Activity Based Costing: A Decision Making Tool with Dr. Joseph Ugras December 2017 1
7-2 Learning Objectives Know the Need for Cost and Profitability Understand how traditional and activity-based costing differ Evaluate the various cost drivers Understand value-added and non-value-added activities Compute the product costs using an activity-based costing system Know the conditions for usefulness for activity-based costing Understand the information provided by activity-based costing systems for strategic decision making Know the criticisms directed at activity-based costing?
7-3 How important is cost information? Why do we need to know the cost of making the product or cost of providing a service? 1. Profitability By Product By Customer 2. Decision Making using Cost data Pricing Value Chain Analysis and Outsourcing Decision 3. Performance Evaluation
7-4 The emergence of ABC/ABM 1987 book by Johnson/Kaplan Cooper and Kaplan s reintroduced ABC in the 90 s
7-5 What are the costs of running a business in a manufacturing environment? Product Costs (Direct Materials, Direct Labor, Manufacturing Overhead) become inventory Balance Sheet prior to moving to the Income Statement Period Costs (Selling and Administrative Expenses) Income Statement immediately
7-6 Traditional Product Costing System Direct Material and Direct Labor traceable to the product Overhead is applied using a cost driver (e.g., Labor Cost, Machine Hours, etc.) Overhead s growth over time with increased use of automation We might have to change from the single OH driver to multiple cost drivers
7-7 Some Points of Cost Trends The relative proportions of what go into product costs have changed significantly with direct labor content dropping to between 5% to 15%, materials content falling between 45% and 55%, and overhead soaring to between 30% and 50%.
7-8 How Overhead Costs are Treated Under Different Systems Activity Based Costing Departmental Overhead Rates Plantwide Overhead Rate Overhead Allocation
7-9 Plantwide Overhead Rate Companies tend to use direct labor as the overhead allocation base.
7-10 Departmental Overhead Rates Finishing Department Painting Department Shipping Department A two stage process is necessary because costs are allocated to departments and then to products.
7-11 Departmental Overhead Rates Stage One: Costs assigned to pools Cost pools Indirect Labor Department 1 Indirect Materials Department 2 Other Overhead Department 3
7-12 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
7-13 Activity Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity, and therefore, affect fixed as well as variable costs. ABC is a good supplement to our traditional cost system I agree!
7-14 How Costs are Treated Under Activity Based Costing ABC differs from traditional cost accounting in three ways. Manufacturing costs Nonmanufacturing costs Traditional product costing ABC product costing ABC assigns both types of costs to products.
All Some 7-15 How Costs are Treated Under Activity Based Costing ABC differs from traditional cost accounting in three ways. Manufacturing costs Nonmanufacturing costs Traditional product costing ABC product costing ABC does not assign all manufacturing costs to products.
Level of complexity 7-16 How Costs are Treated Under Activity Based Costing ABC differs from traditional cost accounting in three ways. Plantwide Overhead Rate Departmental Overhead Rates Activity Based Costing Number of cost pools ABC uses more cost pools.
7-17 How Costs are Treated Under Activity Based Costing ABC differs from traditional cost accounting in three ways. Each ABC cost pool has its own unique measure of activity. Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products. ABC uses more cost pools.
7-18 How Costs are Treated Under Activity Based Costing Activity Activity Cost Pool $ $ $ $ $ $ An event that causes the consumption of overhead resources. A cost bucket in which costs related to a single activity measure are accumulated.
7-19 How Costs are Treated Under Activity Based Costing Activity Measure The term cost driver is also used to refer to an activity measure. An allocation base in an activity-based costing system.
7-20 Cost Driver Analysis Cost drivers are factors that have a direct cause effect relationship to a cost Limit the number of cost drivers and combine into cost pools Cost of measurement should not exceed benefit of using the cost driver Easy to understand Directly related to the activity being performed Appropriate for measurement
7-21 How Costs are Treated Under Activity Based Costing ABC defines five levels of activity that largely do not relate to the volume of units produced. Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products.
7-22 How Costs are Treated Under Activity Based Costing Unit-Level Activity Batch-Level Activity Manufacturing companies typically combine their activities into five classifications. Product-Level Activity Organizationsustaining Activity Customer-Level Activity
7-23 Some Examples: Unit-level costs direct material, direct labor, some of the utility costs Batch-level costs setup, inspection Product-level costs engineering changes, product development Organization Sustaining costs building depreciation, plant manager s salary Customer Level costs Specific customer specific design, inspection, etc.
