Activity Based Cost

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Management Accounting

2010

Second semesterTakayuki Asada

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Chapter4 Activity-Based Cost Systems

After reading this chapter,you will be able to:1)Understand how volume-based cost systems dostort product

and customer costs.

2)Describe why companies producing a more varied and complex

mix of products have higher costs than companies producingonly a narrow range of products.

3)Design a traditional activity-based cost system that links

resource costs to the activities the organization performs and

then from the activities to cost objects,such as products andcustomers.

4)Use the information from an activity-based cost system to

improve operations and to make better decisions about

products and customers. 2



5)Understand the importance of measuring the practical capacity of resources and the cost of unused capacity.

6)Build a time-driven activity-based cost system that is simpler and thatcaptures more complexity than a traditional activity-based cost system.

7)Assign marketing ,distribution,and selling expeses to customers

8)Analyze and manage customer profitability.

9)Appreciate the role for activity-based cost systems for service companies.

10)Discuss the barriers for implementing activity-based cost systems and howthese might be overcome.

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Short caseJonathan Kellogg,ower and chief executive officer

1) He（Owner） was concerned about the recent decline of profitability of hisdelershop.

2) Booth Motors(his company) was a major Ford dealer in the Midwest.

3) Many car models are stocked and stayed in his lot for months.

4) His company had four related lines of business:used cars,parts,service,and

finance and insurance.

6) He still wondered how much each of these business lines contributed to

dealership profitability.

7) He wanted to understand much better the “economic facts” about delershop.

8)It(his accounting systems) reported the revenues for each of the five productlines and assigned the $48 million in directly attributed costs to each line.

9)The $5.4million of operating expense was allocated to each department on

the basis of sales

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1.Traditional Manufactuirng Costing Systems

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An example of the problems of simple cost accounting systems,consider themanufactuirng plant of the Ericson Ice Cream Company.

Exhibit 4-1 Total and product profitability ,Ericson Ice Cream

.

Vanilla Chocolate Strawberry Mocha-

Almond

Total

Production and sales

volume(000)

Unit selling Price

Sales(000)

Material costs(000)

Direct labor(000)

Overhead at 300%Total factory expenses

Gross margin

Gross Margin(%)

Marketing,selling,

Distribution Adm.

Operating profit(loss)

500

$ 4.50

$2,250

750

300

9001,950

$309

13.3%

400

$4.50

$1,800

600

240

7201,560

$240

13.3%

90

$4.65

$418.5

140.4

54

162356.4

$62.1

14.8%

10

$4.95

$49.5

16.5

6

1840.5

$9

18.2%

1,000

$4,518

1,506.9

600

1,8003,906.9

$611.1

13.5%

$ 900.0

($288.9)



Production process of Ice cream products:Ice cream production at the Ericson factory involved preparing

and mixing the ingredients for each flavor in large vats. In a

subsequent stage ,the ice cream mix was packaged into

containers using semiautomatic machines. A final package and

shipping stage was performed manually.

Problem of caluculating overhead:

Ericson’s indirect expenses(about $1.8 million per quarter)were

comprised of the following:

The plant’s indirect expenses($1.8million) were allocated into

products on the basis of each product ‘s direct labor cost.

The cost system’s current overhead rate was 300% of direct labor

cost.

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2.Limitations of Ericson’s Traditional Cost

systems

But ,the Eriricson production environment has

changed.Because of automation,direct labor costs

have decreased and indirect expenses increased.

Erricson ‘s traditional cost sytem is adequate

for the financial for the financial reporting

role of inventory evaluation.

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3. Vanilla Factory and Multiflavor Factory

1) In an Environment of high production variety,

the exclusive use of unit-level drivers

allocates overhead costs leads to product

cost distortion.

2) In a typical year, the multi-flavor factory

produces about 2,500 different

SKUs(Stockkeeping Units),ranging fromspeciality flavors and packages,with annual

production volumes as low as a50 to 100

gallons per year. 8



3) If possible ,you would use the traditonal costing

systems,you could not make clear that the variety of multi-products and the low-volume effects for

production costs are not able to be traced into each

products cost.

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.

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4.Activity –based Cost systems1) Activity-based cost(ABC) systems typically use a simple two-stageapproach similar to but more general than traditional costing system.

