Activity Based Costing: A Tool to Aid Decision Making. M. En C. Eduardo Bustos Farías

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1 Activity Based Costing: A Tool to Aid Decision Making M. En C. Eduardo Bustos Farías 1

2 Ejemplo 1. Portland Power Company 2

3 Activity Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore fixed Por lo tantocosts. ABC is a good supplement to our traditional cost system I agree! 3

4 Activity Based Costing (ABC) Both manufacturing and nonmanufacturing costs may be assigned to to products. A number of of cost pools each origen allocated to to a product or or cost object. 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 at capacity. 4

5 How Costs are Treated Under Activity-Based Costing Activity Based Costing Departmental Overhead Rates Plantwide Overhead Rate Level of Complexity Level of Complexity Overhead Allocation 5

6 Plantwide Overhead Rate Companies tended to use direct labor as the overhead allocation base. There was a belief that direct labor and overhead costs were highly correlated. 6

7 Departmental Overhead Rates Finishing Department Painting Department Shipping Department Many companies have a system in which each department has its own overhead rate. 7

8 Departmental Overhead Rates Stage One: Costs assigned to pools Cost pools Indirect Labor Department 1 Indirect Materials Department 2 Other Overhead Department 3 8

9 Departmental Overhead Rates Stage One: Costs assigned to pools Cost pools Indirect Labor Department 1 Indirect Materials Department 2 Other Overhead Department 3 Stage Two: Costs applied to products Products 9

10 Departmental Overhead Rates Stage One: Costs assigned to pools Cost pools Indirect Labor Department 1 Indirect Materials Department 2 Other Overhead Department 3 Stage Two: Costs applied to products Direct Labor Hours Machine Hours Products Raw Materials Cost Departmental Allocation Bases 10

11 Cost of Idle Capacity inactiva Traditional Cost Accounting The predetermined overhead rate is based on budgeted activity. This results in applying overhead costs of unused, or idle, capacity. Activity Based Costing Products are charged for the costs of capacity they use not for the costs of capacity they don t t use. 11

12 Designing an ABC System Cost Objects (e.g., products and customers) Activities Consumption of Resources Cost 12

13 PELÍCULA 13

14 Designing of an ABC System Steps for Implementing ABC Identify and define activities and activity cost pools. Trace costs to activities and cost objects. Assign costs to activity cost pools. Calculate activity rates. Assign costs to cost objects. Prepare management reports. 14

15 Identify and Define Activities and Activity Cost Pools 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 Organization- sustaining Activity Customer-Level Activity 15

Identify and Define Activities and Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures: Activity Cost Pools at Classic Brass Activity

16 Identify and Define Activities and Activity Cost Pools At Classic Brass, the ABC team, selected the following activity cost pools and activity measures: Activity Cost Pools at Classic Brass Activity Cost Pool Customer orders Product design Order size Customer relations Other Activity Measure Number of customer orders Number of product designs Machine-hours Number of active customers Not applicable 16

17 Identify and Define Activities and Activity Cost Pools Activity Cost Pool is a bucket cubeta in which costs are accumulated that relate to a single activity measure in the ABC system. $ $ $ $ $ $ 17

18 Identify and Define Activities and Activity Cost Pools Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Product Designs - assigned all costs of resources consumed by designing products. Order Size - assigned all costs of resources consumed as a consequence of the number of units produced. Customer Relations assigned all costs associated with maintaining relations with customers. Other assigned all overhead costs that are not associated with the other cost pools. 18

19 Whenever Possible, Directly Trace Cada vez Overhead Costs to Activities and Cost Objects Overhead Costs at Classic Brass (Manufacturing and NonManufacturing) Production Department Indirect factory wages $ 500,000 Factory equipment depreciation 300,000 Factory utilities servicios 120,000 Factory building lease 80,000 $ 1,000,000 Shipping costs traced to customer orders 40,000 General Administrative Department Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60, ,000 Marketing Department Marketing wages and salaries 250,000 Selling expenses 50, ,000 Total overhead costs $ 1,850,000 19

