Activity Based Costing

Composition of Cost
100

0 1 Direct Material 2 Labour 3 Overheads 4

Conventional Costing
Total Cost = Material + Labour+ Overheads
Overheads are allocated to the products on volume based measures e.g. labour hours, machine hours, units produced Will this not distort the costing in the new environment?

ABC provides an Alternative.

Conventional Costing

AB Costing Resources

Economic Element

Expenses

Activities Cost Objects

Work Performed

Cost Objects

Product or service

Basics of A B C
Cost of a product is the sum of the costs of all activities required to manufacture and deliver the product. Products do not consume costs directly Money is spent on activities Activities are consumed by product/services

Basics of A B C (contd.)
ABC assigns Costs to Products by tracing expenses to activities. Each Product is charged based on the extent to which it used an activity The primary objective of ABC is to assign costs that reflect/mirror the physical dynamics of the business

Basics of A B C (contd.)
Provides ways of assigning the costs of indirect support resources to activities, business processes, customers, products. It recognises that many organisational resources are required not for physical production of units of product but to provide a broad array of support activities.

Basics of A B C : How?
Steps: 1. Form cost pools 2. Identify activities 3. Map resource costs to activities 4. Define activity cost drivers 5. Calculate cost
Cost pools are groups or categories of individual expense items

Map resource costs to activities

Financial accounting categorises expenses by spending code; salaries, fringe benefits, utilities, travel, communication, computing, depreciation etc. ABC collects expenses from this financial system and drive them to the activities performed.

Mapping
Accounting Records Salaries 313,000 Depreciation Electricity Supplies Travel Total 155,000 132,000 25,000 100,000 725,000
Activities Business Development ABC Records Salaries Depreciation lectricity Supplies Travel E 20,000 25000 60000 50000 10000 10000 5000 50000 20000 2000 50000 5000 25000 5000 20000 5000 Total 55,000

Maintianing Present Business 80,000 Purhcasing Material Set up Machines Running Machines Resolve Quality Problems Total 125,000 25,000 50,000 13,000

10000 205,000 60000 275,000 37,000 110,000 43,000

313,000 155000 132000

25000 100000 725,000

Activities: Types
Unit level: Performed each time a unit is
produced

Batch level: Performed each time a batch is

produced

Product level: Performed to support production

of different type of product Customer Level: Performed to support servicing customers

Facility level:Residuary head

Define activity drivers The linkage between activities and cost objects, such as products, customers,, is accomplished by using activity drivers. An activity driver is a quantitative measure of the output of an activity. The selection of an activity driver reflects a subjective trade-off between accuracy and cost of measurement.

Activities Drivers Unit Level Acquire and Use material for containers No. of Containers Acquire and Use material for baby-care products No. of products Batch Level Set up manually controlled machines No. of batches of containers Set up computer controlled machines No. of batches of B. Produst Product Level Design and manufacture moulds No.of moulds required Use manually controlled machines Product type (containers) Use conputer controlled machines Product type (B.Products) Customer Level Consult customers No. of consultations Provide warehousing for customers No. of cubit feet

Activity Cost Activity Volume Activity Rat 40,000 80,000 1,000,000 8,000 0.04 10

3,000 12,000

10 20

300 600

5,000 15,000 40,000

5 1 1

1000 15000 40000

4,000 2,000

40 10,000

100 0.2

Faciltiy Level Manage workers Salaries Use main building Square feet 3,000 48,000 15,000 16,000 0.2 3

Building an ABC Model

Identify Resources Identify Activities Identify Cost Objects

Define Activity Drivers

Define Resource Drivers

Enter Resource Costs

Enter Resource Driver Qty.

Enter Activity Driver Qty.

Calculate Costs

ABC: Where to Use?

High Overheads Product Diversity or Multiple Products Customer Diversity Service Diversity Stiff Competition

Heat, light, power--basis of distribution, cubic feet:

A600,000 B200,000 C200,000 1,000,000 cubic feet 6/10 x $40,000 = $24,000 A 2/10 x $40,000 = $8,000 B 2/10 x $40,000 = $8,000 C

Building depreciation--basis of distribution, square feet

Manufacturing 48,000 Selling 9,000 Administrative 3,000 60,000 square feet 48/60 x $3,000 = $2,400 A 6/60 x $3,000 = 300 B 6/60 x $3,000 = 300 C Furniture and fixtures depreciation 75% ($800) = $600 B 25% ($800) = $200 C

Insurance--basis of distribution, square feet for building 48/60 x $1,300 = $1,040 A 6/60 x $1,300 = $130 B 6/60 x $1,300 = $130 C Insurance on inventories--half B; half A Insurance on furniture and fixtures 75% ($60) = $45 B 25% ($60) = $15 C

