Chapter 5: Activity-Based Costing
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1 Chapter 5: -Based ing Management System: A cost-management system (CMS) is a collection of tools and techniques that identifies how management s decisions affect costs. Traditional (Peanut Butter) ing: Traditional ing Approach: a traditional costing approach which uses broad averages to spread costs among products and services even though the resources are consumed in a non-uniform way leads to overcosting and undercosting of products and services. Product cost cross-subsidization if some products are overcosted, other products are undercosted the overcosted products are subsidizing the undercosted products. Traditional System: Two-Stage -Based System:
2 -Based ing: An activity-based approach refines a costing system by focusing on individual activities as the fundamental cost objects. It uses the cost of these activities as the basis for assigning costs to other cost objects such as products or services. Understanding the relationships among activities, resources, costs, and cost drivers is the key to understanding ABC and how ABC facilitates managers understanding of operations. Identify the steps involved in the design and implementation of an activitybased costing system: Designing and Implementing an -Based ing System 2
3 -Based Management: -based management aims to improve the value received by customers and to improve profits by identifying opportunities for improvements in strategy and operations. A value-added cost is the cost of an activity that cannot be eliminated without affecting a product s value to the customer. In contrast, non-value-added costs are costs that can be eliminated without affecting a product s value to the customer. Use activity-based cost information to improve the operations of an organization: -based management Provides costs of value-added and non-value-added activities. Improves managers understanding of operations. Refining a ing System: Three things to consider to improve an existing costing system: 1- Direct-cost tracing: reduce the amount of indirect costs by classifying more costs as direct 2- Indirect-cost pools: expand the number of indirect-cost pools until the costs in each pool are homogeneous 3- -allocation bases: consider using a different cost-allocation base for each indirect-cost pool. based on what causes the cost pool to change -Based ing (ABC): refinement of an existing cost system which focuses on individual activities as the basic cost objects. an activity is an event, task, or unit of work with a specified purpose. examples of activities include designing the product or service, set up of machinery, operating machinery, distribution of finished product, administration. Hierarchies: When thinking about splitting indirect costs into homogeneous cost pools considering four cost hierarchies or cost categories: 1- Output unit-level costs: costs of activities performed on each individual unit of a product or service. 2- Batch-level costs: costs of activities related to a group of units of products or services rather than to each individual unit of product or service. 3- Product-sustaining costs or service-sustaining costs: costs of activities undertaken to support individual products or services regardless of the number of units or batches in which the units are produced. 4- Facility-sustaining costs: costs of activities that cannot be traced to individual products or services but support the organization as a whole. 3
4 4 center Unit-level Batch-level Productlevel Facilitylevel Parts inventory management. Labour-related Plant occupancy Purchase order Machine-related General factory Product prototype testing Production orders Product design Machine setup Personal administration Traditional versus ABC ing: An ABC approach focuses on activities as the fundamental cost objects. The costs of these activities are built up to compute the costs of products, and services, and so on. Simple costing systems have one or a few indirect cost pools, irrespective of the heterogeneity in the facility while ABC systems have multiple indirect cost pools. An ABC approach attempts to use cost drivers as the allocation base for indirect costs, whereas a simple costing system generally does not. The ABC approach classifies as many indirect costs as direct costs as possible. A simple costing system has more indirect costs. Benefits of ABC Systems: 1- Promotes the use of activity-based management (ABM) within the organization. 2- ABM focuses management s attention on the activities that cause costs to be incurred. 3- results in: Better product and pricing decisions. Reduced costs. Performing activities more efficiently. Eliminating activities that do not add value. Improving product design. 4- eventually leads to improved operations and processes, satisfied customers, and increased profits. Definitions: : An activity is a unit of work performed within an organization. It is a description of the work that goes on in an organization, and it consumes resources. Testing materials is an example of an activity. driver: An activity driver is a factor that measures the consumption of an activity by a cost object. If a circuit board is the cost object, and attaching parts is the activity, then the number of parts attached to the board could be the activity driver. object: A cost object is a reason for performing an activity. Products, customers, and services are reasons for performing an activity. driver: A cost driver is an event or causal factor that influences the level and performance of activities and the resulting consumption of resources. The percent of parts received that are defective is an example of a cost driver.
