TM 8-1 AGENDA: Activity-Based Costing (ABC) 1. The activity-based costing model. 2. Differences between traditional costing and activity-based costing. 3. Steps for implementing activity-based costing. 4. The ABC cost hierarchy. 5. An example of activity-based costing. 6. Contrasting traditional costing and activity-based costing product costs. 7. Typical impacts on product costs from implementing activity-based costing. 8. (Appendix 8A) Action analysis report © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-2 ACTIVITY-BASED COSTING MODEL Cost Objects (e.g., products, customers, orders) Activities Consumption of Resources Cost The emphasis is on decision-making and managing activities, not on assigning costs to products for external financial reports. © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-3 DIFFERENCES BETWEEN TRADITIONAL COSTING AND ACTIVITY-BASED COSTING • In traditional costing systems: • All manufacturing costs are assigned to products whether or not they are caused by the products. • Nonmanufacturing costs are not assigned to products—even those nonmanufacturing costs that are caused by the products. • The entire facility may have only one overhead cost pool and a single measure of activity such as direct labor-hours. • Predetermined overhead rates are based on estimated costs at the budgeted or expected level of activity. • In activity-based costing: • Nonmanufacturing costs, as well as manufacturing costs, may be assigned to products. • Some manufacturing costs may be excluded from product costs. • There are a number of overhead cost pools, each of which has its own unique measure of activity. • The allocation bases (i.e., measures of activity) often differ from those used in traditional costing. • The activity rates (i.e., overhead rates) may be based on the level of activity at capacity rather than on the budgeted or expected level of activity. © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-4 STEPS FOR IMPLEMENTING ACTIVITY-BASED COSTING 1. Identify and define activities and activity pools. 2. Wherever possible, directly trace overhead costs to activities and cost objects. 3. Allocate costs to activity cost pools. 4. Calculate activity rates. 5. Assign costs to cost objects using the activity rates and activity measures. 6. Prepare management reports. © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-5 COST HIERARCHY 1. Unit-level activities are performed each time a unit is produced. The costs of unit-level activities should be proportional to the number of units produced. 2. Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. Costs at the batch level do not depend on the number of units produced, the number of units sold, or other unit-level measures of volume. 3. Product-level activities relate to specific products and typically must be carried out regardless of how many batches or units of product are produced or sold. 4. Customer-level activities relate to specific customers and include activities such as sales calls, catalog mailings, and general technical support that are not tied to any specific product. 5. Organization-sustaining activities are carried out regardless of which products are produced, how many batches are run, or how many units are made. © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-6 THE CLASSIC BRASS EXAMPLE Activity Cost Pools at Classic Brass Activity Cost Pool Activity Measure Customer Orders Product Design Order Size Customer Relations Other Number of customer orders Number of product designs Machine-hours Number of active customers Not applicable © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-7 THE CLASSIC BRASS EXAMPLE (cont’d) © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-8 THE CLASSIC BRASS EXAMPLE (cont’d) Exhibit 8-2 Annual Overhead Costs (both Manufacturing and Nonmanufacturing) at Classic Brass Production Department: Indirect factory wages ..................... Factory equipment depreciation ....... Factory utilities ................................ Factory building lease ...................... $500,000 300,000 120,000 80,000 $1,000,000 Shipping costs* ................................... 40,000 General Administrative Department: Administrative wages and salaries .... Office equipment depreciation .......... Administrative building lease ............ 400,000 50,000 60,000 510,000 Marketing Department: Marketing wages and salaries ........... Selling expenses .............................. 