ACCTG 221 / ABC Costing

ACTIVITY BASED COSTING SYSTEMS • First identifies activities in an organization and then assigns the cost of each activity to products and

services based on actual consumption• The aim is to classify and allocate overheads in such a way that better reflects the consumption of

manufacturing/service resources• One of the problems with traditional costing systems is suggested to be their lack of accuracy (in

allocating costs to cost objects) which could lead to flawed decision making• Can be used for both goods and services• ABC: costs > activities > g/s• Traditional: costs > departments > products

Traditional costing systems vs ABC • traditional systems are usually volume based (allocate costs to individual products on unit level basis,

e.g. direct labour hours, units produced, etc)• the ABC method classifies costs into a cost hierarchy:

1. “Unit Level” where we allocate on a volume basis (ie same as volume based) 2. “Batch Level” allocate according to batch activity 3. “Product Level” allocate products responsible for these costs on a volume basis 4. “Facility Level” allocate on volume basis

Traditional systems are appropriate when:• direct costs are the dominant cost (low overheads)• information costs are expensive (lack of computerized systems meant it was costly to implement ABC)• where there is a lack of intense global competition (more competition means businesses need to lower

prices)• a limited range of products is produced (no need for accurate separation of costs for different products)

EXAMPLE: Traditional Costing System• traditional systems will usually use a volume based driver such as labour hours, machine hours, number

of units, etc to allocate overhead to products• for example, Job 1 took 2 labour hours and Job took 6 hours to complete• if overhead is allocated to jobs using direct labour hours, and the overhead (depreciation) was $120;• $120 ÷ 8 hours = $15 per labour hour• Job 1 = 2 x 15 = $30• Job 2 = 6 x 15 = $90

• automation increases have meant overheads have increased to $420 and have reduced Job 2’s labour hours from 6 to only 1 hour

• using the traditional costing system, cost would be allocated;• $420 ÷ 3 = $140 per labour hour• Job 1 = 2 x 140 = $280• Job 2 = 1 x 140 = $140• is this reasonable? the increase in overheads only benefitted Job 2 but Job 1 has been allocated more

overhead - clearly we need another cost driver to allocate overhead• we need to look at the ABC method as obviously there is no cause & effect relationship between our

overheads and labour hours

• the initial $120 of depreciation should be split evenly between the two jobs, as neither incur or use more depreciation

• the additional $300 only benefits Job 2 and so all $300 should be added there• Job 1 = $60• Job 2 = $360

• we could say, as a result of the traditional costing system, Job 1 was initially “over costed” as Job 1 had absorbed too much cost, making it seem less profitable than it is

• we could say, as a result of the traditional costing system, Job 2 was initially “under costed” as it had absorbed too little cost, making it seem more profitable than it really is

Value added vs. non-value added activities • a value added activity increases the worth of a g/s to a customer, the customer is willing to pay for it,

and are essential; e.g. a GPS module in a phone• a non-value added activity increases me spent on g/s but doesn’t increase its worth to the customer,

and is considered unnecessary from the customer’s perspective; they can be reduced, redesigned, or eliminated without affecting market value or quality; e.g. shipping costs from another warehouse for materials

Steps in ABC Costing

1. Identify and Define Activities and Activity Cost Pools2. Assign Costs to Activity Cost Pools3. Calculate Activity Rates4. Assign Activity Costs to Products

cost of direct materials

cost of direct labor

variable manufacturing overhead costs

fixed manufacturing overhead costs

costs of unit-level activities

cost of batch level activities

cost of product line activities

cost of facility support activities

direct costs

indirect costs (overhead)

COST ITEMSTRADITIONAL ABC

costs of unit-level activities e.g. material, packaging, labour, assembly

cost of batch level activities e.g. number of setups, setup hours, movements of materials, inspections

cost of product line activities e.g. engineering and design changes, warehousing of product line materials, production line

dedicated supervisors, purchasing, receiving and shipping

cost of facility support activities e.g. property taxes, plant security, general administrative salaries

EXAMPLE of ABC Costing 1. Identify and Define Activities and Activity Cost Pools At a publishing company, the ABC team, selected the following activity cost pools and activity measures:

2. Assign Costs to Activity Cost Pools

** note that there are no shipping costs as the cost is directly attributed to the customer

Activity Cost Pool Activity Measure

customer orders - assigned all cost of resources that are consumed by taking and processing customer orders

customer orders -> number of customer orders

product designs - assigned all costs of resources consumed by designing products

product design -> number of product designs

order size - assigned all costs of resources consumed as a consequence of the number of units produced

order size -> machine hours

customer relations - assigned all costs associated with maintaining relations with customers

customer relations -> number of active customers

other - assigned all overhead costs that are not associated with the other cost pools

other -> not applicable

assign the costs to the activity cost poolse.g.$500,000 of indirect factory wages25% of which is used in customer ordersso, 25% of 500,000 = 125,000

and $125,000 worth of indirect factory wages should be assigned to the customer orders activity pool

