4-1 Activity- Based Costing and Management Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University 4

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Activity-Activity-Based Based

Costing and Costing and ManagementManagement

Prepared by Douglas Cloud

Pepperdine University

Prepared by Douglas Cloud

Pepperdine University

44

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Explain and illustrate the traditional method of calculating average costs of products.

Explain why the traditional method does not adequately serve modern organizations.

Explain how complexity and diversity are important cost drivers.

Explain and illustrate the activity-based costing method of calculating average costs of products.

ObjectivesObjectivesObjectivesObjectives

After reading this After reading this chapter, you should chapter, you should

be able to:be able to:

After reading this After reading this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinuedContinuedContinued

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Explain and illustrate activity-based management.

Prepare ABC-formatted income statements.

ObjectivesObjectivesObjectivesObjectives

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The Traditional ApproachThe Traditional ApproachThe Traditional ApproachThe Traditional Approach

A company makes two products, A and B, and uses machine hours as its cost driver.

Machine hours per unit 2 4

Total units 100,000 25,000

Total hours 200,000 100,000 300,000

Total overhead cost $900,000

A B Total

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The overhead rate is $3 ($900,000 ÷ 300,000), and the allocations of overhead to products are:

Total hours 200,000 100,000 300,000

Rate x $3 x $3 x $3

Total overhead $600,000 $300,000 $900,000

A B Total

The Traditional ApproachThe Traditional ApproachThe Traditional ApproachThe Traditional Approach

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Activity-Based Costing ApproachActivity-Based Costing ApproachActivity-Based Costing ApproachActivity-Based Costing Approach

Volume is one major driver, measured either in output (units produced) or input (labor hours, machine hours, etc.)

Accountants today recognize two other major influences on cost, complexity and diversity of operations.

ABC is concerned with resource consumption.

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MultiBrick makes 10,000,000 total bricks, but in a dozen

colors, four textures, and eight sizes/shapes, a total of 384

possibilities. The firm mixes and bakes 10 to 18 batches of

bricks per day. MultiBrick sells to over 1,000 customers whose

orders typically include 15 to 20 different kinds of bricks.

MultiBrick Cost Determination Data

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Total manufacturing overhead $800,000

Total output 10,000,000 bricks Model A-42 Model A-88 Model C-11

Total production 6,000 4,000 100,000

Material cost per brick $0.05 $0.04 $0.03

Direct labor cost per brick $0.06 $0.07 $0.04

Overhead rate = $800,000 ÷ 10,000,000 = $0.08 per brick


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Cost calculations: Model A-42 Model A-88 Model C-11


Direct labor cost per brick 0.06 0.07 0.04

Overhead cost at $0.08 0.08 0.08 0.08

Total unit cost $0.19 $0.19 $0.15


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Activity-Based Costing TermsActivity-Based Costing TermsActivity-Based Costing TermsActivity-Based Costing Terms

A cost object refers to whatever segment for which you are estimating the cost.

Examples: Products, customers, geographical areas, and channels of distribution

Cost drivers are activities that cause costs.Examples: Sales, production, number of

products, and number of customers.

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Resource Driver refers to activities that drive resource requirements, and therefore drive costs.

Examples: People, machinery, space, and utilities

An activity driver relates resource-driving activities to products, customers, geographical areas, or other segments of interest.

Activity-Based Costing TermsActivity-Based Costing TermsActivity-Based Costing TermsActivity-Based Costing Terms

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MultiBrick Data for Illustration

Total AmountResource Driver Costs in Pool of Driver RateSetups $120,000 10,000 setups $12

Baking time 600,000 300,000 hours $2

Customer orders 80,000 5,000 orders $16

Total cost $800,000

÷

÷

÷

=

=

=

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Activity Data per Year

Model A-42 Model A-88 Model C-11

Number of setups 150 180 30

baking time, hours 60 50 300

Number of customer orders 30 40 20

Costs, excluding overhead


Direct labor cost per brick 0.06 0.07 0.04


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ABC Analysis of Bricks

Material cost $ 300$ 160$ 3000

Direct labor cost 360280 4000

Overhead:

Setup-based 1,8002,160 360

Baking time 120100 600

Customer order based 480 640 320

Total Cost $3,060$3,340$ 8,280

Divided by annual volume 6,000 4,000 100,000

Average cost per brick $ 0.51$0.835$ 0.083



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Comparison of Traditional Costs and Comparison of Traditional Costs and Activity-Based CostsActivity-Based Costs


Traditional Cost Approach:

Material cost $ 300 $160 $ 3000

Direct labor cost 360 280 4000

Overhead 480 320 8,000

Total cost $1,140 $760 $15,000


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Activity-Based Cost Approach:

Material cost $ 300 $ 160 $ 3000

Direct labor cost 360 280 4000

Overhead 2,400 2,900 1,280

Total cost $3,060 $3,340 $8,280


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Consumption RatiosConsumption RatiosConsumption RatiosConsumption Ratios

Consumption ratios is the resource utilized by a given product divided by the total amount of the resource available.

