Introduction to Accounting
Activity Based Costing:
A Tool to Aid Decision Making
Session 10
February 7,2002
A&MIS 525
1
Activity Based Costing (ABC)
The objective of
activity-based
costing is to
understand
overhead and the
profitability of
products and
customers.
A&MIS 525
ABC is a
good supplement
to our traditional
cost system
I agree!
2
Activity Based Costing (ABC)
Activity-Based Costing
Both manufacturing
and nonmanufacturing
costs may be
assigned to
products.
There are a number
of cost pools each of
which is allocated
using a unique
measure of activity.
Some manufacturing
costs may be excluded
from product
costs.
Allocation bases often
differ from
traditional costing
systems.
Overhead rates may
be based on activity
at capacity.
A&MIS 525
3
How Costs are Treated Under
Activity-Based Costing
Activity Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Overhead Allocation
A&MIS 525
4
Plantwide Overhead Rate
Companies tend to use direct labor
as the overhead allocation base.
A&MIS 525
5
Departmental Overhead Rates
Finishing Department
Painting Department
Shipping Department
A two stage process is
necessary because costs
are allocated to departments
and then to products.
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6
Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
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7
Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
Stage Two:
Costs applied
to products
Products
A&MIS 525
8
Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
Stage Two:
Costs applied
to products
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
Direct
Labor
Hours
Machine
Hours
Raw
Materials
Cost
Products
Departmental Allocation Bases
A&MIS 525
9
Designing an ABC System
Cost Objects
(e.g., products
and customers)
Activities
Consumption
of Resources
Cost
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10
Designing an ABC System
Steps for Implementing ABC
Identify and define activities and activity pools.
Where possible, trace costs to activities and cost
objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.
A&MIS 525
11
Identifying Activity to Include
Unit-Level
Activity
Batch-Level
Activity
A part of the production
process for which management
wants a separate reporting of the
costs of the activity involved.
Product-Level
Activity
Organizationsustaining
A&MIS 525
Activity
Customer-Level
Activity
12
Identifying Activity to Include
Activity Cost
Pool is a “bucket”
in which costs are
accumulated that
relate to a single
activity in the ABC
system.
A&MIS 525
$$
$
$ $
$
13
The Mechanics of ABC
At Classic Brass, the ultimate cost objects are:
Products,
Customer orders, and
Customers.
One overhead cost - shipping - can be traced
directly to customer orders.
The company’s overhead costs are shown on
the next slide.
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14
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total overhead costs
A&MIS 525
500,000
300,000
120,000
80,000
$
400,000
50,000
60,000
1,000,000
40,000
510,000
250,000
50,000
$
300,000
1,850,000
15
Activity-Based Costing at Classic
Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Traced
$/DLH
Traced
Overhead Costs
Cost Objects:
Products, Customer Orders, Customers
A&MIS 525
16
Activity-Based Costing at Classic
Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Cost Objects:
Products, Customer Orders, Customers
A&MIS 525
17
Activity-Based Costing at Classic
Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Second-Stage Allocations
$/MH
$/Order
$/Design
$/Customer
Cost Objects:
Products, Customer Orders, Customers
A&MIS 525
Unallocated
18
Assigning Costs to Activity Cost
Pools
Management at Classic Brass believes overhead should be
distributed as follows:
Activity Cost Pools
Customer Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs traced to customer order
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Order
Size
Customer
Relations
Other
Total
25%
20%
0%
0%
40%
0%
10%
0%
20%
60%
50%
0%
N/A
10%
0%
0%
0%
5%
20%
40%
100%
100%
100%
100%
100%
15%
30%
0%
5%
0%
0%
10%
0%
0%
30%
25%
0%
40%
45%
100%
100%
100%
100%
20%
10%
10%
0%
0%
0%
60%
70%
10%
20%
100%
100%
A&MIS 525
19
Assigning Costs to Activity Cost
Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer
Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
Order
Size
Customer
Relations
Other
Total
$ 125,000
Indirect factory wages
$500,000
Percent consumed by customer orders
25%
$125,000
A&MIS 525
20
Assigning Costs to Activity Cost
Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer
Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
Order
Size
Customer
Relations
Other
Total
$ 125,000
60,000
Factory equipment depreciation
$300,000
Percent consumed by customer orders
20%
$ 60,000
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21
Assigning Costs to Activity Cost
Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer
Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
Order
Size
Customer
Relations
Other
Total
$ 125,000
60,000
-
$ 200,000
12,000
-
$ 100,000
180,000
60,000
-
$ 50,000
-
$ 25,000
60,000
48,000
80,000
60,000
15,000
-
20,000
-
40,000
-
120,000
12,500
-
160,000
22,500
60,000
400,000
50,000
60,000
50,000
5,000
$ 315,000
25,000
$ 257,000
$ 380,000
150,000
35,000
$ 367,500
25,000
10,000
$ 490,500
250,000
50,000
$ 1,810,000
A&MIS 525
$
22
500,000
300,000
120,000
80,000
Computation of Activity Rates
The ABC team has determined that Classic
Brass has the following total activities for
each activity cost pool . . .
