Chapter 5
ABC
– used to produce a refined costing system where job costing is not appropriate
5 - 1

Explain undercosting and overcosting of products and services.
5 - 2

Undercosting and
Overcosting Example
Jose, Roberta, and Nancy order separate items for lunch.
Jose’s order amounts to
Roberta consumed
Nancy’s order is
Total
$14
30
16
$60
What is the average cost per lunch?
5 - 3

Undercosting and
Overcosting Example
$60 ÷ 3 = $20
Jose and Nancy are overcosted.
Roberta is undercosted.
5 - 4

Existing Single Indirect-
Cost Pool System Example
Kole Corporation manufactures a normal lens
(NL) and a complex lens (CL).
Kole currently uses a single indirect-cost rate job costing system.
Cost objects: 80,000 (NL) and 20,000 (CL).
5 - 5

Existing Single Indirect-
Cost Pool System Example
Normal Lenses (NL)
Direct materials
Direct mfg. labor
Total direct costs
$1,520,000
800,000
$2,320,000
Direct cost per unit: $2,320,000 ÷ 80,000 = $29
5 - 6

Existing Single Indirect-
Cost Pool System Example
Complex Lenses (CL)
Direct materials
Direct mfg. labor
Total direct costs
$ 920,000
260,000
$1,180,000
Direct cost per unit: $1,180,000 ÷ 20,000 = $59
5 - 7

Existing Single Indirect-
Cost Pool System Example
INDIRECT-COST
POOL
All Indirect Costs
$2,900,000
INDIRECT
COST-ALLOCATION
BASE
50,000 Direct
Manufacturing
Labor-Hours
$58 per Direct
Manufacturing
Labor-Hour
5 - 8

Existing Single Indirect-
Cost Pool System Example
COST OBJECT:
NL AND CL
LENSES
Indirect Costs
Direct Costs
DIRECT
COSTS
Direct
Materials
Direct
Manufacturing
Labor
5 - 9

Existing Single Indirect-
Cost Pool System Example
Kole uses 36,000 direct manufacturing labor-hours to make NL and 14,000 direct manufacturing labor-hours to make CL.
How much indirect costs are allocated to each product?
5 - 10

Existing Single Indirect-
Cost Pool System Example
NL: 36,000
×
$58 = $2,088,000
CL: 14,000
×
$58 = $812,000
What is the total cost of normal lenses?
Direct costs $2,320,000 +
Allocated costs $2,088,000 = $4,408,000
What is the cost per unit?
$4,408,000 ÷ 80,000 = $55.10
5 - 11

Existing Single Indirect-
Cost Pool System Example
What is the total cost of complex lenses?
Direct costs $1,180,000 + Allocated costs
$812,000 = $1,992,000
What is the cost per unit?
$1,992,000 ÷ 20,000 = $99.60
5 - 12

Existing Single Indirect-
Cost Pool System Example
Normal lenses sell for $60 each and complex lenses for $142 each.
Revenue
Cost
Income
Margin
Normal Complex
$60.00
$142.00
55.10
99.60
$ 4.90
$ 42.40
8.2% 29.9%
5 - 13

Present three guidelines for refining a costing system.
5 - 14

Refining a Costing System
More
Direct-cost tracing
Smaller
Better cause & effect relationship
Indirect-cost pools
Cost-allocation basis
5 - 15

Distinguish between the traditional and the activity-based costing approaches to designing a costing system.
5 - 16

Activity-Based Costing System
Fundamental
Cost Objects
Activities
Costs of Activities
Assignment to Other
Cost Objects
Cost of:
•
Product
•
Service
•
Customer
5 - 17

Refining a Costing System
1. Design of Products and Process
The Design Department designs the molds and defines processes needed (details of the manufacturing operations).
5 - 18

Refining a Costing System
2. Manufacturing Operations
Lenses are molded, finished, cleaned, and inspected.
3. Shipping and Distribution
Finished lenses are packed and sent to the various customers.
5 - 19

Activity-Based Costing System
A cross-functional team at Kole
Corporation identified key activities:
1. Design products and processes.
2. Set up molding machine.
3. Operate machines to manufacture lenses.
4. Maintain and clean the molds.
5 - 20

Activity-Based Costing System
5. Set up batches of finished lenses for shipment.
6. Distribute lenses to customers.
7. Administer and manage all processes.
5 - 21

Activity-Based Costing System
Activity
Indirect Cost
Pool
Design Setup Shipping
Cost
Allocation
Base
Parts-
Square feet
No. of
Setup
Hours
No. of
Shipments
Product
Cost
Objects
Lenses
NL
Lenses
CL
Lenses
Other
5 - 22

Activity-Based Costing System
Quantity produced
No. produced/batch
Number of batches
Setup time per batch
Total setup-hours
NL
80,000
250
CL
20,000
50
320 400
2 hours 5 hours
640 2,000
Total setup costs are $409,200.
5 - 23

Activity-Based Costing System
What is the setup cost per setup-hour?
$409,200 ÷ 2,640 hours = $155
What is the setup cost per direct manufacturing labor-hour?
$409,200 ÷ 50,000 = $8.184
5 - 24

Activity-Based Costing System
Allocation using direct labor-hours:
NL: $8.184
×
36,000 = $294,624
CL: $8.184
×
14,000 = $114,576
Total $409,200
Allocation using setup-hours:
NL: $155
×
640 = $ 99,200
CL: $155
×
2,000 = $310,000
Total $409,200
5 - 25

Describe a four-part cost hierarchy.
5 - 26

Cost Hierarchies
A cost hierarchy is a categorization of costs into different cost pools, based on……
•Cost drivers bases (cost-allocation bases)
•Degrees of difficulty in determining cause-and-effect relationships
5 - 27

