03/09/2010
Management Accounting
Joy Chan ESSCA Angers
Fall 2010
Overview of Session 2 & 3 Activity based costing • How overheads are allocated or recovered • Broad averaging and consequences • Comparisons between Activity based costing vs traditional costing methods • Examples of Activity based costing • Using ABC systems for improving cost management and profitability • Implementing ABC systems – merchandising vs service companies
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Full Costing Product cost are used by manufacturing and merchandising firms to determine inventory values and when the product is sold, the amount of cost of goods sold. Product costs comprises of: • Direct costs – costs identified with specific cost units, eg direct materials and direct labor • Manufacturing overheads – all other costs, ie those that cannot be directly measured in respect of each particular unit of output. This includes factory utilities, maintenance expenses, depreciation for plant and equipment. Period costs comprise of non-product costs such as selling expenses, advertising expenses and interest expenses. Period costs are recorded as expenses in the accounting period in which they are incurred.
Direct and indirect costs
Categories of costs
Direct costs
Indirect costs or overheads
Costs that can be identified with specific cost units – the effect of the cost can be measured in respect of each particular output
These are all other costs: That is, those that cannot be directly measured in respect of each particular unit of output
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The relationship between direct costs and indirect costs
Direct costs of the unit
Fair share of indirect costs (overheads)
Full cost of the unit
The relationship between fixed costs, variable costs and total costs
Fixed costs
Variable costs
Total (or full) costs
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The relationship between direct, indirect, variable and fixed costs of a particular job
Fixed costs
Indirect costs (overheads) Direct costs
Variable costs
Total (or full) cost of a particular job
A cost unit passing through the production process Finishing department
Machining department
Preparation department
Finished goods store
Job A Costs accumulated
* Direct materials * Direct labour * A share of the preparation department’s overheads
+
* Any further direct costs * A share of the machining department’s overheads
+
* Any further direct costs * A share of the finishing department’s overheads
=
Future cost of the job
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Broad Averaging & Consequences • Historically, companies produced a limited variety of products. Indirect costs were relatively small percentage of total costs. So, using simple costing systems to allocate costs were easy, inexpensive and fairly accurate. • However, as product diversity increased, broad averaging resulted in greater inaccuracy of product costs. • Problems of product undercosting (consuming a high level of resources but is reported to have a low cost per unit) or overcosting (consuming a low level of resources but is reported to have a high cost per unit) arose. • Results in product cost subsidization
Selecting a basis for charging overheads There is no “correct” way to assign overheads to jobs. If the operation is capital intensive and overheads are primarily machine based (such as depreciation, machine maintenance, power etc) machine hours is usually the preferred basis of charging overheads to jobs. Otherwise, direct labor hours is usually used. Direct labor hours basis is popular because: • Large jobs should logically attract large amounts of overheads. The length of time that direct labor works on a project is an indication of relative size • Most overheads are related to time – rent, utilities, non-current fixed asset depreciation, supervisor/managers’ salaries and loan interest are all more or less time based • Direct labor hours are capable of being measured for each job
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Simple costing system – Plastim Corp • Plastim Corporation manufactures lenses for the rear taillights of automobiles. Plastim is putting a bid for a multiyear contract with Giovanni Motor, a major automobile manufacturer for two types of lenses: a complex lens, CL5 and a simple lens, S3. The complex lens is a large lens with special features such as multicolor molding and complex shapes that wrap around the corner of the car. Manufacturing CL5 lenses is more complex because various parts of the mold must align and fit precisely. The S3 lens is simpler to make because it has a single color and few special features. • Plastim has historically used a simple costing system that allocates indirect costs using a single indirect cost rate. Using this simple costing system, determine the prices it will quote for these lenses.
Simple costing system – Plastim Corp Step 1:
Identify the products that are the chosen cost objects.
