Manac II

Term II PGP 19 Batch

Pankaj Baag
Faculty Block 01, Room
No 21
Mob: 8943716269
Ph (O): 0495-2809121
Ext. 121
Email:
baagpankaj@iimk.ac.in

Activity-Based Costing

ActivityBased 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!

How Costs are Treated Under

ActivityBased Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.
Manufacturing
costs

Nonmanufacturing
costs

Traditional
product costing

ABC
product costing

ABC assigns both types of costs to products.

How Costs are Treated Under

ActivityBased Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Traditional
product costing

Nonmanufacturing
costs
Mo
st,
not but
all

Some

All

Manufacturing
costs

ABC
product costing

ABC does not assign all manufacturing costs to products.

How Costs are Treated Under

ActivityBased Costing
Level of complexity

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.
ActivityBased
ActivityBased
Costing
Costing
Departmental
Departmental
Overhead
Overhead
Rates
Rates
Plantwide
Plantwide
Overhead
Overhead
Rate
Rate

Number of cost pools

ABC uses more cost pools.

How Costs are Treated Under

ActivityBased Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Each
Each ABC
ABC cost pool has
has its
its
own
own unique measure of activity.
Traditional
Traditional cost systems usually rely
on
on volume
volume measures such as direct labor
hours and/or machine hours to allocate
all
all overhead
overhead costs
costs to
to products.
products.
ABC uses more cost pools.

How Costs are Treated Under

ActivityBased Costing
Activity

An event that causes the

consumption of overhead
resources.

Activity
Cost Pool

A cost bucket in which

costs related to a single
activity measure are
accumulated.

$$
$
$ $
$

How Costs are Treated Under

ActivityBased Costing
Activity
Measure
An allocation base
in an activity-based
costing system.

The term cost driver is

also used to refer to
an activity measure.

How Costs are Treated Under

ActivityBased Costing
Two common types of activity measures:
Transaction
driver

Duration
driver

Simple count
of the number of
times an activity
occurs.

A measure
of the amount
of time needed
for an activity.

Activities that cause costs to be

incurred are called COST DRIVERS:

2-11

 Cost Pools : Meaningful groups

under which costs are collected.
Individual costs can be grouped in
many different ways and therefore
Cost Pools can be defined in many
different ways.
By Type : Labour costs, material
costs etc.
By Source : Department 1,
Department 2 etc.
By Responsibility : Manager 1,
Manager 2 etc.

Recall that Factory Overhead is applied to production in a rational

systematic manner, using some type of averaging/predetermined

manner. There are a variety of methods to accomplish this goal.
These methods often involve tradeoffs between simplicity and

realism

Simple Methods Complex Methods

Unrealistic

Realistic

Historically, firms produced a limited variety of goods while their

indirect costs were relatively small.

Allocating

overhead

averages/predetermined

costs
rate

was
to

simple:

allocate

use

costs

broad

uniformly

regardless of how they are actually incurred

The end-result: overcosting and undercosting

Overcosting a product consumes a low level of resources but is allocated high
costs per unit

Undercosting a product consumes a high level of resources but is allocated low

costs per unit

Cross-subsidization

The results of overcosting one product and undercosting another.

The overcosted product absorbs too much cost, making it seem

less profitable than it really is

The undercosted product is left with too little cost, making it seem
more profitable than it really is

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:

Aerotech produces three circuit boards referred to as Mode I, Mode

II and Mode III. 10,000 units of Mode I are produced in 1 run.
20,000 units of Mode II are produced in 4 runs of 5,000 units. And
4,000 units of Mode III are produced in 10 runs of
400 units.

5-15

Traditional, Volume-Based Product-Costing System

Additional information includes:

Manufacturing overhead is determined as follows

5-16

Traditional, Volume-Based Product-Costing System

Budgeted manufacturing overhead

Budgeted direct-labor hours

$3,894,000
118,000

= $33 per hour

Aerotech applies manufacturing overhead using a predetermined overhead

rate based on direct-labor hours. The total direct labor hours was estimated
to be 118,000. The budgeted manufacturing overhead cost was estimated
at $3,894,000. The estimated cost is divided by the estimated hours
resulting in a predetermined overhead rate of $33 per hour. The overhead
per unit is calculated by multiplying the direct labor hours per unit times the
5-17

Traditional, Volume-Based Product-Costing System

With these product costs, Aerotech

established target selling prices (Cost
125%).

