Activity-Based Costing and Management

Management Accounting: The Cornerstone for

Business Decisions

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

Learning Objectives

1. Explain why functional-based costing approaches may produce distorted costs.

2. Explain how an activity-based costing system works for product costing.

3. Describe activity-based customer and supplier costing.

Learning Objectives

4. Explain how activity-based management can be used for cost reduction.

5. (Appendix) Explain the basics of quality cost management.

6. (Appendix) Explain the basics of environmental cost management.

List Limitations of Functional Cost

Accounting System◙ Distorts costs in multiproduct

situations◙ Does not assign non-unit related

overhead costs appropriately◙ Companies in intensely competitive

industries adopt business practices and strategies to achieve competitive excellence which are not supported by old cost accounting systems

◙ Doesn’t support product diversity

Product Costing Data for PowerPoint Cornerstones

Activity Usage Measures

  Deluxe Regular Total

Units produced 30 300 330

Prime costs $ 2,400 $ 24,000 $ 26,400

DLH 60 240 300

MH 30 120 150

Setup Hrs 9 3 12

Number of moves 18 12 30

How to calculate consumption ratios.7-1

  Consumption Ratios

Overhead Activity Deluxe Regular Activity Driver

Setting up equip.

0.75

0.25 Setup Hrs

Moving goods

0.60

0.40 # of moves

Machining

0.20

0.80 MH

Assembly

0.20

0.80 DLH

Setup Hours for Deluxe 9 / 12 = .75; Regular 3 / 12 = .25

How to calculate activity rates.

Activity Activity Cost Driver Quantity

Setup equip. $3,600 Setup hrs 12Moving goods 2,400 # of moves 30Machining 4,500 MH 50Assembly 1,500 DLH 100

REQUIRED: Calculate activity rates.

7-2

Calculation: The rates are obtained by dividing the activity cost by the total cost driver quantity

Setup rate $3,600 / 12 setup hrs = $300 per setup hour

Mtls handling rate $2,400 / 30 moves = $80 per move

Machining rate $1,500 / 150 MH = $10 per machine hour

Assembly rate $1,500 / 300 DLH = $5.00 per direct labor hour

How to calculate activity rates.7-2

Illustrate Activity-Based Costing

How to calculate activity-based unit

costs.Activity

Deluxe Regular Rate

Units prod. year 30 300

Prime costs $2,400 $24,000

Setup hours 9 3 $300.00

# of moves 18 12 80.00

Machine hours 30 120 30.00

DLH 60 240 5.00

7-3

REQUIRED: Calculate the unit cost for deluxe & regular models.

Calculation: Deluxe RegularPrime Costs $2,400 $24,000Overhead Costs:Setups $300 x 9; $300 x 3 2,700 900Moving Materials

$80 x 18; $ 80 x 12 1,440 960Machining $30 x 30; $30 x 120 900 3,600Assembly $5 x 60; $5 x 240 300 1,200Total manufacturing costs $7,740

$30,660Units produced 30 300

Unit cost (Total costs / Units) $ 258 $102.20

How to calculate activity-based unit

costs.7-3

Illustrate Two Stage Assignment

How to assign resource costs using direct tracing

& resource drivers.Assume each employee is paid $45,000 ($270,000 total cost for 6 employees). The work distribution is the same as exhibit 7-4.REQUIRED: Assign the cost of labor to each of the activities of the credit department.Calculation: The amount of labor cost assigned to each activity is below. The percentage is from Exhibit 7-5.Processing transaction $108,000 (0.4 x $270,000)Preparing statements $ 81,000 (0.3 x $270,000)Answering questions $ 81,000 (0.3 x $270,000)

7-4

How to calculate activity-based

customer costs.Milan company produces precision

parts for 11 major buyers. Of the 11 customers one accounts for 50% of the sales, with the remaining 10 accounting for the remaining sales. The 10 smaller companies purchase approximately equal quantities of parts. Orders placed by the smaller companies are about the same size. Data pertaining to Milan’s customer activity is on the next slide.

7-5

How to calculate activity-based customer costs

7-5Large

Customers Ten Smaller

Customers

Units purchased 1,000,000

1,000,000

Orders placed 4 400

Number of sales calls 20 420

Manufact. costs 6,000,000 6,000,000

Alloc. order filling costs 404,000 404,000

Alloc. sales force costs 220,000 220,000

Currently customer driven costs are assigned based on units sold, a unit level driver.

