Activity-Based Costing and Activity-Based Management

1. CHAPTER 5 Activity-Based Costing and Activity-Based Management

3. Learning Objective 1 Learning objective number 1 is to understand the basic approach in activity-based costing and how it differs from conventional costing. Learning objective number 1 is to understand the basic approach in activity-based costing and how it differs from conventional costing.

4. Assigning Overhead Costs to Products When cost systems were developed in the 1800s, the emphasis was on simplicity because: Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. When cost systems were developed in the 1800s, the emphasis was on simplicity because: Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

5. Plantwide Overhead Rate In the interest of simplicity, companies often established a single overhead pool for an entire factory that used direct labor as the allocation base. Direct labor was the obvious choice because: Direct labor information was already being recorded. Direct labor was a large component of product costs. Managers believed direct labor and overhead costs were highly correlated. In the interest of simplicity, companies often established a single overhead pool for an entire factory that used direct labor as the allocation base. Direct labor was the obvious choice because: Direct labor information was already being recorded. Direct labor was a large component of product costs. Managers believed direct labor and overhead costs were highly correlated.

6. Plantwide Overhead Rate Conditions have changed in three ways. Most companies sell a large variety of products that consume differing amounts of overhead. As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of these growing overheadcosts may not be correlated with direct labor. Technology advancements have reduced the cost and complexity of gathering diverse sources of data. � These changes suggest that a plantwide overhead allocation system may not be optimal for many companies in today�s business environment. Conditions have changed in three ways. Most companies sell a large variety of products that consume differing amounts of overhead. As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of these growing overheadcosts may not be correlated with direct labor. Technology advancements have reduced the cost and complexity of gathering diverse sources of data. � These changes suggest that a plantwide overhead allocation system may not be optimal for many companies in today�s business environment.

7. Departmental Overhead Rates Many companies use departmental overhead rates, instead of a plantwide overhead rate. The nature of the work performed in a department will determine the department�s allocation base. For example:� Overhead costs in a machining department may be allocated using machine hours. Overhead costs in an assembly department may be allocated using direct labor hours.Many companies use departmental overhead rates, instead of a plantwide overhead rate. The nature of the work performed in a department will determine the department�s allocation base. For example:� Overhead costs in a machining department may be allocated using machine hours. Overhead costs in an assembly department may be allocated using direct labor hours.

8. Departmental Overhead Rates Part I Departmental overhead rates will not correctly assign overhead costs in situations where a company has a range of products and complex overhead costs. Part II This is because the departmental approach relies exclusively on volume-related allocation bases. Some overhead costs may be caused by factors that are not related to the volume of production. Part III A more sophisticated approach, such as activity-based costing, is required to account for these other factors. Part I Departmental overhead rates will not correctly assign overhead costs in situations where a company has a range of products and complex overhead costs. Part II This is because the departmental approach relies exclusively on volume-related allocation bases. Some overhead costs may be caused by factors that are not related to the volume of production. Part III A more sophisticated approach, such as activity-based costing, is required to account for these other factors.

9. Activity-Based Costing (ABC) Activity based costing is a technique that uses numerous allocation bases in an attempt to assign overhead costs more accurately to products than the plantwide or departmental approaches discussed thus far.Activity based costing is a technique that uses numerous allocation bases in an attempt to assign overhead costs more accurately to products than the plantwide or departmental approaches discussed thus far.

10. Activity-Based Costing (ABC) The basic idea of ABC is as follows. A customer order triggers a number of activities. Performing the activities consumes resources. The consumption of resources incurs costs. The basic idea of ABC is as follows. A customer order triggers a number of activities. Performing the activities consumes resources. The consumption of resources incurs costs.

