Module 19 n 21

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Activity-Based Costing, Customer Profitability, and Activity-Based Management

Module 19

Peter D.

EASTON

Robert F.

HALSEY

Mary Lea

McANALLY

Al L.

HARTGRAVES

Wayne J.

MORSE

FINANCIAL & MANAGERIAL ACCOUNTING for MBAs 5e

Explain the changes in the modern production environment that have affected cost structures.

Learning Objective

Changing Cost Environment

Fundamental shift from labor-intensive to automated assembly

More time is spent by employees

On scheduling

Setting up

Maintaining

Moving materials to and from equipment

Employees keep equipment running efficiently

RESULT

Increase in manufacturing overhead costs

Changing Production Cost Structure

Many companies’ cost structures are moving to a lower proportion of variable costs and a higher proportion of fixed costs.

Outline the concept of activity-based costing (ABC) and how it is applied.

Learning Objective

Activity-Based Costing (ABC)

Involves determining the cost of activities and tracing their costs to a cost object on the basis of the cost object’s use of units of activity

Underlying premises

Activities drive costs

Costs should be assigned to products/services in proportion to the volume of activities they consume

Cost Object

A product or service provided to a customer

Can be a customer

A revenue-producing event for which management wants to know the cost

Activity-Based Costing (ABC)

Activities performed to fill customer needs consume resources that cost money.

The cost of resources consumed by activities should be assigned to cost objects on the basis of the units of activity consumed by the cost object.

Served by

Customers

Consume

Activities

Have

Resources

Costs

Assigned to

Costs of Resources

Reassigned to*

Activity Pools

Cost Objects

* Based on units of activity utilized by the cost objective

ABC Product Costing Model

Consists of two stages:

Assignment of manufacturing overhead resource costs to activity cost pools for the key activities identified.

Costs can be indirect labor, insurance, maintenance, depreciation, utilities, etc.

Stage 1:

Assignment of costs from activity cost pools to cost objects

Stage 2:

Direct costs are assigned directly to the final cost objects and are, thus, excluded from the activity cost pools.

ABC Product Costing Model

Operationalizing the two-stage model requires the following:

Identifying activities

Assigning cost to activities

Determining the basis (activity cost driver) for

assigning the cost of activities to cost object.

Determining the cost per unit of activity

Reassigning costs from the activity to the cost object on the basis of the cost object’s volume of consumption of activities

Most CRITICAL Step

ABC Product Costing Model

Identifying Activities Example

Expert Ironworks produces custom heavy duty shelving. Filling customer orders requires acquiring raw materials, manufacturing, and shipping as follows:

Supervisors spend 20% of their time with each employee in

purchasing and receiving.

Other costs related to space of which 25% is occupied by purchasing

and 75% by receiving.

Assigning Costs to Activities Example

		Placing Purchase Orders	Receiving Materials
Salaries
	Purchasing agents ($7,800 × 3 agents)	$23,400
	Receiving room employees ($2,400 × 2 employees)		$ 4,800
	Supervisor
	($5,000 × 3/5 purchasing)	3,000
	($5,000 × 2/5 receiving)		2,000
Other costs
	($4,500 × 25% purchasing)	1,125
	($4,500 × 75% receiving)	-	3,375
	Total	$27,525	$10,175

Refining Into Three Activities

Supervisors were found to spend their time:

30% of receiving time was verifying issues

70% spent on unloading, unpacking, and inspecting issues.

Interviews determined how

receiving room employees spent their time:

15% verifying purchase orders

85% unloading, unpacking, and inspecting.

