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Topic6Activity-BasedCostingMAA703ManagementAccounting1EvolutionofABC⚫Conventionalcostingsystemsuseatwo-stageallocationproces

s:1.servicedepartmentcostsareallocatedtoproductiondepartments.2.productiondepartmentoverheadcostsareallocatedtoproductsu

singavolume-basedpredeterminedoverheadrate.2Productcostsdon’tmakesense⚫Problem:Theremaybenorelationshipbetweentheoverheadapplic

ationbaseandthewaythatdifferentproductscauseoverheadcosts⚫Theresult:❖High-volumesimpleproductsareover-costedandover-priced❖Low-volumecom

plexproductsareunder-costedandunder-priced3PlantwideOverheadRatesCompanieshavetendedtousedirectlabourastheoverheadapplicationb

ase.Howeverdirectlabourisnowarelativelyminorpartoftotalmanufacturingcost.Manytasksthatusedtobedonebyhandarenowdonebyautomatedequipment

.4Atwostageprocessisnecessarybecausecostsareallocatedtodepartmentsandthentoproducts.FinishingDepartmentShippingDepartmentPaintingDepartmentDep

artmentalOverheadRates5Department1Department2Department3CostpoolsIndirectLaborIndirectMaterialsOtherOverheadStageOne:Costsassignedto

poolsDepartmentalOverheadRates6Department1Department2Department3CostpoolsStageOne:CostsassignedtopoolsProductsStageTwo:CostsappliedtoproductsDepart

mentalOverheadRatesIndirectLaborIndirectMaterialsOtherOverhead7Department1Department2Department3CostpoolsStageOne:Costsassignedtopoo

lsProductsStageTwo:CostsappliedtoproductsDirectLabourHoursMachineHoursRawMaterialsCostDepartmentalAlloc

ationBasesDepartmentalOverheadRatesIndirectLaborIndirectMaterialsOtherOverhead8CostDistortionscausedby2-stageallocati

ons⚫Thereisanolinkbetweenthecauseofsupportactivitycostsandthebasisforassigningthesecoststoproducts⚫Why?1.Allocationsarebasedonunitorvolum

erelatedmeasures.2.Differentproductsconsumedifferentamountsofsupportactivities.9Questionableprofitmargins⚫Tocompeteinthemarke

tplace,somecompanieshavehadtocutthepricesofhighvolumepopularitems.⚫ButTheyhavebeenabletoachievehighmark-upsonlowvolumespecial

typroducts.10Erosionofcompanyprofits⚫Pricecutsproduceincreasedsalesinunitsbutdecreasedtotalrevenue⚫Highmark-upso

nspecialtyproductsdidn’toffsetthefallinprofitmarginsofhighvolumeproducts11Causesofproblems⚫Increasedp

roductdiversity⚫changingcoststructures⚫useofvolume-basedcostdriversHaveresultedin:distortedproductcosts12Solution:Ac

tivityBasedCosting⚫ABCusescostdriversthatdirectlylinkactivitiesperformedtoproductsmade.⚫costdriversareselectedwhichmeasuretheav

eragedemandplacedoneachactivitybyeachproduct.⚫activitycostpoolsareassignedtoproductsinproportiontothewaythattheyconsu

meeachactivity.13Solution:ActivityBasedCosting⚫ACTIVITIESCONSUMERESOURCES⚫PRODUCTSCONSUMEACTIVITIES⚫Activitie

sareusedtolinkresourcecoststoproducts14ActivityBasedCosting(ABC)Theobjectiveofactivity-basedcostingistoundersta

ndthecausesofoverheadcostsandtoidentifytherealprofitabilityofproductsandcustomers.ABCisagoodsupplementtoourtraditionalcostsystemIagree!15Overh

eadratesmaybebasedonactivityatcapacity.ActivityBasedCosting(ABC)Activity-BasedCostingBothmanufacturingandnonmanufacturingcos

tsmaybeassignedtoproducts.Somemanufacturingcostsmaybeexcludedfromproductcosts.Thereareanumberofcostpools,eachofwhichisallocated

usingauniquemeasureofactivity.Allocationbasesoftendifferfromtraditionalcostingsystems.16HowCostsareTreatedUnderActivity-BasedCostin

