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Chapter 5Activity-based Cost Systems

See also: Kaplan/Atkinson 3rd ed. Ch.4

Cooper/Kaplan: Cost and Effect,

Harvard Business School Press 1998

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Example of misleading traditional cost system

Cole Corporation manufactures two types of lenses for automobile rear lights out of plastic material

– a normal lens (NL) and a complex lens (CL). lenses are molded using machines redesigned according to the requirements of the customers

(model changes)

To cost products, Cole currently uses a single indirect-cost rate job costing system.

The cost objects are the total costs of manufacturing and distributing 80,000 normal lenses (NL) and 20,000 complex lenses (CL).

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Application to two products

Normal Lenses (NL) Complex Lenses (CL) Direct materials $1,520,000 $ 920,000 Direct mfg. labor 800,000 260,000

Total direct costs $2,320,000 $1,180,000

Direct cost per unit: $2,320,000 ÷ 80,000 $1,180,000 ÷ 20,000

= $29 = $59 total direct labor hrs. 36,000 14,000

Indirect costs $2,900,000 direct manufacturing labor hrs. 50,000 Indirect cost rate = $2,900,000 ÷ 50,000

= $58

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Product cost

Normal Lenses (NL) Complex Lenses (CL)

Direct costs $2,320,000 $1,180,000

+ Allocated costs (= 36,000 × $58) (=14,000 × $58)

$2,088,000 $ 812,000

= $4,408,000 $1,992,000

cost per unit $4,408,000 ÷ 80,000 $1,992,000 ÷ 20,000

= $ 55.10 = $ 99.60

Selling price: $ 60 $142

Margin $ 4.90 $ 42.40

Margin %age 8.2% 29.9%

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Refining a Costing System

Guidelines Direct-cost tracing – Classify as many of the total costs

as direct costs as is economically feasible. Indirect-cost pools – Expand the number of cost pools

until each of these pools is homogeneous. Cost-allocation basis – Identify the preferred cost-

allocation base for each indirect-cost pool.

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Activity-Based Costing System

ABC systems refine costing systems by focusing on individual activities as the fundamental cost object they measure utilization of each activity by cost objects and

assign the cost of the activity accordingly

total cost of activity per period

(“cost pool”) total utilization of

activity per period= Cost driver

rate

cost driver units used by cost object

× Cost driver rate

=overhead cost

assignedto cost object

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Activity-based Costing: the fundamental idea:

Resource: Indirect labor

Inspectincomingmaterials

Activity:Move

materialsMaintainmachines

Set upmachines

Preparetooling

Activitycost driver:

Cost driverrate:

Product,Customer:

$ per rece

ipt

# rece

ipts

$ per move

# m

ove

s

$ per maint.h

r.

# m

ain

t. hrs.

$ pe

r set

up h

r.

# se

tup

hrs.

$ pe

r set

up

# se

tup

s

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General Procedure

Determine the set of activities j performed in each department (cost center)

determine a Cost Driver for each activity j measuring the causal relationship between resource consumption of the activity and its utilization by products or customers

assign (budgeted) resource costs to activities j each activity is assigned a cost pool Cj

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General Procedure (cont’d)

determine the total level xj of budgeted utilization

of the activity determine the cost driver rate =

Determine (actual) usage xjl of cost driver j by each user l

Activity-based cost assignment to user l:

xjl Cj

xj

j

Cj

xj

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Key step: Assigning resource costs to activities

Resource costs per activity is an important piece of information to management

This is usually done by interviews with department managers on activities performed the proportion of working time usually spent on each

activity no excessive precision required

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Budgeted Resources

expense activity level

Driver rate

Committed C1j xj = capacity C1j / xj

Flexible C2j xj (expected)

C2j / xj

total C1j + C2j

Separate cost driver rates for committed and flexible cost

C1j C2j

xj xj

+

C1j + C2j

xj + xj

in general

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Cost Hierarchies

ABC systems commonly use a four-level cost hierarchy to identify cost-allocation bases:

1 Output unit-level cost2 Batch level costs3 Product-sustaining costs4 Facility-sustaining costs

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Functions of activities

Unit level activities

batch level activities

product-sustaining • customer sustaining

(sales volume-related)

(related to # of batchesof saleable output)

(activities enabling theproduction of saleableoutput)

(activities enabling tosell products to individualcustomers or markets)

(Costs that may be assigned only to broader output categories)

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Cost hierarchy Output Unit-Level Costs

resources sacrificed on activities performed on each individual unit of product or service.