11. Activity-Based Costing (ABC) Part I An activity in activity-based costing is an event that causes the consumption of overhead resources. Part II Examples of activities include: a.���� Setting up machines b.���� Admitting patients to a hospital c.���� Billing customers d.���� Opening an account at a bank Part I An activity in activity-based costing is an event that causes the consumption of overhead resources. Part II Examples of activities include: a.���� Setting up machines b.���� Admitting patients to a hospital c.���� Billing customers d.���� Opening an account at a bank

12. Activity-Based Costing (ABC) Part I An activity cost pool can be thought of as a �cost bucket� in which costs related to a particular activity are accumulated. Part II An activity measure expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs to products and services. Activity measures may or may not be related to volume. Part III An activity rate is a predetermined overhead rate in an activity-based costing system. Each activity cost pool has its own activity rate that is used to apply overhead costs to cost objects. Part I An activity cost pool can be thought of as a �cost bucket� in which costs related to a particular activity are accumulated. Part II An activity measure expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs to products and services. Activity measures may or may not be related to volume. Part III An activity rate is a predetermined overhead rate in an activity-based costing system. Each activity cost pool has its own activity rate that is used to apply overhead costs to cost objects.

13. Activity-Based Costing (ABC) Part I Taking each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2. Part II A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product. Part I Taking each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2. Part II A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product.

14. Designing an Activity-Based Costing System Part I In most companies, hundreds or even thousands of different activities cause overhead costs. The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Part II Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization�s resources. Part I In most companies, hundreds or even thousands of different activities cause overhead costs. The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Part II Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization�s resources.

15. Designing an Activity-Based Costing System Part I Related activities are frequently combined to reduce the amount of detail and record-keeping costs. � Part II For example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling. � Part III An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured. Part I Related activities are frequently combined to reduce the amount of detail and record-keeping costs. � Part II For example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling. � Part III An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured.

16. Broad Averaging Historically, firms produced a limited variety of goods while their indirect costs were relatively small. Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of how they are actually incurred Peanut-butter Costing The end-result: overcosting & undercosting

17. Over & Undercosting Overcosting � a product consumes a low level of resources but is allocated high costs per unit Undercosting � a product consumes a high level of resources but is allocated low costs per unit

18. Cross-subsidization The results of overcosting one product and undercosting another. The overcosted product absorbs too much cost, making it seem less profitable than it really is The undercosted product is left with too little cost, making it seem more profitable than it really is

20. Cost Hierarchies ABC uses a four-level cost structure to determine how far down the production cycle costs should be pushed: Unit-level (output-level) Batch-level Product-sustaining-level Facility-sustaining-level

21. Hierarchy of Activities A common framework for combining activities in manufacturing companies is as follows: Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment is a unit-level activity. Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities. Product-level activities relate to specific products and must be carried out, regardless of how many batches are run or units produced and sold. For example, designing or advertising a product are product-level activities. Facility-level activities are carried out regardless of which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are facility level activities. A common framework for combining activities in manufacturing companies is as follows: Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment is a unit-level activity. Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities. Product-level activities relate to specific products and must be carried out, regardless of how many batches are run or units produced and sold. For example, designing or advertising a product are product-level activities. Facility-level activities are carried out regardless of which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are facility level activities.

22. Graphic Example of Activity-Based Costing Using activity based costing, the manufacturing overhead costs are allocated to products using a two-stage process. In the first stage, overhead costs are assigned to the six activity cost pools shown on the slide. For example, the production order cost pool may include the salaries of engineers who modify products for individual orders and the costs of scheduling and monitoring orders. In the examples and assignments in this book, the first-stage cost assignments have already been completed. Using activity based costing, the manufacturing overhead costs are allocated to products using a two-stage process. In the first stage, overhead costs are assigned to the six activity cost pools shown on the slide. For example, the production order cost pool may include the salaries of engineers who modify products for individual orders and the costs of scheduling and monitoring orders. In the examples and assignments in this book, the first-stage cost assignments have already been completed.

23. Graphic Example of Activity-Based Costing In the second stage, the costs in the activity cost pools are allocated to products, using activity rates and activity measures. For example, if the total cost in the production order cost pool was $450,000 and the company expected to process 1,200 orders, the activity rate would be $375 per order. Each order would be charged $375 for production order costs. Notice, the example shown on the slide includes two unit-level activities, two batch-level activities, one product-level activity, and one facility-level activity. In the second stage, the costs in the activity cost pools are allocated to products, using activity rates and activity measures. For example, if the total cost in the production order cost pool was $450,000 and the company expected to process 1,200 orders, the activity rate would be $375 per order. Each order would be charged $375 for production order costs. Notice, the example shown on the slide includes two unit-level activities, two batch-level activities, one product-level activity, and one facility-level activity.

