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Activity-Based Costing
McGraw-Hill/Irwin
Copyright 2008 by The McGraw-Hill Companies, Inc. All

ACTIVITY BASED COSTING

Traditional costing system 1. Direct and indirect costs are allocated to process centres or major departments

ABC System 1. The direct and indirect costs are allocated to activities like Purchases, Material handling, Producing the goods, machine set ups, Supervising production workers, Inspecting finished

goods, Dispatching good to customers 2. Cost driver as base for allocation of overheads is not based on cause and effect
relationship

3. There is only one cost driver Or OH allocation

2.Cost driver as base for allocation of overheads is based on cause and effect relationship between overheads and the overhead allocation base (the cost driver) Stores deptt Labour hours or machine hours or units produced 3. There are many allocation bases as per activity chosen and cause
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Traditional, Volume-Based Product-Costing System

Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records:
M I ode Production: Units Runs M II ode M III ode 4 0 ,0 0 1 runs of 0 4 0units 0

1 ,0 0 0 0 2 ,0 0 0 0 1run of 1 ,0 0 0 0 4runs of units 5 0 units ,0 0

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Traditional, Volume-Based Product-Costing System

Additional information includes:

Direct materials Direct labor (hr/board) Setup time (hr/run) Machine time (hr/board)

Mode I Mode II Mode III $ 50.00 $ 90.00 $ 20.00 3 4 2 10 10 10 1 1.25 2

Manufacturing overhead is determined as follows

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Traditional, Volume-Based Product-Costing System

Budgeted manufacturing overhead Budgeted direct-labor hours

$3,894,000 118,000

= $33 per hour

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With these product costs, Aerotech established target selling prices (Cost 125%).

Traditional, Volume-Based Product-Costing System

209.00 x 1.25
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Activity Based Costing System

(ABC)
ABC systems follow a twostage procedure to assign overhead costs to products.
Assigning overhead to products is a difficult process.

I agree!

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Activity Based Costing System

(ABC)
ABC systems follow a two-stage procedure to assign overhead costs to products.
Lets begin by identifying our major activities.

Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.
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Activity Based Costing System

(ABC)
ABC systems follow a two-stage procedure to assign overhead costs to products.
Overhead assigned to activities are called activity cost pools.

Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products.
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ABC System
1. Identify major activities
activity consists of aggregation of tasks having common characteristics) e.g. Activity: purchase of materials : Tasks: receiving a purchase request, inviting quotations, selecting supplier, placing orders, receiving material

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2. Assigning costs to Activity Cost Centers:

Cost incurred on these activities are assigned to these Activity Cost Centers. Direct costs are traced directly. Indirect costs are assigned to activities on the basis of cause and effect cost drivers.

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There must be a cause - effect relationship between the overheads to be allocated and the allocation base otherwise inaccurate allocation of overheads will occur. For an example, it would be wrong to allocate overheads of stores dept. on the basis of labor hours. It should be more appropriately based on number of units handled or used in production process.

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3. Selecting cost drivers for allocating costs to cost objects

The costs accumulated for an activity cost centre are then allocated to different cost objects. For this, a separate activity cost driver or allocation rate is used. In ABC analysis, the tracing of overheads to cost objects requires that cost behavior must be understood so that appropriate cost drivers are identified.

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Identifying activities and cost drivers

depends upon type of activity, Volume related or not volume related Major activity 1. Processing orders for Purchase of materials/ Stores Associated costs Cost drivers 1. No. of purchase orders processed 2. No. of materials and parts requisitions 3. No. of receipts of materials and parts 4. No. of set ups

1. Labor cost of employees working in 2. Handling materials and purchase dept. Parts 2. Labor cost of stores, depreciation of machines used for 3. Inspection of material and moving materials parts purchased 3. Labor cost of inspection team, Depr. Of testing 4. Setting up production equipments procedures 4. Labor cost of works involved in setups and depr. of set up equipments

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Identifying activities and cost drivers

Depends upon type of activity, Volume related or not volume related Major activity 5. Producing the goods 5. Depreciation of machines 6. Supervising production workers 6. No. of assembly 6. Salary of assembly labor hours supervisors 7. No. of inspections 7. Inspecting finished goods 7. Labor cost of inspectors and depreciation of test equipments 8. Dispatching good to 8. No. of boxes packed customers 8. Labor cost of packing and cost of Packing materials
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Associated costs

Cost drivers 5. No. of machine hours

Two Key Points

A large proportion of nonA large proportion of nonunit-level activities unit-level activities A unit-level cost driver, A unit-level cost driver, such as direct labor, such as direct labor, machine hours, or machine hours, or throughput, will not be throughput, will not be able to assign the costs able to assign the costs of non-unit-level activities of non-unit-level activities accurately. accurately. Product diversity Product diversity When the consumption When the consumption ratios differ widely ratios differ widely between activities, no between activities, no single cost driver will single cost driver will accurately assign the accurately assign the resulting overhead costs. resulting overhead costs.