2) ABC systems use, instead of using cost centers, activites foraccumulating costs. The design of an ABC system starts by asking whatActivities are being performed by a department’s resources.

Tracing Costs to Activities(p.139)

3)The employees in charge of indirect labor are doing three kinds of activities.Handle production runs:50% of such labor hours are involved in

scheduling productions orders.Set-up machine:40% of these are the physical handle production runs.Support products:10% of these hours are maintained records on the four

flavors

4)Laura Tunney ,controller made the first two steps of designing ABC.1: Develop the activity dictionary

2:Obtain the sufficient information to assign resource expenses to eachactivity.



5)The remaining overhead costs is:

Expenses----computer system, machine

depreciation, machine maintenance, the

energy to operate the machines

Tunny noted the three different level of the

manufacturing cost hierarchy.

P.140

11

Activity Cost Hierarchy

Run MachinesHandle production run

Set up machines

Support products

unit levelBatch level

Batch level

Product sustaining



Finding at least one activity for each hierarchy level

gave her(Controller) confidence that the complexity

of the manufacturing process could be representedwell enough by the activity-based cost system.

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Handle

Production

runs

St-up

machines

Support

Products

Run

Machines

Total

expense

Indirect labor

(plus 40% fringe

benefits)

Computer

expense

Machinedepreciation

Maintenace

Energy

Activity

Expense

50%

80%

660,000

40%

336,000

10%

20%

144,000

100%

100%

100%

420,000

840,000

300,000

240,000

120,000

60,000

1,560,000



6)Now she saw only categories of expenses ,such as the

company’s spending on computers,energy,and

indirect labor.

In the past: industrial engineers have studied labor andmaterials usages

In the present: we try to focus the activities of handlingproduction runs and setting up machine.

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Tracing Costs from activities to Products(p.141)

1)Now she try to see the quantity required of eachactivity by each of the four products.

2)This knowledge would permit her to relate the

activity costs to each flavor(each product).

3)Activity cost drives:represent the quantity of

activities used to produce individual products.

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Activity Activity cost driver

Handle production runs

Set up machines

Support products

Run Machines

Production runs

Setup hours

Number of products

Machine Hours



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Activity cost

drivers

vanila chocolate strawberry Mocha Total

Directlabor/unit

Machine

hour/unit

Productions

runs

Setup time/run

Total setup time

Number of

products

0.012

0.012

700

4

2,800

1

0.02

0.012

650

2.4

1,560

1

0.02

0.012

500

5

2,500

1

0.02

0.012

150

7.6

1,140

1

20,000

12,000

2,000

8,000

4

Exhibit 4-4 Activity cost dirives

E hibit 4 7 ti it b d ti



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Exhibit 4-7 activity-based costingproduct profitability report(000)

Vanilla Chocolate Strawberry Mocha total

Sales

Material costs

Direct labor

Contribution

Margin

40% fringe

on direct

Labor

Handle

production run

Set up

machines

Supportproducts

Run machine

Total overhead

Gross margin

(%)gross margin

MSDAOperating profit

2,250

750

300

1,200

120

231

117.6

36

210

714.6

485.4

21.6%

1,800

600

240

960

96

214.5

65.52

36

168

580.02

379.98

21.1%

418.5

140.4

54

224.1

21.6

165

105

36

37.8

365.4

(141.3)

(33.8%)

49.5

16.5

6

27

2.4

49.5

47.88

36

4.2

139.8

(112.98)

(228.2)%

4,518

1506.9

600

2,411.1

240

660

336

144

420

1,800

611.1

13.5%

900.0(288.9(



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Exhibit4-8a and b



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The result from the ABC system were quite different from the results usingthe Traditional cost system shown in Exhibit 4-1. Tunny(controller) now understood why the profitability of Ericson had

deteriorated in recent years. The two speciality products, which the previouscost system had reported as the most profitable were in fact the mostuprofutable and were losing lots of money.

Activity-Based Management

Activity based management refers to the actions managers take,onthe basis of an ABC study,to improve the efficiency of the activities andthe profitability of products.1) Pricing change for unprofitable products2) Making more efficiency in the process of set-up and handling of

products.

