ACC3200
Activity-based Cost Management
Learning Objectives
 Calculate cost and profit under activity-based costing.
 Compare results under traditional volume based costing system
and ABC
 Describe approaches that can be used in activity-based
management
4-3
Traditional Volume-Based Cost
Systems
Because indirect costs cannot be directly traced to specific
products or services, they must be assigned or allocated
based on some other observable measure called an
allocation base or cost driver.
Indirect
Costs
$$
Cost Driver
or
Allocation Base
Individual
Products
or Services
We have used units produced or direct labor hours to assign
indirect manufacturing overhead costs to specific products.
Units produced and direct labor hours are examples of a
volume-based allocation measure.
4-4
Volume-Based Cost Systems
Assume that Toyota Motor Manufacturing Kentucky (TMMK)
produces three types of automobiles, with the following cost
and production information:
Avalon
Per Unit Cost Information
Direct Materials
Direct Labor
Manufacturing Overhead
Annual Production Information
Units Produced (in thousands)
Direct Labor Hours Per Unit
Total Direct Labor Hours (in thousands)
$
8,000
2,800
?
100
35
3,500
Camry
Hybrid
Camry
$
7,000
2,400
?
350
30
10,500
$
6,500
2,400
?
50
30
1,500
Total
500
15,500
The purpose of the cost allocation method is to assign the
indirect or manufacturing overhead costs to each product.
4-5
Volume-Based Cost Systems
The total manufacturing overhead cost for the Kentucky
plant is estimated at $3,720,000 (in thousands) per year. In
our example, this cost will be assigned to the three
products on the basis of direct labor hours. The first step is
to calculate the predetermined overhead rate.
Predetermined
Overhead
Rate
=
Estimated Total
Manufacturing Overhead Cost
Estimated Units in the Allocation Base
Predetermined
Overhead
Rate
=
$3,720,000
$15,500
=
$240 per direct labor hour
4-6
Assigning Indirect Cost to Individual
Products or Services
To assign manufacturing overhead costs to the individual
products, we multiply the $240 overhead rate by the number
of direct labor hours required for each product.
Avalon
Annual Production Information
Direct Labor Hours Per Unit
35
× Predetermined Overhead Rate
$
240
Manufacturing Overhead Per Unit
$
8,400
× Number of Units Produced (thousands)
100
Total Manufacturing Overhead
$ 840,000
Camry
Camry
Hybrid
Total
30
$
240
$
7,200
350
$ 2,520,000
30
$
240
$
7,200
50
$ 360,000
$ 3,720,000
The Camry receives the most total manufacturing
overhead cost because it is the highest volume
product and thus requires the most total direct labor
hours.
4-7
Calculate Total Manufacturing Cost
and Profitability
To compute total manufacturing cost, we need to add the
manufacturing overhead cost to the direct material and direct
labor cost, which were provided earlier on a per unit basis.
Avalon
Per Unit Cost Information
Direct Materials
Direct Labor
Manufacturing Overhead
Total Manufacturing Cost Per Unit
$
8,000
2,800
8,400
$ 19,200
Camry
Hybrid
Camry
$
7,000
2,400
7,200
$ 16,600
This analysis shows that the Avalon is the most
costly of the three models on a per unit basis. The
Camry is the next most costly model, followed by
the Camry-Hybrid.
$
6,500
2,400
7,200
$ 16,100
4-8
Calculate Total Manufacturing Cost
and Profitability
If we subtract the total manufacturing cost per unit from the
unit sales price, we get the gross margin for each product.
Remember that gross margin only takes into account the
manufacturing cost of the product, before selling and
administrative costs such as distribution fees, advertising,
dealer costs and profit, and corporate administration charges
have been deducted.
Assumed Selling Price to the Consumer
Less: Total Manufacturing Cost Per Unit
Gross Profit Per Unit
Gross Profit Margin (% of Sales)
Avalon
$ 28,000
19,200
$
8,800
31%
Camry
$ 18,000
16,600
$ 1,400
8%
Camry
Hybrid
$ 35,000
16,100
$ 18,900
54%
4-9
Activity Based Costing (ABC)
Activity Based
Costing (ABC) is
a method of
assigning indirect
costs to products
and services
based on the
activities they
require.