7-24 Product Cost Behavior Unit-level costs are variable in relation to change in production volume Batch, product/process, and organizational level costs are variable for reasons other than changes in production volume
7-25 Product Cost Unit-Level Costs Allocate over number of units produced Cost per unit Batch-Level Costs Allocate over number of units in batch Cost per unit in batch Product- Level Costs Allocate over number of units produced in related product line Cost per unit in product line
7-26 Activity-Based Costing Costs in General Ledger Cost Driver Accumulate in Activity Center Cost Pools Activity Driver Cost Objects
7-27
7-28 ABC Steps: 1. Define Activities, Activity Cost Pools, and Activity Measures 2. Assign Overhead Costs from General Ledger to Activity Cost Pools 3. Calculate Activity Rates 4. Assigning Overhead to Products 5. Prepare Management Reports such as: Product Profitability Customer Profitability Cost of Non-value adding activities Other reports
7-29 Baxter Battery An ABC Example Baxter Battery Company Income Statement Year Ended December 31, 2014 Sales $ 50,000,000 Cost of goods sold Direct materials $ 15,000,000 Direct labor 12,000,000 Manufacturing overhead 14,000,000 41,000,000 Gross margin 9,000,000 Selling and administrative expenses Shipping expenses 3,000,000 Marketing expenses 2,000,000 General administrative expenses 6,000,000 11,000,000 Net operating loss $ (2,000,000) Manufacturing overhead is allocated to products using a single plantwide overhead rate based on machine hours.
7-30 Define Activities, Activity Cost Pools, and Activity Measures At Baxter Battery, the ABC team selected the following activity cost pools and activity measures:
7-31 Define Activities, Activity Cost Pools, and Activity Measures Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders. Design Changes - assigned all costs of resources consumed by customer requested design changes. 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 organization-sustaining costs and unused capacity costs
7-32 Assign Overhead Costs to Activity Cost Pools
7-33 Assign Overhead Costs to Activity Cost Pools Direct materials, direct labor, and shipping are excluded because Baxter Battery s existing cost system can directly trace these costs to products or customer orders.
7-34 Assign Overhead Costs to Activity Cost Pools At Baxter Battery the following distribution of resource consumption across activity cost pools is determined.
7-35 Assign Overhead Costs to Activity Cost Pools Indirect factory wages $6,000,000 Percent consumed by customer orders 30% $1,800,000
7-36 Assign Overhead Costs to Activity Cost Pools Factory equipment depreciation $3,500,000 Percent consumed by customer orders 20% $ 700,000
7-37 Assign Overhead Costs to Activity Cost Pools
7-38 Calculate Activity Rates The ABC team determines that Baxter Battery will have these total activities for each activity cost pool: 10,000 customer orders, 4,000 design changes, 800,000 machine-hours, 2,000 customers served. Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.
Calculate Activity Rates 7-39
7-40 Activity Based Costing at Baxter Battery Direct Materials Direct Labor Shipping Costs Overhead Costs Traced Traced Traced Cost Objects: Products, Customer Orders, Customers
7-41 Activity Based Costing at Baxter Battery Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Customer Orders Design Changes Order Size Customer Relations Other Cost Objects: Products, Customer Orders, Customers
7-42 Activity Based Costing at Baxter Battery Direct Materials Direct Labor Shipping Costs Overhead Costs First-Stage Allocation Customer Orders Design Changes Order Size Customer Relations Other Second-Stage Allocations $/Order $/Change $/MH $/Customer Cost Objects: Products, Customer Orders, Customers Unallocated
7-43 Assigning Overhead to Products Baxter Battery Information SureStart 1. Requires no new design resources. 2. 800,000 batteries ordered with 4,000 separate orders. 3. Each SureStart requires 36 minutes of machine time for a total of 480,000 machine-hours. LongLife 1. Requires new design resources. 2. 400,000 batteries ordered with 6,000 separate orders. 3. 4,000 custom designs prepared. 4. Each LongLife requires 48 minutes of machine time for a total of 320,000 machine-hours.
Assigning Overhead to Products 7-44
7-45 Assigning Overhead to Customers Let s take a look at how Baxter Battery s system works for just one of the 2,000 customers Acme Auto Parts who placed a total of twelve orders. Note that the four orders for LongLifes required a design change. Orders 1. Eight orders for 60 SureStarts per order. 2. Four orders for 50 LongLifes per order. Machine-hours 1. The 480 SureStarts required 288 machine-hours. 2. The 200 LongLifes required 160 machine hours.
