1. activity based costing

8/10/2019 1. Activity Based Costing

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ManagementAccounting

Activity Based Costing


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Kronecker Company, a growing mail order clothing and

accessory company, is concerned about its growing

marketing, distribution, selling and administration expenses. It

therefore examined its customer ordering patterns for the pastyear and identified four different types of customers, as

illustrated in the following table. Kronecker sends catalogs

and flyers to all its customers several times a year. Orders are

taken by mail or over the phone by the toll free number.

Kronecker prides it self on the personal attention it providesshoppers who order over the phone. All purchases are paid for

by check or credit card. It also maintains a very generous

return policy if customers are not satisfied with the product.

Customers must pay return shipping charges, but their

purchase price is then fully refunded.


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Customer 1 Customer 2 Customer 3 Customer 4

Initial Sales Rs. 1000 Rs. 1000 Rs. 2,500 Rs. 3,000

Number of items returned 0 4 2 24

Dollar value of items returned 0 Rs. 200 Rs. 500 Rs. 1,500

Number of orders per year 1 6 4 12

Number of phone orders per year 1 0 0 12Time spent on phone placing

orders

0.25 hour 0 0 1 hour

Number of overnight delivery 1 0 0 12

Number of regular delivery 0 6 4 0

Prices are set so that cost of goods sold is on

average about 75% of the sales price.Customers pay actual shipping charges, but

extra processing is required for overnight

delivery. The company has developed the

following activity cost driver rates for its

support costs.

What advice will you give to the company.

Activity Ac

Process mail orders

Process phone orders

Process returns

Process over night delivery request

Maintain customer relations


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200 500

Net sales $1,000 $800 $2,000

Cost of goods sold, 75%of sales 750 600 1,500

Processing mail orders,$5 per nonphone order 0 30 20

Process phone orders,$80 per hour 20 0 0

Process returns,$5 per item returned 0 20 10

Process overnightdelivery requests,$4 per request

Maintain customerrelations

Customer 1 Customer 2 Customer 3 Custo

Sales $1,000 $1,000 $2,500

Less returns 0

Profit $176 $100 $420

Profit Sales 0.18 0.10 0.17

4 0 0

50 50 50


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Class Assignment Contributions-Section A

G Findings Comments Suggestion

2 Loss for customer 4

Is -1944.

Company incurs a loss when transacting with

Customer 2 and Customer 4.

The cost of goods has been set to 75 percent

appropriate from a managerial point of view

when calculating returns from a particular cu

3 Profits for customer 3

Is 69.33. Profit to

sales ratio is 25%.

In absolute monetary terms, customer 4 is the most

profitable.

Customer Relations should be higher for cus

and returning more number of units as comp

4 Profitability

(Profit/Net Sales) for

customer 4 is 0.03%

And Customer 3 is

0.17%. C-1 is 18%

Although customer type 4 has the highest sales, it has

the highest monetary returns and the lowest profit.

Customer type 3 is by far the most profitable

To reduce the service activity usage or im

cost of providing services. The reason fo

ways to reduce problems that caused the ret

more efficient, to reduce the time spent on t

charge fees to handle overnight delivery requ

5 Customer type 1 is fairly low-cost to serve in spite of

ordering by phone and requesting overnight delivery

because this customer type orders only once a year.

The Company must spend resources and labo

of placing orders by mail instead of phones.

The company should introduce some cap on

This will reduce the cost in process returns.

6 Profitability

(Profit/Net Sales) for

customer 4 is 0.05%

And Customer 3 is

0.21%.

Customer 3 is by far the most profitable in terms of

Gross Profit margin %, even though its sales are less

than customer 4s. Customer 1 and 2 are more

profitable than customer type 4 in terms of profit

margin to sales %.

The company might also explore ways to ma

efficient, to reduce the time spent on the pho

Kronecker may also charge higher fees (than

delivery requests.

7 Customer 2 most of the order are placed over mail but

since they have 20% of the sale items returned inwards

the net sale decrease.

Customer 3 and Customer 1 both of them has almost

similar profit to sales ratio i.e (17-18%) but thediffernce between the two is the sales ratio among