Cost objects: 60,000 simple S3 lenses & 15,000 complex CL5 lenses Step 2:
Identify the direct costs of the products
Direct costs: Direct materials & direct manufacturing labor
Direct materials
60,000
15,000
Simple lenses (S3)
Complex lenses (CL5)
Total
Per unit
Total
Per unit
Total
1,125,000
18.75
675,000
45.00
1,800,000
Direct Mfg labor
600,000
10.00
195,000
13.00
795,000
Total direct costs
1,725,000
28.75
870,000
58.00
2,595,000
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Simple costing system – Plastim Corp Step 3: Select the cost allocation bases to use for allocating indirect costs to the products Since majority of indirect costs consists of salaries paid to supervisors, engineers, manufacturing support and maintenance staff, all supporting direct manufacturing labor. Plastim uses direct manufacturing labor-hours (39,750 hours) as the only allocation base to allocate all direct costs to S3 and CL5. Step 4: Identify the indirect costs associated with each cost allocation base As Plastim uses only a single cost-allocation base, Plastim groups all indirect costs, totaling $2,385,000, into a single overhead cost pool
Simple costing system – Plastim Corp Step 5: Compute the rate per unit of each cost allocation base used to allocate indirect costs to the products Actual indirect cost rate = Actual total costs in indirect cost pool Actual total quantity of cost-allocation rate = $2,385,000/39,750 = $60 per direct manufacturing labor hour
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Simple costing system – Plastim Corp Step 6: Compute the indirect costs allocated to the products S3 lens uses 30,000 direct manufacturing labor hours ($60 * 30,000 hours = $180,000 of indirect costs have been allocated) CL5 lens uses 9,750 direct manufacturing labor hours 60,000
15,000
Simple lenses (S3)
Complex lenses (CL5)
Total
Per unit
Total
Per unit
Total
Direct materials
1,125,000
18.75
675,000
45.00
1,800,000
Direct Mfg labor
600,000
10.00
195,000
13.00
795,000
Total direct costs
1,725,000
28.75
870,000
58.00
2,595,000
Indirect costs alloc 1,800,000
30.00
585,000
39.00
2,385,000
Total costs
$58.75
$1,455,000 $97,00
$3,525,000
$4,980,000
Simple costing system – Plastim Corp Step 7: Compute the total costs of the products by adding all direct and indirect costs assigned to the products 60,000
15,000
Simple lenses (S3)
Complex lenses (CL5)
Total
Per unit
Total
Per unit
Total
Revenues
3,780,000
63.00
2,055,000
137.00
5,835,000
Costs
3,525,000
58.75
1,455,000
97.00
4,980,000
Operating income 255,000
4.25
600,000
40.00
855,000
Profit margin %
6.75%
29.20%
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Refining a Costing system A refined costing system reduces the use of broad averages for assigning the cost of resources to cost objects and provides better measurement of the costs of indirect resources used by different cost objects. 4 reasons why companies around the world prefer a refined costing system: 1.
Increase in product diversity – resources demanded by different products cannot be measured by a simple costing system that allocates indirect costs on a fixed basis. Using a simple costing system will result in inaccurate and misleading product costs
2.
Increase in indirect costs – advances in product and process technologies (computers and automation) have led to increases in indirect costs and decreases in direct costs, particularly direct manufacturing labor costs. Since direct manufacturing labor is not a cost driver of these costs, allocating indirect costs on the basis of direct manufacturing labor costs does not accurately measure how resources are being used
Refining a Costing system 4 reasons why companies around the world prefer a refined costing system: 3.
Advances in information technology – improvements in information technology have made it more cost effective to implement refinements in costing systems. It is more practical now to create systems that have multiple pools of indirect costs for allocating costs to products
4.
Competition in product markets – managers realize the importance of obtaining more accurate cost information to help make important strategic decisions, such as how to price products and which products to sell
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3 guidelines for refining a costing system • Direct cost tracing – classify as many of total costs as direct costs of the cost object as economically feasible • Indirect cost pools – expand the number of indirect cost pools until each of these pools are more homogenous. Homogenous cost pool – all of the costs have the same or similar cause-and-effect (or benefits received) relationship with the cost allocation base. Eg increase in machine hours have an effect of increasing machining costs but not on distribution, and hence to be sub-divided into 2 separate pools • Cost allocation bases – use the cause and effect criterion, when possible, to identify the cost allocation base (the cause) for each indirect cost pool (the effect)
Activity based costing (ABC) This method of costing was developed about 20 years ago as an alternative to the traditional methods of costing discussed earlier. ABC • Is a way of allocating indirect cost to production • Focuses on activities and cost of activities • Each activity has its own cost driver • Uses a separate allocation rate for each activity ABC therefore counts the actual activities that go into making a specific product or delivering a specific service, and attempts to figure the costs of those activities. As such, R&D, design, marketing, distribution and customer service costs in each stage of the value chain have become as important as product costs. The application of overhead on the basis of a few broad rates based on direct labor hours has been replaced in many firms by the ABC system.
