ACTIVITY-BASED COSTING

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Ankur Verma Abhinav Parmar Arvinderpal

ACTIVITY BASED COSTING

Traditional costing system 1. Direct and indirect costs are allocated to process centres or major departments

ABC System 1. The direct and indirect costs are allocated to activities like Purchases, Material handling, Producing the goods, machine set ups, Supervising production workers, Inspecting finished goods, Dispatching good to customers 2.Cost driver as base for allocation of overheads is based on cause and effect relationship between overheads and the overhead allocation base (the cost driver) Stores deptt Labour hours or machine hours or units produced 3. There are many allocation bases as per activity chosen and cause and effect base relationship1-2

2. Cost driver as base for allocation of overheads is not based on cause and effectrelationship

3. There is only one cost driver Or OH allocation

Traditional, Volume-Based Product-Costing System Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records:Mode I Production: Units Runs 10,000 1 run of 10,000 units Mode II 20,000 4 runs of 5,000 units Mode III 4,000 10 runs of 400 units1-3

Traditional, Volume-Based Product-Costing SystemAdditional information includes:

Direct materials Direct labor

Mode I Mode II Mode III $ 50.00 $ 90.00 $ 20.00 60.00 80.00 40.00

Budgeted manufacturing overhead $3,894,000Mode I Mode II Mode III $ 50.00 $ 90.00 $ 20.00 3 4 2 10 10 10 1 1.25 21-4

Direct materials Direct labor (hr/board) Setup time (hr/run) Machine time (hr/board)

Manufacturing overhead is determined as follows

Traditional, Volume-Based Product-Costing SystemUnits produced Direct labor (hr/unit) Total hours Total hours required Mode I 10,000 3 30,000 Mode II 20,000 4 80,000 118,000 Mode III 4,000 2 8,000

Budgeted manufacturing overhead Budgeted direct-labor hours

$3,894,000 118,000

= $33 per hour

Mode I Direct labor (hr/unit) Overhead rate per hour Overhead per unit $ $ 3 33 $ 99 $

Mode II 4 33 $ 132 $

Mode III 2 33 661-5

Traditional, Volume-Based Product-Costing SystemWith these product costs, Aerotech established target selling prices (Cost 125%).Direct materials Direct labor Manufacturing overhead Total $ Mode I Mode II Mode III 50.00 $ 90.00 $ 20.00 60.00 80.00 40.00 99.00 132.00 66.00 209.00 $ 302.00 $ 126.00

$

Cost per unit Target selling price

$

Mode I 209.00 261.25

Mode II $ 302.00 377.50

Mode III $ 126.00 157.50

209.00 x 1.251-6

Activity Based Costing System(ABC)ABC systems follow a twostage procedure to assign overhead costs to products.

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Activity Based Costing System(ABC)ABC systems follow a two-stage procedure to assign overhead costs to products.

Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.1-8

Activity Based Costing System(ABC)ABC systems follow a two-stage procedure to assign overhead costs to products.

Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products.1-9

ABC System1. Identify major activitiesactivity consists of aggregation of tasks having common characteristics) e.g. Activity: purchase of materials :Tasks: receiving a purchase request, inviting quotations, selecting supplier, placing orders, receiving material

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2. Assigning costs to Activity Cost Centers:Cost incurred on these activities are assigned to these Activity Cost Centers. Direct costs are traced directly. Indirect costs are assigned to activities on the basis of cause and effect cost drivers.

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There must be a cause - effect relationship between the overheads to be allocated and the allocation base otherwise inaccurate allocation of overheads will occur. For an example, it would be wrong to allocate overheads of stores dept. on the basis of labor hours. It should be more appropriately based on number of units handled or used in production process.

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3. Selecting cost drivers for allocating costs to cost objectsThe costs accumulated for an activity cost centre are then allocated to different cost objects. For this, a separate activity cost driver or allocation rate is used.

In ABC analysis, the tracing of overheads to cost objects requires that cost behavior must be understood so that appropriate cost drivers are identified.