209.00 x 1.25
Now that Aerotech -estimated the production cost per unit, the target
selling price can be set.
The companys pricing policy has been to set a target price for each
grill equal to 125 percent of the full product cost.
The estimated unit cost is multiplied by 1.25 to arrive at the target
selling price
5-18

Activity Based Costing System (ABC)

ABC systems follow a two-stage
procedure to assign overhead costs
products.
Stage One: Identifyto
significant
activities and assign
overhead costs to each activity in proportion to resources
used.
Stage Two: Identify cost drivers appropriate to each
activity and allocate overhead to the products.
Assigning Overhead to product costs is a difficult process.
Lets begin by identifying our major activities.
The first stage identifies significant activities in the production
process and assigns overhead costs to each activity in accordance with the
cost of the organizations resources used by the activity. The overhead
costs assigned to each activity comprise an activity cost pool.
Overhead assigned to activities are called activities cost pools.
After assigning overhead costs to activity cost pools in stage one, cost
drivers appropriate for each cost pool are identified in stage two.
Then the overhead costs are allocated from each activity cost pool to each
product line in proportion to the amount of the cost driver consumed by the
5-19

How Costs are Treated Under

ActivityBased Costing
ABC defines
four-five levels of activity
that largely do not relate
to the volume of units
produced.

Traditional
Traditional cost
cost systems
systems usually
usually rely
rely on
on volume
volume
measures
measures such
such as
as direct
direct labor
labor hours
hours and/or
and/or machine
machine
hours
hours to
to allocate
allocate all
all overhead
overhead costs
costs to
to products.
products.

How Costs are Treated Under

ActivityBased Costing
Unit-Level
Activity

Batch-Level
Activity

Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level
Activity

Organizationsustaining
Activity

Customer-Level
Activity

In an activity-based cost system, companies typically combine their activities into the
following five classifications:
Unit-level activities are performed each time a unit is produced. For example,
providing power to run processing equipment would be a unit-level activity.
Batch-level activities are performed each time a batch is handled or processed,
regardless of how many units are in the batch. For example, setting up equipment
and shipping customer orders are batch-level activities.
Product-level activities or product sustainable level activities relate to specific
products and must be carried out regardless of how many batches are run or units
are produced or sold. For example, designing or advertising a product would be
product-level activities.
Facility-level activities are required in order for the entire production process to occur.
Customer-level activities relate to specific customers and are not tied to any specific
product. For example, sales calls and catalog mailings would be customer-level
activities.
Organization-sustaining activities are carried out regardless of which customers are
served, which products are produced, how many batches are run, or how many units
are made. For example, heating a factory and cleaning executive offices are
organization-sustaining activities.

 Aerotech identified eight activity cost

pools, which fall into four broad categories:
unit level, batch level, productsustaining level and facility level.
The activity at the unit level must be applied to
each unit produced.
The activity at the batch level must be
performed one time for each batch that goes into
production.
The product-sustaining activities are required
to support the entire product line, but not
needed for each unit or batch.
Facility-level activities are required in order for
the entire production process to occur.

Overhead Costs
Activity
Cost
Pools

Activity
must be
done on
each unit
produced.

Total budgeted cost = $3,894,000

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Activity
performed
on each
batch
produced.

Identification
Identification
of
of Activity
Activity
Cost
Cost Pools
Pools

Facility
Level
Facility
cost pool
$507,400

Activities needed to support Activity required in order

an entire product line
for the production
process to occur.
5-24

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

For
Aerotech,
only the
machinery
cost pool
is at the
unit level.

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

Facility
Level
Facility
cost pool
$507,400

There are five cost

pools at the batch
level: setup, receiving
and inspection, materialhandling, quality
assurance and the
packaging and shipping
cost pool.
The engineering cost
pool is at the productsustaining level and the
facility cost pool is at the
facility level.
5-25

STAGE ONE
Various overhead
costs related
to machinery

Activity
cost
pool

Maintenance

Lubrication

Depreciation

Electricity

Computer Support

Calibration

Machinery Cost Pool

Total budgeted cost = $1,212,600

Aerotech estimated the costs of maintenance, lubrication, depreciation,

electricity, computer support and calibration. These costs are added
together. The sum is the machinery cost pool budgeted cost.

5-26

Calculate
the pool
rate
Cost
Assignment
Aerotech selected
machine hours for the
cost driver, since a
product that uses
more machine hours
should bear a larger
share of machinerelated costs.