20 Assign Costs to Activity Cost Pools At Classic Brass the following distribution of resource consumption across activity cost pools is determined. Activity Cost Pools Customer Product Orders Design Order Size Customer Relations Other Total Production Department Indirect factory wages 25% 40% 20% 10% 5% 100% Factory equipment depreciation 20% 0% 60% 0% 20% 100% Factory utilities 0% 10% 50% 0% 40% 100% Factory building lease 0% 0% 0% 0% 100% 100% Shipping costs ** General Administrative Department Administrative wages and salaries 15% 5% 10% 30% 40% 100% Office equipment depreciation 30% 0% 0% 25% 45% 100% Administrative building lease 0% 0% 0% 0% 100% 100% Marketing Department Marketing wages and salaries 20% 10% 0% 60% 10% 100% Selling expenses 10% 0% 0% 70% 20% 100% **Not included because they are directly traced to customer orders. 20

21 Assign Costs to Activity Cost Pools Production Department Indirect factory wages $ 125,000 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 Activity Cost Pools Customer Product Orders Design Overhead Costs at Classic Brass (Manufacturing and NonManufacturing) Production Department Indirect factory wages $ 500,000 Factory equipment depreciation 300,000 Order Factory utilities 120,000 Factory building Size lease 80,000 $ 1,000,000 Shipping costs traced to customer orders 40,000 General Administrative Department Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60, ,000 Marketing Department Marketing wages and salaries 250,000 Customer Relations Other Total Selling expenses 50, ,000 Total overhead costs $ 1,850,000 Indirect factory wages $500,000 Percent consumed by customer orders 25% $125,000 21

22 Assign Costs to Activity Cost Pools Production Department Indirect factory wages $ 125,000 Factory equipment depreciation 60,000 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 Activity Cost Pools Customer Product Orders Design Overhead Costs at Classic Brass (Manufacturing and NonManufacturing) Production Department Indirect factory wages $ 500,000 Factory equipment depreciation 300,000 Order Factory utilities 120,000 Factory building Size lease 80,000 $ 1,000,000 Shipping costs traced to customer orders 40,000 General Administrative Department Administrative wages and salaries 400,000 Office equipment depreciation 50,000 Administrative building lease 60, ,000 Marketing Department Marketing wages and salaries 250,000 Customer Relations Other Total Selling expenses 50, ,000 Total overhead costs $ 1,850,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20% $ 60,000 22

23 Assign Costs to Activity Cost Pools Activity Cost Pools Customer Orders Product Design Order Size Customer Relations Other Total Production Department Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000 Factory equipment depreciation 60, ,000-60, ,000 Factory utilities - 12,000 60,000-48, ,000 Factory building lease ,000 80,000 General Administrative Department Administrative wages and salaries 60,000 20,000 40, , , ,000 Office equipment depreciation 15, ,500 22,500 50,000 Administrative building lease ,000 60,000 Marketing Department Marketing wages and salaries 50,000 25, ,000 25, ,000 Selling expenses 5, ,000 10,000 50,000 Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000 23

24 Calculate Activity Rates The ABC team determines that Classic Brass will have these total activities for each activity cost pool... 1,000 customer orders 200 new designs 20,000 machine-hours hours 100 customer relations activities Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels. 24

25 Calculate Activity Rates Computation of Activity Rates (a) (b) (a) (b) Activity Cost Pools Total Cost Total Activity Activity Rate Customer orders $ 315,000 1,000 orders $315 per order Product design 257, designs $1,285 per design Order size 380,000 20,000 MHs $19 per MH Customer relations 367, customer $3,675 per customer Other 490,500 Not applicable Not applicable 25

26 Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Traced Traced Traced Cost Objects: Products, Customer Orders, Customers 26

27 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 27

28 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 Stage Allocations $/MH $/Order $/Design $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated 28