250,000 50,000 300,000 Total overhead cost ............................. $1,850,000 *Shipping costs are traced directly to customer orders. © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-9 THE CLASSIC BRASS EXAMPLE (cont’d) Exhibit 8-3 Results of Interviews Customer Orders Production Department: Indirect factory wages ................. Factory equipment depreciation .... Factory utilities ............................ Factory building lease .................. Activity Cost Pools Product Customer Design Order Size Relations Other Total 25% 20% 0% 0% 40% 0% 10% 0% 20% 60% 50% 0% 10% 0% 0% 0% 5% 20% 40% 100% 100% 100% 100% 100% General Administrative Department: Administrative wages and salaries. Office equipment depreciation ...... Administrative building lease ........ 15% 30% 0% 5% 0% 0% 10% 0% 0% 30% 25% 0% 40% 100% 45% 100% 100% 100% Marketing Department: Marketing wages and salaries ....... Selling expenses .......................... 20% 10% 10% 0% 0% 0% 60% 70% 10% 100% 20% 100% Shipping costs* *Shipping costs are directly traced to customer orders. © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-10 THE CLASSIC BRASS EXAMPLE (cont’d) Exhibit 8-4 First-Stage Allocations to Activity Cost Pools Activity Cost Pools Customer Product Order Customer Orders Design Size Relations Production Department: Indirect factory wages ................. $125,000 $200,000 $100,000 Factory equipment depreciation .... 60,000 0 180,000 Factory utilities ............................ 0 12,000 60,000 Factory building lease .................. 0 0 0 Other Total $50,000 0 0 0 $25,000 60,000 48,000 80,000 $500,000 300,000 120,000 80,000 120,000 12,500 0 160,000 22,500 60,000 400,000 50,000 60,000 Shipping costs* General Administrative Department: Administrative wages and salaries. Office equipment depreciation ...... Administrative building lease ........ 60,000 15,000 0 20,000 0 0 40,000 0 0 Marketing Department: Marketing wages and salaries ....... 50,000 25,000 0 150,000 25,000 250,000 Selling expenses .......................... 5,000 0 0 35,000 10,000 50,000 Total ............................................. $315,000 $257,000 $380,000 $367,500 $490,500 $1,810,000 *Shipping costs are directly traced to customer orders. © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-11 THE CLASSIC BRASS EXAMPLE (cont’d) Exhibit 8-5 Computation of Activity Rates Activity Cost Pools (a) Total Cost Customer orders ......... Product design ........... Order size .................. Customer relations ...... Other ......................... (b) Total Activity (a) ÷ (b) Activity Rate $315,000 1,000 orders $315 per order $257,000 200 designs $1,285 per design $380,000 20,000 MHs $19 per MH $367,500 100 customers $3,675 per customer Not applicable $490,500 Not applicable © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-12 THE CLASSIC BRASS EXAMPLE (cont’d) Exhibit 8–7 Data Concerning the Products Ordered by Windward Yachts Standard Stanchions 1. This is a standard design that does not require any new design resources. 2. Four hundred units were ordered during the year, comprising two separate orders. 3. Each stanchion required 0.5 machine-hour, for a total of 200 machine-hours. 4. The selling price per unit was $34, for a total of $13,600. 5. Direct materials for 400 units totaled $2,110. 6. Direct labor for 400 units totaled $1,850. 7. Shipping costs for the two orders totaled $180. Custom Compass Housing 1. This is a custom product that requires new design resources. 2. There was only one order for a single unit during the year. 3. The compass housing required 4 machine-hours. 4. The selling price was $650. 5. Direct materials were $13. 6. Direct labor was $50. 7. Shipping costs were $25. © The McGraw-Hill Companies, Inc., 2006. All rights reserved. TM 8-13 THE CLASSIC BRASS EXAMPLE (cont’d) Exhibit 8-8 Computation of Overhead Costs Activity Cost Pools (a) Activity Rate Standard Stanchions Customer orders ......... $315 Product design ........... $1,285 Order size .................. $19 Customer relations ...... $3,675 (b) Activity (a) × (b) ABC Cost per per per per order design MH customer 2 orders 0 designs 200 MHs Not applicable $630 $0 $3,800 Custom Compass Housing Customer orders ......... $315 per Product design ........... $1,285 per Order size .................. $19 per Customer relations ...... $3,675 per order design MH customer 1 order 1 design 4 MHs Not applicable $315 $1,285 $76 © The McGraw-Hill Companies, Inc., 2006. All rights reserved.