Cost Hierarchies
ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases:
1.
Output unit-level costs
2.
Batch-level costs
3.
Product-sustaining costs
4.
Facility-sustaining costs
5 - 28

1. Output Unit-Level Costs
These are resources sacrificed on activities performed on each individual unit of product or service.
Energy
Machine depreciation
Repairs
Vary with
Output
5 - 29

2. Batch-Level Costs
These are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service.
Setup-hours
Procurement costs
Vary with # of setups etc
5 - 30

3. Product-Sustaining Costs
These are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services.
Design costs
Engineering costs
5 - 31

4. Facility-Sustaining Costs
These are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole.
General administration
– rent – building security
“True” indirect costs
5 - 32

Cost products or services using activity-based costing.
5 - 33

Implementing
Activity-Based Costing
Step 1
Identify cost objects.
Step 2
Identify the direct costs of the products.
NL
CL
Direct material
Direct labor
Mold cleaning and maintenance
5 - 34

Implementing
Activity-Based Costing
Cleaning and maintenance costs of
$360,000 are direct batch-level costs.
Why?
Because these costs consist of workers’ wages for cleaning molds after each batch of lenses is run.
5 - 35

Implementing
Activity-Based Costing
Description
Direct materials
Normal Lenses (NL)
Cost Hierarchy
Category
Unit-level
Direct mfg. labor Unit-level
Cleaning and maint. Batch-level
Total direct costs
$1,520,000
800,000
160,000
$2,480,000
5 - 36

Implementing
Activity-Based Costing
Description
Direct materials
Complex Lenses (CL)
Cost Hierarchy
Category
Unit-level
Direct mfg. labor Unit-level
$ 920,000
260,000
Cleaning and maint. Batch-level
Total direct costs
200,000
$1,380,000
5 - 37

Implementing
Activity-Based Costing
Step 3
Select the cost-allocation bases to use for allocating indirect costs to the products.
(1)
Activity
Design
(2)
Cost Hierarchy
Product-sustaining
Setups Batch-level
Operations Unit-level
(3)
Total Costs
$450,000
$409,200
$637,500
5 - 38

Implementing
Activity-Based Costing
Step 4
Identify the indirect costs associated with each cost-allocation base
.
Overhead costs incurred are assigned to activities, to the extent possible, on the basis of a cause-and-effect relationship.
5 - 39

Implementing
Activity-Based Costing
Step 5
Compute the rate per unit.
(1)
NL CL
Setup-hours: 640 2,000
$409,200 ÷ 2,640 = $155
(5)
Total
2,640
5 - 40

Implementing
Activity-Based Costing
Step 6
Compute the indirect costs allocated to the products.
NL: $155
×
640 =
CL: $155
×
2,000 =
Total
$ 99,200
310,000
$409,200
5 - 41

Implementing
Activity-Based Costing
Step 7
Compute the costs of the products.
NL and CL would show three direct cost categories.
1.
Direct materials
2.
Direct manufacturing labor
3.
Cleaning and maintenance
5 - 42

Implementing
Activity-Based Costing
1.
NL and CL would show six indirect cost pools.
Design
2.
3.
4.
Molding machine setups
Manufacturing operations
Shipment setup
5.
6.
Distribution
Administration
5 - 43

Use activity-based costing systems for activity-based management.
5 - 44

Activity-Based Management
ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits.
1. Product pricing and mix decisions
2. Cost reduction and process improvement decisions
3. Design decisions
5 - 45

1.Product Pricing and
Mix Decisions
ABC gives management insight into the cost structures for making and selling diverse products.
It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs.
5 - 46

2. Cost Reduction and Process
Improvement Decisions
Manufacturing and distribution personnel use
ABC systems to focus on cost-reduction efforts.
Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base.
5 - 47

3. Design Decisions
Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs.
Companies can work with their customers to evaluate the costs and prices of alternative designs.
5 - 48

Compare activity-based costing systems and departmentcosting systems.
5 - 49

ABC and Department
Indirect-Cost Rates
Many companies have evolved their costing system from using a single cost pool to using separate indirect-cost rates for each department:
Design
Manufacturing
Distribution
5 - 50

ABC and Department
Indirect-Cost Rates
Why?
Because the cost drivers of resources in each department or sub-department differ from the single, company-wide, cost-allocation base.
ABC systems are a further refinement of department costing systems.
5 - 51

Job Costing is…….. good
Department Costing is ……..more refined
Activity-Based Costing is…… even more refined
5 - 52

Evaluate the costs and benefits of implementing activity-based costing systems.
5 - 53

1. Significant amounts of indirect costs are allocated using only one or two cost pools.
2. All or most costs are identified as output unit-level costs.
3. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.
5 - 54

4. Products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits.
5. Complex products appear to be very profitable and simple products appear to losing money.
5 - 55

Benefits of ABC Systems
Operations staff often have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.
5 - 56

Limitations of ABC Systems
The main limitations of ABC are the measurements necessary to implement the system.
ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.
5 - 57

Limitations of ABC Systems
Activity-cost rates also need to be updated regularly.
Very detailed ABC systems are costly to operate and difficult to understand.
5 - 58

ABC In Service and
Merchandising Companies
The general approach to ABC in the service and merchandising areas is very similar to the approach in manufacturing.
Costs are divided into homogeneous cost pools and classified as output unit-level, batch-level, product- or service-sustaining, and facility-sustaining costs.
5 - 59

ABC In Service and
Merchandising Companies
The cost pools correspond to key activities.
Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool.
5 - 60