Chapter 5Activity-based Cost Systems

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See also: Kaplan/Atkinson 3rd ed. Ch.4Cooper/Kaplan: Cost and Effect,

Harvard Business School Press 1998

Example of misleading traditional cost system

� Cole Corporation manufactures two types of lensesfor 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 cus tomers

(model changes)

To cost products, Cole currently uses a single

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

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

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

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= $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

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

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

= $ 55.10 = $ 99.60Selling price: $ 60 $142Margin $ 4.90 $ 42.40Margin %age 8.2% 29.9%

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 -

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� Cost-allocation basis – Identify the preferred cost -allocation base for each indirect-cost pool.

Activity-Based Costing System

� ABC systems refine costing systems by focusing on individual activities as the fundamental cost object.

� ABC calculates the costs of individual activities a nd assigns costs to cost objects such as products and services on the basis of the activities undertaken to produce each product or service.

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produce each product or service.

Activity-based Costing: the fundamental idea:

Resource: Indirect labor

Inspectincomingmaterials

Activity:Move

materialsMaintainmachines

Set upmachines

Preparetooling

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materials

Activitycost driver:

Cost driverrate:

Product,Customer:

××××

# receipts

××××

# moves

××××

# maint. hrs.

××××

# setup hrs.

××××

# setups

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

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

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

Cjxj

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� Activity-based cost assignment to user l:

xjl Cjxj

Σj

Key step: Assigning resource costs to activities

� Resource costs per activity is an important piece o f information to management

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

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� the proportion of working time usually spent on eac h activity

� no excessive precision required

Activity-Based Costing System

� A cross-functional team at Cole Corporation identified key activities :� Design products and processes� Set up molding machine� Operate machines to mold lenses� Maintain the machines

Set up batches of finished lenses for shipment.

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� Set up batches of finished lenses for shipment.� Distribute lenses to customers.� Administer and manage all processes at Cole.

Setup data for the normal lens and the complex len s

NL CL� Quantity produced 80,000 20,000� No. produced/batch 250 50� Number of batches 320 400� Setup time per batch 2 hrs 5 hrs� Total setup hours 640 2,000

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� Total setup costs are $409,200 (Cost pool)� Setup cost per hour: $409,200 ÷ 2,640 hrs

= $155 (cost driver rate)

� Cost allocation using setup-hours: $155 × 640 $155 × 2,000

= $ 99,200 = $310,000

Cost allocation using direct manufacturing labor-hours

� Setup cost per direct manufacturing labor hour$409,200 ÷ 50,000 = $8.184 (cost driver rate)

� NL: CL: $8.184 × 36,000 $8.184 × 14,000

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$8.184 × 36,000 $8.184 × 14,000 = $294,624 = $114,576

Compared to:$ 99,200 $310,000

Budgeted Resources �

expense activity level

Driver rate

Committed C1j xj = capacity C1j / xj Flexible C2j xj

(expected) C2j / xj

Separate cost driver rates for committed and flexible cost

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(expected) total C1j + C2j

C1j C2j

xj xj+

C1j + C2j

xj + xj

≠ in general

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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4 Facility -sustaining costs

Functions of activities

� Unit level activities

� batch level activities

� product -sustaining • customer sustaining

(sales volume-related)

(related to # of batchesof saleable output)

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� product -sustaining • customer sustaining

(activities enabling theproduction of saleableoutput)

(activities enabling tosell products to individualcustomers or markets)

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

Cost hierarchy� Output Unit-Level Costs

� resources sacrificed on activities performed on eac h 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

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• Setup hours• Procurement costs

� Product-Sustaining or service-sustaining costs� resources sacrificed on activities supporting indivi dual products or services.

• Design costs• Engineering costs

� Facility-Sustaining Costs� resources sacrificed on activities that cannot be t raced to individual products or

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

Types of activity cost drivers

� Number of transactions� duration of transaction

� if time consumed varies among individual instances of the activity

Accountingcost

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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

Appropriate number of cost drivers

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

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

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linear combination of cost drivers already used� existing cost pools should share in the cost that w ould be

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

Implementing Activity-Based Costing

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

assembling, and distributing S and C.

Step 2: Identify the direct costs of the product.� Cole identifies direct materials costs and direct m anufacturing

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

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� 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.

Implementing Activity-Based Costing

(“,000” omitted)Description Cost Hierarchy (S) (C)

Category

Direct materials Unit-level $1,520 920Direct mfg. labor Unit -level 800 260

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labor Unit -level 800 260Cleaning & Maintenance Batch-level 160 200Total direct costs $2,480 1,380

Implementing Activity-Based Costing

Step 3: Select the cost-allocation bases to use in allocating indirect costs to the products.

Activities identified Cost drivers H-level1 Design design hours 32 Machine setups # of setups 2

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2 Machine setups # of setups 23 Manufacturing operations units 14 Shipment set up # of orders 25 Distribution # of orders 26 Administration 4

(allocated as percentage to costs assigned accordin g to activity-based method)

Implementing Activity-Based Costing

Step 4: Identify the indirect costs associated with each co st-allocation base.� Overhead costs incurred are assigned to activities, to the extent

possible, on the basis of a cause-and-effect relati onship.� Total setup costs are $409,200.

Step 5: Compute the rate per unit of each cost allocation b ase used to allocate indirect costs to the products.

Setup hours: S C Total

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� Setup hours: S C Total640 2,000 2,640

� $409,200 ÷ 2,640 = $155

Step 6: Compute the indirect costs allocated to the product s.� Total cost of setup activity:

S: $155 × 640 = $ 99,200C: $155 × 2,000 = 310,000Total $409,200

Other activities treated analogously

Implementing Activity-Based Costing

� Step 7: Compute the costs of the products by adding all direct and indirect costs assigned to them.S and C would show three direct cost categories.1 Direct materials2 Direct manufacturing labor3 Cleaning and maintenanceS and C would show six indirect cost pools.

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S and C would show six indirect cost pools.1 Design2 Machine setups3 Manufacturing operations4 Shipment setup5 Distribution6 Administration

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

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� not used for management control purposes� otherwise management will have an incentive to choo se cost

drivers strategically

� Decision facilitating for Activity-based Management (ABM)

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

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decisions– Design decisions

ABM decisions

� Product Pricing and Mix Decisions� ABC gives management insight into the cost structur es 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 sy stems

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� Manufacturing and distribution personnel use ABC sy stems to focus on cost reduction efforts.

� Managers set cost-reduction targets in terms of red ucing 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 p rocess designs affect activities and costs.

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

Critique

� ABC systems are full cost systems: they average costs over products according to cost driver utilization: every individual unit carries the same cost per unit of driver utilized

� For change management decisions an incremental costing approach is more adequate, when the size of the cost pool will not change proportionally with t he

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the cost pool will not change proportionally with t he cost driver (non-linearities in the cost function) due to� fixed costs� economies of scale � economies of scope