We would suggest company to increase busi

Customer 3 where profit-sales margin is goo

since the sales are larger they will retain larg


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Group-5

KRONECKER COMPANY

Customer 1 Customer 2 Customer 3 Customer 4

Sales 1000 1000 2500 3000

Return Inwards 200 500 1500

Net Sales 1000 800 2000 1500

Cost of Goods Sold 750 600 1500 1125

Gross Margin 250 200 500 375

Add Selling Overheads 74 100 80 1178

Profit Margin 176 100 420 -803

Overheads

Customer 1 Customer 2 Customer 3 Customer

Rate Orders Total Orders Total Orders Total Orders To

Process Mail Orders 5 0 0 6 30 4 20 0

Process Phone Orders 80 1 20 0 0 0 0 12 9

Process Returns 5 0 0 4 20 2 10 24 1

Process Over-night Delivery Request 4 1 4 0 0 0 0 12 4

Maintain Customer Relation 50 1 50 1 50 1 50 1 5

Total 74 100 80 11


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Activity-Based Costing

Traditional allocation method

Activity-based allocation method

Costs Produ

Costs ProduActivities

First stage Second stage


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Conventional Costing

Expenses

Cost Objects

AB Costing

Resources

Activities

Cost Objects

EconomicElement

WorkPerform

Produservic


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Traditional Costing Systems

Product Costs

Direct labor

Direct materials

Factory Overhead

Period Costs

Administrative expense

Sales expense

Directlaboranddirect

materialsareeasytotrproducts.

Theproblemcomesw

factoryoverhead.


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Todays businesses are working in an

increasingly complex environment.

Use of Advanced Technology

Product Life Cycle

Product Complexity

Channels of Distribution

Quality Requirements

Product Diversity


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ABC systems addresses thefollowing Questions: What activities are being performed by the

organisational resources?

How much does it cost to perform activities?

Why does the oranisation need to perform those

activities? How much of each activity is required for the

organisations products, services, and customers?


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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 individualexpense items


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Levels of Cost Incurrence

Not all costs are volume-related

Unit level

Batch level

Product level

Facility level


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Activities: Types

Unit level: Performed each time a unit isproduced

Batch level: Performed each time a batch isproduced

Product level: Performed to support production of differe

of product Customer Level: Performed to support servicing customers

Facility level:Residuary head


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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 activitiesperformed.

M iABC Records


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Mapping

Accounting Records

Salaries 313,000

Depreciation 155,000

Electricity 132,000

Supplies 25,000

Travel 100,000

Total 725,000

Activities Salaries Depreciati Electricity Supplies

BusinessDevelopment

20,000 25000 5000

Maintianing

Present Business

80,000 60000 50000 5000

PurhcasingMaterial

125,000 50000 20000 20000

Set up Machines 25,000 10000 2000

Running Machines 50,000 10000 50000 Resolve QualityProblems

13,000 5000

Total 313,000 155000 132000 25000

Define activity drivers


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Define activity drivers

The linkage between activities and cost objects, suchas products, customers,, is accomplished by using

activity drivers.

An activity driver is a quantitative measure of theoutput of an activity.

The selection of an activity driver reflects asubjective trade-off between accuracy and cost ofmeasurement.


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Activities Drivers

Unit Level

Acquire and Use material for containers No. of Containers

Acquire and Use material for baby-care p No. of products

Batch Level

Set up manually controlled machines No. of batches of con

Set up computer controlled machines No. of batches of B.

Product Level

Design and manufacture moulds No.of moulds require

Use manually controlled machines Product type (contai

Use conputer controlled machines Product type (B.Prod

Custome r Level

Consult customers No. of consultations

Provide warehousing for customers No. of cubit feet

Faciltiy Level

Manage workers Salaries


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Activities Drivers Activity Cost Activity Volum Activity R

Unit Level

Acquire and Use material for containers No. of Containers 40,000 1,000,000 0.04

Acquire and Use material for baby-care products No. of products 80,000 8,000 10

Batch Level

Set up manually controlled machines No. of batches of containers 3,000 10 300

Set up computer controlled machines No. of batches of B.Produst

12,000 20 600

Product Level

Design and manufacture moulds No.of moulds required 5,000 5 1000

Use manually controlled machines Product type (containers) 15,000 1 15000

Use conputer controlled machines Product type (B.Products) 40,000 1 40000

Customer Level

Consult customers No. of consultations 4,000 40 100

Provide warehousing for customers No. of cubit feet 2,000 10,000 0.2

Faciltiy Level

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

Ascertaining Cost


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Ascertaining Cost

Activities A. Rate A.Volume Containers Baby Product

Unit Level

Acquire and Use material for containers 0.04 1,200,000 48,000

Acquire and Use material for baby-care products 10 7,000 70000

Batch Level

Set up manually controlled machines 300 12 3,600

Set up computer controlled machines 600 16 9600

Product Level

Design and manufacture moulds 1000

1 1,000

4 4000

Use manually controlled machines 15000 1 15,000

Use conputer controlled machines 40000 1 40000

Customer Level

Consult customers 100

Containers 2 200

B.product s 40 4000

Provide warehousing for cust omers 0.2Containers 8,000 1,600

B.products 2,000 400

Faciltiy Level

Manage workers 0.2

Containers 4,000 800

B.product s 10,000 2000

Use main building 3

Containers 5,000 15,000

B.product s 7,000 21000

Total Cost 85,200 151,000


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Lets work an example . . . Assume that a company makes widgets

Management decides to install an ABC system

Remember ABC Steps

Overhead cost drivers are determined. Activity cost pools are created.