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ABC implementation % 60 50 40 30 20 10 0 Manufacturing
Retail
Service
Financial Others and commercial
Cost Hierarchies Cost Hierarchy – categorizes indirect costs into different cost pools according to 4 levels: • Output unit-level costs – cost of activities performed on each individual unit of a product/service. Eg machine operation costs (depreciation/repair/energy costs) • Batch level costs – related to a group of units of products/services rather than each individual unit. Eg procurement costs • Product sustaining costs – costs of activities undertaken to support individual products/services regardless of number of units/batches produced. Eg R&D costs or design costs • Facility sustaining costs – cannot be traced to individual products/services but support the organization as a whole. Eg admin services
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Activity-Based Costing Steps: 1. Identify the activities 2. Estimate the total indirect costs of each activity 3. Identify the allocation base for each activity’s indirect costs (the primary cost driver) 4. Estimate the total quantity of each allocation base
5.
6. 7.
Compute cost allocation rate for each activity (Estimated total indirect costs of activity ÷Estimated total quantity of cost allocation base) Obtain actual quantity of each allocation base used by the cost object Allocate indirect costs to cost object
Cost Drivers - examples Activities: Material purchasing Material handling Production scheduling
Cost Drivers: # of purchase orders # of parts # of batches
Quality inspections
# of inspections
Photocopying
# of pages copied
Warranty service
# of service calls
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Traditional costing vs ABC – A example Cruisers Inc incurs overhead costs in proportion to the number of direct labor hours worked; therefore, the overhead application rate is based on direct labor hours. Estimated total overhead cost to be incurred for the year: $4.2m Estimated total direct labor hours to be worked in the year: 300,000 Overhead application rate =
Estimated total overhead cost Estimated total direct labor hours = $4,200,000 300,000 hrs = $14/direct labor hour Cruisers produced 86 SeaCruiser sailboats during April; a total of 20,620 labor hours were worked Overheads = 20,640 * $14 = $288,960
Traditional costing vs ABC Activity
Estimated Annual Cost
Estimated Total Activity
Predetermined rate per unit of Activity
Production order preparation
$135,000
180 orders
$750/order
Hull and deck mold setup
2,140,000
1,000 setups
2,140/setup
Raw material acquisition
650,000
2,600 receipts
250/receipt
Material Handling 450,000
9,000 moves
50/move
Quality inspection 750,000
6,000 inspections 125/inspection
Cleanup and waste disposal
75,000
250 loads
Total manufacturing overhead
4,200,000
(Cost driver)
300/load
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Actual activity to produce 86 Seacruiser sailboats in April and manufacturing overhead applied Activity
Activity required
Predetermined rate per unit of Activity
Overhead applied Activity
Production order preparation
11 orders
$750/order
$ 8,250
Hull and deck mold setup
86 setups
2,140/setup
184,040
Raw material acquisition
185 receipts
250/receipt
46,250
Material Handling 610 moves
50/move
30,500
Quality inspection 340 inspections
125/inspection
42,500
Cleanup and waste disposal
300/load
5,100
(Cost driver)
Total manufacturing overhead applied
17 loads
$316,640
ABC costing system – Plastim Corp • After reviewing its simple costing system and the potential miscosting of product costs, Plastim decides to implement an ABC system. • Direct costs can be traced to products easily, so the ABC system focuses on refining the assignment of indirect costs to departments, processes, products and other cost objects • To identify these activities, Plastim organizes a team comprised of managers from design, manufacturing, distribution, accounting and administration • It is important to note that an ABC costing system with too many activities becomes complex and unwieldy while one with too few activities may lack sufficient information to measure cause-and-effect relationships between cost drivers and various indirect costs. An ideal system should strike a balance between the two