7-46 Prepare Management Reports Product Margin Calculations The first step in computing product margins is to gather each product s sales and direct cost data. SureStarts LongLifes Total Sales $ 31,300,000 $ 18,700,000 $ 50,000,000 Direct costs Direct material 9,000,000 6,000,000 15,000,000 Direct labor 7,000,000 5,000,000 12,000,000 Shipping 2,000,000 1,000,000 3,000,000
7-47 Prepare Management Reports Product Margin Calculations The second step in computing product margins is to incorporate the previously computed activity-based cost assignments pertaining to each product. SureStarts LongLifes Total Sales $ 31,300,000 $ 18,700,000 $ 50,000,000 Direct costs Direct material 9,000,000 6,000,000 15,000,000 Direct labor 7,000,000 5,000,000 12,000,000 Shipping 2,000,000 1,000,000 3,000,000 ABC cost assignments Customer orders 1,808,000 2,712,000 4,520,000 Design changes 3,040,000 3,040,000 Order size 3,120,000 2,080,000 5,200,000
7-48 Prepare Management Reports Product Margin Calculations The third step in computing product margins is to deduct each product s direct and indirect costs from sales. SureStarts LongLifes Sales $ 31,300,000 $ 18,700,000 Costs Direct material $ 9,000,000 $ 6,000,000 Direct labor 7,000,000 5,000,000 Shipping 2,000,000 1,000,000 Customer orders 1,808,000 2,712,000 Design changes 3,040,000 Order size 3,120,000 2,080,000 Total cost 22,928,000 19,832,000 Product margin $ 8,372,000 $ (1,132,000)
7-49 Prepare Management Reports Product Margin Calculations The product margins can be reconciled with the company s net operating income as follows: SureStarts LongLifes Total Sales $ 31,300,000 $ 18,700,000 $ 50,000,000 Total costs 22,928,000 19,832,000 42,760,000 Product margins $ 8,372,000 $ (1,132,000) $ 7,240,000 Less costs not assigned to products: Customer relations 3,080,000 Other 6,160,000 Total 9,240,000 Ne t operating loss $ (2,000,000)
7-50 Prepare Management Reports Customer Margin Analysis The first step in computing Acme Auto Parts customer margin is to gather its sales and direct cost data. Acme Auto Parts Sales $ 29,200 Direct costs Direct material 7,500 Direct labor 6,700 Shipping 1,700
7-51 Prepare Management Reports Customer Margin Analysis The second step is to incorporate Acme Auto Parts previously computed activity-based cost assignments. Acme Auto Parts Sales $ 29,200 Direct costs Direct material 7,500 Direct labor 6,700 Shipping 1,700 ABC cost assignments Customer orders 5,424 Product design 3,040 Order size 2,912 Customer relations 1,540
7-52 Prepare Management Reports Customer Margin Analysis The third step is to compute Acme Auto Parts customer margin of $384 by deducting all its direct and indirect costs from its sales. Acme Auto Parts Sales $ 29,200 Direct costs Direct material $ 7,500 Direct labor 6,700 Shipping 1,700 Customer orders 5,424 Product design 3,040 Order size 2,912 Customer relations 1,540 28,816 Customer margin $ 384
7-53 Product Margins Computed Using the Traditional Cost System The first step in computing product margins is to gather each product s sales and direct cost data. SureStarts LongLifes Total Sales $ 31,300,000 $ 18,700,000 $ 50,000,000 Direct costs Direct material 9,000,000 6,000,000 15,000,000 Direct labor 7,000,000 5,000,000 12,000,000
7-54 Product Margins Computed Using the Traditional Cost System The second step in computing product margins is to compute the plantwide overhead rate. Manufacturing Overhead Costs at Baxter Battery Production Department Indirect factory wages $ 6,000,000 Factory equipment depreciation 3,500,000 Factory utilities 2,500,000 Factory building lease 2,000,000 Total manufacturing overhead $ 14,000,000 Plantwide manufacturing overhead rate = $14,000,000 800,000 MH = $17.50 per machine-hour Machine-hours SureStarts (800,000 @ 0.60 hours) 480,000 LongLifes (400,000 @ 0.80 hours) 320,000 Total machine-hours 800,000
7-55 Product Margins Computed Using the Traditional Cost System The third step in computing product margins is allocate manufacturing overhead to each product. Machine Overhead Overhead Hours Rate Allocated SureStarts 480,000 $ 17.50 $ 8,400,000 LongLifes 320,000 17.50 5,600,000 Total overhead allocated to products $ 14,000,000 480,000 hours $17.50 per hour = $8,400,000