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Identifying activities and cost driversdepends upon type of activity, Volume related or not volume relatedMajor activity 1. Processing orders for Purchase of materials/ Stores Associated costs Cost drivers 1. No. of purchase orders processed

1. Labor cost of employees working in purchase dept. 2. Handling materials and 2. Labor cost of Parts stores, depreciation of machines used for moving materials 3. Inspection of material and 3. Labor cost of parts purchased inspection team, Depr. Of testing equipments 4. Setting up production 4. Labor cost of procedures works involved in setups and depr. of set up equipments

2. No. of materials and parts requisitions

3. No. of receipts of materials and parts

4. No. of set ups

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Identifying activities and cost driversDepends upon type of activity, Volume related or not volume relatedMajor activity 5. Producing the goods Associated costs 5. Depreciation of machines Cost drivers 5. No. of machine hours

6. Supervising production workers

6. Salary of assembly 6. No. of assembly supervisors labor hours

7. Inspecting finished goods 7. Labor cost of inspectors and depreciation of test equipments8. Dispatching good to customers 8. Labor cost of packing and cost of Packing materials

7. No. of inspections

8. No. of boxes packed

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Two Key PointsA large proportion of nonunit-level activities A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately. Product diversity When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs.

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Cost DriversA characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .Degree of Correlation Cost of Measurement1-17

Behavioral Effects

Direct versus Indirect CostsVolume-Based Costing Activity-Based Costing All production costs An effort is made to except direct account for as many materials and direct costs as possible as labor are lumped direct costs of together in one production. overhead cost pool.Indirect Costs1-18

Interviewing and Paper TrailsThe information for ABC systems initially comes from interviews with employees in the support departments and a review of each departments records.

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StoryboardingA procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities.Step 1 Step 2 Step 3 Step 4

These are the steps we follow to build a memory board.

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Machinery cost pool

MaintenanceDepreciation Computer Support

LubricationElectricity Calibration

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Engineering cost poolEngineering salaries Engineering supplies Engineering software Depreciation

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Facility cost poolPlant depr. Plant mgmt. Plant maint. Property taxes Insurance Security

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Overhead CostsTotal budgeted cost = $3,894,000Activity must be done on each unit produced.

Activity Cost Pools

Identification of Activity Cost Pools

Unit LevelMachinery cost pool $1,212,600Activity performed on each batch produced.

Batch LevelSetup cost pool $3,000

ProductSustaining LevelEngineering cost pool $700,000

Facility LevelFacility cost pool $507,400

Activities needed to support an entire product line

Activity required in order for the production process to occur.

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Unit Level Machinery cost pool $1,212,600

Batch Level Setup cost pool $3,000 Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000

ProductSustaining Level Engineering cost pool $700,000

Facility Level Facility cost pool $507,400

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STAGE ONEVarious overhead costs related to machinery

Maintenance Depreciation Computer Support

Lubrication Electricity Calibration

Activity cost pool

Machinery Cost PoolTotal budgeted cost = $1,212,600

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STAGE TWOCalculate the pool rateBudgeted Machinery Costs = $1,212,600 Budgeted Machine Hours 43,000 = $28.20/hour

Cost Assignment

Mode I: $28.20 per hr. 1 hr. per unit $28.20 per unit

Mode II: $28.20 per hr. 1.25 hr. per unit $35.25 per unit

Mode III: $28.20 per hr. 2 hr. per unit $56.40 per unit1-27

STAGE ONECalculation of total setup costTotal budgeted setup cost $20 per hour 10 hr. per setup $200 cost per setup 15 production runs $ 3,000 Total

Activity cost pool

Setup Cost PoolTotal budgeted cost = $3,000

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STAGE TWOCalculate the pool rateBudgeted Setup Costs Planned Production Runs = $3,000 15 runs = $200 per run

Cost Assignment

Mode I: (1 Run) $200 per run 10,000 units per run = $.02 per unit

Mode II: (4 Runs) $200 per run 5,000 units per run = $.04 per unit

Mode III: (10 Runs) $200 per run 400 units per run = $.50 per unit1-29

STAGE ONEVarious overhead costs related to engineeringEngineering salaries Engineering supplies Engineering software Depreciation

Activity cost pool

Engineering Cost PoolTotal budgeted cost = $700,000

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STAGE TWOAllocate based on engineering transactions

Engineering Cost PoolTotal budgeted cost = $700,000

Cost Assignment

Mode I: 25% $700,000 10,000 units = $17.50 per unit

Mode II: 45% $700,000 20,000 units = $15.75 per unit

Mode III: 30% $700,000 4,000 units = $52.50 per unit1-31

STAGE ONEVarious overhead costs related to general operationsPlant depr.Plant mgmt. Plant maint.