29 Assigning Costs to Cost Objects Let s take a look at how our system works for just one customer Windward Yachts. postes Standard Stanchions (no design required) units ordered with 2 separate orders. 2. Each stanchion required 0.5 machine-hours hours. 3. Selling price is $34 each. 4. Direct materials total $2, Direct labor totals $1, Shipping costs total $180. Yates de barlovento Custom Compass Housing (requires new design) 1. One order during the year. 2. Each housing required 4 machine-hours hours. 3. Selling price is $650 each. 4. Direct materials total $ Direct labor totals $ Shipping costs total $25. 29

30 Assigning Costs to Cost Objects Overhead Cost for the Standard Stanchions (a) (b) (a) (b) Activity Cost Pools Activity Rate Activity ABC Cost Customer orders $ $ 630 Product design 1, Order size ,800 Customer relations 3,675 N/A The customer-level cost is assigned to customers directly; it is not assigned to products. Overhead Cost for the Custom Housing (a) (b) (a) (b) Activity Cost Pools Activity Rate Activity ABC Cost Customer orders $ $ 315 Product design 1, ,285 Order size Customer relations 3,675 N/A 30

31 Prepare Management Reports Standard Stanchions Sales $ 13,600 Cost: Direct materials $ 2,110 Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design - Order size 3,800 8,570 Product margin $ 5,030 Custom Compass Housing Sales $ 650 Cost: Direct materials $ 13 Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285 Order size 76 1,764 Product margin $ (1,114) 31

32 Prepare Management Reports Customer Profitability Analysis Windward Yachts Product margins: Standard stanchion $ 5,030 Custom compass housing (1,114) Total product margin 3,916 Less: Customer relations 3,675 Customer margin $

33 Product Margins Traditional Cost Accounting System Standard Stanchions Compass Housing Sales $ 13,600 $ 650 Costs Direct materials (2,110) (13) Direct labor (1,850) (50) Manufacturing overhead (10,000) (200) Product margin $ (360) $ units x 0.5 MH/unit x $50/MH = $10,000 Predetermined manufacturing overhead rate = $1,000,000 20,000 MH = $50/MH 33

34 Difference Between ABC and Traditional Product Costs Batch-level or product-level costs will ordinarily shift overhead costs from high-volume products produced in large batches to low-volume products produced in small batches. Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organization- sustaining costs and the costs of idle capacity are not assigned to products. 34

35 Targeting Process Improvement Activity-based costing can be used to identify areas that would benefit from process improvements. 35

36 Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because External reports are less detailed than internal reports. 2. It may be difficult to make changes to the company s accounting system. 3. ABC does not conform to GAAP. 4. Auditors may be suspect of the subjective allocation process based on interviews with employees. 36

37 Benefits of ABC Systems Significant amounts of indirect costs are allocated using only one or two cost pools. All or most costs are identified as output unit-level costs. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity. 37

38 Benefits of ABC Systems Products that a company is well-suited to Bien preparado make and sell show small profits while products for which a company is less suited show large profits. Complex products appear to be very profitable and simple products appear to be losing money. 38

39 Benefits of ABC Systems Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services. 39

40 Limitations of ABC ABC systems are a major project requiring substantial resources. The benefits of increased accuracy must outweigh these additional costs. ABC produces numbers, like product margins, that are at odds with numbers desigualdades produced by traditional costing system. Some managers find it difficult to adjust to this change. ABC data can be misinterpreted and must be used with care when making decisions. 40

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.