gOverheadAllocationPlantwideOverheadRateDepartmentalOverheadRatesActivityBasedCosting17Activity-based

costing⚫isawayofmeasuringboththecostofcostobjectsandtheperformanceofactivities⚫canhelpsolveproblemssuchas❖distorte

dproductcosts❖poorcostcontrol⚫theformofABCadopteddependsontheproblemsthatneedtobeaddressed18DesigninganABCSy

stemCostObjects(e.g.,productsandcustomers)ActivitiesConsumptionofResourcesCost1920IdentifyingandDefiningActivitiesAnACTIVITYisap

artoftheproductionprocessforwhichmanagementwantsaseparatereportingofcosts.Unit-LevelActivitiesBatch-LevelActivitiesProd

uct-sustainingActivitiesFacility-sustainingActivities21OutputUnit-LevelCosts...–areresourcessacrificedonactivitiesperformedone

achindividualunitofproductorservicee.g.EnergyusedbymachinesMachinedepreciationorrepairsTheKeyQuestion:Doestheamountoftheactivitycostpoolincrea

sewiththenumberofunitsproduced?22Batch-LevelCosts...–areresourcessacrificedonactivitiesthatarerelatedtoabatchofu

nitsratherthantoeachindividualunitofproductorservice.Set-upactivitycostsmaybedrivenbyset-uphours.This

willdependonthenumberset-upscarriedouti.e.onthenumberofbatchesproducedandthetimeeachset-uptakes.23Product-Sustain

ing...–(orservice-sustaining)costsareresourcessacrificedonactivitiesundertakentosupportindividualproductsorservices.Designcostsmaybedrivenbythet

imespentbyengineersdesigningtheproductitselfandplanninghowitwillbemade.24Facility-SustainingCosts...–areresourcessa

crificedonactivitiesthatcannotbetracedtoindividualproductsorservicesbutwhichsupporttheorganizationasawhole.⚫Generaladministr

ation❖rent❖buildingsecurity❖CEO’ssalary25DifferentformsofABC⚫Simpleapproach-includesmanufacturingoverheadonly⚫ABCsystemforalli

ndirectcosts-includesmanufacturingandnon-manufacturingcosts⚫Comprehensivesystem-includesallproduct-relatedcosts,exceptdir

ectmaterial26TheMechanicsofABCClassicBrassLtdmakesfinelymachinedbrassfittingsforavarietyofapplications.Forthiscompany,th

eultimatecostobjectsare:Products,Customerorders,andCustomers.Oneoverheadcost-shipping-canbetraceddi

rectlytocustomerorders.Thecompany’sactivitycostpoolsareshownonthenextslide.27Step1:IdentifyandDefineActivitiesandActivityCostPo

olsAtClassicBrass,theABCteam,selectedthefollowingactivitycostpoolsandactivitymeasures:ActivityCostPoolActivityMeasur

eCustomerordersNumberofcustomerordersProductdesignNo.ofproductsdesignedOrdersizeMachine-hoursCustomerrelationsNumberofactiv

ecustomersOther(notassignedtoproducts)ActivityCostPoolsatClassicBrass28Step1:IdentifyandDefineActivitiesandActivityCostPools⚫CustomerOrders-assign

edallcostsofresourcesthatareconsumedbytakingandprocessingcustomerorders.⚫ProductDesigns-assignedallcostsofresourcesconsu

medbydesigningproducts.⚫OrderSize-assignedallcostsofresourcesconsumedasaconsequenceofthenumberofunitsproduced.⚫Cu

stomerRelations–assignedallcostsassociatedwithmaintainingrelationswithcustomers.⚫Other–assignedalloverheadcoststhatarenotassociatedwit

htheothercostpools.29ProductionDepartmentIndirectfactorywages500,000$Factoryequipmentdepreciation300,000Factoryutilities120,

000Factorybuildinglease80,0001,000,000$Shippingcoststracedtocustomerorders40,000GeneralAdministrativeDepartmentAdministrativewagesandsalaries400,

000Officeequipmentdepreciation50,000Administrativebuildinglease60,000510,000MarketingDepartmentMarketingwagesandsalaries250,000Sellingexpenses

