Activity Based Costing
Notes to Chapter 7
Examples
•
•
•
•
Split a restaurant bill
Split profit in a partnership
Allocate cost to products
Cost of a degree program?
– What is cost of an international student?
– What is the cost of an auditing student?
– What is the cost of a cand. merc. student?
• Multi-product firms are found everywhere.
2
Indirect cost – Classic Pen
•
•
Classic Pen was a low cost producer of pens. They had a profit
margin of at least 20% of revenue
Five years ago the firm started producing red pens
•
Last year purple was added
•
The controller of Classic Pen was disappointed by the result from
last quarter
• Same production technology
• Could be sold at a premium price 3% higher than the two other types of
pens
– Profit margin 10% “higher”
– The controller pondered if Classic Pen should continue to introduce new pens
instead of focusing on the blue and black
– The production manager pointed out the influence of the new types on the
production
3
Indirect cost – Classic Pen
• The costing system of Classic Pen was simple:
– All indirect costs were aggregated at factory level and allocated
to products based upon the direct labor cost
– At this time the overhead rate was 300% of direct labor cost
– Before new types of pens were introduced the overhead rate
was only 200% of direct labor cost
– Classical Pen uses only one cost center
• This would not change even if several cost centers were
introduced. The biases in the production costs would
remain.
4
Indirect cost – Classic Pen
Blue
Black
Red
Purple
Total
Units
50.000
40.000
9.000
1.000
100.000
Price
4,50
4,50
4,65
4,95
Sales
Materials
Labor
Overhead
225.00
75.000
30.000
90.000
180.000
60.000
24.000
72.000
41.850
14.040
5.400
16.200
4.950
1.650
600
1.800
451.800
150.690
60.000
180.000
Total man.
cost.
195.000
156.000
35.640
4.050
390.690
Oper.inc
30.000
24.000
6.210
900
61.110
return. %
13,3%
13,3%
14,8%
18,2%
13,5%
5
Indirect cost – Classic Pen
• Before:
– Production primarily manual
– Total indirect cost were less that the direct labor cost
– Classic Pen’s two products were identical with respect to volume
and batch size
• Direct labor cost and indirect cost has decreased due to
automation
• As low volume products were introduced the result was
increased demand for:
–
–
–
–
Increased planning
More setups of machines
More quality control
Computers to keep track of jobs and product specifications
6
Indirect cost – Classic Pen
•
Same physical output, same cost of material
•
The firm has approximately
– Property taxes, security cost and heating cost which are unchanged
– Much higher indirect and support costs due to the larger and more
diversified product mix and more complex production
•
One unit of the high volume standard product (blue or black) uses
approximately the same amount of direct labor as one unit of red or
purple
•
The traditional costing system would fundamentally report identical
costs for the standard and special products, independent of production
volume
The use of indirect and support activities by the special products are
higher that the use by the standard products
•
7
Indirect cost – Classic Pen
ABC at Classic Pen - Analysis of the cost structure:
• Indirect labor
– 50% of the indirect labor costs are caused by what the controller
called “handling of production batches”
– 40% of the indirect labor cost were caused by th physical change
from one color to another and were called setup costs
– 10% of the time was used to an activity which the controller labeled
support activities
• Computer costs
– 20% allocated to “support activities,”
• This is an activity which is already found in the catalogue of
activities as it was used to account for the 4 products
– 80% of computer resources were used to produce batches and are
closely related to handling of production batches
8
Indirect cost – Classic Pen
Activity Cost
Driver
Blue
Black
Red
Purple
Total**
0,02
0,02
0,02
0,02
2.000
Mach. h/unit
0,1
0,1
0,1
0,1
10.000
Prod. series
70
65
50
15
200
4
2,4
5,6
5,6
--
280
156
280
84
800
1
1
1
1
4
50.000
40.000
9.000
1.000
DL h/unit
Setup
time/batch
Tot.setup.hours
# products
**Volume
9
Indirect cost – Classic Pen
Indirect labor
50% 40%
IT
Maintenance
Energy
10%
80%
Handling
Depreciation
20%
Setup
Support
activities
Operation
10
Indirect cost – Classic Pen
• Three categories of indirect cost remained:
– Machine depreciation
– Machine maintenance
– Energy for running the machines
• These costs were incurred to maintain the
production capacity for the production of pens.