–
–
–
–
1,000 customer orders,
200 new designs,
20,000 machine-hours
100 customers.
Now the team can compute the individual
activity rates.
A&MIS 525
23
Computation of Activity Rates
Activity Cost Pools
1,000
Orders
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
200
Designs
20,000
machinehours
100
Customers
Other
125
Customer
Orders
Indirect factory wages
$ 125,000
Number of orders
÷
1,000
Indirect factory wages/order
$
125
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24
Computation of Activity Rates
Activity Cost Pools
1,000
Orders
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$
125
60
-
200
Designs
$
1,000
60
-
60
15
100
-
50
5
315
125
1,285
-
$
A&MIS 525
20,000
machinehours
100
Customers
$
$
5
9
3
2
19
500
-
N/A
1,200
125
-
-
$
Other
$
1,500
350
3,675
25
Assigning Costs to Cost
Objects
Let’s take a look at how our system works for just
one customer - Windward Yachts.
– Windward ordered two products - Stanchions and
customer compass housings. Here are the details:
Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours .
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
6. Shipping costs total $180.
A&MIS 525
26
Assigning Costs to Cost
Objects
Let’s take a look at how our system works for just
one customer - Windward Yachts.
– Windward ordered two products - Stanchions and
customer compass housings. Here are the details:
Custom Compass Housing (requires new design)
1. One order during the year.
2. Each housing required 4 machine-hours .
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labor totals $50.
6. Shipping costs total $25.
A&MIS 525
27
Assigning Costs to Cost
Objects
Overhead cost of two orders for standard stanchions.
Activity Cost Pools
2 Orders
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
No new
design
200
machine
hours
N/A
Total
250
$125 per order × 2 orders = $250
A&MIS 525
28
Assigning Costs to Cost
Objects
Overhead cost of two orders for standard stanchions.
Activity Cost Pools
No new
design
2 Orders
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$
250
120
-
$
-
200
machine
hours
$
1,000
1,800
600
-
N/A
$
-
Total
$
1,250
1,920
600
120
30
-
-
400
-
-
520
30
100
10
630
-
3,800
-
100
10
4,430
$
A&MIS 525
$
$
$
29
Assigning Costs to Cost
Objects
Overhead cost of one order for custom compass housing.
Activity Cost Pools
1 Order
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$
1 new
design
4 machine
hours
N/A
Total
125
$125 per order × 1 order = $125
A&MIS 525
30
Assigning Costs to Cost
Objects
Overhead cost of one order for custom compass housing.
Activity Cost Pools
1 new
design
1 Order
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$
125
60
-
$
60
15
100
-
50
5
315
125
1,285
-
$
1,000
60
-
$
A&MIS 525
4 machine
hours
$
20
36
12
N/A
$
8
$
76
$
-
Total
$
1,145
96
72
-
168
15
-
175
5
1,676
$
31
Product Margins
Standard Stanchions
Sales
Cost:
Direct materials
Direct labor
Shipping costs
Customer orders
Product design
Order size
Product margin
$
13,600
$
8,570
5,030
$ 2,110
1,850
180
630
3,800
Custom Compass Housing
Sales
Cost:
Direct materials
Direct labor
Shipping costs
Customer orders
Product design
Order size
Product margin
A&MIS 525
$
$
13
50
25
315
1,285
76
650
1,764
$ (1,114)
32
Product Margins
Standard Stanchions
Sales
Cost:
Direct materials
Direct labor
Shipping costs
Customer orders
Product design
Order size
Product margin
$
13,600
$
8,570
5,030
$ 2,110
1,850
180
630
3,800
Custom Compass Housing
Sales
Windward Yachts
Cost:
Product margins:
Direct materials
Standard stanchion
5,030
Direct$labor
Custom compass housing
(1,114)
Shipping
costs
Customer
orders
Total product margin
3,916
Product design
Less: Customer relations
3,675
Order size
Customer margin
$ 241
Product margin
A&MIS 525
$
$
13
50
25
315
1,285
76
650
1,764
$ (1,114)
33
Product Margins
Traditional Cost Accounting System
Sales
Costs
Direct materials
Direct labor
Manufacturing overhead
Product margin
Standard
Stanchions
$
13,600
$
Predetermined manufacturing
=
overhead rate
A&MIS 525
(2,110)
(1,850)
(10,000)
(360)
$1,000,000
20,000 MH
Compass
Housing
$
650
$
(13)
(50)
(200)
387
= $50/MH
34
Product Margins
Traditional Cost Accounting System
Sales
Costs
Direct materials
Direct labor
Manufacturing overhead
Product margin
Standard
Stanchions
$
13,600
$
(2,110)
(1,850)
(10,000)
(360)
Compass
Housing
$
650
$
(13)
(50)
(200)
387
400 units x 0.5 MH/unit x $50/MH = $10,000
A&MIS 525
35
Difference Between ABC and
Traditional Product Costs
ABC will ordinarily shift
batch-level and
product-level
overhead costs from
high-volume
products produced
in large batches to
low-volume products
produced in small
batches.