		Placing Purchase Orders		Verifying Purchase Orders		Unload Unpack Inspect	Total Costs
Salaries
	Purchasing agents ($7,800 × 3 agents)	$23,400
	Receiving room employees ($2,400 × 2 emp.)
	($2,400 × 2 employees × 15% verifying)			$ 720
	($2,400 × 2 employees × 85% unload, etc.)					$4,080
	Supervisor
	($5,000 × 3/5 purchasing)		3,000
	($5,000 × 2/5 receiving x 30% verifying)				600
	($5,000 × 2/5 receiving x 70% verifying)					1,400
Other costs
	($4,500 × 25% purchasing)		1,125
	($4,500 × 75% receiving)		-		-	3,375
	Total		$27,525		$ 1,320	$ 8,855	$37,700

Cost per Unit of Activity

Each activity results in a different rate

Rates are used to apply costs to cost objectives

Cost per unit of activity cost driver

Cost of activity

Units of cost driver

Cost per Unit of Activity

Each activity results in a different rate

Rates are used to apply costs to cost objects

Assume direct materials totaling $120,000 are to be acquired during the month.

Monthly Costs:	Placing Purchase Orders	Verifying Purchase Orders	Unloading Unpacking Inspecting
Total cost of activity	$27,525	$ 1,320	$ 8,855
Units of cost driver:
Number of purchase orders	÷ 300
Number of purchase orders		÷ 300
Number of dollars of materials	—	—	120,000
Cost per unit of activity	$ 91.75	$ 4.40	$ 0.074

Assigning Activity Costs to Cost Objectives

Assigning costs to one purchase which has a materials cost of $1,600.

Costs for Purchase Order 1 :
Direct materials costs	$ 1,600

Activity costs:
Placing purchase order	$ 91.75
Verifying purchase order	4.40
Unloading/unpacking/inspecting ($0.074 × $1,600)	118.40
Costs assigned to cost objective	$214.55

Activities & Their Relationship to Purchase Orders

Purchasing Department $37,700

Resource Costs

Purchase Order 1 $214.55

Other purchase orders $37,485.45

Cost Objects

Placing purchase orders $27,525

Verifying purchase orders $1,320

Unloading/ Unpacking/ Inspecting $8,855

Activity Cost Pool

Assigning Costs to a Job Example

The following activity costs were determined in the Machining and Finishing Departments:

Machining Dept: Setup $160

Conversion $ 32 per machine hour

Finishing Dept: Polishing $33 per labor hour

Packing $ 5 per pound

If Job 554 requires 21 machine hours in the machining department and 32 labor hours in the finishing department, and weighs 230 pounds, what is the total activity cost assigned to Job 554?

Activity Costs assigned to Job 554:

Machining Department:
Setup	$ 160
Conversion ($32 × 21 machine hours)	672

Finishing Department:
Polish ($33 x 32 labor hours)	1,056
Pack ($5 x 230 pounds)	1,150
Total activity cost assigned to Job 554	$3,038

Assigning Costs to a Job Example

Direct materials and direct labor must be directly traced to determine the total coast of Job 554.

Perform product costing using both traditional and activity-based costing methods.

Learning Objective

Traditional Product Costing

Plantwide overhead allocations are used often where production of only one product occurs.

Departmental rates produce a more accurate allocation of overhead costs than plantwide rates.

Although product costs determined with department rates may not be as precise as those determined with ABC, they are used because of relative simplicity.

Traditional Product Costing Example

Jump Start produces two energy drinks in 800 gallon batches in two departments--mixing and bottling. A total of 60 batches are estimated to be produced with 2,400 machine hours and estimated total manufacturing overhead of $156,000.

Data for the products follows:

	Explosion	Eruption
Machine hours required per batch Total machine hours	18 hours 1,080 hours	22 hours 1,320 hours
Direct materials cost	$260 per batch	$380 per batch
Total direct labor cost per batch	$80	$100
Total direct labor hours	240 hours	300 hours
Direct labor hours per batch	4 hours	5 hours

Traditional Product Costing Example

Overhead rate: $156,000 ÷ 2,400 = $65 per machine hour

Machine Hours for 60 Batches
Departments	Explosion	Eruption	Total
Mixing	400	600	1,000
Bottling	680	720	1,400
Totals	1,080	1,320	2,400

Additional data:

Machine hours—Explosion: 1,080 ÷ 60 = 18 hours per batch

—Eruption: 1,320 ÷ 60 = 22 hours per batch

	Explosion	Eruption
Direct materials cost	$ 260	$ 380
Direct labor cost	80	100
Overhead cost:
Explosion: 18 hours × $65	1,170
Eruption: 22 hours × $65	0	1,430
Unit cost per batch	$ 1,510	$ 1,910

Unit Cost of Each Batch:

Departmental Rates Costing Example

Assign a portion of the total overhead to the production departments

Assign departmental costs to the products

Two Steps

Additional data:

Direct Labor Hours for 60 Batches
Departments	Explosion	Eruption	Total
Mixing	180	220	400
Bottling	60	80	140
Totals	240	300	540

Machine Hours for 60 Batches
Departments	Explosion	Eruption	Total
Mixing	400	600	1,000
Bottling	680	720	1,400
Totals	1,080	1,320	2,400

Overhead Per Department
Mixing	$40,000
Bottling	$116,000

Dept.	Overhead Application Base
Mixing	Direct labor hours in mixing
Bottling	Machine hours in bottling

Departmental Rates Costing Example

Computation of departmental rates:

Overhead costs per activity		Mixing	Bottling
Department manufacturing overhead		$40,000	$116,000
Quantity of overhead application base
Total direct labor hours in mixing	÷ 400
Total machine hours in bottling	-		÷ 1,400
Overhead rates per department	$ 100.00		$ 82.86
	Per direct labor hour		Per machine hour

Departmental Rates Costing Example

Additional data:

Mixing direct labor hours per batch:

Explosion: 180 ÷ 60 = 3.00 direct labor hours

Eruption: 220 ÷ 60 = 3.67 direct labor hours

Bottling machine hours per batch:

Explosion: 680 ÷ 60 = 11.33 machine hours

Eruption: 720 ÷ 60 = 12.00 machine hours

Total Cost per Batch:

	Explosion	Eruption
Direct materials cost	$260	$ 380
Direct labor cost	80	100
Manufacturing overhead
Mixing: $100 × 3 direct labor hours	300
Mixing: $100 × 3.67 direct labor hour		367
Bottling: $82.86 × 11.33 machine hours	939
Bottling: $82.86 × 12 machine hours	-	994
Total costs per batch	$1,579	$1,841

Applying Overhead with ABC Example

Additional data:

Overhead Activity	Total Activity Cost	Activity Cost Driver (Number of)	Activity Quantity	Unit Activity Rates
Direct department costs—mixing	$ 32,000	Labor hours	400	$80.00
Direct department costs—bottling	39,000	Machine hours	1,400	27.86
Common overhead costs
Support services
Receiving	17,000	Purchase orders	320	53.13
Inventory control	15,000	Batches produced	60	250.00
Engineering resources
Production setup	11,000	Production runs	18	611.11
Engineering and testing	16,000	Tests	400	40.00
Building and grounds
Maintenance, machines	12,000	Maintenance visits	150	80.00
Depreciation, machines	14,000	Machine hours	2,400	5.83
	$156,000

Applying Overhead with ABC Example

		Explosion		Eruption
Overhead costs	Rate	Activity	Cost of Activity	Activity	Cost of Activity
Mixing	$ 80.00	220	$17,600	180	$14,400
Bottling	27.86	680	18,943	720	20,057
Receiving	53.13	240	12,750	80	4,250
Inventory control	250.00	30	7,500	30	7,500
Production setup	611.11	4	2,444	14	8,556
Engineering and testing	40.00	200	8,000	200	8,000
Maintenance, machines	80.00	70	5,600	80	6,400
Depreciation, machines	5.83	1,080	6,300	1,320	7,700
Total overhead product cost			$79,137		$76,863

Each activity rate is multiplied by the actual activity to determine the cost allocated to each product batch.

Cost per Unit ABC Example

There were 60 batches of product resulting in a cost of $1,659 for Explosion and $1,761 for Eruption.

	Explosion	Eruption
Total factory overhead product cost	$79,137	$76,863
Batches produced	÷ 60	÷ 60
Factory overhead cost per batch	1,319	1,281
Direct material cost per batch	260	380
Direct labor cost per batch	80	100
Total batch product cost using ABC	$ 1,659	$ 1,761

ABC provides more accurate cost data for internal decision making.