REQUIRED: Assign cost using ABCCalculation: The appropriate drivers are orders

placed and number of sales calls. The activity rates are:

$808,000 / 404 = $2,000 per order$440,000 / 440 = $1,000 per callUsing the information, the customer-driven costs can

be assigned to each group of customers as follows:Large Ten Smaller

Order filling costs:($2,000 x 4), ($2,000 x 400) $ 8,000 $ 800,000

Sales force costs:($1,000 x 20), (1,000 x 420) $20,000 $ 420,000

How to calculate activity-based

customer costs.7-5

How to calculate activity-based supplier

costs.Assume that a purchasing manager uses

two suppliers, Murray, Inc. and Plata Assoc., as the source of two machine parts: Part A1 and Part B2. Consider two activities repairing products (under warranty) and expediting products. Repairing products occurs because of parts failure (bought from suppliers). Expediting products occurs because suppliers are late in delivering needed parts. Activity cost information and other data needed for supplier costing follows:

7-6

How to calculate activity-based supplier

costs.1. Activity costs caused by suppliers (e.g. failed

parts or late delivery)Activity CostsRepairing products $400,000Expediting products $100,000

2. Supplier Data

7-6

Murray Inc. Plata Assoc.

A1 B2 A1 B2

Purchase price $ 20 $ 52 $ 20 $ 52

Units purchased 40,000 20,000 5,000 5,000

Failed units 800 190 5 5

Late shipments 30 20 - -

REQUIRED: Determine the cost of each supplier using ABC.

Calculation: Using the previous data, the activity rates for assigning costs to suppliers are computed as follows:

Repair rate = $400,000 / 1,000* = $400 per failed part*(800 + 190 + 5 + 5)

Expediting rate = $200,000 / 50* = $2,000 per late delivery *(30 + 20)

Using the above rates and the activity data, the total purchasing cost per unit for each component is computed:

How to calculate activity-based supplier

costs.7-6

How to calculate activity-based supplier

costs.7-6

Murray Inc. Plata Assoc.

A1 B2 A1 B2

Purchase price

$20 x 40,000 $ 800,000

$52 x 20,000 $1,040,000

$24 x 5,000 $120,000

$56 x 5,000 $280,000

Repairing prod.

$400 x 800 320,000

$400 x 380 152,000

$400 x 5 2,000

$400 x 5 2,000

Expediting prod.

$2,000 x 30 60,000

$2,000 x 20 - 40,000

-

-

Total costs $1,180,000 $1,232,000 $122,000 $282,000

Units 40,000 20,000 5,000 5,000

Total unit cost $ 29.50 $ 61.60 $ 24.40 $ 56.40

7-6

How to calculate activity-based supplier

costs.

Illustrate the Process-Value Analysis

Driver Analysis

ActivitiesPerformance

Analysis

WHY? HOW WELL?

WHAT?

Match Definitions

Activity Inputs

Value-added Activities

Activity Outputs

Identifying those factors that are the root causes of activity costs

Identifying, describing & evaluating the activities an organization performs

Resources consumed by the activity in producing an output

Activity Analysis

Driver Analysis

Activities necessary to stay in business

The result or product of an activity

Define Non-Value Added Activities

◙ All activities other than those absolutely essential to remain in business

Provide some examples◙ Scheduling◙ Moving◙ Waiting◙ Storing◙ Inspecting

How to assess non-value added costs.

Consider the following two activities: (1) Performing warranty work, cost $240,000. The warranty cost of the most efficient competitor is $20,000. (2) Purchasing components, cost $300,000 (15,000 purchase orders). A benchmarking study reveals that the most efficient level would use 5,000 purchase orders and entail a cost of $110,000.

REQUIRED: Determine the non-value added cost of each activity.

7-7

Calculation: Determine the value content of each activity. Is it value added? Performing warranty work is non-value added. If done correctly the first time it is not needed. Therefore, the cost of the activity is $240,000. The cost of the competitors is also non-value added but is irrelevant.

Purchasing is necessary so materials are available for production and thus is value-added. However, it is not performed as efficiently as possible as shown in the benchmarking study. The non-value added cost is $190,000 ($300,000 - $110,000).

How to assess non-value added costs.7-7