4-10
Stage 1: Assign Indirect Costs To
Activities
Level
Facility
level
Customer
level
Product
level
Batch
level
Unit
level
Activities
Sample Activities
Performed to support all of the
Installing and maintaining
company's products or services. equipment. Paying for
insurance, utilities, and taxes.
Performed for specific
customers.
Designing for special customer
needs. Negotiating prices for a
large customer.
Performed to support individual
product lines.
Research and development for
a new product. Special tools
used only for certain models.
Performed for a group of units
or customers all at once.
Resetting robotics for a
specific batch run for a
model being produced.
Performed for each unit or
customer (one at a time).
Installation of frame,
engine, body style, and
tires for a specific model.
4-11
Form Activity Pools and Assign
Indirect Costs to Each Pool
TMMK has identified the following cost pools:
TMMK Manufacturing Overhead Cost Pools
Machining
and
Installation
Machine
Setup
Product
Engineering
and Design
Quality
Control
4-12
Form Activity Pools and Assign
Indirect Costs to Each Pool
Recall that the total manufacturing overhead cost in our Toyota
example was $3,720,000 (in thousands). Now we must assign
this total cost to one of the four activity cost pools.
4-13
Form Activity Pools and Assign
Indirect Costs to Each Pool
The general production engineer makes $120,000 per year.
Allocation of time worked across the four activity cost pools
is as follows:
Activity Cost Pool
Machining and Installation
Machine Set-Up
Engineering and Product Design
Quality Control
Hours
Spent
800
600
200
400
2,000
÷
÷
÷
÷
Allocation
Percentage
2,000 = 40%
2,000 = 30%
2,000 = 10%
2,000 = 20%
100%
Production
Manager's
Salary
Salary
Allocation
$ 120,000 $ 48,000
120,000
36,000
120,000
12,000
120,000
24,000
$ 120,000
Since the supervisor spends 40% of his time overseeing
machining and installation activities, $48,000 (40% x $120,000)
should be assigned to that activity cost pool.
4-14
Stage 2: Assign Activity Costs to
Individual Products or Services
Select an activity cost driver for each of the activity cost pools.
A cost driver is a measure of the underlying activity that occurs
in each activity cost pool. The goal is to identify a driver that
has a cause and effect relationship with the underlying activity.
ABC systems include measures that capture something other
than the sheer volume of units produced or customers sold.
These measures are called nonvolume-based cost drivers.
Volume-Based Allocation Measures
(used in traditional cost systems)
Number of units produced
Number of direct labor hours
Number of machine hours
Direct materials cost
Nonvolume-Based Cost Drivers
(used in activity based costing)
Number of batches or setup time
Processing time per unit
Number of quality inspections
Number of design changes
4-15
Select an Activity Cost Driver for
Each Cost Pool
Machine hours will be used as the driver for the machining and
installation activity. Number of set-ups will be used as the activity
driver for the set-up activity. Engineering hours will be used as
the driver to assign engineering and design costs. Inspection
time will be used to assign quality control costs.
4-16
Assign Indirect Costs to Products or
Services Based on Activity Demands
There are two methods that can be used to assign indirect
costs to individual products or services based on their
activity requirements: activity rates or activity proportions.
The two methods are mathematically equivalent and will
provide identical results as long as there are no rounding
errors in the rates or proportions. The method used will
depend on the type of information provided and whether you
have complete information on all product or service lines.
Activity Rates
Activity Proportions
4-17
Activity Rate Method
The activity rate method is very similar to the
predetermined overhead rate computed earlier.
Activity
Rate
=
Total Activity Cost
Total Activity Driver
Total indirect costs assigned to the machining pool was
$825,000, the total machine hours required by each of the
three Toyota models is as follows:
Avalon
Machine Hours 3,000
Camry
10,500
Camry
Hybrid
1,500
Total
15,000
$825,000
Activity Rate =
= $55 per machine hour
15,000
4-18
Activity Rate Method
To assign the cost to the products, we multiply the activity
rate by the activity requirements of each individual product.