STAGE TWO
Budgeted Machinery Costs=
Budgeted Machine Hours
=

Mode I:
$28.20 per hr.
1 hr. per unit
$28.20 per unit

$1,212,600
43,000
$28.20/hour

Mode II:
$28.20 per hr.
1.25 hr. per unit
$35.25 per unit

Mode III:
The budgeted
$28.20 per hr.
machinery costs are
2 hr. per unit
divided by the
$56.40 per unit
budgeted number of
machine hours to
Then,
for each circuit board, the machinery cost pool rate is multiplied
arrive
at the
by the number
of machine hours per board
machinery
cost pool
5-27

Calculation of
total setup cost

Activity
cost
pool
The budgeted cost for
the setup cost pool is
determined by
multiplying the setup
cost per hour by the
number of hours
required per setup then
multiplying that by the
number of production
runs.

STAGE ONE
Total budgeted setup cost
$20 per hour
10 hr. per setup
$200 cost per setup
15 production runs
$ 3,000 Total

Setup Cost Pool

Total budgeted cost = $3,000

5-28

Calculate
the pool
rate

STAGE TWO
Budgeted Setup Costs =
Planned Production Runs
=

$3,000
15 runs
$200 per run

Cost
Assignment
The budgeted setup
costs are divided by
the planned
production runs to
arrive at the setup
cost pool rate.
Then, for each
circuit board, the
setup cost pool rate
is divided by the
number of units per
run to arrive at the

Mode I: (1 Run)
$200 per run
10,000 units per run
= $.02 per unit

Mode II: (4 Runs)

$200 per run
5,000 units per run
= $.04 per unit

Mode III: (10 Runs)

$200 per run
400 units per run
= $.50 per unit

5-29

STAGE ONE
Various overhead
costs related
to engineering

Activity
cost
pool

Engineering salaries

Engineering software

Engineering supplies

Depreciation

Engineering Cost Pool

Total budgeted cost = $700,000

Aerotech estimated the costs of engineering salaries, supplies,

software and depreciation. These costs are added together. The sum
is the engineering cost pool budgeted cost
5-30

Allocate based
on engineering
transactions

STAGE TWO
Engineering Cost Pool
Total budgeted cost = $700,000

Cost
Assignment
The engineering
department has
estimated that 25%
of its time is spent
on Mode I, 45% on
Mode II and 30%
spent on Mode III.
For each board, the
percentage of
engineering time is
multiplied by the
budgeted
engineering cost
then divided by the

Mode I:
25% $700,000
10,000 units
= $17.50 per unit

Mode II:
45% $700,000
20,000 units
= $15.75 per unit

Mode III:
30% $700,000
4,000 units
= $52.50 per unit

The result is the engineering cost per unit.

5-31

STAGE ONE
Various overhead
costs related
to general
operations

Activity
cost
pool

Plant depr.

Property taxes

Plant mgmt.

Insurance

Plant maint.

Security

Facility Cost Pool

Total budgeted cost = $507,400

Aerotech estimated the costs of plant depreciation, management

salaries, maintenance, property taxes, insurance and security. These
costs are added together. The sum is the facility cost pool budgeted
cost.

5-32

Calculate
the pool
rate
Cost
Assignment
Aerotech has selected to
use direct labor hours as
the cost driver for
facilities cost.
The budgeted facilities
cost is divided by the
budgeted direct labor
hours to arrive at the
facilities cost per hour.
The facilities cost per
unit is calculated by
multiplying the facilities
cost per hour by the
number of direct labor

STAGE TWO
Budgeted Facilities Cost=
Budgeted Direct-Labor Hours
=

Mode I:
$4.30 per hr.

3 hr. per unit

$12.90 per unit

$507,400
118,000
$4.30/hour

Mode II:
$4.30 per hr.

4 hr. per unit

$17.20 per unit

Mode III:
$4.30 per hr.

2 hr. per unit

$8.60 per unit

5-33

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

For
Aerotech,
only the
machinery
cost pool
is at the
unit level.

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

Facility
Level
Facility
cost pool
$507,400

There are five cost

pools at the batch
level: setup, receiving
and inspection, materialhandling, quality
assurance and the
packaging and shipping
cost pool.
The engineering cost
pool is at the productsustaining level and the
facility cost pool is at the
facility level.
5-34

 Aerotech has four other batch level

cost pools: receiving and inspection,
material handling, quality assurance,
and packaging and shipping.
Each of these departments has
estimated the costs and the
percentage of time spent on each of
the three circuit boards.
The budgeted costs are multiplied by
the percentage to determine the cost
per unit for each board.

