ActivityBased Costing

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Chapter 10
Activity-Based Costing and Management
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Overview

• Need good estimate of controllable costs to
  improve quality of decisions
• Choices that we make when allocating costs
  determine the validity of the estimated profit
  margin
• Activity based costing is a method to refine our
  allocation and improve validity of estimate
• Activity based management is the process of
  taking ABC data to improve the effectiveness of
  business processes
• Focused on Customer
• Focused on Production
• Focused on Product concepts and design

LO1 Understand the elements of an
activity-based costing (ABC) system
3
Decisions When Allocating Costs
LO1 Understand the elements of an
activity-based costing (ABC) system
4
Forming Cost pools

• Includes all costs
• Pre and post production
• Takes business process view
• A collection of activities
• Activities are the core building block of ABC
  systems
• Horizontal view of organization
• Traditional costing takes vertical view
• Prepares activity map for each product
• Similarity to bill of materials and routing sheet

LO1 Understand the elements of an
activity-based costing (ABC) system
5
Activities at United Parcel Service
LO1 Understand the elements of an
activity-based costing (ABC) system
6
Forming Cost Pools

• Activities can pertain to any level in the
  activity hierarchy
• Activities done for each unit, each batch, each
  product or for the facility as a whole
• The corresponding cost pools will correspond to
  the cost hierarchy
• Unit, batch, product and facility level cost pools

LO1 Understand the elements of an
activity-based costing (ABC) system
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4,740,180
0.95
1
10
2
9.50
3
4,503,171 / 4,740,180
1
1,359,600 / 135,960
2
10.00 direct labor per linear foot x 0.95 /
labor
3
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Cost Pools at MKC
LO1 Understand the elements of an
activity-based costing (ABC) system
9
Which Pools to Allocate?
LO1 Understand the elements of an
activity-based costing (ABC) system
10
Which Drivers to Choose?

• Activity based costing systems pick drivers that
  correspond to activities
• Thus, we have unit, batch, product and facility
  level drivers
• In contrast, traditional systems only employ
  unit-level drivers
• Units, direct labor, machine hours.

LO1 Understand the elements of an
activity-based costing (ABC) system
11
ABC Better Drivers
LO1 Understand the elements of an
activity-based costing (ABC) system
12
Test Your Knowledge!
The costs associated with a companys security
department would be considered what type of
activity?

• Unit level
• Batch level
• Customer level
• Facility level

Security costs would be considered a facility
level activity.
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Marketing support 0.70 x 60,000 42,000
Customer order related 0.20 x 60,000
12,000 General administration 0.10 x
60,000 6,000. All other cost pools would
have zero cost allocated to them.
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Better Drivers at MKC
LO1 Understand the elements of an
activity-based costing (ABC) system
15
What Denominator Volume to Use?

• In Chapter 9
• Denominator volume actual volume
• All costs would be allocated
• No distinction between demand supply of
  capacity
• ABC de-links demand and supply
• Uses practical capacity as denominator volume

LO1 Understand the elements of an
activity-based costing (ABC) system
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Example

• Cost 55,000, Capacity 11,000 unitsA uses
  4,000 units B uses 6,000 units.
• Traditional method
• Rate 5.50 /unit A 22,000, B 33,000
• ABCs approach
• Rate 5 / unitA 20,000, B 30,000,
  Unassigned 5,000!
• Supply is 11,000 units demand is 10,000 units

LO1 Understand the elements of an
activity-based costing (ABC) system
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225,000
225,000
2.8125
1
2.25
3
126,562.50
101,250
2
4
56,250
45,000
33,750
42,187.50
180,000
225,000
45,000
0
5
225,000 / 80,000
1
2
45,000 square feet x 2.8125 / square foot
225,000 / 100,000
3
45,000 square feet x 2.25 / square foot
4
225,000 - 180,000
5
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What to do with Unassigned Cost?

• This is the cost of capacity not used
• ABC brings this cost to managerial action.
• Disposition depends on reason for the unused
  capacity
• If
• True excess, get rid of capacity or re-deploy
• Accommodate variability in production, allocate
  to product
• Seasonal, allocate to product
• Peak load pricing, time of day pricing
• Customer related, allocate to customer

LO1 Understand the elements of an
activity-based costing (ABC) system
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Measurement Issues

• Definition Capacity at which average cost begins
  to increase
• Difficult to measure
• Typically, maximum feasible production after
  allowing for scheduled maintenance
• Some argue that practical capacity is not right
  idea
• Theoretical capacity

LO1 Understand the elements of an
activity-based costing (ABC) system
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Summary Steps in ABC

• Identify all activities and pool like activities
  together
• Analyze accounts and allocate costs from accounts
  to cost pools to determine cost in each pool
• Determine driver for each pool
• Determine rate using practical capacity
• Step 1 in any allocation process
• Assign costs from pools to objects
• Step 2 in any allocation process

LO1 Understand the elements of an
activity-based costing (ABC) system
21
Test Your Knowledge!
The greatest advantage associated with
activity-based costing is that

• it is easy to design and implement.
• it allocates all overhead costs based on the same
  cost driver.
• it allows for multiple cost pools and multiple
  cost drivers.
• it allows for multiple cost pools but only a
  single cost driver.