25. An Example: Plastim

26. Plastim & Simple Costing

27. Plastim & Simple Costing

31. Plastim and ABC Illustrated

32. Plastim and ABC Rate Calculation

33. Plastim and ABC Product Costs

34. Plastim and ABC Product Costs

35. Plastim: Simple & ABC Compared

36. ConclusionsSingle-Rate Costing and ABC Each method is mathematically correct Each method is acceptable Each method yields a different cost figure, which will lead to different Gross Margin calculations Only Overhead is involved. Total Costs for the entire firm remain the same � they are just allocated to different cost objects within the firm Selection of the appropriate method and drivers should be based on experience, industry practices, as well as a cost-benefit analysis of each option under consideration

37. Take Away Commonly, with single-rate overhead application: The high-volume product is overcosted, while The low-volume, complex product is undercosted.

38. 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 an imprecise science. Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable.

39. ABC vs. Simple Costing Schemes ABC is generally perceived to produce superior costing figures due to the use of multiple drivers across multiple levels ABC is only as good as the drivers selected, and their actual relationship to costs. Poorly chosen drivers will produce inaccurate costs, even with ABC

40. Activity-Based Management A method of management that used ABC as an integral part in critical decision-making situations, including: Pricing & product-mix decisions Cost reduction & process improvement decisions Design decisions Planning & managing activities

41. Signals that suggest that ABC implementation could help a firm: Significant overhead costs allocated using one or two cost pools Most or all overhead is considered unit-level Products that consume different amounts of resources Products that a firm should successfully make and sell consistently show small profits Operations staff disagreeing with accounting over manufacturing and marketing costs

42. ABC and Service / Merchandising Firms ABC implementation is widespread in a variety of applications outside manufacturing, including: Health Care Banking Telecommunications Retailing Transportation

43. Benefits of Activity-Based Costing ABC improves the accuracy of product costing by: Increasing the number of cost pools used to accumulate overhead costs. Using activity cost pools that are more homogeneous than departmental cost pools. Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. Activity-based costing improves the accuracy of product costs in three ways:� It increases the number of cost pools used to accumulate overhead costs. It uses activity cost pools that are more homogeneous than departmental cost pools. It assigns overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. Some activity measures may be unit-level in nature, while others may be batch-level, product-level or facility-level in nature. In addition, activity-based costing highlights the activities that could benefit most from process improvement efforts, such as Six Sigma.Activity-based costing improves the accuracy of product costs in three ways:� It increases the number of cost pools used to accumulate overhead costs. It uses activity cost pools that are more homogeneous than departmental cost pools. It assigns overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. Some activity measures may be unit-level in nature, while others may be batch-level, product-level or facility-level in nature. In addition, activity-based costing highlights the activities that could benefit most from process improvement efforts, such as Six Sigma.

44. Limitations Activity-Based Costing The cost of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when:� Products differ substantially in volume, batch size, and in the activities they require. Conditions have changed substantially since the existing cost system was established. 3.��Overhead costs are high and increasing and no one seems to understand why. 4.��Management does not trust the existing cost system and it ignores data from it when making decisions. The cost of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when:� Products differ substantially in volume, batch size, and in the activities they require. Conditions have changed substantially since the existing cost system was established. 3.��Overhead costs are high and increasing and no one seems to understand why. 4.��Management does not trust the existing cost system and it ignores data from it when making decisions.

45. Activity-Based CostingCritical Assumption Part I The cost in each activity pool is strictly proportional to its activity measure. When this assumption is violated, the accuracy of ABC data can be called into question. Part II For example, managers should be particularly alert to product costs that contain allocated facility-level costs. Part I The cost in each activity pool is strictly proportional to its activity measure. When this assumption is violated, the accuracy of ABC data can be called into question. Part II For example, managers should be particularly alert to product costs that contain allocated facility-level costs.

46. Modifying the ABC Model The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: Selling and administrative costs should be assigned to products, where appropriate. Facility-level costs should be removed from product costs. The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: Selling and administrative costs should be assigned to products, where appropriate. Facility-level costs should be removed from product costs.