Compare activity-based costing to traditional methods. Assess implementation issues involved in activity-based costing systems.

Learning Objective

Limitations of ABC

Complete analysis requires consideration beyond manufacturing costs to include nonmanufacturing

Activity can be measured on practical capacity, actual capacity, or other estimate

Practical capacity preferred over actual capacity because

Does not hide the cost of idle capacity within product costs

Gives a truer cost of activities used to produce the product

Comparing Overhead Cost Allocation Methods

ABC views operations of the company as activities.

Traditional methods

Undercost Explosion

Overcost Erruption

ABC

Most accurate costing method

	Explosion	Eruption
Traditional plantwide rate	$1,510	$1,910
Traditional departmental rate	1,579	1,841
ABC	1,659	1,761

ABC Implementation Issues

After switching to ABC, companies may find that only 10 to 15% of their products are profitable

Causes management to alter the product mix by minimizing unprofitable products which causes profits to increase

Implementation mirrors the complexity of the organization

Complete conversion to ABC requires auditors to accept the system when used for financial reporting

Analyze customer profitability using activity-based costing.

Learning Objective

ABC and Customer Profitability

ABC may be used for customer profitability analysis

Customer costs to be analyzed

Cost incurred to sell the goods or services

Cost incurred to provide service

Actions possible from analysis

Convert customers to profitability or increase profitability

Seek to terminate unprofitable customer relationships

Customer Profitability Profile Graph

Once a company knows the amount of profits or losses generated by each customer, it can create a customer profitability profile.

ABC Customer Profitability Analysis

Step 1: Identify the activities related to serving customers.

Step 2: Prepare a customer profitability analysis.

Step 3: Take proactive steps to increase profit.

ABC Customer Profitability Analysis Example

Manning Building Supplies prepared the following list concerning its customer activities:

Activity	Activity Cost Driver	Cost per Unit of Driver Activity
Visits to customers	Visits	$400
Remote contact	Number of contacts	30
Processing and shipping	Customer orders	150
Repackaging	Number of requests	120
Billing and collection	Invoices	40

The largest customer, Haskell Construction, will be analyzed.

ABC Customer Profitability Analysis Example

Customer cost information:

Activity	Activity Cost Driver	Cost per Unit of Activity
Visits to customers	Visits	$400
Remote contact	Number of contacts	30
Processing and shipping	Customer orders	150
Repackaging	Number of requests	120
Billing and collection	Invoices	40

Customer activity costs for Haskell Construction:

	Activity Cost Driver Data	Cost per Unit of Driver Activity	Customer Activity Cost
Visits to customers	4	$400	$1,600
Remote contact	3	30	90
Processing and shipping	6	150	900
Repackaging	2	120	240
Billing and collection	5	40	200
Total customer activity cost			$3,030

ABC Customer Profitability Analysis Example

Customer profitability ratio: $13,970 / $79,000 = 17.7%

Customer Profitability Analysis:
Customer sales	$79,000.
Less cost of goods sold	62,000.
Gross profit on sales	17,000.
Less activity costs	(3,030)
Customer profitability	$13,970.

Customers found to generate lower profitability should be flagged and efforts made to correct the situation or terminate the customer.

Explain the difference between activity-based costing and activity-based management.

Learning Objective

Activity-Based Management

Identification and selection of activities to maximize the value of activities while minimizing their cost from the perspective of the final consumer

Helps focus managerial attention on what is most important among the activities performed to create value for customers

Activity-Based Costing

The evolution of ABC within the context of a product life cycle.

Introduced in the 1980’s

Expanded functionality

4th Generation

Activity-Based Costing

Integral part of business performance management solutions.

Profitability management

Performance measurement

Financial management

Sustainability

Human capital management

Activity-Based Costing

In its current state, a single ABC model can support a number of needs including:

Historical Cost Measurement

Resource Planning

Performance Measurement

Other Analyses

The End