TUTORIAL -ABC. Ir. Haery Sihombing/IP Pensyarah Pelawat Fakulti Kejuruteraan Pembuatan Universiti Teknologi Malaysia Melaka

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1 TUTORIAL -ABC Ir. Haery Sihombing/IP Pensyarah Pelawat Fakulti Kejuruteraan Pembuatan Universiti Teknologi Malaysia Melaka

2 TOTAL COST for a COST OBJECT EXAMPLE: 1 Direct Cost (Labor Material) Overhead Cost + Total Object Cost

3 TRADITIONAL COST ACCOUNTING Arbitrarily allocates to the cost objects Total Company s s overhead is allocated o the products based on volume based measure (e.g.( labor hours, machine hours) Assumption: relation between overhead and the volume based measure

4 TRADITIONAL COST ACCOUNTING Two products: Product A and Product B Product A : 1 hours of direct labor (direct labor cost 1 *RM20/hour =RM 20.00/hours) Demand = 100 Product B: 2 hours of direct labor (direct labor cost 2 *RM20/ hour =RM 40.00/hours) Demand = 950

5 TRADITIONAL COST ACCOUNTING TOTAL OVERHEAD = RM 100, TOTAL DIRECT LABOR = 2,000 Hours RM 100,000/2000 Hours = RM 50/ Hours Product A : 1 hours of direct labor Product B : 2 hours of direct labor TCA Overhead Allocation : A = RM 50/unit B = RM 100/unit

6 ACTIVITY BASED COSTING More Accurate Cost Management Methodology Focuses on indirect costs (overhead) Traces rather than allocates each expense category to the particular cost object Makes indirect expense direct

7 ABC Basic Premise Cost objects consume activities Activities consume resources This consumption of resources is what driver costs Understanding this relationship is critical to successfully managing overhead

8 When To Use ABC Overhead is high Products are diverse: complexity, volume, amount of direct labor Cost of errors are high Competition is stiff

9 ABC Steps Identifies activities Determine cost for each activity Determine cost drivers Collect activity data Calculate product cost

10 ABC Illustration 1. INDENTIFY ACTIVITIES Set-up Machining Receiving Packing Engineering

11 ABC Illustration 2. DETERMINE ACTIVITY COST Set-up Machining Receiving Packing Engineering = RM 10,000 = RM 40,000 = RM 10,000 = RM 10,000 = RM 30,000

12 ABC Illustration 3. DETERMINE COT DRIVERS Set-up Machining Receiving Packing Engineering = Number of Setups = Machining Hours = Number of Receipt = Number of Deliveries = Engineering Hours

13 ABC Illustration ABC Illustration 4. ACTIVITY DATA 4. ACTIVITY DATA 75,500 75,500 24,500 24,500 15,000 15, ,000 15, ,000 30,000 Engineering Engineering 7,500 7, ,500 2, ,000 10,000 Packing Packing 7,500 7, ,500 2, ,000 10,000 Receiving Receiving 38,000 38, ,000 2, ,000 40,000 Machining Machining 7,500 7, ,500 2, ,000 10,000 Set Set-up up RM RM PRODUCT PRODUCT B RM RM PRODUCT PRODUCT A Cost Cost (RM) (RM) ACTIVITY ACTIVITY

14 ABC Illustration 5. PRODUCT COST CALCULATION Overhead for Product A = RM 24,500 : 100 = RM 245 Overhead for Product B = RM 75,000 : 950 = RM

15 PRODUCT COST TCA Vs. ABC Cost for Product A : Cost for Product B : Overhead TCA RM 50,00 Overhead ABC RM 245,00 Direct Cost TCA RM 20,00 Direct Cost ABC RM 20,00 TOTAL TCA RM 70,00 TOTAL ABC RM 265,00 Overhead TCA RM 100,00 Overhead ABC RM Direct Cost TCA RM 40,00 Direct Cost ABC RM 40,00 TOTAL TCA RM 140,00 TOTAL ABC RM 119,47

16 Undercosting & Overcosting EXAMPLE: 2 Jose, Roberta, and Nancy order separate items for lunch. Jose s order amounts to $14 Roberta consumed 30 Nancy s order is 16 Total $60 What is the average cost per lunch?

17 Undercosting & Overcosting $60 3 = $20 Jose and Nancy are overcosted. Roberta is undercosted.

18 Existing Single Indirect- Cost Pool System EXAMPLE: 3 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).

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

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

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

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

23 Existing Single Indirect- Cost Pool System 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?

24 Existing Single Indirect- Cost Pool System 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

25 Existing Single Indirect- Cost Pool System 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

26 Existing Single Indirect- Cost Pool System Normal lenses sell for $60 each and complex lenses for $142 each. Normal Complex Revenue $60.00 $ Cost Income $ 4.90 $ Margin 8.2% 29.9%

27 Refining a Costing System Direct-cost tracing Indirect-cost pools Cost-allocation basis

28 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). 2. Manufacturing Operations Lenses are molded, finished, cleaned, and inspected. 3. Shipping and Distribution Finished lenses are packed and sent to the various customers.

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

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

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

32 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

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

34 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

35 Activity-Based Costing System Allocation using direct labor-hours: NL: $ ,000 = $294,624 CL: $ ,000 = $114,576 Total $409,200 Allocation using setup-hours: NL: $ = $ 99,200 CL: $155 2,000 = $310,000 Total $409,200

36 Cost Hierarchies A cost hierarchy is a categorization of costs into different cost pools. Cost drivers bases (cost-allocation bases) Degrees of difficulty in determining cause-and-effect relationships

37 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

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

39 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

40 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

41 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. rent General administration building security

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

43 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.

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

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

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

47 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.

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

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

50 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

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

52 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

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

54 SUMMARY of ABC APPOACH ABC is more accurate cost management system than Traditional Cost Accounting (TCA) Traditional Cost Accounting (TCA) is unable to calculate the true of a product

55 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.

56 Benefits of ABC Systems 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. Complex products appear to be very profitable and simple products appear to be losing money.

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

58 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.

59 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.