Finished product:

3. Calculate Activity Rates The ABC team determines that the company will have these total activities for each activity cost pool:- 1,000 customer orders- 200 new designs- 20,000 machine hours- 100 customer relations activitiesIn order to calculate the activity rates, we divide the total cost for each activity by total activity levels:

4. Assign Activity Costs to Products - first, identify all the activities related to a given product or service- second, determine how many units of each activity are used per unit of product- third, assign costs to products using the cost-driver rates for each activity

Assume we want to calculate the costs of two jobs: Job 1 and Job 2 are received by one customer as follows:

e.g.Customer Order Total: 315,000Customer Orders: 1,000

315,000 ÷ 1,000

Customer Order rate = $315 per order

JOB 1 - 400 units ordered with 2 separate orders- Each stanchion required 0.5 machine hours- Selling price is $34 each- Direct materials total $2,110- Direct labor total $1,850- Shipping costs total $180

JOB 2 - One order during the year- Each housing required 4 machine hours- Selling price is $650 each- Direct materials total $13- Direct labor total $50- Shipping costs total $25

What if we had done the previous example with a Traditional Costing System?

Customer Profitability Analysis:

Job 1 Job 2

Sales 13,600 650

Costs:

Direct Materials (2,110) (13)

Direct Labor (1,850) (50)

Manufacturing Overhead (10,000) (200)

Product Margin $ (360) $ 387

Margin for Job 1 -$360

Margin for Job 2 387

Total Margin 17

Less: Customer Relations 3,675

Customer Margin $3,648

How is the overhead calculated?- Manufacturing Overhead Rate?

$1,000,000 ÷ 20,000 Machine Hours= $50 per MH

Job 1? 400 units x 0.5MH/unit x $50 per MH = $10,000

Job 2? 1 unit x 4MH/unit x $50 per MH = $200

EXAMPLE of ABC Costing for a service company Erin Sacks CPA provides accounting, tax, and legal services to her clients. She charges a fee of $85.40 per hour (including labour costs and overhead) for accounting and $125.40 (also including labour costs and overhead) per hour for tax and legal services. Erin has four categories of overhead and the expected overhead costs for each category for next year are as follows:

Currently overhead is applied using a predetermined overhead rate based upon budgeted direct labour hours. Overhead rates per hour are the same for both services but direct labour rates are different. As with last year, for next year, 10,000 direct labour hours are budgeted (for both services). Operating profits declined last year and Ms Sacks has decided to use ABC procedures to evaluate her hourly fees. She has gathered the following information from last year’s records:

Required; a) What is the total cost allocated to “Accounting Services” using the traditional costing system?

• the $85.40 Sacks charges includes the labour fee• $254,000 ÷ 10,000 direct labour hours = $25.40• so $85.40 = $25.40 + $60.00 (the direct labour charge)• there were in total 4000 direct labour hours for accounting services• Overhead costs: 4000 x 25.40 = 101,600• Direct Labour Costs: 4000 x 60.00 = 240,000• Total allocated costs: 101,600 + 240,000 = $341,600

b) What is the total cost allocated to “Accounting Services” using the ABC system?

Activity Costs Expected Activity

Advertising and Miscellaneous $56,000 2000 pages

Computer Fees 48,000 1000 computer hrs

Secretary’s Salary 50,000 200 clients

Fixed Overhead 100,000 10000 labour hrs

$254,000

Activity Accounting Tax and Legal Services

Advertising and Miscellaneous (in pages) 1000 1000

Computer Fees (in computer hours) 250 750

Secretary’s Salary (number of clients) 32 168

Direct Labour Hours 4000 6000

Activity Total Cost Cost Driver Rate per unit Units Cost Allocation

Advertising and Miscellaneous 56,000 2,000 28 1,000 28,000

Computer Fees 48,000 1,000 48 250 12,000

Secretary’s Salary 50,000 200 250 32 8,000

Fixed Overhead 100,000 10,000 10 4,000 40,000

Direct Labour Hours n/a n/a n/a n/a 240,000

328,000

ACCTG 221 / Process Costing and Spoilage

PROCESS COSTING (chapters 17 & 18)

Process Costing Systems are for masses of identical/similar units of product or service (e.g. food) • where the unit cost of a product or service is obtained by assigning total costs to many identical units• each unit receives the same or similar amounts of direct materials costs, direct labor costs, and

manufacturing overhead• unit costs are computed by dividing total costs incurred by the number of units of output from the

production process

Job Costing Systems are for distinct, identifiable units of a product or service (e.g. house)