Other Overhead Costs

Receiving and Inspection Cost Pool

Board
Overhead
Mode I
$ 200,000
Mode II
200,000
Mode III
200,000

%
6%
24%
70%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.20
=
2.40
=
35.00

Material-Handling Cost Pool

Board
Overhead
Mode I
$ 600,000
Mode II
600,000
Mode III
600,000

%
7%
30%
63%

Units
10,000
20,000
4,000

= Cost/Unit
= $
4.20
=
9.00
=
94.50

Quality-Assurance Cost Pool

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

%
20%
40%
40%

Units
10,000
20,000
4,000

= Cost/Unit
= $
8.42
=
8.42
=
42.10

Packaging and Shipping Cost Pool

Board
Overhead
Mode I
$ 250,000
Mode II
250,000
Mode III
250,000

%
4%
30%
66%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.00
=
3.75
=
41.25
5-36

Other Overhead Costs

Receiving and Inspection Cost Pool

Board
Overhead
Mode I
$ 200,000
Mode II
200,000
Mode III
200,000

%
6%
24%
70%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.20
=
2.40
=
35.00

Material-Handling Cost Pool

Board
Overhead
Mode I
$ 600,000
Mode II
600,000
Mode III
600,000

$14.82

%
7%
30%
63%

Units
10,000
20,000
4,000

= Cost/Unit
= $
4.20
=
9.00
=
94.50

Quality-Assurance Cost Pool

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

The cost per unit

for each of these
batch level costs
is added together
for each board.

%
20%
40%
40%

Units
10,000
20,000
4,000

= Cost/Unit
= $
8.42
=
8.42
=
42.10

Packaging and Shipping Cost Pool

Board
Overhead
Mode I
$ 250,000
Mode II
250,000
Mode III
250,000

%
4%
30%
66%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.00
=
3.75
=
41.25
5-37

Product Cost from ABC

These are the new product costs when
Aerotech uses ABC.
Mode I
Direct materials $ 50.00
Direct labor
60.00
Machinery
28.20
Setup
0.02
Engineering
17.50
Facilities
12.90
Other
14.82
Total
$ 183.44

Mode II
$ 90.00
80.00
35.25
0.04
15.75
17.20
23.57
$ 261.81

Mode III
$ 20.00
40.00
56.40
0.50
52.50
8.60
212.85
$ 390.85

Now Aerotech has new product costs for each board. It is the sum of the
costs for direct materials, direct labor, machinery, setup, engineering,
5-38
facilities and costs accumulated as other costs.

Distorted Product Costs

Traditional costing
ABC costing
Original target selling price
ABC target selling price

[$209.00 1.25]

Both original and ABC target

selling
prices are based on (Cost 125%).

Mode I
$
209.00
183.44

Mode II
$
302.00
261.81

Mode III
$ 126.00
390.85

261.25
229.30

377.50
327.26

157.50
488.56

[$183.44 1.25]

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
Using the existing target pricing policy, the unit cost based on ABC
costing is multiplied by 1.25 to arrive at the ABC target selling price.
Under ABC costing, the selling price for Mode I and Mode II boards
has decreased, but the selling price for the Mode III board has
increased significantly.
5-39

Distorted Product
Costs
Traditional costing
ABC costing
Cost distortion per unit
Units produced
Total cost distortion

Can you identify any problems Aerotech

is likely to face as a result of this
distortion?

Mode I
$ 209.00
183.44
25.56
10,000
255,600

Mode II
$ 302.00
261.81
40.19
20,000
803,800

Mode III
$
126.00
390.85
(264.85)
4,000
(1,059,400)

Traditional costing understates the cost of complex,

low volume products

The cost per unit under ABC costing is deducted from the traditional costing
unit cost.
This is cost distortion per unit.
The problem with cost distortion is more evident when the cost distortion per
unit is multiplied by the number of units produced.
The essence of the problem is that the traditional, volume-based costing
system was over costing the high-volume product lines (Modes I and II) and
under costing the complex, relatively low volume product line (Mode III).
The high-volume products basically subsidized the low volume line.
The activity-based costing system revealed this problem by more accurately
assigning overhead costs to the three product lines.
5-40
When the costs are understated, so is the selling price.
See