Avalon
Machine Hours
3,000
Activity Rate
$
55
Allocated to Product $ 165,000
3,000 × $55 = $165,00
Camry
10,500
$
55
$ 577,500
Camry
Hybrid
1,500
$
55
$ 82,500
Total
15,000
$
55
$ 825,000
4-19
Activity Proportion Method
Let's assign the total cost of the set-up activity ($795,000),
which will be allocated based on the number of set-ups. A set-up
occurs every time the company switches from producing one
product to another. Once the set-up activities are complete, a
production batch for that specific product is run. The batch size
is the number of units produced after each set-up.
Total Units Produced
Average Batch Size*
Number of Set-Ups
Avalon
100,000
250
400
100,000 ÷ 250 = 400
Proportion of Set-Ups
*Units per batch
Camry
350,000
1,000
350
Camry
Hybrid
50,000
200
250
Total
500,000
1,000
400 ÷ 1,000 = 40%
40%
35%
25%
100%
4-20
Activity Proportion Method
The allocation of the machine set-up cost to the specific
models is shown in the table below.
Avalon
Machine Set-Up Cost $ 795,000
Activity Proportion
40%
Allocated to Product $ 318,000
Camry
$ 795,000
35%
$ 278,250
Camry
Hybrid
$ 795,000
25%
$ 198,750
Total
$ 795,000
100%
$ 795,000
4-21
Stage 2: Assign Activity Costs to
Individual Products or Services
To complete the Stage 2 ABC allocations, we need to add up the
cost of all four activities for each product line.
Machining and Installation
Machine Set-Up
Engineering and Product Design
Quality Control
Total Manufacturing Overhead Cost
Avalon
$ 165,000
318,000
240,000
270,000
$ 993,000
Camry
$ 577,500
278,250
120,000
180,000
$ 1,155,750
Camry
Hybrid
$ 82,500
198,750
840,000
450,000
$ 1,571,250
Total
$ 825,000
795,000
1,200,000
900,000
$ 3,720,000
Notice that the total amount of overhead cost is the same as in
the traditional costing example ($3,720,000).
4-22
Stage 2: Assign Activity Costs to
Individual Products or Services
Machining and Installation
Machine Set-Up
Engineering and Product Design
Quality Control
Total Manufacturing Overhead Cost
Avalon
$ 165,000
318,000
240,000
270,000
$ 993,000
Camry
$ 577,500
278,250
120,000
180,000
$ 1,155,750
Camry
Hybrid
$ 82,500
198,750
840,000
450,000
$ 1,571,250
Total
$ 825,000
795,000
1,200,000
900,000
$ 3,720,000
HOWEVER!!! Under ABC, the Camry-Hybrid receives the
highest total overhead allocation, even though it is the lowest
volume product. The reason is that this product is produced in
small batches and requires a lot of engineering and product
design, and quality inspections.
4-23
Stage 2: Assign Activity Costs to
Individual Products or Services
To calculate the cost per unit, we need to divide the
total manufacturing overhead by the number of
units of each product.
Total Manufacturing Overhead Cost
Units Produced (Thousands)
Manufacturing Overhead Cost Per Unit
Avalon
$ 993,000
100
$
9,930
Camry
$ 1,155,750
350
$
3,302
Camry
Hybrid
$ 1,571,250
50
$
31,425
$
Total
3,720,000
4-24
Comparison of Volume-Based and
Activity Based Cost Systems
Traditional vs. ABC Costing Method
$35,000
Manufacturing Overhead
Cost Per Unit
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
$-
Avalon
Camry
Camry-Hybrid
Traditional
$8,400
$7,200
$7,200
ABC
$9,930
$3,302
$31,425
4-25
Calculate Total Manufacturing Cost
and Gross Margin
The ABC analysis shows that the Toyota Camry is the most
profitable product, with a 29.4% gross margin, compared to
26% for the Avalon and negative 15.2% for the Camry-Hybrid.