3) Designing changes of some products4) Change of minimum order size of unprofitable runs



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Time-Driven Activity-Based Costing

The common approach to activity-based costing, assigns many resourceexpenses to activities on the basis of interviews and surveys, As noted

earlier,this approach is time consuming,expensive ,often inaccurate,and difficultto update. The time-diriven activity –based costing requires that only twoparameters be estimated:

1. The unit cost of supplying capacity for each department or process2. The consumption of capacity (unit times) by each transaction or product

Unit cost estimate The cost of resources that supply capacity The Practical capacity of the resources suppliedcase :Indirect labor costs and resource

indirect labor cost per hour= $840,000/ 20,000 hours = $42 per hourUnit time estimate

The second piece of new information is an estimate of the time used on aresource when an activity is performed.



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At the first glance, it may be difficult to appreciate the difference betweentraditional and time-driven ABC. But, in the time-driven approach,theABCproject team directly observes the quantity of time required to schedule aproduction run and to set up machines for different products.1) Further advantage of TDABC, the ease of updating a time-dirivenABC

model to reflect changes in operating conditions.

2) Managers can also easily update the cost dirves rates.

3) The cost driver rates change when there has been a shift in the efficiency of

the activity,such as when employees get more edfficientat scheduling orperformaingchageovers.



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Time equations

Time Driven ABC accomodates the complexity of real-world operationswith time equations,a new feature that enables the modelto reflect how particular order and activity characteristicscause processing times to vary.

Rather than the standard 5 hours for all the activitiesrequired to scheduleand excute a production run,the ABC project team mightestimate the following tme equation fot the activity handleproduction runs on the basisof how the order was received.

Indirect labor time to handle production runs= 4 hours+2 hours(of telephone order)+1 hour(if fax order)+0.2 hours (if electric order)



5. Marketing ,Selling ,Distribution ,and Adminnistrative

Expenses : Tracing Costs to CustomersExhibit 4-9 Marketing,sales,technical ,and Administrative Activities

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Activity Activity expenses Activity Cost Driver

Provide marketing and

technical support

Travel to customers

Service customers

Handle customer orders

Ship to customers

salaries and benefits of marketing and

technical support personnel

Salesperson salaries;travel and

entertainment expendituresSalaries and benefits of customer

service representatiives

Salaries and benefits of

adminisitarative and customer

support staffs to receive orders and

coordinate production to schedule

deliveries

Costs of shipping finished goods to

customers;some customers requsired

immediate,overnight delivery;others

could be seviced using low-cost

common carriers

Estimated proportion

of time spent on

each customer

Actual expenditures

Estimated quantity of

time spent on each

customer

Time equation

Combination of time

equation and actual

shipping records



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6. Managing Customer Profitablity

The output from an ABC customer analysis is oftenportrayed as a whale Curve,a plot of cumulativeprofitability versus the number of customers wherecustomers are ranked on the horizontal axis from most

profitable to least profitable. While cumulative salesfollow the usual 20-80 rule—20% of the customersprovide 80% of the sales—the whale curve forcumulative profitability typically reveals that the mostproftable 20% of customers generate between 150%

and 300% of total profits.



7.Service Companises

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Although ABC had its origins in manufactuirng companies,today many

services organizations are obtaining great benefits from this approach.

In practices,the actual construction of an ABC model is nearly identicalfor both types of companies.



8.Implementation Issues

Lack of clear business purpose

Lack of senior Management commitment

Delagating the Project to cunsultantsPoor ABC model design

Individual and organizational resistance to

changePeople feel threatened

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Summary

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This Chapter introduced activity-based cost systems for manufacturingand service companies. ABC systems drive the cost of indirect and supportresources-manufacturing resources in factories and marketing,selling,distribution,and administrative resources-to the activities ,they perform and

then to the cost objects.

To develop an ABC model, management accountants should estimateactivity cos driver rates using the practical capacity of the resourcessupplied. They should also make appropriate tradeoffs in the design of themodel,balancing the cost of more accurate measurment for more complex

Models with the benefits from the greater accuracy.

Despite the apparent attraction of increased accuracy and managerilarelevance from ABC individual and organizational resistance can arise toblock the effective use of these systems. Management accountants mustbe sensitive to the conditions that cause such resistance to arise and

devise good contermeasuress to overcome them.

Documents

Activity Based Cost