7-56 Product Margins Computed Using the Traditional Cost System The fourth step is to actually compute the product margins. SureStarts LongLifes Total Sales $ 31,300,000 $ 18,700,000 $ 50,000,000 Cost of goods sold Direct materials $ 9,000,000 $ 6,000,000 $ 15,000,000 Direct labor 7,000,000 5,000,000 12,000,000 Manufacturing overhead 8,400,000 24,400,000 5,600,000 16,600,000 14,000,000 41,000,000 Product margin $ 6,900,000 2,100,000 9,000,000 Selling and administrative 11,000,000 Ne t operating loss $ (2,000,000) Shipping expenses $ 3,000,000 Marketing expenses 2,000,000 General administrative expenses $ 6,000,000 11,000,000
7-57 Differences Between ABC and Traditional Product Costs SureStarts LongLifes Product margins traditional $ 6,900,000 $ 2,100,000 Product margins ABC 8,372,000 (1,132,000) Change in reported margins $ 1,472,000 $ (3,232,000) The traditional cost system overcosts the SureStarts and reports a lower product margin for this product. The traditional cost system undercosts the LongLifes and reports a higher product margin for this product.
7-58 Let us Practice Gallatin Carpet Cleaning
7-59 Differences Between ABC and Traditional Product Costs There are three reasons why the reported product margins for the two costing systems differ from one another. Traditional costing allocates all manufacturing overhead to products. ABC costing only assigns manufacturing overhead costs consumed by products to those products.
7-60 Differences Between ABC and Traditional Product Costs There are three reasons why the reported product margins for the two costing systems differ from one another. Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. ABC costing also uses non-volume related allocation bases.
7-61 Differences Between ABC and Traditional Product Costs There are three reasons why the reported product margins for the two costing systems differ from one another. Traditional costing disregards selling and administrative expenses because they are assumed to be period expenses. ABC costing directly traces shipping costs to products and includes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned to products.
7-62 Let us Practice Derinice Icecream
7-63 Activity Based Management ABC models are useful in process analysis and continuous improvement initiatives, some consulting firms coined the term activity-based management (ABM). ABM refers to any of the actions that might be taken based on the ABC information.
7-64 Through ABC/ABM Focus might shift toward more profitable businesses / customers Find ways of performing tasks better, faster, and cheaper Connections to total quality management, process improvement, reengineering, elimination of non-value-added activities, lean management
7-65 Activity Analysis (Value-added) Value-added activity Increases worth of product or service to a customer Customer is willing to pay for it Non-value-added activity Increases time spent on product or service but does not increase worth Unnecessary from customer perspective Can be reduced, redesigned or eliminated without affecting market value or quality
7-66 Activity Analysis Create a Process Map (detailed flowchart) for each process Identify each step the product goes through Create Value Chart Identify stages and time spent in stages from beginning to end of process Value-Added Examples: Processing Time Service Time Non-Value-Added Examples: Inspection Time Transfer Time Idle Time
7-67 Cycle Time Analysis Goal: Eliminate or minimize activities that add the most time and cost and the least value Cycle Value- Non- Time = Added + Value-Added Time Time
7-68 Manufacturing Cycle Efficiency Ratio Manufacturing Cycle Efficiency (MCE) = Value-Added Processing Time Total Cycle Time 100% efficiency unrealistic Reducing non-value-added activities will increase MCE Value-added activity usually represents about 10%-20% of total cycle time
7-69 Non-Value-Added Activities Attributed to following factors Systemic Physical Human Eliminating or reducing non-value-added activities that create the most costs will Increase product/service quality Decrease cycle time and cost JIT & Lean Implementations are geared to reduce non-value-added activities
7-70 Targeting Process Improvement Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements by focusing on activities to eliminate waste, decrease processing time, and reduce defects. ABC activity rates can also provide valuable clues concerning where there is waste and the opportunity for improvement. Benchmarking can be used to compare activity cost information with standards of performance achieved by other organizations.
7-71 Activity-Based Costing and External Reporting Most companies do not use ABC for external reporting because... 1. 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.