Building repairs--basis for distribution, square feet

48/60 x $4,000 = $3,200 A 6/60 x $4,000 = $400 B 6/60 x $4,000 = $400 C

Telephone--basis for distribution, number of extensions

Total extensions -- 45 9/45 x $1,800 = $360 A 27/45 x $1,800 = $1,080 B 9/45 x $1,800 = $360 C

Cost Distributions __A__ $24,000 __B__ $ 8,000 __C__ $8,000

(a) (b)

(c)

(d)

(e)

Heat, light, power Depreciation: Building Furniture and fixtures Machinery and equipment Insurance: Inventories Building Furniture and fixtures Machinery and equipment Building repairs Machinery repairs Telephone expense Totals

2,400 20,000

300 600

300 200

100 1,040 850 3,200 1,900 360 $53,850

100 130 45

130 15

400

400

1,080 $10,655

360 $9,405

Costing of a 100-unit batch of CS-29 carburetors

Department Hours(%) Casting/Stamping 21(17) Grinding 12(10) Machining 58 (46) Assembly 35(28) Total, proposed method 126= 100% Total, present method 126

Huron Automotives

Costing of a 100-unit batch of CS-29 carburetors First Proposal Revised Proposal Department Casting/Stamping Grinding Hours 21 12 (%) (17) (10) Rate $52.97 48.14 Total $1,112.37 577.68 Rate $53.12 46.75 561.00 Machining 58 (46) 87.52 5,076.16 86.50 5,017. 00 Assembly 35 (28) 40.19 1,406.65 39.14 1,369. 90 Total, proposed method Total, present method Difference 126 = 101% due to rounding 55.96 8,172.86 8,063. 42 7,050.96 55.96 7,050. 96 $1,012 (14% .46 more) Total $1,115 .52

126

$1,121.90

(16% more)

Note
Indicated cost is higher under the proposed methods primarily because a CS-29 carburetor spends a higher-than-average proportion of time in the highest machining department and a less-than-average proportion in the low-cost assembly department.

Costing of spare parts for inventory: First Proposal Department Casting/Stamping Grinding Machining Total, proposed method Total, present method Difference Hours 304 270 1,115 1,689 (%) (18) (16) (66) Rate $52.97 48.14 87.52 Total $16,102.88 12,997.80 97,584.80 126,685.48 Revised Proposal Rate $53.12 46.75 86.50 Total $16,148.4 8 12,622.50 96,447.50 125,218.4 8 55.96 94,516.44

1,689

55.96

94,516.44

$32,169.04 (34% more)

$30,702.0 4

(32% more)

Note
Indicated cost is higher under the proposed methods primarily because spares do not pass through the low-cost assembly department, and because they spend a higher-thanaverage proportion of time in the machining department

Costing of work done for other divisions: First Proposal Department Casting/Stamping Grinding Machining Hours 674 540 2,158 (%) Rate Total (20) $52.97 $ 35,701.78 (16) 48.14 25,995.60 (64) 87.52 188,868.1 6 Total, proposed method Total, present method Difference 3,372 250,565.5 4 3,372 55.96 55.96 188,697.1 2 $ (33% 61,868.42 more) 188,697.12 247,714.88 Revised Proposal Rate $53.12 46.75 86.50 Total $ 35,802.88 25,245.00 186,667.00

$ 59,017.76 (31% more)

Note
The differences between the costs that result from the two proposed methods are not so great as the differences between the present method and either proposal. This is because the actual average overhead cost per hour in each department in July (Exhibit 2) did not differ greatly from the predetermined rates in Exhibit 4.

All three of these examples cited show that the present method gives lower costs than those under the proposed methods. However, it should be noted that some products are being overvalued by the present system. It is reasonable to assume that there are some products that require a relatively large amount of assembling time. Such products would, under the present system, be costed at more than their costs under the proposed systems.

Plant as a single cost center

Labor cost in custom work reduced by 30 percent Reduced labor cost for the plant: Overhead is: Increased by new depreciation: $400,000/60 months Decreased by variable costs with reduced labor: 10% *$40.48 * 3,712 hours *30% Net increase in overhead Total overhead becomes $1,099,323 + $2,159 Total labor cost Total cost becomes Total hours become 31,412 - (3,712*30%) = 30,298 hours Plant-wide rate per hour is $1,735,431/30,298 hours = $57.28 Custom work costs if entire plant is treated as a single cost center: Prior to new machine: 3,712 hrs. @ $55.96 After new machine: 2,598 hrs. @ $57.28 Net decrease of 28%, or in total dollars $ 81,664 * 30% = $24,499 $ 658,448 - 24,499 = $633,949 $ 6,667