5 Example: XY Company manufactures four products, namely A, B, C and D, using the same plant and processes. The following information relates to a production period: Direct Sale Price Product Volume Material cost per unit per unit Machine time per unit Direct Labor cost per unit A 500 $ 11 $ 5 ¼ hour $ 3 B 5000 $ 11 $ 5 ¼ hour $ 3 C 600 $ 34 $16 1 hour $12 D 7000 $32.5 $17 1 ½ hours $ 9 The total production overheads, $59,880 recorded by the cost accounting system are analyzed under the following headings which should each be regarded as cost drivers for purposes of activity based costing: Mfg. Overhead Mfg. Overhead s Allocation bases Factory overhead recorded to machine-oriented activity $37,425 Machine Hours Set up $ 4,355 Number of set-ups Ordering materials $ 1,920 Number of material orders Handling materials $ 7,580 Number of times material was handled Administration for spare parts $ 8,600 Number of spare parts Total Mfg. Overhead s $59,880 However, investigation into the production overhead activities for the period reveals the following totals: Product Total Number of set-ups Total Number of material orders Total Number of times material was handled Total Number of spare parts A B C D Required: a- Present an overview diagram of traditional and ABC costing systems. b- Calculate the production overhead cost for manufacturing each of the four products using the present absorption (traditional) costing system (Hint: manufacturing overhead has been allocated based on machine hours). c- Calculate the production overhead cost for manufacturing each of the four products using activity based costing. Your answer should show in detail how this is based on each product s share of production overhead costs for each cost driver. d- Compute the total cost per unit under each system. 5
6 The Solution: a- an overview diagram of traditional and ABC costing systems: 1- Traditional ing System: Indirect Pool Allocation Base object: Product line Mfg. Support Machine Hours Indirect s Direct s Direct CoGS 2- ABC System: Indirect Pool Allocation Base object: Product line Machine Operations Set-Up Ordering Handling Spare Parts No. of Machine Hours No. of Set- Ups No. of Material Orders Indirect s Direct s No. of Times Material was handled No. of Spare Parts Direct CoGS b- Calculating the production overhead cost for manufacturing each of the four products using the present absorption (traditional) costing system: The overhead costs are allocated by products on a machine hour base. Product Mfg. Overhead Machine time Total Machine Allocation Mfg. Overhead s Volume s per unit Hours Rate allocated to each product A 500 ¼ hour 125 hours 125 $4.8 = $ 600 B 5000 ¼ hour 1,250 hours 1,250 $4.8 = $ 6000 C hour 600 hours 600 $4.8 = $ 2,880 D ½ hours 10,500 hours 10,500 $4.8 = $ 50,400 Total $59, ,475 hours $4.8 per hour $59,880 6
7 c- ABC: 1- Machine-related costs: Machine hour rate = $37,425 12,475 Hours = $3 per hour Machine operations Product Driver Allocation (Machine Hours) Rate A $ 375 B 1,250 3 $ 3,750 C $ 1,800 D 10,500 3 $31,500 Total $37, Set-up related costs: per set-up = $4, set-ups = $ per set up Set-up Product Driver Allocation (Set-Up) Rate A 1 $ $ B 5 $ $ C 2 $ $ D 8 $ $ Total $ 4, Material ordering related costs: per order = $1, orders = $192 per order Material ordering Product Driver Allocation (Material Orders) Rate A 1 $192 $ 192 B 4 $192 $ 768 C 1 $192 $ 192 D 4 $192 $ 768 Total $1, Material handling related costs: per material handling = $7, = $303.2 per time Material handling Product Driver Allocation (Handling Material) Rate A 2 $303.2 $ B 9 $303.2 $ C 3 $303.2 $ D 11 $303.2 $ Total $ 7,580 s such as materials-handling costs vary with the number of parts handled (a function of batches and complexity of products) rather than with the machine-hours, an output-unit level cost driver, which was the only cost driver in the present (simple or traditional) costing system. 7
8 5- Spare parts: per part = $8, = $860 per part Spare parts Product Driver (spare parts) Allocation Rate A 2 $860 $1,720 B 4 $860 $3,440 C 1 $860 $ 860 D 3 $860 $2,580 Total $8,600 The Mfg. overhead allocated for each product under the ABC: Product Mfg. Overhead s The Product Mfg. Machine St-Up Ordering Handling Spare Parts Overhead s A $ 375 $ $ 192 $ $1,720 $ 3, B $ 3,750 $1, $ 768 $2,728.8 $3,440 $ 12, C $ 1,800 $ $ 192 $ $ 860 $ 4, D $31,500 $ 2,177.5 $ 768 $3,335.2 $2,580 $ 40,360.7 Total $37,425 $ 4,355 $1,920 $ 7,580 $8,600 $ 59,880 d- Computing the total cost per unit: 1- The Volume-based system: 2- ABC System: Product Material cost per unit Direct Labor cost per unit Mfg. Overhead Per Unit Total Per Unit A $ 5 $ 3 $1.2 $ 9.2 B $ 5 $ 3 $1.2 $ 9.2 C $16 $12 $4.8 $32.8 D $17 $ 9 $7.2 $33.2 Product Material cost per unit Direct Labor cost per unit Mfg. Overhead Per Unit Total Per Unit A $ 5 $ 3 $6.33 $ B $ 5 $ 3 $2.41 $10.41 C $16 $12 $7.17 $35.17 D $17 $ 9 $5.77 $31.77 Term Definition Prepared by Dr. Helal Afify
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