7-72 When to Use ABC Companies use ABC when: They have a wide variety of products or services High overhead costs are not proportional to the unit volume of individual products Automation makes it difficult to assign overhead to products using direct labor or machine hours Profit margins are difficult to explain Hard-to-make products show big profits and easyto-make products show losses
7-73 The Symptoms of a Broken System Do I really know what my products costs? Cooper s Diagnostic Tools: Functional managers want to drop seemingly profitable lines; Hard-to-make products show big profits; Departments have their own cost systems; You have a high-margin niche all to yourself; Competitors prices are unrealistically low. The existing cost systems were meant primarily to value inventory and provide data for the profit and loss statements but are being now used for other reasons
7-74 Benefits of Activity-Based Costing and Activity-Based Management Enhanced product profitability analysis Enhanced customer profitability analysis More accurate cost determination and analysis of the true cost of product and customer diversification Should we outsource some part of the process? More efficient production Connects well with Quality, Lean Management, JIT implementations Ability to link with the ERP system in place Setting up an activity-based costing system as a prerequisite for improving business processes and for any re-engineering program More effective performance evaluation
7-75 Traditional vs. ABC Costing When ABC is implemented cross subsidy is reduced, i.e., Cost is reduced for high-volume, standard products Cost is increased for low-volume, complex specialty products
7-76 New Cost drivers recognized by ABC Product variety number of different types of products Product complexity number of processes through which a product flows
7-77 ABC Costing Considerations Number and diversity of products/services produced Diversity and differential degree of support services used for different products Extent to which common processes are used Effectiveness of current cost allocation methods Rate of growth of period costs
7-78 Use ABC Costing for 1. Product Variety and Process Complexity 2. Lack of Commonality in Overhead Costs 3. Problems with Current Cost Allocations 4. Changes in Business Environment
7-79 Use ABC Costing for 1. Product Variety and Process Complexity Caused by mass customization Too many choices, opportunity for errors Pareto Principle Commonality of parts Reduced by Simultaneous (or Concurrent) Engineering Design for Manufacturability
7-80 Use ABC Costing when 2. Lack of Commonality in Overhead Costs Some products/services use substantially more overhead than others 3. Problems with Current Cost Allocations Significant changes in process with no change in cost allocations Expense majority of period costs when incurred 4. Changes in Business Environment Increase in competition or change in management strategy
7-81 Continuous Improvement Eliminates non-value-added activities to reduce cycle time Makes products/performs services with zero defects Reduces product costs on an ongoing basis Simplifies products and processes ABC Costing Supports Continuous Improvement
7-82 Advantages of ABC and ABM Identify and monitor significant technology costs Trace technology costs directly to products Increase market share Identify the cost drivers that create or influence cost Identify activities that do not contribute to perceived customer value Understand the impact of new technologies on all elements of performance Translate company goals into activity goals Analyze the performance of activities across business functions Analyze performance problems Promote standards of excellence
7-83 ABC Limitations Substantial resources required to implement and maintain. Resistance to unfamiliar numbers and reports. Desire to fully allocate all costs to products. Potential misinterpretation of unfamiliar numbers. Does not conform to GAAP. Two costing systems may be needed.
7-84 Criticisms of ABC Significant amount of time and cost to implement Must overcome barriers to change Does not conform to GAAP
Time-Based Activity-Based Costing One recent development aimed both at improving the accuracy of ABC data and reducing the administrative burden involved with developing and maintaining the systems is called time-based ABC. Time-based ABC involves making direct estimates of the resource demands imposed by each transaction, product, service, or customer. Traditionally, to build an ABC model, employees are asked to estimate the proportion of their total time spent in the various activities in which they are engaged. These estimates are now made by managers saving time and improving consistency. 7-85
7-86 Characteristics of Successful ABC Implementations Strong top management support Link to evaluations and rewards Cross-functional involvement
7-87 Some Further Reading R. S. Kaplan The Evolution of Management Accounting. Accounting Review (July 1984): 390-418. H. T Johnson and R. S. Kaplan. Relevance Lost: The Evolution of Management Accounting (Boston: Harvard Business School Press, 1987): R. Cooper, Does Your Company Need a New Cost System? Journal of Cost Management (Spring 1987): 45-49 R. S. Kaplan, and R. Cooper, Make Cost Right: Make the Right Decisions, Harvard Business Review, September October 1988 R. S. Kaplan and R. Cooper, Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance, Harvard Business School Press, 1997 R. S. Kaplan, and S. Anderson, Time-Driven Activity Based Costing, Harvard Business School Press, 2007