Since MultiBrick is producing a total of 10,000,000 bricks, the consumption ratio of each model is:

Model A-42: 6,000 bricks ÷ 10,000,000 = 0.06%

Model A-88: 4,000 bricks ÷ 10,000,000 = 0.04%

Model C-11: 100,000 bricks ÷ 10,000,000 = 1.00%

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Consumption RatiosConsumption RatiosConsumption RatiosConsumption Ratios

Model A-42: 150 setups ÷ 10,000 total = 1.50%

Model A-88: 180 setups ÷ 10,000 total = 1.80%

Model C-11: 30 setups ÷ 10,000 total = 0.30%

Model A-42: 60 hours ÷ 300,000 total = 0.0200%

Model A-88: 50 hours ÷ 300,000 total = 0.0167%

Model C-11: 300 hours ÷ 300,000 total = 0.1000%

Model A-42: 30 orders ÷ 5,000 total = 0.60%

Model A-88: 40 orders ÷ 5,000 total = 0.80%

Model C-11: 20 orders ÷ 5,000 total = 0.40%

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Who Uses ABC?Who Uses ABC?Who Uses ABC?Who Uses ABC?

• Productive/Service Costing 58%

• Process Analysis 51%

• Performance Management 49%

• Profitability Assessment 38%

• Value-Based Management 18%

Primary Objective

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Who Uses ABC?Who Uses ABC?Who Uses ABC?Who Uses ABC?

• Public Sector

40%

• Service

24%

• Manufacturing

24%

• Consulting

11%

Industry

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Kinds of VariabilityKinds of Variability

1. Unit level activities2. Batch level activities3. Sustaining activities4. Facility-sustaining or company-

sustaining activities

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Types of Activities (continued)Types of Activities (continued)

Unit level activities are those performed each time a unit is produced or sold.

Examples: Materials, components, drilling and welding

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Batch level activities are those that a company performs when it makes a group of units, regardless of how many units are in the batch.

Example: Machine setups


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Sustaining activities arise because a company does particular types of business, or maintains a particular product or service.

Examples: Advertising devoted to the product, engineering and development related to the product.


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Facility-sustaining or company-sustaining activities and costs relate to an entire plant, office, or company as a whole.

Example: Rent of the corporate headquarters building


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ABC and EthicsABC and EthicsABC and EthicsABC and Ethics

Because some costs are on the borderline between being direct or indirect to a product or line, managerial accountants must use some judgment in assigning costs to products. Whenever decisions involve judgment, the potential for an ethical conflict exists.

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Activity-Based Management Activity-Based Management (ABM)(ABM)


Activity-Based Management (ABM) is using information about activities to

manage many aspects of an organization, rather than simply managing costs.

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Re-engineering describes the development of new ways to perform existing activities and ways to stop performing non-value-adding activities.

Benchmarking is the practice of comparing your company with some of the industry leaders.

Process value analysis (PVA) uses activity analysis to manage costs. PVA focuses on manufacturing processes and seeks to reduce or optimize the activities performed within a process.



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Process Value Analysis (PVA)Process Value Analysis (PVA)Process Value Analysis (PVA)Process Value Analysis (PVA)

PVA focuses on manufacturing processes and seeks to reduce or optimize the activities

performed within a process.

Value-added: An operation that actually changes the physical aspects of the part.

Examples: Turning, milling, and drilling

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Non-Value-added, but necessary: An operation/activity that does not change the physical aspects of the part, but is necessary in order to do so.

Examples: Setup time and inspecting

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Non-Value-added, and unnecessary: An activity that does not changes the physical aspects of the part and is not necessary for value added operations to be performed.

Examples: Queue time

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ABC/ABM and World-Class ABC/ABM and World-Class ManufacturingManufacturing

ABC/ABM and World-Class ABC/ABM and World-Class ManufacturingManufacturing

ABC is most beneficial for companies with a great deal of complexity and

diversity in their products and operations.

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ABC/ABM Analysis and ABC/ABM Analysis and Income ReportingIncome Reporting

ABC/ABM Analysis and ABC/ABM Analysis and Income ReportingIncome ReportingPatterson Homewares, Inc.

Income Statement for 20X2, in thousandsFlooring Tile Carpet Total

Sales $300.4 $503.5 $623.3 $1,427.2Unit-level variable costs 190.1 161.1 249.3 600.5Unit-level C/M $110.3 $342.4 $374.0 $ 826.7Batch-level variable costs 9.6 26.4 52.8 88.8Batch-level C/M $100.7 $316.0 $321.2 $ 737.9Product-sustaining costs 89.2 56.7 73.7 219.6Product margin $ 11.5 $259.3 $247.5 $ 518.3Facility-sustaining costs 220.5Income $ 297.8

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The EndThe End

Chapter 4Chapter 4

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4-1 Activity- Based Costing and Management Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University 4