4,508 $2,159 $1,101,482 633,949 $1,735,431

$207,724 148,813 $ 58,911

Treating each department as a cost center

Present overhead is $40.48 *3,712 hours Add: Additional overhead (net) New total custom work overhead New total hours: 3,712 *70% = 2,598 hrs. New hourly overhead rate: $152,421/2,598 = Labor hourly rate New custom work hourly rate Custom work costs using five cost center approach: Prior to new machine: 3,712 hrs. @ $62.48 After new machine: 2,598 hrs. @ $80.67 Net decrease of 9.6%, or in total dollars $150,262 2,159 $152,421 $ 58.67 22.00 $ 80.67

$231,926 209,581 $ 22,345

Note
If there is only one cost center, the purchase of a new machine results in a substantial decrease in the cost of custom carburetors and fuel injectors; whereas if there are five cost centers, the purchase of the machine results in significantly less change in the cost of items going through the custom work department. This is an interesting phenomenon. The proposed system reflects more accurately what has actually happened to costs.

Margin under Full Cost

Revenues (100 units @ $113) Less: Materials Labor and overhead Gross margin *From Question 1 calculations. Present Method $11,300 4,200 7,051* $ 49 Proposed Method $11,300 4,200 8,173* $ (1,073)

Note: This suggests that with the more accurate costing under the proposed method, carburetor CS-29 is a loss leader.

Differential Income
Revenues Less: Materials Labor Differential income $11,300 4,200 2,641* $ 4,459 $11,300 4,200 2,785+ $ 4,315

*1.26 hrs. @ $20.96 +21 hrs. @ $21.60 + 12 hrs. @ $18.00 + 58 hrs. @ $25.00 + 35 hours @ $19.00 = $2,785

Differential Income
Both methods reveal that, if Huron has excess capacity, in the short run (at least), CS-29 should not be dropped, unless so doing would save about $5,400 in overhead costs that were assumed to be nondifferential in the above calculation (proposed method). neither the present nor the refined full cost data were helpful in making this decision

Full-cost analysis: Revenues Less Materials Labor and overhead Gross margin
*From

Differential Analysis
CS-29 CS-30 $11,300 4,200 8,173* $ (1,073) $11,300 8,000 3,867+ $ (567)

Question 1 calculations +12 hrs. @ $52.97 + 7 hrs. @ 48.14 + 17 hrs. @ $87.52 + 35 hrs. @ $40.19 = $3,867 Differential cost analysis CS-29 CS-30 (assuming all overhead costs are fixed): Revenues Less: Materials Labor Differential income $11,300 4,200 2,785* $ 4,315 $11,300 8,000 1,475* $ 1,825

*21 hrs. @ $21.60 + 12 hrs. @ $18.00 + 58 hrs. @ $25.00 + 35 hrs. @ $19.00 = $2,785 (see Question 4.)
**12 @ $21.60 + 7 @ $18.00 + 17 @ $25.00 + 35 @ $19.00 = $1,475

Note
Above analysis shows that, if all factory overhead is nondifferential with respect to whether CS-29 or CS-30 carburetors are produced, CS-29 is the more attractive product. Note that the full-cost analysis would be valid if all overhead costs assigned to the CS-29 and CS-30 carburetors were in fact differential; i.e., Huron would prefer to fill the order with the CS-30 if differential CS-29 overhead costs were $5,388 ($8,173 - $2,785) and differential CS-30

Benefits with new method

Pricing. Since Huron appears be a price follower, I see no benefits here from the proposed method. A possible exception might be the pricing of spares. Cost control. Again, I see no benefits from the proposal in this regard. If Huron wants better cost control, it should develop flexible budgets for labor and overhead on a department-by-department (responsibility center) basis. Inventory valuation. I see no benefits here from the proposal s more accurate costing. If adopted for tax purposes, it appears that the proposed approach would cause a one-shot tax increase (because since more production costs are capitalized in inventoriable spares, less will be charged to cost of the goods sold which are not inventoried). Charges to other divisions. In the long run, it is probably beneficial that these transfer prices be made more accurate. For example, there is no reason for the machining department to maintain capacity for an outside division and then sell this capacity at below the true full costs. More accurate costs here might suggest in the long run that some other division s machining capacity should be expanded. Judging departmental performance. (Same comments as for cost control.) Diagnostic uses. It is here that I think the proposal has most merit; for example, if carburetor CS-29 is revealed to be a loss leader by more accurate costing, I think this is something of which management should be aware.

