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Activity Based Costing:A Tool to Aid Decision Making
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill
Activity Based Costing (ABC)
The objective of activity-basedcosting is tounderstand
overhead and theprofitability of
products andcustomers.
ABC is agood supplementto our traditional
cost system I agree!
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Ov erhead rates maybe based on acti v ity
at capacity.
Activity Based Costing (ABC)
Acti v ity-Based Costing
Both manufacturingand nonmanufacturing
costs may beassigned toproducts.
Some manufacturingcosts may be excluded
from product
costs.
There are a number of cost pools each of
which is allocatedusing a unique
measure of acti v ity.
Allocation bases oftendiffer from
traditional costingsystems.
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H ow Costs are Treated UnderActivity-Based Costing
Overhead Allocation
P lantwideOv erhead
Rate
DepartmentalOv erhead
Rates
Acti v ity BasedCosting
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P lantwide Overhead Rate
C ompanies tend to use direct labor direct labor as the overhead allocation base.
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A two stage process isnecessary because costs
are allocated to departmentsand then to products.
F inishing Department
Shipping Department
Painting Department
Departmental Overhead Rates
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Department1
Department2
Department3
C ost poolsC ost pools
IndirectLabor
IndirectMaterials
O ther Ov erhead
Stage One:Stage One:C osts assignedC osts assignedto poolsto pools
Departmental Overhead Rates
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Department1
Department2
Department3
C ost poolsC ost pools
Stage One:Stage One:C osts assignedC osts assignedto poolsto pools
P roducts
Stage Two:Stage Two:C osts appliedC osts appliedto productsto products
Departmental Overhead Rates
IndirectLabor
IndirectMaterials
O ther Ov erhead
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Department1
Department2
Department3
C ost poolsC ost pools
Stage One:Stage One:C osts assignedC osts assignedto poolsto pools
P roducts
Stage Two:Stage Two:C osts appliedC osts appliedto productsto products
Direct
Labor Hours
Machine
Hours
Raw
MaterialsC ost
Departmental Allocation Bases
Departmental Overhead Rates
IndirectLabor
IndirectMaterials
O ther Ov erhead
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Designing an ABC System
Cost O bjects(e.g., products
and customers)Acti v ities
Consumptionof Resources
Cost
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Designing an ABC System
Steps for Implementing AB CSteps for Implementing AB C
Identify and define activities and activity pools.Where possible, trace costs to activities and costobjects.
Assign costs to activity cost pools.C alculate activity rates.
Assign costs to cost objects.Prepare management reports.
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I dentifying Activity to I nclude
A part of the productionA part of the productionprocess for which managementprocess for which management
wants a separate reporting of thewants a separate reporting of thecosts of the acti v ity in v ol v ed.costs of the acti v ity in v ol v ed.
Unit-Le v elActi v ity
Batch-Le v elActi v ity
P roduct-Le v elActi v ity
Customer-Le v elActi v ityO rganization-
sustaining
Acti v ity
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I dentifying Activity to I nclude
Acti v ity Cost P oolActi v ity Cost P oolis a ³bucket´ in
which costs areaccumulated thatrelate to a single
activity in the AB C system.
$
$
$ $
$$
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The Mechanics of ABC
At Classic Brass, the ultimate cost objects are:P roducts,Customer orders, andCustomers.
O ne o v erhead cost - shipping - can be traceddirectly to customer orders.
The company¶s o v erhead costs are shown onthe next slide.