Direct Materials
Direct Labor
Manufacturing Overhead
Total Manufacturing Cost
Unit Selling Price to Customer
Gross Profit Per Unit
Gross Profit Margin (% of Sales)
$28,000 - $20,730 = $7,270
Avalon
$ 8,000
2,800
9,930
20,730
28,000
$ 7,270
26.0%
Camry
$ 7,000
2,400
3,302
12,702
18,000
$ 5,298
29.4%
Camry
Hybrid
$ 6,500
2,400
31,425
40,325
35,000
$ (5,325)
-15.2%
$5,298 ÷ $18,000 = 29.4%
4-26
Activity Based Management
Activity based management (ABM) includes all the actions
that managers take to improve operations or reduce costs
based on the ABC data. The first step in any improvement
program is to target areas that need improvement.
What
Activities
Are
Performed?
How Much
Does it Cost
to Perform
Each
Activity?
Does the
Activity Add
Value to the
Customer?
4-27
Activity Based Management
In our Toyota example, the ABC analysis revealed that the
Camry-Hybrid was much more costly to produce than the
other models. If this had been a realistic scenario, what
should Toyota managers do with this information?
One possibility is for managers to rethink the pricing of the
Camry-Hybrid. The price would need to be increased
substantially, and it is not clear that customers would be
willing to pay that kind of premium.
Activity-based Management
Life Cycle Cost Management
TQM
Target Costing
JIT
4-29
Life Cycle Cost Management
In pursuing cost management, managers need to set their
cost reduction goals across all stages of the product life
cycle, including
1. product introduction,
Costs tend to be higher.
2. growth,
Most revenue earned.
3. maturity, and
4. eventual decline.
In today’s digital and technological age,
product life cycles become increasingly short.
4-30
Total Quality Management
The second highest cost assigned to the Camry-Hybrid was
due to quality control. In managing quality costs, managers
must balance four types of quality costs:
1. Prevention costs,
2. Appraisal or inspection costs,
3. Internal failure costs, and
4. External failure costs.
4-31
Target Costing
The basic idea behind target costing is to determine what the
target cost must be in order to meet the market price and still
provide a profit for the company's shareholders. The target
cost should reflect all of the costs that are incurred across
the entire value chain. In target costing, the price is set by
the market based on what consumers are willing to pay for a
product or service. Let’s begin to look at target pricing at
Toyota by using the following estimates:
Estimated Market Price
Annual Demand in Units
Life Cycle in Years
Target Profit (Return on Sales)
$30,000
20,000
3
20%
4-32
Target Costing
The target cost would be computed by subtracting the target
profit from the market price, as follows:
Market
Price
$30,000
̶
Target Profit
(20% × $30,000)
$6,000
=
Target
Cost
$24,000
The $24,000 target cost is the most that can be spent on the
product and still achieve the 20% return on sales (given a
market sales price of $30,000). It is important to realize that the
target cost includes more than just the manufacturing costs.
4-33
Target Costing
Given the target unit cost, how much can Toyota
spend on the new model across its entire life
cycle and still meet the target profit?
Units Sold Each Year
Life Cycle in Years
Total Units
Target Cost Per Unit
Total Target Cost
20,000
3
60,000
$
24,000
$ 1,440,000,000
4-34
Target Costing
Once the target cost is set, the next step is to determine
whether it is feasible to design, develop, manufacture and
deliver the product at this target cost.
?
Target
Cost
Design
Product
Develop
Process
Estimate
Cost
Cost Reduction Goals
Compare the estimated cost with the target cost to
see if cost reduction is necessary.
Make
Product
4-35
Just-in-Time (JIT) Inventory
In a JIT system, materials are purchased and units are made
only as they are needed to satisfy customer demand. JIT is a
"demand pull" system, where materials and products are
pulled through the manufacturing system based on customer
demand.
In a traditional manufacturing setting where products are
pushed through the system and often end up sitting in
inventory. One advantage of a JIT system is that it eliminates
problems in product costing associated with holding inventory.
4-36
Summary of ABC and ABM
To gain the true benefits of activity based costing, managers
must move from simply measuring costs, to find ways to manage
or reduce costs. Although ABC and ABM have many potential
benefits, these benefits must be weighed against the costs of
obtaining the more accurate information. Implementing an ABC
can be a difficult task. It requires a great deal of time and effort
from many employees across the entire organization.
End of Topic 6