ACCG304 Lecture 12: Activity Based Costing Lecture Objective Upon completing this lecture, students will gain an understanding of the role and application of Activity based Costing and how it refines cost allocation on the basis of resource consumption, thereby leading to more accurate product and service costing. Lecture Outline 12.1 12.2 12.3 12.4 Description of activity based costing. Activities / transactions as cost drivers Reasons for implementing Activity Based Costing Other Factors to consider in Activity Based Costing. • Value Chain Analysis • Cost Driver Analysis • Hierarchy of Activities Activity Based Costing Procedures. 12.5 ACCG304 Lecture 12 –Activity Based Costing -2- 12.1 Description of Activity Based Costing (ABC) The most difficult task in calculating unit costs of production is the determination of the amount of overhead (indirect) cost to be allocated to each job or each unit of product or service. There are three different approaches to help accountants and managers in allocating overhead costs to products. A summary of the operation of these three methods are as follows: Method 1 Method 2 Method 3 Plant-Wide Overhead Rate Departmental Overhead Rates Activity Based Costing (ABC) ABC also involves a multiple stage allocation process. The procedure starts with the assignment of overhead costs to cost pools. However, cost pools here are not departments but represent separate and distinct production activities, such as machine setups, materials requisitions required etc. Once the cost of activities has been determined and related to a cost driver, these are allocated to jobs (batches) according to the usage made of activities required for their completion. ABC systems assume that activities are the reason for cost incurrence and that products (and customers) create the demand for activities. Costs are assigned to products (or batches) based on the product's (batch's) consumption or demand for each activity in the production cycle. Activity Based Costing (ABC) (also called Transactions Based Costing) is a method of assigning costs to goods and services that assumes all costs vary with activities used to produce goods and services. An ACTIVITY is a process or procedure that causes work. A COST DRIVER is an event or an activity that results in the incurrence of cost. ABC develops COST DRIVERS that directly link the activities performed to the products manufactured. These COST DRIVERS measure the average demand placed on each activity by the various products. Then activity costs are assigned to products in proportion to the demand that the products place, on average, on the activities. ACCG304 Lecture 12 –Activity Based Costing -3- 12.2 Activities / transactions as cost drivers Traditionally, cost accountants have used only volume-related allocation bases (labour hours, machine hours, units produced, etc.) to allocate overhead from cost pools (cost centres or departments) to products. However, many costs in factories do not vary with the volume of production but with transactions. Every time companies perform activities, they generate transactions. Transactions generate overhead costs in such activities as inspection, setup or job scheduling etc. Using the number of related transactions as measured by the relevant cost driver, for allocating non-volume related overhead production costs, provides a more effective and accurate product costing system. Volume-related and non-volume-related cost drivers Volume related cost drivers are those activities that cause costs to vary in line with the level of production. Non-Volume related cost drivers are those activities that cause costs to vary with transactions that are not related to the quantity of production. Activities such as machine setups, inspection, storeroom costs are not directly related to production but will affect production costs. It will be necessary to define a set of NON-VOLUME related cost drivers to enable a more accurate method of allocating these costs to production (which are not volume related as is the case under traditional methods). Value-added versus nonvalue-added activities By specifying each activity in the manufacture of a product, managers are able to determine the cost drivers regulating each value activity. Customers determine the value of these activities by the price they are willing to pay for the product or service. This process encourages managers to identify VALUE-ADDED ACTIVITIES and NONVALUEADDED ACTIVITIES. The emphasis of the cost management system on activities can help management to identify NONVALUE-ADDED costs and attempt to eliminate the activities that cause them. Nonvalue added costs such as storage time for materials, wait time in between processes etc., result in a waste of resources. The goal of