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Cost Drivers
A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .
Degree of Correlation Cost of Measurement
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Behavioral Effects

Direct versus Indirect Costs

Volume-Based Costing Volume-Based Costing All production costs All production costs except direct except direct materials and direct materials and direct labor are lumped labor are lumped together in one together in one overhead cost pool. overhead cost pool.

Activity-Based Costing Activity-Based Costing An effort is made to An effort is made to account for as many account for as many costs as possible as costs as possible as direct costs of direct costs of production. production.

Indirect Costs
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Interviewing and Paper Trails

The information for ABC systems initially comes from interviews with employees in the support departments and a review of each departments records.

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Storyboarding
A procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities.
Step Step 1 1 Step Step 2 2 Step Step 3 3 Step Step 4 4 These are the steps we These are the steps we follow to build a follow to build a memory board. memory board.

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Machinery cost pool

Maintenance Depreciation Computer Support

Lubrication Electricity Calibration

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Engineering cost pool

Engineering salaries Engineering supplies Engineering software Depreciation

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Facility cost pool

Plant depr. Plant mgmt. Plant maint. Property taxes Insurance Security

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Overhead Costs
Activity must be done on each unit produced. Total budgeted cost = $3,894,000

Activity Cost Pools

Identification Identification of Activity of Activity Cost Pools Cost Pools

Unit Level
Machinery cost pool $1,212,600
Activity performed on each batch produced.

Batch Level
Setup cost pool $3,000

ProductSustaining Level
Engineering cost pool $700,000

Facility Level
Facility cost pool $507,400

Activities needed to support an entire product line

Activity required in order for the production process to occur.

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Unit Level Machinery cost pool $1,212,600

Batch Level Setup cost pool $3,000 Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000

ProductSustaining Level Engineering cost pool $700,000

Facility Level Facility cost pool $507,400

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STAGE ONE
Various overhead costs related to machinery
Maintenance Depreciation Computer Support Lubrication Electricity Calibration

Activity cost pool

Machinery Cost Pool

Total budgeted cost = $1,212,600

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STAGE TWO
Calculate the pool rate
Budgeted Machinery Costs = $1,212,600 Budgeted Machine Hours 43,000 = $28.20/hour

Cost Assignment

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STAGE ONE
Calculation of total setup cost

Activity cost pool

Setup Cost Pool

Total budgeted cost = $3,000

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STAGE TWO
Calculate the pool rate
Budgeted Setup Costs = $3,000 Planned Production Runs 15 runs = $200 per run

Cost Assignment

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STAGE ONE
Various overhead costs related to engineering
Engineering salaries Engineering supplies Engineering software Depreciation

Activity cost pool

Engineering Cost Pool

Total budgeted cost = $700,000

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STAGE TWO
Allocate based on engineering transactions

Engineering Cost Pool

Total budgeted cost = $700,000

Cost Assignment

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STAGE ONE
Various overhead costs related to general operations
Plant depr. Plant mgmt. Plant maint. Property taxes Insurance Security

Exh. 5-9

Activity cost pool

Facility Cost Pool

Total budgeted cost = $507,400

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STAGE TWO
Calculate the pool rate
Budgeted Facilities Cost = $507,400 Budgeted Direct-Labor Hours 118,000 = $4.30/hour

Exh. 5-9

Cost Assignment

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Other Overhead Costs

Receiving and Inspection Cost Pool
Board Overhead Mode I $ 200,000 Mode I I 200,000 Mode I I I 200,000 % 6% 24% 70% Units 10,000 20,000 4,000 Board Mode I Mode I I Mode I I I = Cost/Unit = $ 1.20 = 2.40 = 35.00

Material-Handling Cost Pool

Overhead $ 600,000 600,000 600,000 = Cost/Unit = $ 8.42 = 8.42 = 42.10 % 7% 30% 63% Units 10,000 20,000 4,000 = Cost/Unit = $ 4.20 = 9.00 = 94.50

Quality-Assurance Cost Pool

Board Mode I Mode II Mode II I Overhead $ 421,000 421,000 421,000 % 20% 40% 40% Units 10,000 20,000 4,000
Board Mode I Mode I I Mode I I I