A&MIS 525
36
Difference Between ABC and
Traditional Product Costs
Under ABC both
manufacturing and
nonmanufacturing costs
may be assigned to
products. Organizationsustaining costs and the
costs of idle capacity
are not assigned to
products.
A&MIS 525
37
Ease of Adjustment
Costs that adjust automatically to changes in activity:
– Direct materials.
– Shipping.
Costs that could be adjusted to changes in activity:
–
–
–
–
–
–
Direct labor.
Factory utilities.
Administrative wages and salaries.
Office equipment depreciation.
Marketing wages and salaries.
Selling expenses.
Costs that are difficult to adjust to changes in activity:
– Factory equipment depreciation.
– Factory building lease.
– Administrative building lease.
A&MIS 525
38
Custom Compass Housing
Sales
Green costs:
Direct materials
Shipping costs
Green margin
Yellow costs:
Direct labor
Indirect factory wages
Factory utilities
Administrative wages
Office equip. depreciation
Marketing wages
Selling expenses
Yellow margin
Red costs:
Factory equip. depreciation
Factory building lease
Admin. Building lease
Red margin
A&MIS 525
$
$
13
25
50.00
1,145.00
72.00
168.00
15.00
175.00
5.00
96
0
0
650
38
612
1,630
(1,018)
96
$ (1,114)
39
Simplified Approach to ABC
After the first-stage allocation is complete,
computation of activity rates for each activity cost
pool can be simplified as follows:
Computation of the Activity Rates
Customer
Product
Orders
Design
Costs from firststage allocation $ 315,000 $ 257,000
Total activity
÷ 1,000
÷ 200
Cost per unit
of activity
$
315 $
1,285
A&MIS 525
Customer
Order Size Relations
$ 380,000
÷ 20,000
$ 367,500
÷ 100
$
$
19
Other
$ 490,500
N/A
3,675
40
Simplified Approach to ABC
Standard Stanchions:
Sales
Costs:
Direct materials
Direct labor
Shipping costs
Customer orders (2)
Product design
Order size (200)
Product margin
$
$
13,600
$
8,570
5,030
2,110
1,850
180
630
3,800
2 orders @ $315 per order
A&MIS 525
41
Simplified Approach to ABC
Custom Compass Housing
Sales
Costs:
Direct materials
Direct labor
Shipping costs
Customer orders (1)
Product design
Order size
Product margin
$
$
13
50
25
315
1,285
76
$
650
1,764
(1,114)
1 design @ $1,285 per design
A&MIS 525
42
Simplified Approach to ABC
Customer margin for Windward Yachts is shown
Customer Profitability
Analysis
below:
Product margins:
Standard stanchion
Custom compass housing
Total product margins
Less: Customer relations
Customer margin
A&MIS 525
$
5,030
(1,114)
3,916
(3,675)
241
43
End of Chapter 8I call this
quality
time!
A&MIS 525
44
Puzzle
A shipping company had trouble
determining how much it should cost to
ship materials from Ohio to a point near
the Atlantic ocean. In spite of numerous
trips within the Great Lakes area, the
company still found it difficult to predict
costs. What do you suppose was making
cost estimation difficult?
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45
Agenda Today
• Clarify our views of the activity paradigm
• Discuss efficiency & effectiveness
• Summarize the basics about the
relationship of standards to the costs
incurred
• Review some problems
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46
Basic Activity View
Inputs
Outputs
A&MIS 525
47
Activities
• Activities are about actions, doing
something, effort, work done, not
the consequences of the work or
effort.
• Metrics or measures are the ways
we are going to quantify the volume
of activity during a time period.
Different activities require different
metrics.
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48
Activity Terminology
• Statistics represent the numeric
values assigned to the metrics for a
period.
• Data sources are the primary or
secondary sources of the statistics.
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49
Thinking About Activities
Inputs
1. Labor
2. Materials
Activities
Assembling
Processing
3.