50,000300,000Totaloverheadcosts1,850,000$OverheadCostsatClassicBrass(ManufacturingandNonManufacturing)Step2:WheneverPossible,D

irectlyTraceOverheadCoststoActivitiesandCostObjects30Step3:AssignCoststoActivityCostPoolsCustomerOrdersProductDesignOrderSizeCustomerR

elationsOtherTotalProductionDepartmentIndirectfactorywages25%40%20%10%5%100%Factoryequipmentdepreciation20%0%6

0%0%20%100%Factoryutilities0%10%50%0%40%100%Factorybuildinglease0%0%0%0%100%100%Shippingcosts**GeneralAdministrativeDepartme

ntAdministrativewagesandsalaries15%5%10%30%40%100%Officeequipmentdepreciation30%0%0%25%45%100%Administrativebuildinglease0%0%0%0%100%100%MarketingDe

partmentMarketingwagesandsalaries20%10%0%60%10%100%Sellingexpenses10%0%0%70%20%100%ActivityCostPoolsAtCla

ssicBrassthefollowingdistributionofresourceconsumptionacrossactivitycostpoolsisdetermined.**Notincludedbecausetheyaredirectlytracedtocusto

merorders.31CustomerOrdersProductDesignOrderSizeCustomerRelationsOtherTotalProductionDepartmentIndirectfactor

ywages125,000$FactoryequipmentdepreciationFactoryutilitiesFactorybuildingleaseGeneralAdministrativeDepartmentAdministr

ativewagesandsalariesOfficeequipmentdepreciationAdministrativebuildingleaseMarketingDepartmentMarketingwagesandsalariesSelli

ngexpensesTotalActivityCostPoolsIndirectfactorywages$500,000Percentconsumedbycustomerorders25%$125,00

0Step3:AssignCoststoActivityCostPoolsProductionDepartmentIndirectfactorywages500,000$Factoryequipmentd

epreciation300,000Factoryutilities120,000Factorybuildinglease80,0001,000,000$Shippingcoststracedtocustomerorders40,000GeneralAdm

inistrativeDepartmentAdministrativewagesandsalaries400,000Officeequipmentdepreciation50,000Administrativebuildinglease60,

000510,000MarketingDepartmentMarketingwagesandsalaries250,000Sellingexpenses50,000300,000Totaloverheadcost

s1,850,000$OverheadCostsatClassicBrass(ManufacturingandNonManufacturing)32CustomerOrdersProductDesignOrderSizeCustomerRelationsOt

herTotalProductionDepartmentIndirectfactorywages125,000$Factoryequipmentdepreciation60,000FactoryutilitiesFactorybuildingleaseG

eneralAdministrativeDepartmentAdministrativewagesandsalariesOfficeequipmentdepreciationAdministrativebuildingleaseMarketingDepartmentMark

etingwagesandsalariesSellingexpensesTotalActivityCostPoolsProductionDepartmentIndirectfactorywages500,000$Factoryequipmentdeprecia

tion300,000Factoryutilities120,000Factorybuildinglease80,0001,000,000$Shippingcoststracedtocustomerorders40,000GeneralAdministrativeDepartmentAdmi

nistrativewagesandsalaries400,000Officeequipmentdepreciation50,000Administrativebuildinglease60,000510,000MarketingDepartmentMarketingwagesandsala

ries250,000Sellingexpenses50,000300,000Totaloverheadcosts1,850,000$OverheadCostsatClassicBrass(Manufac

turingandNonManufacturing)Factoryequipmentdepreciation$300,000Percentconsumedbycustomerorders20%$60,000Step3:AssignCostst

oActivityCostPools33CustomerOrdersProductDesignOrderSizeCustomerRelationsOtherTotalProductionDepartmentIndirectfactorywages125,000

$200,000$100,000$50,000$25,000$500,000$Factoryequipmentdepreciation60,000-180,000-60,000300,000Factoryutilities-12,00060,000-48,000120,000F

actorybuildinglease----80,00080,000GeneralAdministrativeDepartmentAdministrativewagesandsalaries60,00020,00040,000120,000160,000400,000Officeequipme

ntdepreciation15,000--12,50022,50050,000Administrativebuildinglease----60,00060,000MarketingDepartmentMarketingwagesandsal

aries50,00025,000-150,00025,000250,000Sellingexpenses5,000--35,00010,00050,000Total315,000$257,000$380,000$367,500$490,500$1,810,00

