Management Accounting:
A Road of Discovery
Management Accounting:
A Road of Discovery
James T. Mackey
Michael F. Thomas
Presentations by:
Roderick S. Barclay
Texas A&M University - Commerce
James T. Mackey
California State University - Sacramento
© 2000 South-Western College Publishing
Chapter 9
What did it really cost us?
Activity-based costing
Key Learning Objectives
1. Identify situations that create a
need for new cost systems.
2. Explain the three production
characteristics justifying ABC.
3. Describe how ABC uses
resources and activities to
calculate product costs.
4. Compare the allocation of batch
costs in a traditional cost
system and an ABC system.
5. Discuss how different cost
allocations can affect income
statements and profits.
6. [Appendix A] Summarize the
differences between ABC’s Bill
of Activities and a traditional
standard cost card.
Overview
Overhead Costing Methods
Traditional
Volume-Based Only Costing
Overhead
resource costs
Overhead
resource costs
Overhead
resource costs
‘Capacity consumes Resources”
Capacity
Cost
Pool
(applied using volume-based cost driver)
‘Products consume capacity’
Products
Products
Products
Products
Products
Applied directly to products
Direct Materials
Direct Labor
Activity-Based Costing
Activity-Based and Volume Based Costing
Overhead
resource costs
Overhead
resource costs
Overhead
resource costs
‘Activities consumes resources”
Activity Based Cost
Pools (apply cost by
activity cost driver
or volume based
cost driver)
Activity Based Cost
Pools (apply cost by
activity cost driver
or volume based
cost driver)
Activity Based Cost
Pools (apply cost by
activity cost driver
or volume based
cost driver)
‘Products consume activities’
Products
Products
Products
Products
Products
Applied directly to products
Direct Materials
Direct Labor
Part I
Traditional Volume-Based Cost Allocation
Vs.
Activity-Based Costing
Factory Overhead Resources

Factory overhead resources are budgeted for
the planned capacity.



The production volume uses and consumes
the available capacity.


“Products consume capacity and Capacity
consumes resources”.
Thus, capacity consumes resources!
Thus, products consume capacity!
This justifies assigning overhead to products
based upon the volume of products made

Thus, volume-based cost drivers seem logical.
Traditional Accounting Systems




Examples of the previously defined process are;
direct labor hours for labor intensive production and
machine hours for machine intensive production.
Traditional accounting systems use simple volumebased cost drivers to assign overhead costs to
products.
Volume-based drivers are most closely related to the
volume of outputs and the need for overhead
capacity.
Volume-based cost drivers are easy to measure
because they are directly product related.
Comparing Traditional Product Costing
and ABC
Traditional Costing
Resources
Direct materials
And
Overhead
Direct labor
Allocated
Traced directly
Using
DL hours
Products
Comparing Traditional Product Costing
and ABC
Activity-Based Costing
Resources
Product
level
Batch
level
traced
directly
charged
Per
batch
Product
line
charged
equally to
each
product
in the line
Products
Facilities
level
charged
equally to
all
products
An Illustration


Assume only two products are made — A & B.
Overhead costs = $200. Machine runtime = 20 hours.
Using the machine hours to assign costs, the POR =
($200/20 hours) = $10 per machine hour.
Unit Cost Standards for Products A & B:
Product
Direct Labor
Direct Materials
Mfg. Overhead (2 hrs x $10)
Unit Costs
A
$10
$10
$20
$40
B
$10
$10
$20
$40
A&B unit costs are identical when volume drivers allocate O/H.
This is deceiving when non-volume overhead activities are not the
same for each product!
Part II
Activity-Based Cost Drivers
Same Volume Different Overhead
Activities




For every company there are a series of move-waitsetup-run activities for each production process.
Volume-based cost drivers assign costs through the
run activities only. The other activities are ignored
for costing purposes because that may not be related
to the volume of output.
Ordering costs are a good example. Ordering costs
change with the number of orders, not necessarily
the number of units, or volume, ordered.
The cost to order one unit is approximately the same
as an order for 100 units since they are virtually
identical activities.
An Illustration