4.
5.
6.
Assembling
Stamping
Insurance
Storing
Parts
Equipment
Services
Warehouse
A&MIS 525
Outputs
Products
Intermediate
products
Assembly
Steel part
Risk reduction
Availability
50
An Observation
• Defining activities can be difficult,
particularly in service and creative work.
• Even when we can define an activity, it
can be difficult to separate measures of
activity level from measures of output.
It is simpler to focus on outputs, which
is what the text tends to do in places.
• But properly defining activities is crucial
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51
Related Terminology
• What does it mean to be efficient?
• What does it mean to be effective?
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52
Efficiency
• Measures of efficiency nearly always
compare the inputs to an activity or process
with its outputs. The greater the output per
unit of input, the more efficient. The fewer
the units of input required to make one unit
of output, the greater the efficiency.
• Efficiency is a general concept that relates to
entities ranging from individuals performing a
single task to entire economies.
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53
Efficiency
• Since the productivity of labor has been so key
to the wealth of a society, we continue to focus
on the productivity of people. Sales per
person, gross margin per person, and physical
output per person, are measures of efficiency
as well as measures of productivity.
• Cost per sales dollar, or cost per unit of output
are the most common measures of efficiency
used in managerial accounting.
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54
Efficiency in Accounting
• In accounting we use cost standards, flexible
budgets and profitability measures to
evaluate efficiency. These standards relate
the work done to the cost incurred to achieve
that work. Physical measures are useful, but
the ultimate measures include profitability.
• We may measure other operating variables
because we believe they relate to profitability
in the longer run.
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55
Basic Activity View
INPUTS
Just
in
time
Outputs
Input/Output
A&MIS 525
56
Input/Output Relationships
Yield or Productivity
INPUTS
OUTPUTS
Efficiency
A&MIS 525
57
Basic Activity View
Utilization
Productivity
Rates
INPUTS
Outputs
Input/Output
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58
Effectiveness
• Effectiveness is concerned with the
achievement of objectives. Making a
sales goal, achieving a target market
share, completing a project on
schedule, satisfying customers, and
retaining employees--which may or
may not change productivity. So
effectiveness is a separate issue:
Did we achieve the goal?
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59
Effectiveness Measures
•
•
•
•
Percent of the goal achieved.
Percent variance from goal.
Improvement from past experience
Percent of the goal achieved compared
with last period.
• Percent variance from goal compared
with last period.
• Examples from your experience?
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60
Effectiveness Measures
• Headcount, cycle time, customer
satisfaction, and other measures
are believed to lead to greater
profitability. But they are not
measures of efficiency per se.
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61
Operational (Technical) Control
Provides feedback to employees
and their managers about the
efficiency of activities being
performed. Measures of
effectiveness might include cycle
times, spoilage rates, lost units, late
shipments, etc.
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62
• Break for it!
A&MIS 525
63
Standard Costing
• A management system that makes
sense in a technical planning and
control context
• Concerned with economic efficiency, not
effectiveness beyond this one isssue.
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64
Roots
• Originated as part of the scientific
management movement of the early to mid
20th century.
• Represents a move away from arbitrary
management methods to those based on
observable “scientific” information. This
movement followed the successes of
medicine and agriculture earlier in the 20th
century.
A&MIS 525
65
Substance
• Standards represent the output that
should be achieved at a specified
level of perfection based on the
operating capacities of people,
equipment, management, process
design, etc.
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66
Relationship Overview
Standard cost
+ Unfavorable variances
- Favorable variances
= (Actual) cost incurred (GAAP)
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67
Relationship Overview (dr/cr)
Standard cost (dr)
+ Unfavorable variances (dr)
- Favorable variances (cr)
= (Actual) cost incurred (dr)
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68
Formulae
• Output achieved x unit standard = total
input at standard
• Materials, labor and driver activity:
AQO (output) x sq (unit standard) = SQ
(total material, labor or driver activity
“allowed” at standard)
• Standard cost per unit = Σ(sq x sp)
A&MIS 525
69
Formulae
• Standard cost of production =
AQO x Σ(sq x sp)
• When the price variance is isolated and
recorded at usage,
aq•ap = sp•sq + (ap–sp)aq + (aq-sq)sp
aq•ap = sp•sq + ap•aq – sp•aq + aq•sp sq•sp
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70
Today’s Quote
• Nothing in the world can take the place of
PERSISTENCE.
• Talent will not; nothing is more common than
unsuccessful men with talent.
• Genius will not; unrewarded it's almost a proverb.
• Education will not; the world is filled with educated
derelicts.
• PERSISTENCE and DETERMINATION alone are
omnipotent.
_Calvin Coolidge
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71