Exh. 5-9

Property taxesInsurance Security

Activity cost pool

Facility Cost PoolTotal budgeted cost = $507,400

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STAGE TWOCalculate the pool rateBudgeted Facilities Cost = $507,400 Budgeted Direct-Labor Hours 118,000 = $4.30/hour

Exh. 5-9

Cost Assignment

Mode I: $4.30 per hr. 3 hr. per unit $12.90 per unit

Mode II: $4.30 per hr. 4 hr. per unit $17.20 per unit

Mode III: $4.30 per hr. 2 hr. per unit $8.60 per unit1-33

Other Overhead CostsRe c e ivin g an d In s pe c t ion Cos t P oolBoard Mode I Mode II Mode III Ove rh e ad $ 200,000 200,000 200,000 % 6% 24% 70% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 1.20 = 2.40 = 35.00

Mat e rial-Han dlin g Cos t P oolBoard Mode I Mode II Mode III Ove rh e ad $ 600,000 600,000 600,000 % 7% 30% 63% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 4.20 = 9.00 = 94.50

Qu alit y-As s u ran c e Cos t P oolBoard Mode I Mode II Mode III Ove rh e ad $ 421,000 421,000 421,000 % 20% 40% 40% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 8.42 = 8.42 = 42.10

P ac kagin g an d Sh ippin g Cos t P oolBoard Mode I Mode II Mode III Ove rh e ad $ 250,000 250,000 250,000 % 4% 30% 66% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 1.00 = 3.75 = 41.251-34

Other Overhead CostsRe c e ivin g an d In s pe c t ion Cos t P oolBoard Mode I Mode II Mode III Ove rh e ad $ 200,000 200,000 200,000 % 6% 24% 70% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 1.20 = 2.40 = 35.00

Mat e rial-Han dlin g Cos t P ool

$14.82

Board Mode I Mode II Mode III

Ove rh e ad $ 600,000 600,000 600,000

% 7% 30% 63%

Un its 10,000 20,000 4,000

= Cos t/Un it = $ 4.20 = 9.00 = 94.50

Qu alit y-As s u ran c e Cos t P oolBoard Mode I Mode II Mode III Ove rh e ad $ 421,000 421,000 421,000 % 20% 40% 40% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 8.42 = 8.42 = 42.10

P ac kagin g an d Sh ippin g Cos t P oolBoard Mode I Mode II Mode III Ove rh e ad $ 250,000 250,000 250,000 % 4% 30% 66% Un its 10,000 20,000 4,000 = Cos t/Un it = $ 1.00 = 3.75 = 41.251-35

Product Cost from ABCThese are the new product costs when Aerotech uses ABC.Mode I Direct materials $ 50.00 Direct labor 60.00 Machinery Setup Engineering Facilities Other Total Mode II $ 90.00 80.00 Mode III $ 20.00 40.00

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Product Cost from ABCThese are the new product costs when Aerotech uses ABC.Mode I Direct materials $ 50.00 Direct labor 60.00 Machinery 28.20 Setup 0.02 Engineering 17.50 Facilities 12.90 Other 14.82 Total $ 183.44 Mode II $ 90.00 80.00 35.25 0.04 15.75 17.20 23.57 $ 261.81 Mode III $ 20.00 40.00 56.40 0.50 52.50 8.60 212.85 $ 390.851-37

Distorted Product CostsBoth original and ABC target selling prices are based on (Cost 125%).Mo de I Mo de II Tra dit io n a l co s t in g $ 209.00 $ 302.00 ABC co s t in g 183.44 261.81 u n it s 10,000 20,000 To t a l co s t s Tra dit io n a l ABC Mo de III To t a l $ 126.00 390.85 4,000