Consider the two products, A & B. Only ten are made in
total — 9 units of A and 1 unit of B in two batches.
Ordering costs based on non-volume activity cost
drivers.
Product A
(9 units)
Product B
(1 unit)
Issue Purchase Order
One
One
Telephone Vendors
Five
Five
Authorization
One
One
Mail
One
One
Activities


Different volume, but the same non-volume activities.
Each unit of A & B consume non-volume cost
differently.
Alternatives

When activities rather than volume are assumed to
consume overhead resources then Activity-based
or Transaction-based, costing is used.
‘Activities consume resources’
and
‘Products consume activities’

Activities, not just volume, are used to assign costs!
Different Products Consume Different
Activities







Now, assume manufacturing overhead consists of two
departments — setups and maintenance.
Each department costs $100 to operate. ($200 total)
The cost drivers are ‘the number of setups’ and ‘the number of
machine hours worked’.
In our simple world there are two setups. One for each type of
product.
The cost per setup for an activity level of two setups is ($100/2)
$50 per batch.
The remaining overhead costs for maintenance are assigned per
machine hours. The activity level required for 10 units is 20
hours (2 hours per unit x 10 units).
The cost per unit of machine activity driver is ($100/20 hours)
$5 per machine hour.
Calculation of Activity-Based Unit Costs
Total product costs per batch
A (9 units) B (1 unit)
Direct labor ($10 for both products)
$90
$10
90
10
50
50
90
10
$320
$80
Direct materials ($10 for both products)
Nonvolume cost driver (batch cost)
Setup costs (1 each x $50)
Volume driver — machine hours
Maint. costs (A=18 hrs x $5) (B=2 hrs x $5)
Totals
Cost per unit — A ($320 / 9 units)
$35.555
B ($80 / 1 unit)
Note that POR per machine hour is now $5 instead of $10.
$80
Results of Calculation
Products
Activity-based drivers
Volume-based drivers
A
$35.55
$40.00
B
$80.00
$40.00
The high volume product (A) subsidizes the low volume
product (B) when volume-based cost drivers alone are used.
Part III
A More Complex Activity-Based
Costing Solution
An Illustration
Tommar Machine company has four overhead activity
cost pools with unique cost drivers that products
consume differently.
Overhead activity
Setup
Quality control
Maintenance
Shipping
Total costs
Budgeted
Costs
Cost driver
$30,000 Number of setups
45,000 q.c. hours
120,000 Machine hours
25,000 Number of shipments
$220,000
Budgeted
activity level
600
4,500
24,000
2,500
A Single Volume Driver
Total overhead costs = $220,000
Using machine hours POR = $220,000 / 24,000 hours
= $9.167 per machine hour
Using one volume driver — machine hours
Use the following data for the next illustration.
Subassembly AA
Made in batches of 100, $800 in
materials, $1,000 labor per batch and
50 hours of machine capacity.
Subassembly BB
Made in batches of 60, $900 in
materials, $1,000 labor per batch and
20 hours of machine capacity.
Volume Driver Unit Costs
AA
Direct materials
Direct labor
BB
$800.00
$900.00
$1,000.00
$1,000.00
Overhead applied:
($9.17 x 50 machine hours)
$458.50
($9.17 x 20 machine hours)
Total costs
$183.40
$2,258.50
Unit costs — ($2.258.50/100)
($2,083.40/60)
$2,083.40
= $22.59
= $34.72
Activity Based Cost Allocations —
The Physical Flows
Indirect costs
Total overhead costs = $220,000
Stage One
Assign overhead costs to activity cost pools.
‘activities consume overhead resources’
Setups
=
$30,000 / 600
= $ 50
Quality inspection hours =
$45,000 / 4,500
= $ 10
Machine hours
=
$120,000 / 24,000
=$
Purchase orders
=
$25,000 / 2,500
= $100
5
Stage Two
Assign cost drivers to products
‘products consume activities’
Subassembly AA
Subassembly BB
Plus
Direct materials and Direct Labor
Use ABC to Calculate the Cost of
Subassemblies AA and BB
The following activity data and direct costs
have been collected for two subassemblies.
Subassembly AA
Subassembly BB
$800
$900
$1,000
$1,000
100
60
Number of setups
2
2
Inspection hours
5
3
Machine hours
50
20
Number of orders
20
40
Direct material
Direct labor
Units completed
Unit Costs Using ABC
Subassembly AA
Subassembly BB
Direct material
$ 800
$ 900
Direct labor
$1,000
$1,000
Number of setups
2 x $50 = $ 100
2 x $50 = $ 100
Inspection hours
5 x $10 = $
3 x $10 = $
Machine hours
50 x $5 = $ 250
20 x $5 = $ 100
20 x $10 = $ 200
40 x $10 = $ 400
$2,400
$2,530
Number of orders
Total
Unit costs
(2,400/100)=
(2,530 / 60) =
50
30
$24 per unit
$42.17 per unit
ABC vs. Volume-Based Costs
Subassembly AA
Subassembly BB