0$ActivityCostPoolsStep3:AssignCoststoActivityCostPools34Step4:CalculateActivityRatesDirectMaterialsDirectLaborShippingCostsO

verheadCostsTracedTracedTracedCostObjects:Products,CustomerOrders,Customers35Step4:CalculateActivityRatesDirect

MaterialsDirectLaborShippingCostsOrderSizeCustomerOrdersProductDesignCustomerRelationsOtherOverheadCostsCostObjects:Products,Cust

omerOrders,CustomersFirst-StageAllocation36Step4:CalculateActivityRatesDirectMaterialsDirectLaborShippingCostsCostObjects:Products,CustomerOr

ders,CustomersOrderSizeCustomerOrdersProductDesignCustomerRelationsOtherOverheadCostsFirst-StageAllocationSecond-Sta

geAllocations$/MH$/Order$/Design$/CustomerUnallocated37Step4:CalculateActivityRatesTheABCteamestimatesthatC

lassicBrasswillhavethefollowingtotalactivitiesforeachactivitycostpool...❖1,000customerorders,❖200newdesigns,❖20,000machine-

hours❖100customers.Nowtheteamcancomputetheindividualactivityratesbydividingthetotalcostforeachactivitybythetotalactivitylevels38Step4:Calcul

ateActivityRatesAfterthefirst-stageallocationiscomplete,computationofactivityratesforeachactivitycostpoolcanbedoneasfollows:Computatio

noftheActivityRatesCustomerOrdersProductDesignOrderSizeCustomerRelationsOtherCostsfromfirst-stageallocation315,000$257,000$380

,000$367,500$490,500$Totalactivity1,00020020,000100N/ACostperunitofactivity315$1,285$19$3,675$perorderperdesignperMHpercust.perMHpercustomer.÷÷÷÷

39Step5:AssignCoststoCostObjectsLet’stakealookathowoursystemworksforjustonecustomer–WindwardYachts.StandardStanchions(nodesignrequired

)1.400unitsorderedwith2separateorders.2.Eachstanchionrequired0.5machine-hours.3.Sellingpriceis$34each.4.Directmateria

lstotal$2,110.5.Directlabortotals$1,850.6.Shippingcoststotal$180.CustomCompassHousing(requiresnewdesign)1.Oneorderduringtheyear.2

.Eachhousingrequired4machine-hours.3.Sellingpriceis$650each.4.Directmaterialstotal$13.5.Directlabortotals$50.6.Shippingcoststo

tal$25.40Step5:AssignCoststoCostObjects(a)(b)(a)(b)ActivityCostPoolsActivityRateActivityABCCostCustomerorders315$2630$Productdes

ign1,2850-Ordersize192003,800Customerrelations3,675N/AOverheadCostfortheStandardStanchions(a)(b)(a)(b)ActivityCostPoolsActivityR

ateActivityABCCostCustomerorders315$1315$Productdesign1,28511,285Ordersize19476Customerrelations3,675N/AOverheadCostfortheCustomHousin

gThecustomer-levelcostisassignedtocustomersdirectly;itisnotassignedtoproducts.41Step6:PrepareManagementReportsStandardStanc

hionsSales13,600$Cost:Directmaterials2,110$Directlabor1,850Shippingcosts180Customerorders630Productdesign-Orde

rsize3,8008,570Productmargin5,030$42Step6:PrepareManagementReportsCustomCompassHousingSales650$Cost:Directmaterials13$Directlabor50Shippingco

sts25Customerorders315Productdesign1,285Ordersize761,764Productmargin(1,114)$43WindwardYachtsProductmargins:Stan

dardstanchion5,030$Customcompasshousing(1,114)Totalproductmargin3,916Less:Customerrelations3,675Customermargin241$Step6:Prepa

reManagementReportsCustomerProfitabilityAnalysis44ProductMarginsStandardStanchionsCompassHousingSales13,600$650

$CostsDirectmaterials(2,110)(13)Directlabor(1,850)(50)Manufacturingoverhead(10,000)(200)Productmargin(360)

$387$TraditionalCostAccountingSystem(MH=machinehour)Predeterminedmanufacturingoverheadrate$1,000,00020,000MH=$50/MH=400unitsx0.5M