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Distorted Product CostsBoth original and ABC target selling prices are based on (Cost 125%).Mo de I Tra dit io n a l co s t in g209.00 $ AB C co s t in g u n it s Tra dit io n a l AB C 183.44 10,000 To t a l co s t s 2,090,000 1834400 6,040,000 504,000 8634000 8634000 5236200 1563400 Mo de II Mo de III To t a l $ 302.00 261.81 20,000 $ 126.00 NA 390.85 n a 4,000 n a

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Distorted Product CostsBoth original and ABC target selling prices are based on (Cost 125%).Tra dit io n a l co s t in g ABC co s t in g Origin a l t a rget s ellin g p rice ABC t a rget s ellin g p rice Mo de I $ 209.00 183.44 Mo de II $ 302.00 261.81 Mo de III $ 126.00 390.85

.

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Distorted Product CostsBoth original and ABC target selling prices are based on (Cost 125%).Tradition al cos tin g ABC cos tin g Origin al targe t s e llin g price ABC targe t s e llin g price Mode I $ 209.00 183.44 261.25 229.30 Mode II $ 302.00 261.81 377.50 327.26 Mode III $ 126.00 390.85 157.50 488.56

The selling price of Mode I and II are reduced and the selling price for Mode III is increased.[$209.00 1.25] [$183.44 1.25]1-41

Distorted Product CostsCan you identify any problems Aerotech is likely to face as a result of this distortion?Mode I Tradition al cos tin g $ 209.00 ABC cos tin g 183.44 Cos t dis tortion pe r u n it 25.56 Un its produ ce d 10,000 Total cos t dis tortion 255,600 Mode II $ 302.00 261.81 40.19 20,000 803,800 Mode III $ 126.00 390.85 (264.85) 4,000 (1,059,400)

Traditional costing understates the cost of complex, low volume products.1-42

Indicators of Need for ABCDirect labor is a small percentage of total costs Product-line profit margins are hard to explain

Sales are increasing, but profits are declining.

Line managers do not believe the product costs reportsSome products that have reported high profit margins are not sold by competitors1-43

Marketing does not use costs reports for pricing decisions

The use of ABC costing information to help management make decisions1-44

Activity-based costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs. Activity-based management focuses on managing activities to reduce costs.

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Activities

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Cost Assignment View

Resource costs

Activities

Cost Objects1-47

Cost Assignment View

Resource costsProcess ViewActivity Analysis Activity Evaluation

Root Causes

Activity Triggers

Activities

Performance Measures

Cost Objects1-48

Activities

Nonvalueadded activities UnnecessaryReduce or Eliminate

NecessaryContinually Evaluate and Improve1-49

1. Identify Activities.

2. Identify Non-Value-Added Activities.3. Understand Activity Linkages, Root Causes,

and Triggers.Specify parts Select vendor Receive parts Produce goods Inspect finished goods Rework defective products

4. Establish Performance Measures. 5. Report Non-Value-Added Costs.1-50

Process time

Inspection time

Storage time

Move time

Waiting time1-51

Customer profitability analysis uses activity-based costing to determine the activities, costs, and profit associated with serving particular customers.

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Required special packaging. Orders small quantities. Demand fast service.

Often changes orders.

Orders frequently.

A costly customer1-53

Customer-Related Activities Order processing Sales contacts (phone calls, faxes, etc.) Sales visits Shipment processing Billing and collection Design/engineering change orders Special packaging Special handling

Cost Driver Base Purchase orders Contacts Visits Shipments Invoices Design changes Units packaged Units handled

Cost Drive Rate $ 150 100 1,000 200 160 4,000 40 60

A company may use these customer related costs to help determine the profitability of each customer.1-54

No materials are purchased and no products are manufactured until they are needed.

The primary goal of a JIT production system is to reduce or eliminate inventories at every stage of production.

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Smooth, uniform production ratePull method of production

Purchase is small lot sizesQuick, inexpensive setups

High quality materialsEffective preventive maintenance

TeamworkMultiskilled workers1-56

Long-term contracts with suppliers.

