Activity Based Costingeggggeggggggggggggggggggggggg

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1. 1.
Activity Based Costing

2. 2
Traditional Costing Systems
Often the most difficult part of computing accurate unit costs is
determining the proper amount of overhead costto assign to
each product, service, or job.
Unlike direct materials and direct labor costs which can usually be
easily traced to the product, overhead is an indirector common
cost that generally cannot be traced.

3. 3
The Need for a New Costing System
Companies that continue to use plantwide predetermined overhead
rates based on direct labor or machine hours, where the correlation
with overhead no longer exists, experience significant product cost
distortions.

4. 4
Overhead Costs
A single predetermined overhead rate is used throughout the
year for the entire factory operation for the assignment of
overhead costs
In job order costing, direct labor hours or costs are commonly
used as the relevant activity base
In process costing, machine hours are commonly used as the
relevant activity base

5. 5
Activity-Based Costing
Allocates overhead to multiple activity cost pools and assigns
the activity cost pools to products by means of cost drivers
An activity is any event, action, transaction, or work sequence
that causes the incurrence of cost in producing a product or
providing a service
A cost driver is any factor or activity that has a direct cause-
effect relationship with the resources consumed

6. 6
Activity-Based Costing
Allocates costs to activities first, and then to the products,
based on the product’s use of those activities
Activities consume resources
Products consume activities

7. 7
Activity Based Costing
Costs
Consumed by:
Consumed by:
Products
Activities
Resource Drivers:
Costs are assigned to
activities based on
effort expended
Activity Drivers:
Activity costs are
assigned to products
on unique
consumption patterns
1.ABC focuses on activities in the
costing process.
2.Costs are traced from activities to
products, based on the product’s
demand for these activities during
the production process.
3.ABC theory contends that,
virtually all of a company’s
activities exists to support
production and delivery of
services, they should all be
included as product costs.

8. 8
ABC is extremely valuable to an organization, because it provides information on
the range, cost and consumption of operating activities. Specific benefits of and
strategic use for this information are:
• More accurate product costs enable better strategic decisions regarding:
• Product pricing
• Product mix.
• Make vs. Buy
• Investments in R&D, Process automation, etc..
• Increased visibility of the activities performed enables a company to:
• Focus more on the management of activities, such as improving the efficiency of high
cost activities.
• Identify and reduce non-value added activities.
Activity-Based Costing

9. 9
Activity-Based Costing
ABC allocates overhead in a two-stage process:
Overhead is allocatedto activity cost pools, each of
which is a distinct type of activity,
Overhead in the cost pools is assignedto products using
cost driverswhich represent and measure the number of
individual activities undertaken or performed to produce
products or render services.

10. 10
Activity-Based Costing
Not all products or services share equally in activities.
The more complex a product’s manufacturing operation, the
more activities and cost drivers it is likely to have.

11. 11© 2004 Superfactory™. All Rights Reserved.
Activity-Based Costing System
Overhead Costs
Products
Assembly
Cost Pool
Numbe
r of
Parts
Inspecting
and
Testing
Cost Pool
Numbe
r of
Tests
Painting
Cost Pool
Numbe
r of
Parts
Super-
vising
Cost Pool
Direct
Labor
Hours
Ordering
and
Receiving
Materials
Cost Pool
Numbe
r of
POs
Setting
Up
Machines
Cost Pool
Numbe
r of
Setups
Machining
Cost Pool
Machin
e Hours

12. 12
Unit Costs under ABC
Activity-based costing involves the following steps:
1Identify the major activities that pertain to the manufacture of
specific products and allocate manufacturing overhead costs to
activity cost pools.
2Identify the cost drivers that accurately measure each activity’s
contributions to the finished product and compute the activity-based
overhead rate.
3Assign manufacturing overhead costs for each activity cost pool to
products using the activity-based overhead rates (cost per driver).