Packaging and Shipping Cost Pool

Overhead $ 250,000 250,000 250,000 % 4% 30% 66% Units 10,000 20,000 4,000 = Cost/Unit = $ 1.00 = 3.75 = 41.25
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Other Overhead Costs

Receiving and Inspection Cost Pool
Board Overhead Mode I $ 200,000 Mode I I 200,000 Mode I I I 200,000 % 6% 24% 70% Units 10,000 20,000 4,000 Board Mode I Mode I I Mode I I I % 20% 40% 40% Units 10,000 20,000 4,000
Board Mode I Mode I I Mode I I I

= Cost/Unit = $ 1.20 = 2.40 = 35.00

Material-Handling Cost Pool

$14.82
Board Mode I Mode II Mode II I Overhead $ 421,000 421,000 421,000

Overhead $ 600,000 600,000 600,000 = Cost/Unit = $ 8.42 = 8.42 = 42.10

% 7% 30% 63%

Units 10,000 20,000 4,000

= Cost/Unit = $ 4.20 = 9.00 = 94.50

Quality-Assurance Cost Pool

Packaging and Shipping Cost Pool

Overhead $ 250,000 250,000 250,000 % 4% 30% 66% Units 10,000 20,000 4,000 = Cost/Unit = $ 1.00 = 3.75 = 41.25
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Product Cost from ABC

These are the new product costs when Aerotech uses ABC.

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Product Cost from ABC

These are the new product costs when Aerotech uses ABC.

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Distorted Product Costs

Both original and ABC target selling prices are based on (Cost 125%).

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Distorted Product Costs

Both original and ABC target selling prices are based on (Cost 125%).

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Distorted Product Costs

Both original and ABC target selling prices are based on (Cost 125%).

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Distorted Product Costs

Both original and ABC target selling prices are based on (Cost 125%).

The selling price of Mode I and II are reduced and the selling price for Mode III is increased.
[$209.00 1.25] [$183.44 1.25]
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Distorted Product Costs

Can you identify any problems Aerotech is likely to face as a result of this distortion?

Traditional costing understates the cost of complex, low volume products.

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Indicators of Need for ABC

Direct labor is a Direct labor is a small percentage small percentage of total costs of total costs Sales are increasing, Sales are increasing, but profits are declining. but profits are declining. Product-line profit Product-line profit margins are hard margins are hard to explain to explain Line managers do not Line managers do not believe the product believe the product costs reports costs reports Some products that Some products that have reported high have reported high profit margins are not profit margins are not sold by competitors sold by competitors
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Marketing does not Marketing does not use costs reports for use costs reports for pricing decisions pricing decisions

The use of ABC costing information to help management make decisions

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Activity-based costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs. Activity-based management focuses on managing activities to reduce costs.

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Activities

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Cost Assignment View

Resource costs Resource costs

Activities

Cost Objects Cost Objects

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Cost Assignment View

Resource costs Resource costs

Process View
Activity Analysis Activity Evaluation

Root Root Causes Causes

Activity Activity Triggers Triggers

Activities

Performance Performance Measures Measures

Cost Objects Cost Objects

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Activities

Nonvalueadded activities Unnecessary

Reduce or Eliminate

Necessary
Continually Evaluate and Improve
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1. Identify Activities. 2. Identify Non-Value-Added Activities. 3. Understand Activity Linkages, Root Causes,

and Triggers.
Select Select vendor vendor

Specify Specify parts parts

Receive Receive parts parts

Produce Produce goods goods

Inspect Inspect finished finished goods goods

Rework Rework defective defective products products

4. Establish Performance Measures. 5. Report Non-Value-Added Costs.

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Process time

Inspection time

Storage time

Move time

Waiting time
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Customer profitability analysis uses activity-based costing to determine the activities, costs, and profit associated with serving particular customers.

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Required special packaging. Orders small quantities. Demand fast service.

Often changes orders.

Orders frequently.

A costly
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Customer-Related Activities Order processing Sales contacts (phone calls, faxes, etc.) Sales visits Shipment processing Billing and collection Design/engineering change orders Special packaging Special handling

Cost Driver Base Purchase orders Contacts Visits Shipments Invoices Design changes Units packaged Units handled

Cost Drive Rate $ 150 100 1,000 200 160 4,000 40 60

A company may use these customer A company may use these customer related costs to help determine the related costs to help determine the profitability of each customer. profitability of each customer.
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No materials are purchased and no products are manufactured until they are needed.

The primary goal of a The primary goal of a JIT production system is JIT production system is to reduce or eliminate to reduce or eliminate inventories at every inventories at every stage of production. stage of production.