A activity cost pool is a pool of individual costs that all have thesame cost driver.

All overhead costs are then allocated to one of the activity cost pools.

An overhead rate is then calculated for each cost pool using the following formula: Costs in activity cost pool/base The base is, of course, the cost driver

Overhead costs are then allocated to each product according to howmuch of each base the product uses.

Overhead Cost Drivers are


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Overhead Cost Drivers are

Determined:

Management decides that all overhead costs only hthree cost driverssometimes called activities (obvsimplification of the real world)

Direct labor hours

Machine hours

Number of purchase orders


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All overhead costs are then allocated to one of

the activity cost pools.Direct

Machin

#ofPurchas

Which overhead costs do you

thinkaredrivenbydirectlaborhours?

General Ledger

Payroll taxes $1,000

Machine maintenance $500Purchasing Dept. labor $4,000

Fringe benefits $2,000

Purchasing Dept.Supplies

$250

Equipmentdepreciation $750

Electricity $1,250

Unemploymentinsurance

$1,500

All overhead costs are then allocated to one of the activity cos


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All overhead costs are then allocated to one of the activity cos

Dire

$1,000

2,0001,500

$4,500

Mach

#ofPurchas

Overhead driver by direct labor

hours

General Ledger





$250


Electricity $1,250


$1,500

All h d t th ll t d t f th ti it


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All overhead costs are then allocated to one of the activity

cost pools.Dire

$1,000

2,0001,500

$4,500

Mach

$500

750

1,250

$2,500

#ofPur

General Ledger





$250


Electricity $1,250

UWnehmicphlooyvmeernhteadcost

indsruivreanncbeymachineh

sar$e1,500ours?

All h d t th ll t d t f th ti it


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All overhead costs are then allocated to one of the activity

cost pools.DirectL

$1,000

2,0001,500

$4,500

Machine

$500

750

1,250

$2,500

#ofPurchas

$4,000

250$4,250

And finally, which overhead costs are

drivenby#ofpurchaseorders?

General Ledger





$250


Electricity $1,250


$1,500

An overhead rate is then calculated for each cost pool


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p

DAgaintheformulasis:

Machin

#ofPurchas

$1,000

2,0001,500

$4,500

$500

750

1,250

$2,500

$4,000

250

$4,250

CostsinActivityCostPool/Base=rate

Assumethefollowingbases:

Directlaborhours=1,000

Machinehours=250Purchase

orders=100

TheABCratesare:

$4,500/1,000=$4.50perdirectlaborhour

$2,500/250=$10permachinehour

$4,250/100=$42.50perpurchaseorder

Overhead costs are then allocated to each


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Overhead costs are then allocated to eachproduct according to how much of each base

uses.

$4,500/1,000=$4.50perdirectlaborhour

$2,500/250=$10permachinehour$4,250/100=$42.50perpurchaseorder

Letsassumethecompanymakestwoproducts,WidgetAandWidgetB:

Lets also assume that each product uses the following activity

ofoverheadcostdrivers:

Noticethat allbaseun

accountedfor.

Base WidgetA WidgetB Total

Directlaborhours 400 600 1,000

Machinehours 100 150 250

Purchaseorders 50 50 100

Now lets allocate overhead to


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Widget A:

Inthiscase,400hoursusedtomakeWidgetAismultipliedbytherateof

$4.50.Thisgivestotaloverheadappliedforthisactivitycostpoolof$1,800

toWidgetA.

BaseA Rate Alloca

Directlaborhours 400 $ 4.5

0

$ 1,8


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Continuing the calculation:

Lets do the saethig fothe othetwo ates, to get the total aout

ofoverheadappliedtoWidgetA:

WidgetA Base Rate Alloca

Directlaborhours 400 $ 4.50 $ 1,8

Machinehours 100 $ 10.00 $ 1,0

Purchaseorders 50 $ 42.50 $ 2,1

Total $ 4,925.00



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Now let s allocate overhead to

Widget B:

Lets do the same thing for the other two rates, to get the total

ofoverheadapplied.

Theoriginaloverheadtobeappliedwas$4,500ofdirectlabordrivenoverhead+$2,500ofmachinehourdrivenoverhead+$4,250of

purchaseorderdrivenoverhead=$11,250totaloverheadtoapply.

Theactualoverheadallocatedwas$4,925forWidgetA+$6,350=

$11,250overheadapplied.

WidgetB Base Rate Allocated

Directlaborhours 600 $ 4.50 $2,700.00

Machinehours 150 $ 10.00 $1,500.00

Purchaseorders 50 $ 42.50 $2,125.00

Total $6,325.00

S P bl T di i l


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Same Problems TraditionalMethod

Okay, so what if we had allocated the overhead in this companytraditional cost accounting allocation.

