ABC: Brief Example (1)

ABC: Brief Example (2)

AIRCO is a manufacturer of industrial air conditioning units. The units range in size and power
from 5 to 20 tons.1 Each unit has more than 200 parts, including holding tanks, electronic
controllers, metal sheets, cooling coils, wires, and insulation material. Almost 90% of
manufacturing workers are hourly workers, and the company operates two shifts. The
organization of the manufacturing process is conventional, with separate departments for
purchasing, engineering, job scheduling, materials handling, shipping, accounting, and human
resources. AIRCO developed an ABC system to assist in the analysis of product profitability. Its
first step was to identify the resource cost pools that make up total overhead of $4,458,605 at the
plant (Exhibit 5.12). The resource costs (indirect labor, computer and software, etc.) are from the
firms accounting system, which collects resources costs in these 11 categories.

The next step is to identify production activities and to use resource consumption cost drivers to
assign the resource costs to the activity cost pools. The activity cost pools are machines; data
record maintenance; material handling; product changeover (setup); scheduling and production
preparation; materials receiving and handling; product shipment; and customer service (Exhibit
5.13, column 1). The assignment of resources to activities typically uses resource consumption
cost drivers. Instead of using cost drivers, AIRCO determined the estimated contribution of each
resource to each activity based on managers and employees experience. For example, the
resource, maintenance costs, $60,000, was assigned entirely to the activity, machines. To
illustrate, the cost of the machine activity was determined from the resources as follows (other
activities were obtained in a similar way):

The machine activity cost, and the cost of other activities is shown in column 2 of Exhibit 5.13.
The use of estimated percentages in place of other types of resource consumption cost drivers is
a practical and convenient approach that is often used in implementing ABC costing.

The next step in ABC is to identify activity consumption cost drivers, to identify the total
amounts for these cost drivers, and then to determine the ABC-based application rate. This is
shown in Exhibit 5.13, columns 3, 4, and 5, respectively. Thus, the cost of machine time is
assigned to each of the products based on machine hours used by that product times the rate of
$5.89 per machine hour ($5.89 = $435,425/73,872). This is done in the same manner for the
other activities. The determination of ABC cost and profitability analysis for AIRCOs key
product lines is the final step and is shown in Exhibit 5.14. Note that this analysis shows that the
5-ton, 6-ton and 12.5-ton products are not profitable.

The ABC analysis can be compared to the volume-based approach that AIRCO used prior to
ABC. The volume-based overhead costs were assigned to products based on a rate of $12.02 per
direct labor hour. The results are shown in Exhibit 5.15. Note that the ABC and volume-based
methods show significantly different results for some of the products, particularly the 6-ton and
12.5-ton models. While the detailed calculations of the ABC costs for these products is not
shown, the company reports that the 12.5-ton model required significantly more raw materials
receipts (the cost driver for material receiving and handling) than other products, and it also
required more setup time and customer service contacts. Thus, the ABC costs for the 12.5-ton
model are significantly higher than for volume-based costs. Similarly, the 6-ton prod-uct has
higher costs under ABC because of its relatively high use of setup time and customer service
contact. The ABC information provides the company a useful basis for becoming more
competitive, for example, by reconsidering the pricing of certain products and looking for ways
to increase efficiency in the use of its activities.