Only a few suppliers.

Parts delivered in small lots.

Grouped payments to vendor.

Minimal inspection of materials.1-57

Activity based costing in service industry As useful as in mfg. industry Mangers want more detailed and accurate information about the cost of producing products and services they are selling Airlines, ins co, banks, hospitals, fin service firms, hotels railroads, Air France, American express, Bank of America, DHL, Fed Ex, US postal service1-58

ABC at service companies: Identifying Activities Activity cost pools Cost drivers Classification of activities at Unit level : batch level, product sustaining level, facility (general operations) level1-59

Bajaj Allianze General Insurance Co. Ltd Claims Department Classification of activities at Unit level : Entering initial claim into computer batch level: moving a batch of claims from one processing step to the next product sustaining level: maintenance of the medical service provider network ( physicians, hospitals ) facility (general operations) level: general administration of claims business unit1-60

ABC at Delaware medical centre (Primary Care Unit- OPD) Patient Appointment New routine extended complex Continuing routine extended complex Every appointment needs Regd. nurse 1 : vital signs/preparing patient for Primary health care professional PHCP 1: physician / intern / resident doctor or nurse practitioner1-61

ABC team identified : Activities Physician time Practitioner nurse time Intern or resident time Regd. Nurse time Clerical time: new patients Clerical time : continuing Billing Facility

cost drivers Physician minutes with patient P-Nurse minutes with patient Intern minutes with patient Regd. Nurse minutes with patient New patient visits Continuiing patient visits Billing lines (items on a bill) Patient visits (both new and continuing)

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Activity : physician time Cost driver : physician minutes with patient Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 960000 240000 4 R 80000 320000 8000 $40 E 100000 400000 5000 $80 C 60000 240000 2000 $120

Activity Nurse Practitioner time Cost driver : NP minutes with patient Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 90000 30000 3 R 12000 36000 1200 $30 E 10000 30000 500 $60 C 8000 24000 320 $751-63

Activity : intern or resident time Cost driver : intern or resident minutes with patient Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 412500 125000 3.30 R 40000 132000 4000 $33 E 50000 165000 2500 $66 C 35000 115500 1000 $115

Activity : Rgd. nurse time Cost driver : RN minutes with patient Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 281980 245200 1.15 R 132000 151800 13200 $11.50 E 80000 92000 8000 $11.50 C 33200 38180 3320 $11.501-64

Activity : Clerical time new patients Cost driver : New patients number Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 135300 12300 11.00 R 7200 79200 7200 $11 E 3000 33000 3000 $11 C 2100 23100 2100 $11

Activity : Cleical time continuing patients Cost driver : cont. patients number Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 61100 12220 5.00 R 6000 30000 6000 $5 E 5000 25000 5000 $5 C 1220 6100 1220 $51-65

Activity : Billing Cost driver : Billing lines on a bill Cost cost driver rate PV driver pool qty Type qty 38480 76960 0.50 R 26400 E 24000 C 26560

activity cost 13200 12000 13280

no. of visits 13200 8000 3320

activity cost /p $1.00 $1.50 $4.00

Activity : Facility Cost driver : number of new plus cont. patients visits Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 245200 24520 10.00 R 13200 132000 13200 $10 E 8000 80000 8000 $10 C 3320 33200 3320 $101-66

Costing of service 1. Each patient sees either a physician or PN or intern or resident not all four 2. each patient is either a new patient or a continuing patient and not both. 3. to compute cost of particular appointment, we should select only one of primary health care professionals, and select one of the two clerical time categories new or continuing. 4. finally since every appointment involves RN , billing, and use of primary care unit facility, all of these activities must be included in the cost calculation.1-67

Cost of extended appointment for a new patient seeing a nurse practitioner Activity Cost Nurse practitioner time RN time Clerical time new patients Billing Facility

Total

94.001-68

Cost of extended appointment for a new patient seeing a nurse practitioner Activity cost Nurse practitioner time 60.00 RN time 11.50 Clerical time new patients 11.00 Billing 1.50 Facility 10.00

Total

94.001-69

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