0 CHAPTER 6 Activity-Based Costing 2009 Cengage

1 Introduction Overhead costs have soared to 60 percent or more of total product costs in heavily automated manufacturing environments. As overhead costs increase and make up a larger portion of the total costs of products, accuracy in overhead application has become much more important. 1

2 Activity-Based Costing In this chapter we introduce a different approach to overhead allocation using Activity-Based Cost Drivers as opposed to Volume-Based Cost Drivers 2

3 Categories of Overhead Costs Unit-level costs are incurred each time a unit is produced. Examples: ØSupplies for factory ØDepreciation on factory machinery ØEnergy costs for factory machinery ØRepairs and maintenance of factory machinery 3

4 Categories of Overhead Costs Batch-level costs are incurred each time a batch of goods is produced. Examples: ØSalaries related to purchasing and receiving ØSalaries related to moving material ØQuality control costs ØDepreciation of setup equipment 4

5 Categories of Overhead Costs Product-level costs are incurred as needed to support the production of each different type of product. Examples: ØSalaries of engineers ØDepreciation of engineering equipment ØProduct development costs (testing) ØQuality control costs 5

6 Categories of Overhead Costs Facility-level costs simply sustain a facility’s general manufacturing process. Examples: ØDepreciation or rent of a factory building ØSalary of a plant manager ØInsurance, taxes, etc. ØTraining 6

7 Activities and Cost Drivers: Unit Level Activity • Machining Potential Cost Driver • Machine hours, labor hours or number of units produced • Maintenance of • Machine hours machines 7

Activities and Cost Drivers: Product Level Activity Potential Cost Driver Product Testing 8 Number of change orders, number of tests, hours of testing time Supervision Number of supervision hours 8

9 Activities and Cost Drivers: Batch Level Activity Potential Cost Driver Purchasing Number of purchase orders or number of parts Receiving Machine setups Amount of material or number of receipts Number of setups Customer orders Number of orders, number of customers 9

10 Activities and Cost Drivers: Facility Level Activity Potential Cost Driver Plant Occupancy Square footage, number of employees, labor hours, machine hours 10

11 Unit-, Batch-, Product-, and Facility. Level Costs Key Concept Unit-level costs are incurred each time a unit is produced. Batch-level costs are incurred each time a batch of goods is produced. Product-level costs are incurred as needed to support the production of each type of product. Facility-level costs simply sustain a facility’s general manufacturing process. 11

12 Activity-Based Costing Key Concept The key feature of an Activity-Based Costing system is allocating overhead costs based on activities that drive costs rather than on the volume or number of units produced. 12

Traditional Overhead Allocation and ABC - An Example 13 Top. Sail Construction Modular-Home Builder Builds 2 basic models and a fastdelivery Cottage 13

Estimated Manufacturing Overhead Costs for 2008 14 14

Costs per Unit Using Volume-Based OH Allocation 15 15

16 Stage 1: Identification of Activities 16

17 Stage 2: Identification of Cost Drivers & Allocation of Costs Activity Cost Driver Inspections Number of inspections Purchasing Number of purchase orders Supervision Hours of supervisor time Delivery & setup Setup time (days) 17

18 Estimated Cost Driver Activity 18

19 Calculation of Predetermined Activity Rates 19

20 Cost of Units Based on Activity. Based Costing 20

21 Cost Comparisons between Traditional and ABC Costing 21

22 Price Comparison between Traditional and ABC Costing 22

23 Activity-Based Costing Key Concept Volume-based costing systems often result in over-costing high volume products and under-costing lowvolume products. This cross subsidy is eliminated by the use of ABC. 23

ABC Systems in Service Industries 24 Although ABC was developed for use primarily by manufacturing companies, it has gained widespread acceptance in the service sector. 24

ABC Systems in Service Industries 25 Problems ØType of work performed in service industries tends to be non- repetitive ØActivities differ for each customer service or ØServices have proportionately more facility-level costs 25

26 ABC Systems and Nonmanufacturing Activities ABC is used to determine the cost of providing a selling or administrative service. ØExample: The U. S. Post Office used ABC to help determine the costs and benefits of allowing customers to pay using debit and credit cards. 26

27 Benefits of Activity-Based Costing q. Using ABC in the budgeting process provides more accurate estimates of resources q. Provides more accurate cost information for day-to-day decision making q. Costs that appeared to be indirect using volume-based costing systems are now traced to specific activities using cost drivers 27

28 Limitations of Activity-Based Costing q. High measurement costs q. The higher the potential for cost distortions, the more likely the company will benefit from ABC q. Distortions result from diverse products Diverse products: products that consume resources in different proportions 28

29 Backflush Costing Companies using JIT generally have little or no inventory or finished goods. ØAll manufacturing costs are flushed directly into cost of goods sold ØIf the company has small amounts of inventory on hand at the end of the period, manufacturing costs are backflushed into the appropriate materials inventory, WIP inventory or finished goods inventory 29