Conclusion
The proposal should be adopted in this case, The costs of implementing it appear to be minimal. If the proposal were costly, the chief benefit, diagnostic information, could be gained by an annual ad hoc five-cost-center product costing, without changing the routine costing system. The proposal should not be adopted solely on the justification of improved accuracy; the improved accuracy is worthless if it doesn t lead to better decision Incidentally, whether the one- or five-cost center approach is used, at least the overhead portion of the hourly costing rate should be a predetermined rate based on estimates of annual volume and overhead costs; otherwise, month-to-month volume variations will result in erratic product costs, because of spreading the monthly fixed overhead over varying volumes. Thus, the revised proposal is superior to the first proposal.

California Creamery

Table 1 Old System Costs

Polynesian Fantasy D M 2.00 D 1.20 L O 1.20 * H 2.40 200% 5.60 Vanilla 1.80 1.20 1.20 * 2.40 200% 5.40

Note
Under the old system, the only difference shown between the costs of Polynesian Fantasy and Vanilla ice creams was due to the $.20 difference in direct material costs (see Table 1). The overhead rate was 200% of direct labor dollars ($600,000 $300,000). The new system costs took some calculating. Table 2 shows the calculation of the cost driver rates. Table 3 uses these rates to calculate the product costs. The total costs for Polynesian Fantasy and Vanilla are $9.07 and $4.64 respectively.

Table 2 New System Calculate cost drivers

Activity

Budgeted Cost $80,000 95,000 122,000 175,000 110,000 18,000 600,000

Purchasing Material handling Blending Freezing Packaging Quality control Total mfg OH cost

Activity cost Budgete driver d activity Purchase orders 909 Setups 1,846 Blender hrs Freezer hrs Packaging machine hrs Batches 1,000 1,936 1,100 286

Cost driver rate $88.01 51.46 122.00 90.39 100.00 62.94

 Cost system designs have no effect on real product costs whatever those real costs are is not affected by what the cost accountants are doing. However, there is a material difference between the costs revealed by the two cost models. Will s understanding of reality would improve materially if he adopted the new cost system. The new cost system is a better cost model. The differing cost effects of machine times and batch sizes are averaged out in the old system. Until and unless operating decisions are changed, the effect on total company profits of switching to the new cost system would be zero. All the differences at the product level even out in the aggregate.

Wilkerson Company

Outline
Wilkerson Company manufactures pumps, flow controllers and high quality valves. The Company s competitors had been reducing prices on pumps, sp Wilkerson had to match up the reduced prices. The price cuts led to a decline led to a decline in the profit from 10% to 3%. Wilkerson purchases semi-finished products components assemble them in the company s manufacturing facility. The company allocated the overhead cost to the product as a percentage of the direct labor cost and it was rated at 300%.

Cost drivers
Overhead Costs were recorded based on 4 cost drivers: Machine Hours Production Runs Number of Shipments and Hours of Engineering Work

Calculation of Cost Driver Rates

Overheads Machine related --> Expenses Cost Pool Cost Driver Cost Driver Rate 3,36,000 11,200 $30/ machine hour Set up Labor Receiving and Production Control 40,000 1,80,000 11,200 $250/ru n $1125/run Engine ering 1,00,00 0 Packaging and Shipping 1,50,000 11,200

11,200 11,200

$80/ru n $500/shipment

Calculation of Per Unit Cost

Items Direct Costs Direct Material Direct Labor Overhea Machine ds Related Exp Valves Pumps Flow Control 16 10 20 12.5 0.5x30=15 (50x250)/12500 = 1 (375x80)/12500=2 .40 (50x1125)/12500= 4.50 (70x500)/12500=2 .80 $58.20 22 10 0.3x30=9 (100x250)/4000 =6.25 (625x80)/4000= 12.50 (100x1125)/4000=1 2.50 (220x500)/4000=27 .50 $115.38

0.5x30+15 (10x250)/7500 Setup Labor =0.33 (250x80)/7500 Engineering =2.66 (10x1125)/7500= Rec&Prodn Cost 1.50 Packing & (10x500)/7500=0 Shipping .67 $46.17

TOTAL COST

Volume Based costing vs. Activity Based Costing:

Flow Control
87 105

Particulars Actual Price Value Based costing: Standard Unit Cost Gross margin Activity Based costing: Standard Unit Cost Gross margin

Valves
86

Pumps

56 34.90%

70 19.50%

62 41%

46.17 46.30%

58.2 33.10%

115.38 -9.90%

Conclusion
ABC divides the indirect cost to several cost drivers A more accurate method of calculation. In value based accounting the indirect cost is allocated on the proportion of direct labor only. Under activity based costing method the gross margin for flow controllers is negative The Company has the freedom to raise the price