H/unitx$50/MH=$10,00045DifferencesBetweenABCandTraditionalProductCostingABCwillordinarilyshiftoverheadcostsfromhigh-volumeproductsproducedinlarge

batchestolow-volumeproductsproducedinsmallbatches.UnderABCbothmanufacturingandnonmanufacturingcostsmaybeassignedtoproducts.Orga

nization-sustainingcostsandthecostsofidlecapacityarenotassignedtoproducts.46Activity-basedversusconventionalproductcosts⚫Conventionalcosting

assumesproductcostsaredrivenbyvolume-basedcostdrivers⚫Conventionalcostingignoresbatchsize-unitsproducedinlargebatchesconsumearelatively

lowamountperunitofbatchcosts⚫ABCcanincludenon-manufacturingcosts47ABCbenefitswillbegreatestwhere...⚫Overheadco

stsareasignificantproportionoftotalcost,andalargepartofoverheadisnotdirectlyrelatedtoproductionvolume⚫Thebusinesshasadiverseproductrange,andtheindiv

idualproducts’useofsupportresourcesdiffersfromtheiruseofvolume-basedcostdrivers48ABCbenefitswillbegreatestwhere...⚫Productionactivi

tyinvolvesdiversebatchsizesandproductcomplexity.⚫Therearelikelytobehigh‘costs’associatedwithmakinginappropriatedecision

s,basedoninaccurateproductcosts.⚫Thecostofdesigning,implementingandmaintaininganABCsystemisrelativelylowduetosophisticatedITsupport49Impe

dimentstointroducingABC⚫LackofawarenessofABC⚫UncertaintyaboutthepotentialbenefitsfromABC⚫Firmsunderstandthen

eedforchangebutareconcernedabouttheextensiveresourcerequirementstoimplementABC⚫Resistancetochangeamongmanagersande

mployees❖ReadingbyBoothandGiacobbe50Otheractivity-basedcostingissues⚫SourcesofvariationsintypesofABCinclud

ewhether❖actual(past)orbudgetedcostsareanalysed❖theimplementationisaone-offprojectoranon-goingsystem❖costobjects,otherthanproducts,areincluded51

Otheractivity-basedcostingissues⚫Implicationsofexcesscapacity❖ABCestimatesthecostofresourcesusedtoperformact

ivitiestoproduceandsellproducts,whichmaynotalwaysequalthecostofresourcessupplied❖needtoaccountforthecost

sofunusedcapacitywhenbudgetedcostshavebeenusedtogenerateactivity-basedproductcosts52Otheractivity-basedco

stingissues⚫Behaviouralissues❖changecanbeperceivedasthreateningABCmayrequirechangesindatacollectedandcollectionandanalysisprocedures❖‘b

ottom-up’changemanagementmaygivesomedegreeofownershipofanychangescausedbyABC❖managementmustbeseenascommittedtothechangeprocess53Limitationsofact

ivity-basedcosting⚫Ifahighleveloffacility-levelcostsareallocatedtoproducts,thiscanleadtoanarbitraryelementofproductco

st⚫Unitisedbatch,productandfacility-levelcostscanleadtoproductcoststhatareoflimitedusefordecisionmaking⚫Th

ecostofupdatinganABCsystemcanbeveryhigh,butthisisneededtoavoidproducingoutdated,irrelevantinformation54Activity-basedcostinginservic

eorganisations⚫ABCcanbedifficulttoimplementinservicefirms,because❖highlevelsoffacilitycostscauseproblemswithcostingservices❖individualactiv

itiesaredifficulttoidentifybecausetheyarenon-repetitive❖anon-repetitiveproductionenvironmentmakesitdifficulttoid

entifyserviceoutputs55Activity-basedmanagement(ABM)⚫Processofusinginformationfromactivity-basedcostingtoanalyseactivities,costdriversandperforma

ncesothatcustomervalueandprofitabilityareimproved⚫Customervalue❖thefeaturesofaproductwhichcustomersarewillingtopay56UsingABMtoreducecosts⚫Identifyth

emajoropportunitiesforcostreduction⚫Determinetherealcausesofthesecosts⚫Developaprogramtoeliminatethecauses,and,therefore,thecosts⚫Introduceperfo

rmancemeasurestomonitortheeffectivenessofcostreductionefforts57Identifyingthemajoropportunitiesforcostr