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ABC costing system – Plastim Corp Step 1: Identify the products that are the chosen cost objects Cost objects are S3 and L5 lenses Step 2: Identify the direct costs of these products Direct material costs, direct manufacturing costs and mold cleaning and maintenance costs (since mold cleaning and maintenance costs can be traced directly as batch level costs as they have to be incurred after each batch of lenses are manufactured). Description
Cost hierarchy category
60,000
15,000
Simple (S3)
Complex (CL5)
Total
Per unit
Total
Per unit
Total
Direct materials
Output unit level
1,125,000
18.75
675,000
45.00
1,800,000
Direct mfg labor
Output unit level
600,000
10.00
195,000
13.00
795,000
Mold cleang&maint
Batch level
120,000
2.00
150,000
10.00
270,000
1,845,000
30.75
1,020,000
68.00
2,865,000
Total Direct costs
ABC costing system – Plastim Corp Step 3: Select the cost allocation bases to use for allocating indirect costs to products Step 4: Identify the indirect costs associated with each cost allocation base Step 5: Compute the rate of unit of each cost allocation base used to allocate indirect costs to the products Step 6: Compute the indirect costs allocated to the products Step 7: Compute total costs by adding all direct and indirect costs
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Activity
Cost hierarchy category
Total indirect cost
Cost allocation base
Overhead activity cost allocation rate
Step 3
Step 5
Cause-and-effect relationship
Step 4 Design
Product sustaining
$450K
100
Parts sq feet
$4500 Per part sq feet
More parts, larger surface, more cost
Setup moldg mac
Batch level
$300K
2000
Setup hrs
$150
Per setup hr
More setup hrs, Indirect setup costs
Moldg Output unit mac opns level
$637.5 K
12,750
Moldg mac hr
$50
Per moldg mac hr
More mac hrs, more operatg mac costs
Shipping
$81K
200
Shipmt $405
Per shipmt
More shipments, more shipping costs
Distributn Output unit level
$391.5 K
67,500
Cubic feet deliver
$5.80
Per cubic feet delivered
More cubic feet delivered, more costs
Admin
$255K
39,750
Direct mfg labor hrs
$6.41 51
Per direct mfg labor hrs
Demand for admin increases w direct mfg hrs
Batch level
Facility sustaining
ABC costing system – Plastim Corp 60,000
Cost description
15,000
Simple lens (S3)
Complex lens (CL5)
Total
Total
Per unit
Per unit
Total
Direct costs Direct materials
$1,125,000
$18.75
$675,000
$45.00
$1,800,000
Direct manufacturing labor
$600,000
$10.00
$195,000
$13.00
$795,000
Direct mold cleaning and maintenance costs
$120,000
$2.00
$150,000
$10.00
$270,000
$1,845,000
$30.75
$1,020,000
$68.00
$2,865,000
$135,000
$2.25 $315,000
$21.00
$450,000
$225,000
$15.00
$300,000
$187,500
$12.50
$637,500
Total direct costs (Step 2) Indirect cost of activities Design S3, 30 parts sq feet x $4,500 CL5, 70 parts sq feet x 4,500 Setup of molding machines S3, 500 set up hours x $150
$75,000
$1.25
CL5, 1500 set up hours x $150 Molding machine operations S3, 9000 molding machine hours x $50 CL5, 3750 molding machine hours x $50
$450,000
$7.50
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ABC costing system – Plastim Corp 60,000
Cost description
15,000
Simple lens (S3)
Complex lens (CL5)
Total
Total
Per unit
Per unit
Total
Shipping S3, 100 shipments x $405
$40,500
$0.67
CL5, 100 shipments x $405
$40,500
$2.70
$81,000
$130,500
$8.70
$391,500
$255,000
Distribution S3, 45,000 cubic feet delivered x $5.80
$261,000
$4.35
CL5, 22,500 cubic feet delivered x $5.80 Administration S3, 30,000 dir mfg labor-hours x $6.4151
$192,453
$3.21 $62,547
$4.17
$493,953
$8.23
$233,547
$15.57
$727,500
$2,998,953
$49.98
$1,981,047
$132.07
$4,980,000
CL5, 9,750 dir mfg labor-hours x $6.4151 Total indirect costs allocated (Step 6) Total costs (Step 7)
Simple costing using single indirect cost pool
ABC System
Comparison
Direct cost categories
Direct materials
Direct materials
+1
Direct mfg labor
Direct mfg labor
Total direct costs
$2,595,000
$2,865,000
$270,000
Indirect cost pools
Mfg labor hours only
6 categories from design, setup to admin
5
Total indirect costs
$2,385,000
$2,115,000
($270,000)
Total costs assigned to S3
$3,525,000
$2,998,953
($526,047)
Cost per unit S3
$58.75
$49.98
($8.77)
Total costs $1,455,000l assigned to CL5
$1,981,047
$526,047
Cost per unit CL5
$132.07
$35.77
Direct mold cleang & maintenance
$97.00