Energy Machine depreciation Repairs

Batch-Level Costs resources sacrificed on activities that are related to a group of units of product(s)

or service(s) rather than to each individual unit of product or service. Setup hours Procurement costs

Product-Sustaining or service-sustaining costs resources sacrificed on activities supporting individual products or services.

Design costs Engineering costs

Facility-Sustaining Costs resources sacrificed on activities that cannot be traced to individual products or

services but support the organization as a whole General administration Rent Building security

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Types of activity cost drivers

Number of transactions duration of transaction

if time consumed varies among individual instances of the activity

intensity or direct charging number of staff of different wage

groups assigned to an activity per time unit

resources actually used for the individual instance of an activity

Accountingcost

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Appropriate number of cost drivers

Small cost pools do not alter unit costs much if additional information has to be acquired on a cost

driver consider the information cost and compare it to the benefit of the better decision

do not add a cost driver which is an approximate linear combination of cost drivers already used existing cost pools should share in the cost that would be

assigned to that pool according to the weights of the linear combination

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Implementing Activity-Based Costing

Step 1: Identify the chosen cost objects. The objective is to calculate the total costs of designing,

assembling, and distributing S and C.

Step 2: Identify the direct costs of the product. Cole identifies direct materials costs and direct manufacturing

labor as direct costs. Cleaning and maintenance costs of $360,000 are also identified as

direct costs of the lenses. Cleaning and maintenance costs of $360,000 are direct batch-level-

costs. Why? Because these costs consist of workers’ wages for

maintenance of machines after each batch of phones is run. The old cost system classified cleaning and maintenance costs

as part of the $2,900,000 indirect costs. Recall that indirect costs were allocated to products using direct

manufacturing labor-hours.

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Primary purposes of Activity-based Cost Systems

Analysis of decisions on the structure and design of productive system more transparency of the factors causing costs phasing out non-value-added activities sporadic stand-alone analyses, not integrated in on-line

accounting system

not used for management control purposes otherwise management will have an incentive to choose cost

drivers strategically

Decision facilitating for Activity-based Management (ABM)

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Activity-Based Management

ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits.– Product pricing and mix decisions– Cost reduction and process improvement

decisions– Design decisions

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ABM decisions

Product Pricing and Mix Decisions ABC gives management insight into the cost structures for

making and selling diverse products. provides more accurate product cost information and more

detailed information on costs of activities and the drivers of those costs.

Cost Reduction and Process Improvement Decisions Manufacturing and distribution personnel use ABC systems

to focus on cost reduction efforts. Managers set cost-reduction targets in terms of reducing the

cost per unit of the cost-allocation base. Design Decisions

Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs.

Companies can work with their customers to evaluate the costs and prices of alternative design choices.

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Critique

ABC systems are full cost systems they average fixed costs over products according to cost

driver utilization: every individual unit carries the same cost per unit of driver utilized

costs for which a cost driver is not available (e.g. leading a department) are allocated to cost pools of measurable activities

For change management decisions an incremental costing approach is more adequate, when the size of the cost pool will not change proportionally with the cost driver (non-linearities in the cost function) due to fixed costs economies of scale economies of scope

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CC-Problems

5-35 (=11), requirements 1.-3. (10%) 5-29 (=11.5-30) ( 5%) 5-31 (=11.5-32) ( 5%) 5-17 (=11.5-19) ( 5%) 5-19 (Excel)(=11.5-21,5-22) ( 8%) 5-23 (=11.5-24) ( 8%) 5-33 (10%)