eduction⚫Value-addedactivities❖essentialtothecustomer,orbusiness⚫Non-value-addedactivities❖canbeeliminatedwithoutdetrimenttoeitherthecust

omersorthebusiness58Value-AddedCosts⚫Avalue-addedcostisacostthatcustomersperceiveasaddingvalue,orutility,toaproductorservicee.g.foracomputer:–Ad

equatememory–Pre-loadedsoftware–Reliability–Easy-to-usekeyboards59Non-value-addedcosts⚫Anon-value-addedcostisacostthatcustomersdonotperceiveasadding

value,orutility,toaproductorservice.vCostofexpeditingvReworkvRepairvMaterialinspectionvIdletime60Activity-BasedManagement⚫

ABMcanbeusedforlProductpricingandmixdecisionslCostreductionandprocessimprovementdecisionslDesigndecisions61ProductPricin

gandMixDecisions⚫ABCgivesmanagementinsightintothecoststructuresformakingandsellingadiverserangeofproducts.⚫Itprovidesmoreacc

urateproductcostinformationandmoredetailedinformationoncostsofactivitiesandthedriversofthosecosts.62CostReductionandPro

cessImprovementDecisions⚫ManufacturinganddistributionpersonneluseABCsystemstofocusoncostreductionefforts.⚫M

anagerssetcost-reductiontargetsintermsofreducingthecostperunitofthecost-allocationbase.63DesignDecisions⚫Managementcanidentifyandevaluatenewdesigns

toimproveperformancebyevaluatinghowproductandprocessdesignsaffectactivitiesandcosts.⚫Companiescanworkwiththeircustomerstoevaluatethecostsandp

ricesofalternativedesignchoices.64Just-In-TimeProductionSystems⚫Just-in-time(JIT)productionsystemstakea“demandpull”approachinwhichgoodsareonlymanufac

turedwhenneededtosatisfycustomerorders.⚫Demandtriggerseachstepoftheproductionprocess,startingwithcustomerdemandforafinishedproductattheendofthepro

cess,tothedemandfordirectmaterialsatthebeginningoftheprocess.65MajorFeaturesofaJITSystem⚫ThefivemajorfeaturesofaJITsystemare:lOrganiz

ingproductioninmanufacturingcellslHiringandretainingmulti-skilledworkerslEmphasizingtotalqualitymanagementlReducingman

ufacturingleadtimeandsetuptimelBuildingstrongsupplierrelationships66KeyfeaturesofJITproduction1.A‘pull’methodofco-ordinatingpro

ductionwhichuseskanbans.‘Kanban’istheJapanesetermforcardorvisiblerecord.Nothingismanufacturedatanystageuntilitsneedissignalledfromth

esubsequentstage,viaakanban.2.Simplifiedproductionprocesses.Non-value-addedactivitiesareidentifiedandremoved.67KeyfeaturesofJITproduction3.Purchaseo

fmaterials,andmanufactureofsub-assembliesandproductsinsmalllotsBatchsizestendtobesmallandinventorylevels

arelow.4.Quickandinexpensivesetupsofproductionmachinery.Toproduceinsmallbatchessetuptimesmustbereduced.68Key

featuresofJITproduction5.High-qualitylevelsforrawmaterials,componentsandfinishedproducts6.Effectivepreventativemaintenanceofequipme

nt7.FlexibleworkteamsManyfirmshavemovedfromrigidassemblylinestowardswork-basedteammadeupofmulti-skilledemployees.69CostsofJIT⚫Substantial

investmentisneededtochangetheproductionfacilitiessoastominimisenon-value-addedactivities⚫Anincreaseintheriskofinventoryshortagesandtheassociatedloss

ofproductionandsales.❖Astrikeatthefactoryofasuppliercancauseatotalshutdownofproduction.❖In2001a14daystrikebyemployeesatasupplierofsteeringp

artscostHoldenanestimated$20Maday.70BenefitsofJIT⚫Savingsininventory-carryingcosts⚫Lowerinsurancecosts⚫Fewerlossesduetospoilage,obsole

scenceandtheft⚫Noopportunitycostsofhighinventory⚫Eliminationofnon-value-addedactivities⚫Meetscustomersneedsmoreeffectively71ENDOFTOPIC672