l.jpgSlide 45

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.

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Product Margins Computed Using the Traditional Cost System

The fourth step is to actuallycompute the product margins.

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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.

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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.

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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.

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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.

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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 l.jpgSlide 52

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 l.jpgSlide 53

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.


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