13. 13
Computing Overhead Rates
Availability and ease of obtaining data relating to the activity cost
driver is an important factor that must be considered in its
selection.
The activity-based overhead rate is computed as shown below:
Estimated
Overhead per
Activity
Expected Use of
Cost Drivers per
Activity
Activity-based
Overhead Rate =

14. 14
Setting OH Rates: Choices of Level of Aggregation
Plantwiderate: simplest but most subject to distortion when
products vary in their use of resources
Departmental rates: more complex but subject to distortion
when costs that are not unit driven are substantial and products
use these costs differently
ActivityBasedRates:more complex and potentially more
accurate

15. 15
Using A Plantwide Rate
Mixing
Forming
Packaging
Inspection Engineering
Product 1 Product 2
Total OH
All products
pass through
the same
departments
& use the same
resources
in the same
way in each
OR
overhead costs
are small

16. 16
Using Departmental Rates to Apply Overhead
Mixing
Forming
Packaging
Inspection Engineering
Product 1 Product 2
Not all
products
pass through
the same
departments
But when
they do,
they use
the same
resources
in the same
way in each
Thus, an
inspection in
mixingis the
same for per unit
of mixing cost
driver for all products

17. 17
Productive/Service Costing 58%
Process Analysis 51%
Performance Management 49%
Profitability Assessment 38%
Value-Based Management 18%
Primary Objective
Who Uses ABC?

18. 18
•Public Sector 40%
•Service 24%
•Manufacturing 24%
•Consulting 11%
Industry
Who Uses ABC?

19. 19
Activity-Based Costing -Step 1
Identify the major activities that pertain to the manufacture of
specific products and allocate manufacturing overhead costs
to activity cost pools

20. 20
UNIT-LEVEL ACTIVITES
The work efforts that transform resources into individual products and resources
CUSTOMER-LEVEL ACTIVITES
Performed to meet the needs of specific customers
BATCH-LEVEL ACTIVITES
Manufacturing or service technology that affect multiple units of activity equally and
simultaneously
PRODUCT -LEVEL ACTIVITES
Support specific products or service lines
FACILITY-LEVEL ACTIVITIES
Support all of the organizations processes
Activity-Based Costing -Step 1

21. 21
INTERVIEW OR
PARTICIPATIVE
APPROACH
ABC teams include or
interview operating
employees.
RECYCLING
APPROACH
Reuses documentation
of processes used for
other purposes.
Activity-Based Costing -Step 1
TOP DOWN APPROACH
ABC teams of middle-
management or above
develop the activity
dictionary.

22. 22
Activity-Based Costing –Step 2
Identify the cost drivers that accurately measure the activities
consumed and compute the overhead rate

23. 23
The ABC teams should gather data on the costs of all
the activities identified in Step 1.
Examine
accounting
records for
recorded cost
information.
Ask employees to
provide
information on
the time they
work on various
activities.
Activity-Based Costing –Step 2

24. 24
When estimating the cost of
an activity, only the costs
associated with the product
should be used (practical
capacity). The cost of
“unused capacity” should
not be applied to products.
EXAMPLE
Suppose we rent a 1,000
square foot warehouse for
$1,000 per month. Only 800
sq. ft. are used to store
Product A. The rest of the
warehouse is “unused”.
How much rent cost should be
allocated to Product A?
Activity-Based Costing –Step 2

25. 25
20%, or $200 should
be assigned to
“unused capacity”
80%, or $800
should be assigned
to Product A
Activity-Based Costing –Step 2

26. 26
EXAMPLE #1
XCo has 4 employees in its Quality Control Dept. Salaries and costs
for the department total $360,000 per year. XCo produces 500,000
units of product a year. What is the appropriate activity, # of
employees or units of product? What is the cost-driver rate?
EXAMPLE #1
The proper activity in this case is the # of units produced.
The cost-driver rate would be:
$360,000 ÷500,000 units = $.72 per unit
Two pieces of
information are
required to compute
the cost-driver rate:
•Activity Cost
•Activity VolumeActivity
Cost
÷
Activity
Volume
=
Cost-Driver
Rate
Activity-Based Costing –Step 2