Activity-based costing allows for multiple cost
pools and multiple cost drivers.
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Accounts to Cost Pools MKC
LO2 Argue the decision usefulness of ABC
systems.
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Step 1 Calculating Rates
LO2 Argue the decision usefulness of ABC
systems.
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Step 2 Determine Product cost
LO2 Argue the decision usefulness of ABC
systems.
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Reporting ABC data

• ABC product cost reports contain more detail than
  reports under traditional product costing systems
• These reports report different elements of the
  cost hierarchy in separate lines
• A sample report might have

LO2 Argue the decision usefulness of ABC
systems.
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LO2 Argue the decision usefulness of ABC
systems.
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1,500
500
1
200
100,000
2
750,000 / 1,500 of practical capacity
1
200 orders x 500/ordr 100,000
2
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Advantages of ABC reports

• Captures the complexity of the production process
• Speaks the language of the user
• Highlights that not every cost is related to
  volume
• Volume is still the most important driver though
• Produces more accurate costs, enabling better
  decisions
• Avoids cross-subsidization
• Total profit will not change by changing cost
  allocation system
• Only the allocation of costs has changed

LO2 Argue the decision usefulness of ABC
systems.
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ACTIVITY BASED MANAGEMENT
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Three major Branches

• Product planning
• Customer Planning
• Resource Planning

LO3 Explain the importance of activity-based
management.
31
Product Planning

• Can use ABC information to
• Refine prices
• Unbundle services and price each separately
• Paper vs. Electronic ticket
• Pick the right costs for the decision horizon
• Short-term Variable costs only?
• Medium-term Variable costs and SOME capacity
  costs
• Long-term All costs?
• Refine the product mix
• Can help trim unprofitable products
• Be sure to consider
• Cost interactions product-line level costs
• Revenue interactions Loss-leader products

LO3 Explain the importance of activity-based
management.
32
Decisions at MKC

• Deemphasize the platinum line and/or increase its
  price
• This low-volume line is a high consumer of
  overhead resources
• This feature hidden in volume-based allocation
  systems
• Silver line was picking up much of Platinums
  cost
• Avoid confusion about a products true profit
  margin
• ABC includes SGA costs and provides better cost
  estimates

LO3 Explain the importance of activity-based
management.
33
Customer Planning Grouping Costs Differently
LO3 Explain the importance of activity-based
management.
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Customers Vary In Their Profitability

• Low-Profit Customers
• Small order sizes
• Unpredictable ordering pattern, hard to plan for
• Frequent order change requests
• Demand immediate deliveries
• Need to carry inventory to satisfy customer
  demands
• Require more customization
• Demand delivery at site
• Frequent sales force contact
• Demand immediate and frequent after sales service
• Rigid requirements
• Not paying on time

• High-Profit Customers
• Large order sizes
• Predictable ordering patterns, easy to plan for
• Minimal order change requests
• Planned deliveries
• Minimal inventory requirements
• Require minimal customization
• Less pre-sales support
• Less after sales support
• Easy to deal with, has well organized purchase
  procedures
• Flexible relationship
• Pays on time

LO3 Explain the importance of activity-based
management.
35
Whale Curve
LO3 Explain the importance of activity-based
management.
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Customer Planning

• Profitable customers
• Nurture and grow
• Offer incentives to increase volume of business
• Waive late fees
• Unprofitable customers
• Change pricing to reflect the cost of resources
  consumed
• E.g., Unbundle delivery costs
• Change behavior
• Use of ATMs instead of teller services
• Give lower priority
• No waiver of late fees

LO3 Explain the importance of activity-based
management.
37
Drop Unprofitable Customers?

• Might offer hard-to-measure benefits
• A large (but unprofitable) customer might allow
  for scale economies in production
• Might offer exposure in market place
• A small and demanding (but unprofitable) customer
  might be a good way to test and refine systems
• But, sometimes, there is no option but to drop
• Usually, a last step that firms are reluctant to
  take

LO3 Explain the importance of activity-based
management.
38
Resource Planning

• ABC creates a map of how a product consumes
  activities and, thereby, resources
• We can use the activity map and production
  forecasts to generate the demand for resources
• Same as generating the demand for materials or
  labor
• We can match with supply of resources to reduce
  unneeded capacity
• Reporting of unused capacity is useful in drawing
  managerial attention to capacity supplied but not
  used

LO3 Explain the importance of activity-based
management.
39
Manage Processes

• ABC provides a detailed (financial) look at the
  production process
• Can use to target efforts to improve efficiency /
  effectiveness
• General steps
• Develop a process map for each activity
• Identify as value-adding or not
• Seek ways to improve value obtained (eliminate
  non-value-adding activities)

LO3 Explain the importance of activity-based
management.
40
ABC and Pre-Production Processes

• ABC can also help with pre-production process
• Target costing (More in Chapter 13)
• Form cross-functional teams with design,
  manufacturing and marketing
• These teams can use ABC data to consider cost
  impact of decisions at the time of design
• These decisions have the greatest influence on
  cost

LO3 Explain the importance of activity-based
management.
41
Exercise 10.30
Computing cost of activity (LO2). The University
Credit Union (UCU) has engaged your services to
determine the cost of its various activities. The
following data are available for a representative
branch.
The average branch processes 600,000 deposits and
1,250,000 check transactions each year.
Required Compute the cost per deposit and the
cost to process a check.
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Exercise 10.30 (Concluded)
Compute the cost per deposit and the cost to
process a check.
The next step is to divide the total cost in the
cost pool by the denominator volume to get the
overhead rate per unit driver. We have