Machine hour driver Activity-based drivers
$22.59
$24
$34.72
$42.17
While subassemblies AA & BB have increased unit costs, other
higher volume products will have lower unit costs.
No costs have changed.
All the overhead costs will still be assigned to production.
Part IV
When Do We Know We Have a
Problem?
What are some symptoms of costing system failure?
Symptoms of Accounting System
Problems
Where observed The symptoms
The conflict
Sales
1. Competitors sales prices
on standard products
(our high-volume
products) appear
unrealistically low.
Compared with industry
averages, accounting
reports show our sales
prices are based on
average markups, yielding
normal profit.
Sales
2. Customers still buy our
specialty products even
as we keep raising
prices. But competitors
do not want to be in our
specialty products
market even though it
appears very profitable.
Accounting reports show
abnormally high profits for
specialty products, which
should increase
competition but doesn’t.
Symptoms of Accounting System
Problems (more)
Where observed The symptoms
The conflict
Production
3. Production management
wants to drop the
specialty line because
it’s too expensive and
expand high-volume
product lines because
these products can be
made more efficiently.
Accounting reports show
specialty products are more
profitable than commodity
products.
Production
4. The costs of some
activities are out of
control , such as
purchasing, setups, and
materials handling.
Even though specialty
products appear more
profitable, the unfavorable
overhead costs variances
support Production’s belief
that they are more costly
than commodity products
(standard homes).
Symptoms of Accounting System
Problems (the end)
Where observed The symptoms
Accounting
The conflict
5. Sales and production are Sales and production are in
suspicious of accounting conflict due to conflicting
reports that show highaccounting reports.
volume (commodity)
products are less
profitable than lowvolume (specialty)
products.
When Will Products Have Different Costs?
When multiple product lines exist
and
Different products use different resources and
activities
and / or
Different products use different amounts of the
same resource or activity
Questions About Volume Drivers

Do products consume overhead resources in the
same proportion as the volume driver allocates costs?





Refer back to our example of 9 units of A and one
unit of B.
Overhead assigned using only machine hours.
9 units of A were made for every unit of B.
Hence, the overhead costs using the volume driver
were assigned 90% to ‘A’ and 10% to ‘B’.
A test: For the expanded process with many
departments, what percent of the resources are
occupied supporting ‘A’ or ‘B’? Given the analysis that
follows, do you think the volume drivers allocate
overhead costs correctly?
The Test
Overhead
resources
consumed
Purchasing
department
activity
Storage
department
activities
Activity
driver
Purchase
orders
Time & space Number of
orders
% consumed % consumed
Scheduling
department
activities
Quality
control
department
activities
Time
% consumed % consumed
Product A
50%
90%
50%
60%
Product B
50%
10%
50%
40%
Quality
control
department
activities
Overhead
resources
consumed
Purchasing
department
activities
Storage
department
activities
Scheduling
department
activities
Activity
Purchase
orders
Time & space
Number of
orders
Time
Resources
used
% consumed
% consumed
% consumed
% consumed
Product A
50%
90%
50%
60%
Product B
50%
10%
50%
40%
A Consumption Ratio Test for Setups
How does the cost accounting system allocate setup costs
(Overhead is allocated using direct labor hours)
Standard homes Custom homes
Standard direct labor hours per home
1,000
Production quotas
x
Total direct labor hrs per product line
100,000
2,500
100
Direct labor consumption ratio
x
10
25,000
4 to 1
Actual consumption ratio
Standard homes Custom homes
Budgeted setups
20
10
x setup hours (time to setup)
x 150
x 200
Total setup hours per product line
3,000
2,000
Setup hours consumption ratio
3 to 2
Part V
Two Stage Allocations and the
Activity-Based Costing Hierarchy
Products Consume Activities and
Activities Consume Resources
Resource Categories
1. People
Direct labor, indirect labor, supervisors,
purchasing agents, sales personnel,
management, administrative staff,
computer information systems personnel,
the accounting group, etc.
2. Materials
Direct materials, indirect materials,
purchasing forms, invoices, office
supplies, etc.
3. Direct technology Tools and equipment used by people in
performing activities. Their use can be
trace directly to the activity.
4. Facilities
Buildings and grounds, heat and light,
property taxes and insurance, etc.
Example Activities at Multree Homes