There are 2 methods for PROCESS COSTING: - Weighted Average

• all units and costs are considered together to determine average cost per “equivalent unit”• this is regardless of whether the costs were incurred last period or currently

- FIFO • costs are accounted for by layer• cost per “equivalent unit” for this period is computed separately from the cost per “equivalent unit” for

the last period

How to calculate an “equivalent unit”? - the calculation differs depending on whether you are using WA or FIFO - the WA method

• calculates cost per EU of all work done to date (regardless of the period in which it was done)• assigns this cost to EUs completed & transferred out of the process, and to incomplete units still in-

process• WA costs is the total of all costs in the work-in-process account divided by the total equivalent units of

work done to date• the beginning balance of the work-in-process account (work done in a prior period) is blended in with

current period costs• (note, in a service business, you will have NO BWIP/EWIP account and so can only apply WA method)

Steps for costing out production in process costings (same for both methods) 1. Summarise the flow of physical units of output 2. Compute output in terms of equivalent units 3. Summarise total costs to account for 4. Compute cost per equivalent unit 5. Assign total costs to units completed and to units in EWIP (ending work-in-process)

Example: Armando Company produces MP3 players and uses a WA process costing system for its manufacturing department. Armando has NO BWIP inventory. All direct materials are added at the beginning of the process and conversion costs are added gradually.

Solution (using steps) 1) Units to account for MUST = units accounted for

• Units to account for: units in BWIP + units started (BWIP 0 + units started 24,000)• Units accounted for: units completed + units in EWIP + spoilage (UC 20,000 + EWIP 4,000 + S 0)

2) Calculate equivalent units

< as 100% of material is present< as only 25% of CC complete, so only 25% of the total 4,000

3) Summarise the total costs to account for • Cost of BWIP $0• + costs added (materials $126,000 & CC $42,000)• = Total Costs of $168,000

4) Compute cost per equivalent unit • Unit cost for material? $126,000 ÷ 24,000EU = $5.25• Unit cost for CC? $42,000 ÷ 21,000EU = $2.00• Total? $5.25 + $2.00 = $7.25

5) Assign total costs to units completed and to units in EWIP • Need to value inventories• Goods transferred out? $7.25 x 20,000 units = $145,000• EWIP? ($5.25 x 4,000) + ($2.00 x 1,000) = $23,000

Units started 24,000

Unit completed and transferred out 20,000

Units in process (material 100%, cc 25%) 4,000

Costs:

Materials $126,000

Conversion Costs 42,000

Total Costs $168,000

Materials Conversion

Units completed 20,000 20,000

EWIP 4,000 1,000

Total Equivalent Units 24,000 21,000

EXAMPLE: Shiraz Company produces CD players and wants to use a weighted average process costing system. Here is the information for last month:- there was a BWIP of 1000 units, $1000 cost (Materials 20% - $400 and CC 60% - $600)- there was NO damaged units

Solution (using steps) 1) Units to account for MUST = units accounted for

• Units to account for: units in BWIP + units started (BWIP 1,000 + units started 10,500)• Units accounted for: units completed + units in EWIP + spoilage (UC 9,500 + EWIP 2,000 + S 0)

2) Calculate equivalent units (remem that in WA, the equiv units are not identified separately)

< see above for % completion of BWIP

< see above for % completion of units

3) Summarise the total costs to account for

4) Compute cost per equivalent unit • Unit cost for material? ($400 + $19,600) ÷ 10,000EU = $2 per EU• Unit cost for Conversion Costs? ($600 + $9,650) ÷ 10,250EU = $1 per EU• Total? $2 + $1 = $3 full cost per unit

5) Assign total costs to units completed and to units in EWIP • Need to value inventories• Goods transferred out? $3 x 9,500 units = $28,500• EWIP? ($2 x 500) + ($1 x 750) = $1,750

Units started 10,500

Unit completed and transferred out 9,500

Units in process (material 25%, CC 37.5%) ?

Costs:

Materials $19,600

Conversion Costs 9,650

Total Costs $30,250

remember! : units to account for = units accounted for

BWIP - 1,000 Units completed - 9,500

Units started - 10,500 EWIP (plug) - 2,000

Spoilage - 0

Materials Conversion

BWIP <- IGNORE 200 600

Units completed 9,500 9,500

Spoilages 0 0

EWIP 500 750

Total Equivalent Units 10,000 10,250

BWIP (M$400, CC$600): $1000 Completed Goods: $?

Costs added (M$19,600, CC$9,650): $29,250 EWIP: $?

Total: $30,250 Total: MUST BE $30,250