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Using ABC Systems for improving Cost management and Profitability • Pricing and product mix – An ABC system gives managers cost information that helps in making and selling diverse products. For example, Plastim could match its competitor’s price of $53 for S3 lens and still make a product because the ABC cost of S3 lens is $49.98 (instead of $58.75 under simple costing). Focusing on complex lenses would be a mistake because the cost is higher. • Cost reduction and process improvement decisions – the ABC system focus on how and where to reduce costs. For example, Plastim could have a performance target of decreasing distribution cost per cubic foot of products delivered from $5.80 to $5.40 by improving the efficiency of its distribution system
Using ABC Systems for improving Cost management and Profitability • Design decisions – Management can evaluate how its current product and process designs affect activities and costs as a way of identifying new designs to reduce costs. For example, if Plastim continued to use its direct manufacturing labor hours based system to choose among alternative designs, which design choices would Plastim have favored? Those designs that reduce direct manufacturing labor hours the most would be preferred. This would be a false signal as ABC system reveals, the cause-andeffect relationship between direct manufacturing labor hours and indirect costs is weak, and so reducing direct manufacturing labor hours would have only a minimal effect on reducing indirect costs • Planning and Managing activities –ABC systems are used for planning and managing activities. Companies specify budgeted costs for activities and at year-end, budgeted and actual costs are compared to provide feedback on how well activities were managed
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ABC in Merchandising and Service Companies • ABC Approach for manufacturing industries is similar to merchandising and service companies • Costs are divided into homogenous cost pools which correspond to activities. • Service and Merchandising companies must also confront the problems of measuring activity cost pools and identifying and measuring allocation bases
ABC in Merchandising and Service Companies –An illustration ABC help banks such as Bank of America with strategic analysis, measurement, and management of service delivery. Most banks offer customers multiple service channels for transactions such as traditional branches, ATMs, and internet banking. ABC can help answer questions like: • What costs are associated with branch transactions vs online transactions? • Which channel will help reduce overall costs? • How much does it cost to get a new customer to use online banking?
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ABC in Merchandising and Service Companies –An illustration Example of cost drivers for banks: Activity 1. Transaction processing – cost of associated with executing deposits, withdrawals, transfers and other banking business (cost driver – number of transactions per channel) 2. Products/service offerings – selecting service offerings, creating and developing new services, supporting existing offerings (cost driver – number of products/services per channel) 3. Customer acquisition and retention – acquiring new customers and structuring programs to retain existing customers (cost driver – number of targeted customers per channel)
Summary of ABC Costing •
ABC is generally perceived to produce superior costing figures due to the use of multiple drivers across multiple levels
•
ABC is only as good as the drivers selected, and their actual relationship to costs. Poorly chosen drivers will produce inaccurate costs, even with ABC
•
ABC systems are likely to yield the most benefits when indirect costs are a high percentage of total costs or when products and services make diverse demands on indirect resources
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Warning Signs That Suggest That ABC Could help a Firm: • • • • •
Significant overhead costs allocated using one or two cost pools Most or all overhead is considered unit-level Products that consume different amounts of resources Products that a firm should successfully make and sell consistently show small profits Operations staff disagreeing with accounting over manufacturing and marketing costs
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