Sales Department






Advertising
Answering customer inquiries
Taking sales orders
Coordinating sales with production
Customer follow-up after completion
Production




Schedule production
Order materials
Set up equipment
Rough framing, roofing, install windows,
carpeting, etc.
Some More Activities at Multree Homes

Warehousing and Shipping







Receive materials
Inspect materials
Store materials
Deliver materials to production
Prepare completed houses for shipping
Load trucks
Deliver to retailers or customers
Some More Activities at Multree Homes

Accounting





Pay bills
Prepare payroll
Run cost accounting system and create reports
Run financial accounting system and create
reports
Collect revenues from customers.
Still More Activities at Multree Homes

Computer Information Systems






Run order entry system
Prepare production schedules
Process manufacturing data into costing system
Run accounts receivable and payable systems
Issue reports from general ledger system
Prepare sales reports and forecast information
The ABC Idea
The ABC concept is fully illustrated in Exhibit
9-8, which can be found on p. 325.
Review this exhibit so everyone can fully
understand the information and cashflow
aspects of Activity Based Costing.
Activity Levels in ABC Systems
Product (unit)
level activities
These activities are needed for each individual
product. They are traced directly to each product.
Batch level
activities
These activities are needed for each batch of
products. They are traced directly to batches and
then allocated equally to each product in the batch.
Product line level
activities
These activities are unique to individual product
lines. They are allocated equally to each product in
the line at Multree. In other companies, they might
be allocated separately based on their unique cost
drivers (different cause-effect relationships).
Facilities level
activities
These activities are associate with a facility. At
Multree, they are allocate to all products equally.
These also might be allocated separately based on
their unique cost drivers (different cause-effect
relationships).
Comparing Traditional Product Costing
and ABC
Traditional Costing
Resources
Direct materials
And
Overhead
Direct labor
Allocated
Traced directly
Using
DL hours
Products
Comparing Traditional Product Costing
and ABC
Activity-Based Costing
Resources
Product
level
Batch
level
traced
directly
charged
Per
batch
Product
line
charged
equally to
each
product
in the line
Products
Facilities
level
charged
equally to
all
products
Discussion
Activity-based costing systems can include a large
number of cost drivers segregated into four categories.
Activity-based cost
hierarchy
Unit-level (volume
based cost drivers)
Definition
Examples
Costs consumed as one
unit is made
Direct materials, direct
labor, power
Nonvolume-based cost drivers
Batch-level
Costs consumed when
a different type of
product is started
Purchasing costs,
setups
Product sustaining
Costs consumed to
support specific
product lines
Product line
documentation, unique
tools and dies
Facility sustaining
Costs consumed by the
company that cannot
be traced to products
Corporate salaries and
administrative costs
Part VI
How Do We Use the Cost
Information?
For Which Purposes are Volume-Base Drivers
Sufficient?
ABC Income Statements


Examine the ABC income statements found in
Exhibits 9-16 and 9-17, p. 335.
They will provide an illustration of the
information content in ABC systems, how the
information applies to production and pricing
decisions, as well as forecasting and
performance measurement.
What Do We Use Cost Information For?






Determining whether to ad or drop product lines.
Determining product pricing.
Deciding whether or not to outsource a product or
activity (make or buy, perform ourselves or outsource
the activity).
To facilitate redesign of a product.
To facilitate redesign of an internal activity.
To perform customer profitability analysis.