41 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. 41

42 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. 42

43 EXAMPLE 1 43

44 ABC Illustration - Background Information Comtek Sound, Inc. makes two products, a radio with a built-in compact disc player and one with a built-in tape player. Comtek has budgeted sales of 50,000 CD units and 200,000 tape units. Both products require two direct labor-hours to complete. The company plans to work 500,000 hours to meet the budgeted production. All production is sold to auto manufacturers for installation in new cars and trucks. Direct materials cost $90 per unit for the CD unit and $50 for the Tape unit. Direct labor costs at $10 per hour are $20 for both the CD and Tape unit. 44

45 Unit Product Costs (Using a Plantwide Overhead Rate) Total overhead costs for the current year are estimated to be $10,000,000. The company develops the following predetermined overhead rate based upon direct labor-hours: Predetermined overhead rate = $10,000, ,000 DLH = $20 per DLH CD Unit Tape Unit Direct materials $ 90 $ 50 Direct labor Overhead (2 DLH x $20/DLH) Unit product cost $ 150 $

46 Gathering the Information recogiendo Required to Develop ABC Units Costs The ABC project team at Comtek has developed the following basic information: Activity and Activity Measures Estimated Overhead Cost Expected Activity Total CD Tape Labor related (DLH) $ 800, , , ,000 Machine related (MH) 2,100,000 1,000, , ,000 Machine setups (setups) 1,600,000 4,000 3,000 1,000 Production orders (orders) 450,000 1, Product testing (tests) 1,700,000 20,000 16,000 4,000 Material receipts (receipts) 1,000,000 5,000 1,800 3,200 Parts administration (part types) 350, General factory (MH) 2,000,000 1,000, , ,000 $ 10,000,000 46

47 Computing Activity Rates Using the basic information, the activity rates can be calculated: Activity and Activity Measures Estimated Overhead Cost Total Expected Activity Activity Rate Labor related (DLH) $ 800, ,000 $ 1.60 per DLH Machine related (MH) 2,100,000 1,000, per MH Machine setups (setups) 1,600,000 4, per setup Production orders (orders) 450,000 1, per order Product testing (tests) 1,700,000 20, per test Material receipts (receipts) 1,000,000 5, per receipt Parts administration (part types) 350, per par type General factory (MH) 2,000,000 1,000, per MH $ 10,000,000 47

48 ABC Overhead Rates Using the new activity rates, overhead can be assigned (or allocated) to the two products based upon activity: CD Units Tape Units Expected Expected Activity and Activity Measures Activity Amount Activity Amount Labor related (DLH) 100,000 $ 160, ,000 $ 640,000 Machine related (MH) 300, , ,000 1,470,000 Machine setups (setups) 3,000 1,200,000 1, ,000 Production orders (orders) , ,000 Product testing (tests) 16,000 1,360,000 4, ,000 Material receipts (receipts) 1, ,000 3, ,000 Parts administration (part types) , ,000 General factory (MH) 300, , ,000 1,400,000 Total overhead cost assigned $ 4,660,000 $ 5,340,000 Number of units produced 50, ,000 Overhead cost per unit $ $ ABC overhead rates per unit 48 ABC overhead rates per unit

49 Comparison of Product Costs Notice that the unit product cost of a tape unit decreased from $110 to $ Activity-Based Costing Direct-Labor Costing CD Units Tape Units CD Units Tape Units Direct material $ $ $ $ Direct labor Overhead Unit product cost $ $ $ $ while the unit cost of a CD unit increased from $150 to $

50 Shifting of Overhead Cost Activity-Based Costing Direct-Labor Costing CD Units Tape Units CD Units Tape Units Direct material $ $ $ $ Direct labor Overhead Unit product cost $ $ $ $ Low-volume product When a company implements activity-based costing, overhead cost often shift from high-volume to low-volume products with a higher unit product cost resulting for the low-volume products. 50

51 EXAMPLE 2 51

52 Activity Dictionary: Cardiology Ward Activity Name Activity Description Activity Type Cost Object(s) Activity Driver Supervising Scheduling, Secondary Activities Percentage nurse coordinating, within time nurses and performance department spend on evaluation each activity Treating Administering Primary Patient types Number of patients medicine and treatments changing dressings Continued 52