continuous improvement in production methods and techniques requires the systematic and continuous elimination of waste. Waste includes people’s time, materials and capital not spent on activities that add value to the products or services required by the customer. ACCG304 Lecture 12 –Activity Based Costing -4- COMPARISON OF TRADITIONAL AND ACTIVITY BASED COSTING TRADITIONAL PRODUCT COSTING ACTIVITY BASED COSTING TOTAL OVERHEAD COST TOTAL OVERHEAD COST 1. Overheads assigned to production departments 1. Overheads assigned to cost centres/cost pools 2. Cost driver rates calculated for each cost pool. 2. Departmental overhead allocation rates calculated. Dept 1 Dept 2 Dept 3 Activity 1 Activity 2 Activity 3 3. Overheads allocated to products based on production volume 3. Overheads allocated to products based on activity level PRODUCTS PRODUCTS ACCG304 Lecture 12 –Activity Based Costing -5- 12.3 Reasons for Implementing Activity Based Costing The main reasons for implementing an ABC system are as follows: • • Different cost allocation methods provide different estimates of how much it costs to make a product. Traditional overhead allocation methods such as plant wide or departmental overhead rates do not provide an accurate basis of determining the cost of production where multiple products are manufactured in the same plant and production procedures are reasonably complex. Activity Based Costing provides more detailed measures of production costs that related to the cause of the cost. ABC systems provide better information for marketing and product pricing decisions as well as decisions about which products to keep or eliminate due to more accurate costing information being available. Factory managers are aided by the availability of better information about the costs associated with activities as well as the cost drivers associated with activities. To enable control over production costs, factory managers learn to control the cost drivers. Better financial information and more accurate product costs are provided by ABC however ABC requires greater record keeping at more costs. Before ABC systems are implemented a cost benefit analysis should be undertaken. • • • 12.4 Evaluating ABC Evaluating overhead allocation on VOLUME BASED DRIVERS results in reliable product cost information only if the cost being allocated is triggered by units of output or varies in proportion to units of output. Where NON-VOLUME RELATED costs (mainly fixed costs) need to be traced to production, traditional overhead allocation methods will result in distorted product costs. In these situations the problem is in finding a COST DRIVER that bears some relationship to the activity being undertaken. For example, machine set-up costs should be allocated on the basis of the number of set-ups required to manufacture a product. • Value chain analysis A VALUE CHAIN is the linked set of value-creating activities leading from raw material sources to the ultimate end use of the products and services produced. The activities in a VALUE CHAIN include : a. Manufacturing Operations b. Marketing c. Service d. Technology Development ACCG304 Lecture 12 –Activity Based Costing -6- Managers use the VALUE CHAIN as a way of breaking down a company’s strategic activities to understand cost behaviour. Value chain analysis is a long-run approach which extends beyond the company’s boundaries; the company is only one part of the overall chain of value-creating activities. • Cost driver analysis The purpose of value chain analysis is to determine where managers can lower costs from design to distribution in the company’s segment of the chain. Managers do this by analysing changes in the costs of each value activity through cost driver analysis. • Hierarchy of activities As stated earlier, an ACTIVITY is a process or procedure that causes work and if that activity results in the incurrence of cost it is also a COST DRIVER. In a manufacturing organisation ACTIVITIES may be classified according to : 1. Manufacturing Operations a. Unit Related Activities which may be further classified as: are those whose levels are related to the number of units produced. are those whose levels are related to the number of batches produced. are those activities performed to support the production of individual products. are those performed to provide the managerial infrastructure and to support the upkeep of the plant. which also may be sub-classified as relating to: b. Batch Related Activities c. Product Sustaining Activities d. Facility Sustaining Activities 2. Sales and Marketing Operations a. Product Related b. Corporate Image Sales and marketing operations are classified as expenses, and as such may not be inventoried. 