• The Controller calls the production activities
“running the machines”
11
Indirect cost – Classic Pen
• Identification of cost hierarchy
• Four activities which explain the indirect cost at Classic
Pen represents three levels in the cost hierarchy:
Activity
Cost hierarchy
Running machines
Unit level
Handling of batches
Batch level
Setups of machines
Batch level
Product sustaining
Product
12
Indirect cost – Classic Pen
Cost-driver rates
Aktivitycost
Handling
prod.batches
66.000
Setups of mach
33.600
Aktivitydriver
#Batches
Driver
quantity
200
Rate
330 pr
batch
#Setup hours
800 42 pr setup
hour
Product sustain
14.400
# Products
4
3.600 pr
product
Running
machines
42.000
# Machine
hours
10.000
4,20 per
machine ht
156.000
13
Indirect cost – Classic Pen
Assigned IPO
Blue
Handling
prod.batches
Setups of
machines
Product
sustain
Running
machines
Total cost
assigned
Black
Red
Lilla
Total**
23.100
21.450
16.500
4.950
66.000
11.760
6.552
11.760
3.528
33.600
3.600
3.600
3.600
3.600
14.400
21.000
16.800
3.780
420
42.000
59.460
48.402
35.640
12.498
156.000
14
Indirect cost – Classic Pen
Profitability
Blue
Black
Red
Lilla
Total**
225.000
180.000
41.850
4.950
451.800
75.000
30.000
12.000
59.460
60.000
24.000
9.600
48.402
14.040
5.400
2.160
35.640
1.650
600
240
12.498
150.690
60.000
24.000
156.000
176.460
142.002
57.240
14.988
390.690
Operating
income
48.540
37.998
(15.390)
(10.038)
61.110
B.M. %
21,6%
21,1%
-36,8%
-202,8%
13,5%
Sales
Materials
Labor
40%
Support
Total
prod.cost
15
Assigning service department costs
to activities
• Untraceable or common costs
• Rough estimates of product cost
– This is estimation by means of allocation
• Cause and effect relationship
• Link cost to activities
– How are the activities using resources
– What type of measures do we have
– Fixed or variable costs
16
Ingredients
• Aggregate cost pools
• LLA’s
• Allocation
17
Example
18
Impressionist
19
20
ABC Definitions
21
Indirect cost – Classic Pen
Indirect labor
50% 40%
IT
Maintenance
Energy
10%
80%
Handling
Depreciation
20%
Setup
Support
activities
Operation
22
Activity cost drivers
•
•
•
•
Unit level activities
Batch level activities
Product sustaining activities
Customer sustaining activities
23
Activity cost drivers
• Transaction drivers
• Duration drivers
• Intensity drivers
24
Problem 7.15
Problem 7.15
OV1 = 750,000 + 0.4 DL
OV2 = 200,000 + 0.2 DM + 1.5T
OV3 = 750,000
OV4 = 1,500 S
Problem 7.15
Problem 7.15
Problem 7.15
Problem 7.15
q
UCI
UCabc
q
UCI
UCabc
q
UCI
UCabc
2500
170
216
5000
141
171
2500
778
778
2500
630
631
500
558
562
0
0
0
2400
1392
1343
5200
1221
1192
0
0
0
30
Problem 7.15
The Firm’s Technology
32
The Firm’s Technology
•Factor inputs
•Production
•Output
z1,…z8
f,g,h
q = (q1, …,qn)
z5
z6
h
z3
z7
f
z4
z8
g
q = (q1,…,qn)
33
Account structure
34
Marginal costs
Impressionists estimation:
35
Marginal costs
The Modernisms estimation:
36
Example 7.3
37
Example 7.3
38
Example 7.3 – Modern School
39
41
K ≤ 200
q12
q22
Solution : K = 200, L1 =
= 50, L2 =
= 200
200
200
Total cost = 100* 200 + 150*50 + 175* 200
MC1 = 150, MC2 = 350
Marginal costs
• The marginal cost have a linear structure
• The ABC cost results in marginal cost
• The Impressionist School leads to different
product cost
43
Problem 7.8
8. unit versus marginal cost
Return to Example 7.3 and focus on the constant
returns to scale case of α = β = .5. Determine
total cost, marginal cost of each product, unit cost
of each product under the impressionism school,
and unit cost of each product under the
modernism school for each of the following output
pairs: q = [3, 8], q = [8, 3] and q = [10, 10]. Also
determine the corresponding percentage
estimation errors.
44
Example 7.3
45
Example 7.3
46
Example 7.3 – Modern School
47
Problem 7.8 Product one
Example 7.3
q1
q2
TC
MC
UCt
UCabc
7
9 632.33
47.60
54.99
47.60
3
8 408.70
47.60
58.39
47.60
8
3 480.50
47.60
50.58
47.60
10
10 808.37
47.60
53.89
47.60
48
Problem 7.8 Product two
Example 7.3
q1
q2
TC
MC
UCt
UCabc
7
9 632.33
33.24
27.49
33.24
3
8 408.70
33.24
29.19
33.24
8
3 480.50
33.24
25.29
33.24
10
10 808.37
33.24
26.95
33.24
49
Problem 7.9
9. unit versus marginal cost
Repeat the above for the mixed case of α = .55
and β = .45.
50
Problem 7.9
Product one – non-linear
Example 7.3
q1
q2
TC
MC
UCt
UCabc
3
8 418.73
57.54
59.82
54.50
8
3 549.08
59.49
57.80
56.28
10
10 899.24
60.81
59.95
57.41
51
Ex 7.9 Product two – non-linear
q1
q2
TC
MC
UCt
UCabc
3
8 418.73
31.97
29.91
31.90
8
3 549.08
33.03
28.90
32.94
10
10 899.24
32.73
29.97
32.51
52
Decreasing Returns
Marginal Cost for Product 1
Marginal cost for product 1: MC1
53
Decreasing Returns
Marginal Cost for Product 2
Marginal cost product 2
54
Decreasing Returns
Impressionism Error for First product
55
Decreasing Returns
Impressionism Error for Second product
56
Decreasing Returns
ABC Error for First Product
57
Decreasing Returns
ABC Error for second Product
58
Increasing Returns
Impressionisms Error for First Product
59
Increasing Returns
Impressionisms error for second product
60
Increasing Returns
ABC Error for First Product
61
Increasing Returns
ABC Error for Second Product
62
Mixed Returns
Impressionisms error for second product
63
Mixed Returns
Impressionisms error for second product
64
Mixed Returns
ABC Error for First Product
65
Mixed Returns
ABC Error for Second Product
66
Errors
• Error is the norm
• Errors are functions of the accounting system
• Different accounting systems produce different
errors
– Which department
– Which product
• Where to put errors
• Where in the organization is precision
important?
• Portfolio of errors
68
Conclusion
• ABC costing allows fine tuning of accounting
system to technology
• Is usable in a service organization
• Requires more data collection
• Assumes linearity in
– Use of production factors
– Cost functions
• Allocation of errors
• Theory of second best
69