53 Activity Name Activity Description Activity Type Cost Object(s) Activity Driver Providing Bathing, Primary Patient types Labor hours hygienic care changing bedding and clothes, walking patients Responding to Answering Primary Patient types Number of patient calls, counseling, requests requests providing snacks, etc. Monitoring Monitoring Primary Patient types Monitoring patients vital signs hours and posting patient information 53

54 Cardiology Ward Example (Cont d) Percentage of of Time for for Each Activity Activity Supervisor Nurses Supervising nurses 100 % 0 % Treating patients 0 25 Providing hygienic care 0 20 Responding to requests 0 40 Monitoring patients

55 Cardiology Ward Example (Cont d) Unbundling of of General Ledger Costs principales Chart of of Accounts View Supervising $ 50,000 Supplies 40,600 Uniforms 8,200 Salaries 300,000 Computer 1,200 Monitor 80,000 Total $480,000 55

56 Cardiology Ward Example (Cont d) Unbundling of General Ledger Costs ABC View Supervising nurses $ 52,280 Treating patients 90,000 Providing hygienic care 76,600 Responding to requests 133,200 Monitoring patients 127,920 Total $480,000 56

57 Cardiology Ward Example (Cont d) Assignment of of Secondary Activity Costs to to Primary Activities $90,000 + (0.25 x $52,280) Treating patients $103,070 $76,600 + (0.20 x $52,280) Providing hygienic care 87,056 $133,200 Responding + to (0.40 requests x $52,280) 154,112 Monitoring $127,920 patients + (0.15 x $52,280) 135,762 57

58 Cardiology Ward Example (Cont d) Rate Calculations Treating patients: $103,070/30,000 = $3.44 per per treatment Providing hygienic care: $87,056/16,000 Responding to to requests: $154,112/80,000 = $5.44 per per hour of of care care = $1.93 per per request Monitoring patients: $135,762/200,000 = $0.68 per per monitoring hour 58

59 Cardiology Ward Example (Cont d) Bill of of Activities Activity Intensive Activity Driver Normal Intermediate Care Total Production (output) Patient days 10,000 5,000 3,000 Treating patients Treatments 5,000 10,000 15,000 30,000 Providing hygienic care Hygienic hours 5,000 2,500 8,500 16,000 Responding to requests Requests 30,000 40,000 10,000 80,000 Monitoring patients Monitoring hours 20,000 60, , ,000 59

60 Cardiology Ward Example (Cont d) Assigning Cost: Final Cost Objects Normal Treating patients: $3.44 x 5,000 $ 17,200 Providing hygientic care: $5.44 x 5,000 27,200 Responding to requests: $1.93 x 30,000 57,900 Monitoring patients: $0.68 x 20,000 13,600 Total cost $115,900 Units 10,000 Nursing cost per patient day $

61 Cardiology Ward Example (Cont d) Assigning Cost: Final Cost Objects Intermediate Treating patients: $3.44 x 10,000 $ 34,400 Providing hygientic care: $5.44 x 2,500 13,600 Responding to requests: $1.93 x 40,000 77,200 Monitoring patients: $0.68 x 60,000 40,800 Total cost $166,000 Units 5,000 Nursing cost per patient day $

62 Cardiology Ward Example (Cont d) Assigning Cost: Final Cost Objects Intensive Care Treating patients: $3.44 x 15,000 $ 51,600 Providing hygientic care: $5.44 x 8,500 46,240 Responding to requests: $1.93 x 10,000 19,300 Monitoring patients: $0.68 x 120,000 81,600 Total cost $198,740 Units 3,000 Nursing cost per patient day $

CHAPTER 7 Accounting 1B. Activity-Based Costing(ABC): A tool to Aid Decision Making

CHAPTER 7 Accounting 1B. Activity-Based Costing(ABC): A tool to Aid Decision Making CHAPTER 7 Accounting 1B Activity-Based Costing(ABC): A tool to Aid Decision Making Global Business Situation Using technology and productivity More emphasis on cost measurement and control Increasingly