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Smooth, uniform production rate

Pull method of production

Purchase is small lot sizes

Quick, inexpensive setups

High quality materials

Effective preventive maintenance

Teamwork
Multiskilled workers
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Long-term Long-term contracts with contracts with suppliers. suppliers. Only a few Only a few suppliers. suppliers. Parts delivered Parts delivered in small lots. in small lots.

Grouped Grouped payments to payments to vendor. vendor.

Minimal Minimal inspection of inspection of materials. materials.

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 Activity based costing in service industry As useful as in mfg. industry Mangers want more detailed and accurate information about the cost of producing products and services they are selling Airlines, ins co, banks, hospitals, fin service firms, hotels railroads, Air France, American express, Bank of America, DHL, Fed Ex, US postal service

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ABC at service companies: Identifying Activities Activity cost pools Cost drivers Classification of activities at Unit level : batch level, product sustaining level, facility (general operations) level
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Bajaj Allianze General Insurance Co. Ltd Claims Department Classification of activities at Unit level : Entering initial claim into computer batch level: moving a batch of claims from one processing step to the next product sustaining level: maintenance of the medical service provider network ( physicians, hospitals ) facility (general operations) level: general administration of claims business unit
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 ABC at Delaware medical centre (Primary Care UnitOPD) Appointment Patient routine extended complex New Continuing routine extended complex Every appointment needs Regd. nurse 1 : vital signs/preparing patient for Primary health care professional PHCP 1: physician / intern / resident doctor or nurse practitioner

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 ABC team identified : Activities Physician time Practitioner nurse time Intern or resident time Regd. Nurse time Clerical time: new patients Clerical time : continuing Billing Facility

cost drivers Physician minutes with patient P-Nurse minutes with patient Intern minutes with patient Regd. Nurse minutes with patient New patient visits Continuiing patient visits Billing lines (items on a bill) Patient visits (both new and continuing)

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Activity : physician time Cost driver : physician minutes with patient Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 960000 240000 4 R 80000 320000 8000 $40 E 100000 400000 5000 $80 C 60000 240000 2000 $120

Activity Nurse Practitioner time Cost driver : NP minutes with patient Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 90000 30000 3 R 12000 36000 1200 $30 E 10000 30000 500 $60 C 8000 24000 320 $75
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Activity : intern or resident time Cost driver : intern or resident minutes with patient Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 412500 125000 3.30 R 40000 132000 4000 $33 E 50000 165000 2500 $66 C 35000 115500 1000 $115

Activity : Rgd. nurse time Cost driver : RN minutes with patient Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 281980 245200 1.15 R 132000 151800 13200 $11.50 E 80000 92000 8000 $11.50 C 33200 38180 3320 $11.50
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Activity : Clerical time new patients Cost driver : New patients number Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 135300 12300 11.00 R 7200 79200 7200 $11 E 3000 33000 3000 $11 C 2100 23100 2100 $11

Activity : Cleical time continuing patients Cost driver : cont. patients number Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 61100 12220 5.00 R 6000 30000 6000 $5 E 5000 25000 5000 $5 C 1220 6100 1220 $5

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Activity : Billing Cost driver : Billing lines on a bill Cost cost driver rate PV driver pool qty Type qty 38480 76960 0.50 R 26400 E 24000 C 26560

activity cost 13200 12000 13280

no. of visits 13200 8000 3320

activity cost /p $1.00 $1.50 $4.00

Activity : Facility Cost driver : number of new plus cont. patients visits Cost cost driver rate PV driver activity no. of activity pool qty Type qty cost visits cost /p 245200 24520 10.00 R 13200 132000 13200 $10 E 8000 80000 8000 $10 C 3320 33200 3320 $10

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 Costing of service 1. Each patient sees either a physician or PN or intern or resident not all four 2. each patient is either a new patient or a continuing patient and not both. 3. to compute cost of particular appointment, we should select only one of primary health care professionals, and select one of the two clerical time categories new or continuing. 3.4. finally since every appointment involves RN , billing, and use of primary care unit facility, all of these activities must be included in the cost calculation.
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 Cost of extended appointment for a new patient seeing a nurse practitioner Activity Cost Nurse practitioner time RN time Clerical time new patients Billing Facility

Total

94.00
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 Cost of extended appointment for a new patient seeing a nurse practitioner Activity cost Nurse practitioner time 60.00 RN time 11.50 Clerical time new patients 11.00 Billing 1.50 Facility 10.00

Total

94.00
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End of Chapter 5
This is my kind of cost pool!

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