27. 27
EXAMPLE #2
XCo has a customer service center where
customers can call to ask questions. Customers
pay a fixed fee for each call they make to the
service center. In addition, other XCo
departments also use the service center. It costs
XCo $1,260,000 a year to operate the center. The
center receives 120,000 calls per year. The center
handles 1,000,000 minutes of calls.
What is the appropriate cost driver; total
minutes per call or number of calls?
What is the cost-driver rate?
EXAMPLE #2
Since customers are charged “per call”,
the proper activity in this case is the # of
calls handled by the center.
The cost-driver rate would be:
$1,260,000 ÷120,000 units = $10.50 per
call
Activity-Based Costing –Step 2

28. 28
Activity-Based Costing –Step 3
Assign overhead costs for each activity cost pool to products
using the overhead rates

29. 29
Activity-Based Costing –Step 3
1. Identify all
the activities
related to a
given product
or service.
2. Determine
how many
units of each
activity are
used per unit
of product.
3. Assign costs
to products
using the cost-
driver rates for
each activity

30. 30
Activity-Based Costing –Step 3
Example: Yazz, Inc. produces 130,000 units of Product A and 400,000
units for Product B. Using the following cost information, how
much overhead should be allocated to Product A? Activity Cost-Driver Base
Cost-Driver
Rate
Factory Floor SpaceSquare Footage 50.000$ 20,000 Sq. Ft.
Electricity Kilowatts 0.050$ 15,000 KW
Water Gallons 0.160$ 80,000 Gal.
Quality Control Units Inspected 0.850$ 135,000 Units
Packaging - InnerOunces of popcorn 0.025$ 270,000 Oz.
Packaging - OuterBoxes 1.250$ 135,000 Boxes
Resources Used by
Product A

31. 31
Activity-Based Costing –Step 3Activity
Cost-Driver
Base
Cost-Driver
Rate Cost Assigned
Factory Floor
Space
Square
Footage
50.000$ 20,000 Sq. Ft.1,000,000.00$
Electricity Kilowatts 0.050$ 15,000 KW 750.00$
Water Gallons 0.160$ 80,000 Gal. 12,800.00$
Quality Control Units
Inspected
0.850$ 135,000 Units 114,750.00$
Packaging - InnerOunces of
popcorn
0.025$ 270,000 Oz. 6,750.00$
Packaging -
Outer
Boxes 1.250$ 135,000 Boxes 168,750.00$
Total Cost Assigned to Product A1,303,800.00$
Resources Used
by Product A

32. 32
Activity-Based Overhead Rate
Estimated Overhead Cost Per Activity /
Expected Use of Cost Drivers Per Activity

33. 33
Cost Driver
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 with
the cost
Cost of
Measuring the
Driver
Behavioral
Effects of Using It

34. 34
Benefits of Activity-Based Costing
ABC leads to more activity cost pools with more relevant cost
drivers
ABC leads to enhanced control of overhead costs since
overhead costs can be more often traced directly to activities
ABC leads to better management decisions by providing more
accurate product costs, which contributes to setting selling
prices that will achieve desired product profitability levels

35. 35
Benefits of ABC
ABC leads to better management decisions . More accurate
product costing helps in setting selling prices and in deciding to
whether make or buy components.
Activity-based costing does not, in and of itself, change the
amount of overhead costs.

36. 36
Limitations of ABC
ABC can be expensive to use, as a result of the higher cost of
identifying multiple activities and applying numerous cost
drivers
Some arbitrary overhead costs will continue, even though
more overhead costs can be assigned directly to products
through multiple activity cost pools

37. 37
An ABC Example: Setting RatesCost Pool Cost Cost driver Activity
level
Rate
Engineering $500,000 Hours spent 20,000
Setups $450,000 No. of setups 800
Machining $1,000,000 Machine hrs 100,000
Inspections $400,000 Inspection
hrs
10,000
Space $125,000 No. of
facilities

Utilities $90,000 No. of
facilities



Divide cost by
activity level

38. 38
An ABC Example: Setting RatesCost Pool Cost Cost driver Activity
level
Rate
Engineering $500,000 Hours spent 20,000 $25/hr.
Setups $450,000 No. of setups 800 $562.5/setup
Machining $1,000,000 Machine hrs 100,000 $10/MHR
Inspections $400,000 Inspection
hrs
10,000 $40/insp.
Space $125,000 No. of
facilities
?
Utilities $90,000 No. of
facilities
?