3. General Administration Operations comprise activities that support the management of operations relating to all aspects of corporate operations. Includes areas such as, accounting, information systems, general management etc . ACCG304 Lecture 12 –Activity Based Costing -7- 10.5 Activity Based Costing Procedures The implementation of an Activity Based Costing system requires the completion of the following four steps: 1. Identify the major activities that result in cost incurrence within the organisation. 2. Determine the most suitable cost driver(s) for each activity. 3. Create a cost centre / cost pool for each activity and relate this to a cost driver. 4. Trace the cost of activities to products according to the product's use of that activity. ACCG304 Lecture 12 –Activity Based Costing -8- Lecture Demonstration Exercise 1 McWood Company manufactures two products known as Widgets and Didgets. Projected sales and production for the coming year are: Widgets 10,000 units Didgets 20,000 units Both products require 2 direct labour hours for completion. Cost details for materials and labour are as follows: Product Widgets Didgets Direct materials $40.00 $30.00 Direct Labour (@ $10.00 per hour) $20.00 $20.00 The estimated manufacturing overhead for the coming year is $1,200,000. Traditional Costing Information • The company has always used direct labour hours in the past to allocate overhead to units of production with the projected production quantity being used as the denominator. Activity Based Costing Information • Although the same amount of direct labour hours are required for each product, Widgets are a more complex product than Didgets and utilise more production facilities in its manufacture. The company has analysed production activities and relevant cost drivers in its manufacturing process which are listed below: Expected Number of Events or Transactions Activity Centre & (Cost Driver) Traceable Total Widgets Didgets Costs 1. Labour related (Labour Hours) $114,000 60,000 20,000 40,000 2. Equipment Costs (Machine Hour) 273,000 130,000 60,000 70,000 3. Equipment Setups (setups) 300,000 3,000 2,000 1,000 4. Production Order (orders) 180,000 1,200 400 800 5. Material Issues (requisitions) 156,000 5,000 2,500 2,500 6. Quality Control (Inspections) 60,000 20,000 10,000 10,000 7. General Overhead (machine hours) 117,000 130,000 60,000 70,000 $1,200,000 Required: (a) Assuming that the company applies overhead to products on the basis of direct labour hours (Traditional Method) calculate: (i) the predetermined overhead rate that would be used (ii) Determine the unit cost of manufacture of Widgets and Didgets Assuming that the company uses Activity Based Costing to charge overhead to products, calculate: (i) Compute the predetermined overhead cost per transaction for each of the seven (7) activity centres listed above. (ii) Using the rates developed in b (i), determine the amount of overhead to be applied to each unit of product. (iii) Determine the Unit Cost of manufacture of each product and compare this the answer obtained in 1(b) above (b) ACCG304 Lecture 12 –Activity Based Costing -9- Lecture Demonstration Exercise 2 Anderson Company uses a conventional two-stage cost allocation system. In the first stage, all manufacturing support costs are assigned to two production departments, P1 and P2, based on machine hours. In the second stage, direct labour hours are used to allocate support costs to individual products. Anderson Company manufactures two products, X and Y, for which the following information is available: Item Units Sold Direct materials cost per unit Direct labour wage rate per hour Direct labour wage rate per hour Direct labour hours in P1 per unit Direct labour hours in P2 per unit Product X 1,000 $60 $25 $15 2 1 Product Y 3,000 $25 $25 $15 1 3 P1 P2 During 1997 manufacturing support costs totaled $200,000. Machine hours in production departments P1 and P2 were 5,000 and 15,000 hours respectively. Direct labour hours in production departments P1 and P2 were 3,000 and 10,000 DLH respectively. Anderson Company is considering implementing an activity-based costing system. Its controller has compiled the following information for activity cost analysis: COST Driver Demanded Activity Material Movement Activity Costs $30,000 Activity Cost Driver Number of Production runs Machine setups 100,000 Number of Setups Number of Units Number of Shipments $500 per setup 60 140 Activity Support Driver Rate $30 per run. Product X 200 Product Y 800 Quality Inspections 50,000 $12.50 per unit 1,000 3,000 Shipment 20,000 $100 per shipment 80 150 Total Support Costs $200,000 Required: (a) Determine the unit costs for each of the two products under the existing cost accounting system. (b) Determine the unit costs for each of the two products if the proposed ABC system is adopted.