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Produc t on Depar t en tndirec t f ac tory wages 500,000$Fac tory equipmen t deprecia tion 300,000 Fac tory u tilities 120,000 Fac tory building lease 80,000 1,000,000$
Shipping cos ts traced to cus tomer orders 40,000 General Adminis tra tive Depar tmen tAdminis tra tive wages and salaries 400,000 Off ice equipmen t deprecia tion 50,000 Adminis tra tive building lease 60,000 510,000
Marke ting Depar tmen tMarke ting wages and salaries 250,000 Selling expenses 50,000 300,000
To tal overhead cos ts 1,850,000$
Overhead Cos ts a t Classic Brass(Manu f ac turing and NonManu f ac turing )
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Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingC osts Overhead C osts
Traced $/ DLH Traced
Cost O bjects:P roducts, Customer O rders, Customers
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Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingC osts
Order Size
C ustomer Orders
ProductDesign
C ustomer Relations
Other
Overhead C osts
Cost O bjects:P roducts, Customer O rders, Customers
F irst-Stage Allocation
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Activity-Based Costing at Classic Brass
DirectMaterials
DirectLabor
ShippingC osts
Cost O bjects:P roducts, Customer O rders, Customers
Order Size
C ustomer Orders
ProductDesign
C ustomer Relations
Other
Overhead C osts
F irst-Stage Allocation
Second-Stage Allocations
$/ MH $/ O rder $/ Design $/ Customer
Unallocated
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Assigning Costs to Activity Cost P ools
Customer Orders
ProductDesign
Order Size
Customer Relations Other Total
Production DepartmentIndirect factory wages 25% 40% 20% 10% 5% 100%Factory equipment depreciation 20% 0% 60% 0% 20% 100%Factory utilities 0% 10% 50% 0% 40% 100%Factory building lease 0% 0% 0% 0% 100% 100%
Shipping costs traced to customer order N/AGeneral Administrative Department
Administrative wages and salaries 15% 5% 10% 30% 40% 100%Office equipment depreciation 30% 0% 0% 25% 45% 100%Administrative building lease 0% 0% 0% 0% 100% 100%
Marketing DepartmentMarketing wages and salaries 20% 10% 0% 60% 10% 100%Selling expenses 10% 0% 0% 70% 20% 100%
Activity Cost Pools
Management at C lassic Brass believes overhead should bedistributed as follows:
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Customer Orders
ProductDesign
Order Size
Customer Relations Other Total
Production DepartmentIndirect factory wages 125,000$
Factory equipment depreciationFactory utilitiesFactory building lease
General Administrative DepartmentAdministrative wages and salariesOffice equipment depreciationAdministrative building lease
Marketing Department
Marketing wages and salariesSelling expenses
Total
Activity Cost Pools
Assigning Costs to Activity Cost P ools
Indirect factory wages $500,000Percent consumed by customer orders 25%
$125,000
Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.
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Customer Orders
ProductDesign
Order Size
Customer Relations Other Total
Production DepartmentIndirect factory wages 125,000$
Factory equipment depreciation 60,000 Factory utilitiesFactory building lease
General Administrative DepartmentAdministrative wages and salariesOffice equipment depreciationAdministrative building lease
Marketing Department
Marketing wages and salariesSelling expenses
Total
Activity Cost Pools
Assigning Costs to Activity Cost P ools
Factory equipment depreciation $300,000Percent consumed by customer orders 20%
$ 60,000
Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.
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Customer Orders
ProductDesign
Order Size
Customer Relations Other Total
Production DepartmentIndirect factory wages 125,000$ 200,000$ 100,000$ 50,000$ 25,000$ 500,000$
Factory equipment depreciation 60,000 - 180,000 - 60,000 00,000 Factory utilities - 12,000 60,000 - 48,000 120,000 Factory building lease - - - - 80,000 80,000
General Administrative DepartmentAdministrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000 Office equipment depreciation 15,000 - - 12,500 22,500 50,000 Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000 Selling expenses 5,000 - - 5,000 10,000 50,000
Total 15,000$ 257,000$ 80,000$ 67,500$ 490,500$ 1,810,000$
Activity Cost Pools
Assigning Costs to Activity Cost P oolsU
sing the total costs and percentage consumption of overhead, costs are assigned to activity pools.
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Computation of Activity Rates
The AB C team has determined that C lassicBrass has the following total activities for each
activity cost pool . . .1,000 customer orders,200 new designs,20,000 machine-hours100 customers.
N ow the team can compute the individualN ow the team can compute the individualactivity rates.activity rates.
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Difference Between ABC andTraditional P roduct Costs
AB C will ordinarily shiftbatch-level and
product-level
overhead costs fromhigh-volume
products produced inlarge batches to low-
volume productsproduced in small
batches.
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Difference Between ABC andTraditional P roduct Costs
U nder AB C bothmanufacturing andnonmanufacturing
costs may beassigned to products.
Organization-sustaining costs and
the costs of idlecapacity are not
assigned to products.
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E ase of Adjustment
Costs that adjust automatically to changes in acti v ity:Direct materials.Shipping.
Costs that could be adjusted to changes in acti v ity:Direct labor.
actory utilities.Administrati v e wages and salaries.O ffice equipment depreciation.Marketing wages and salaries.
Selling expenses.Costs that are difficult to adjust to changes in acti v ity:
actory equipment depreciation.actory building lease.
Administrati v e building lease.