Lets assume the base is direct labor hours.

What would be the amount allocated to each product?

Calculation


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Calculation

General Ledger

Thisthetotaloverheaweregiven,thetotal

amountis$11,250as

explainedontheprev

slide.

Base WidgetA

Directlaborhours 400

Machinehours 100

Purchaseorders 40

Totaldirectlaborhoare 1,000, also g

earlier.


Machine maintenance $500

Purchasing Dept. labor $4,000



$250

Equipment

depreciation

$750

Electricity $1,250


$1,500

Calculation


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Calculat o

The rate would be:

OH Rate = Overhead/Direct Labor Hours

$11,250/1,000 = $11.25 per hour.

Applying overhead using this rate:

Widget A: 400 hours x $11.25 = $4,500

Widget B: 600 hours x $11.25 = $6,750

Total overhead applied = $11,250

Comparison


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p

Whichismoreaccurate?

ABCCosting!

Notethesearetotal costs.Togetper-unit costswewoulddividebythenumberofuproduced.

Widget A Widget B

TraditionalMethod

$4,500 $6,750

Activity BasedCosting

$4,925 $6,325

Difference -$425 $425

Overhead Costs at Classic Brass (Manufacturing


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Production Department Indirect

factory wages

Factory equipment depreciation Factory

utilitiesFactory building lease

$ 500,000

300,000

120,00080,000 $

Shipping costs traced to customer orders General

Administrative Department

Administrative wages and salaries Office

equipment depreciation

400,000

50,000

Administrative building lease Marketing

Department

60,000

( g

and NonManufacturing)

Marketing wages and salaries 250,000

Selling expenses 50,000 30

Total overhead costs $ 1,85

Activity Based Costing at Classic Brass


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Activity-Based Costing at Classic Brass

DirectMaterials

DirectLabor

ShippingCosts

Overhead Cos

Traced $/DLH Traced

Products or Customers



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DirectMaterials

DirectLabor

ShippingCosts

CustomerOrders

(# of Orders)

OrderSize

(Mach Hrs)

ProductDesign

CustomerRelations(# of Customers)

Overhead Cos

First-Stage Allocation




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DirectMaterials

DirectLabor

ShippingCosts

CustomerOrders

ProductDesign

OrderSize

CustomerRelations

Overhead Cos

First-Stage Allocation

Second-Stage Allocations

$/MH$/Order $/Design $/Customer



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Indirect Costs


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Not easily and conveniently traceable to cost

objects Cost element is shared among cost objects

Physically impossible to trace

Not cost effective to trace

Indirect Costs


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Need for allocation

Estimate product or activity cost

What does it really cost?

Increase awareness of indirect costs

Activities are not free

Plan more cost efficient operations

Now that we know what it costs, what should we do?

Allocation of Indirect Costs


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Typical allocation methods

Ability to bear

Fairness or equity

Benefits received

Cause and effect

Traditional Allocation Method


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Indirect costs allocated to cost object based on the

cost objects consumption of some measure ofactivity, usually labor hours

$10,000,000 total indirect cost 400,000total labor hours

= $25 per hour rate

A product consuming 6 labor hours would be charged$150 ($25 x 6) of indirect costs

Criticisms of Traditional Overhead


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Allocation

Assumes all overhead is volume-related

Factory-wide or departmental rates

All related to single activity measure

Departmental focus, not process focus

Focus on costs incurred, not cause of costs


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Conventional Costing Total Cost = Material + Labour+ Overheads

Overheads are allocated to the products on volume based me.g. labour hours, machine hours, units produced

Will this not distort the costing in the newenvironment?

ABC provides an Alternative.

Activity-Based Costing (ABC)


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Purpose

Allocation of indirect costs based on causal activities

Attempts to identify directlink between cost and costobject

Results in better allocation

Does not provide true cost

ABC Definitions


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Activity based costing is an approach for

allocating overhead costs.

An activity is an event that incurs costs.

A cost driver is any factor or activity that has a direcand effect relationship with the resources consumed

Overview of ABC


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Identifies activities required to produce the

product or service

Determines the cost of the activities

Allocates costs to the cost object based onthe objects consumption of activities

B i f A B C


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Basics of A B C

Cost of a product is the sum of the costs of all activrequired to manufacture and deliver the product.

Products do not consume costs directly

Money is spent on activities

Activities are consumed byproduct/services

B i f A B C ( td )


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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

B i f A B C ( td )


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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.

Building an ABC Model


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IdentifyResources

IdentifyActivities

IdentifObjects

DefiResou

Drive

DefineActivityDrivers

EnterResource

Costs

EnterResourceDriver Qty.

Enter ActivityDriver Qty.


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Thank you.

1. activity based costing

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