Activity-Based Costing and

Management

McGraw-Hill/Irwin
Traditional, Volume-Based Product-
Costing System
Aerotech produces three complex printed circuit boards
referred to as Mode I, Mode II, and Mode III.
The following information is obtained from company
records:

Mode I Mode II Mode III

Production:
Units 10,000 20,000 4,000
Runs 1 run of 10,000 4 runs of 10 runs of
units 5,000 units 400 units

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Traditional, Volume-Based Product-
Costing System
Mo d e I Mo d e I I Mo d e I I I
Direct mat erials $ 50.00 $ 90.00 $ 20.00
Direct lab o r 60.00 80.00 40.00
Man u f act u rin g o verh ead 99.00 132.00 66.00
To t al $ 209.00 $ 302.00 $ 126.00

Additional information includes:

Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor (hr/board) 3 4 2
Setup time (hr/run) 10 10 10
Machine time (hr/board) 1 1.25 2

Manufacturing overhead is determined as follows

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Traditional, Volume-Based Product-
Costing System
Mode I Mode II Mode III
Units produced 10,000 20,000 4,000
Direct labor (hr/unit) 3 4 2
To tal hours 30,000 80,000 8,000

To tal hours required 118,000

Budgeted manufacturing overhead $3,894,000

= $33 per hour
Budgeted direct-labor hours 118,000

Mode I Mode II Mode III

Direct labor (hr/unit) 3 4 2
Overhead rate per hour $ 33 $ 33 $ 33
Overhead per unit $ 99 $ 132 $ 66

5-4
Traditional, Volume-Based Product-
Costing System
With these product costs, Aerotech established target
selling prices (Cost × 125%).
Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
To tal $ 209.00 $ 302.00 $ 126.00

Mo d e I Mo d e I I Mo d e I I I
Co st p er u n it $ 209.00 $ 302.00 $ 126.00
Targ et sellin g p rice 261.25 377.50 157.50

209.00 x 1.25
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Activity Based Costing System (ABC)
ABC systems follow a two-stage procedure to assign
overhead costs to products.

Stage One
Identify significant activities and assign overhead costs
to each activity in proportion to resources used.
Stage Two
Identify cost drivers appropriate to each activity and
allocate overhead to the products.

5-6
 Overhead Costs
Total budgeted cost = $3,894,000 Identification
Identification
Activity
must be
of
of Activity
Activity
done on Activity Cost
Cost Pools
Pools
each unit Cost
produced. Pools
Product-
Unit- Batch- Sustaining- Facility-
Level Level Level Level

Machinery Setup Engineering Facility

cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Activity Activities needed to support Activity required in order

performed an entire product line for the production
on each process to occur.
batch
produced. 5-7
 Product-
Unit- Batch- Sustaining- Facility-
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Receiving/Inspection
cost pool $200,000

Material-Handling
cost pool $600,000

Quality-Assurance
cost pool $421,000

Packaging/Shipping
cost pool $250,000
5-8
 STAGE ONE

Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600

5-9
 STAGE TWO
Calculate Budgeted Machinery Costs = $1,212,600
the pool Budgeted Machine Hours 43,000
rate = $28.20/hour

Mode I: Mode II:

$28.20 per hr. $28.20 per hr.
1 hr. per unit 1.25 hr. per unit
$28.20 per unit $35.25 per unit
Cost
Assignment
Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit

5-10
 STAGE ONE

Total budgeted setup cost

Calculation of
$20 per hour
total setup cost 10 hr. per setup
$200 cost per setup
15 production runs
$ 3,000 Total

Activity
cost Setup Cost Pool
pool Total budgeted cost = $3,000

5-11
 STAGE TWO
Calculate Budgeted Setup Costs = $3,000
the pool Planned Production Runs 15 runs
rate = $200 per run

Mode I: (1 Run) Mode II: (4 Runs)

$200 per run $200 per run
10,000 units per run 5,000 units per run
= $.02 per unit = $.04 per unit
Cost
Assignment
Mode III: (10 Runs)
$200 per run
400 units per run
= $.50 per unit

5-12
 STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool
pool Total budgeted cost = $700,000

5-13
 STAGE TWO
Allocate based Engineering Cost Pool
on engineering Total budgeted cost = $700,000
transactions

Mode I: Mode II:

25% × $700,000 45% × $700,000
10,000 units 20,000 units
= $17.50 per unit = $15.75 per unit
Cost
Assignment
Mode III:
30% × $700,000
4,000 units
= $52.50 per unit

5-14
 STAGE ONE
Various overhead Plant depr. Property taxes
costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507,400

5-15
 STAGE TWO
Calculate Budgeted Facilities Cost = $507,400
the pool Budgeted Direct-Labor Hours 118,000
rate = $4.30/hour

Mode I: Mode II:

$4.30 per hr. $4.30 per hr.
× 3 hr. per unit × 4 hr. per unit
$12.90 per unit $17.20 per unit
Cost
Assignment
Mode III:
$4.30 per hr.
× 2 hr. per unit
$8.60 per unit

5-16
 Other Overhead Costs
Re c e ivin g an d In s pe c t ion Cos t P ool
Board Ove rh e ad × % ÷ Un its = Cos t/Un it
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Mat e rial-Han dlin g Cos t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/Un it
Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Qu alit y-As s u ran c e Cos t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/Un it
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

P ac ka gin g a n d Sh ippin g Cos t P oo l

Board Ove rh e ad × % ÷ U n its = Cos t/U n it
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25
5-17
 Other Overhead Costs
Re c e ivin g an d In s pe c t ion Cos t P ool
Board Ove rh e ad × % ÷ Un its = Cos t/Un it
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Mat e rial-Han dlin g Cos t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/Un it
$14.82 Mode I
Mode II
$ 600,000
600,000
×
×
7%
30%
÷
÷
10,000
20,000
= $
=
4.20
9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Qu alit y-As s u ran c e Cos t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/Un it
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

P ac ka gin g a n d Sh ippin g Cos t P oo l

Board Ove rh e ad × % ÷ U n its = Cos t/U n it
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25
5-18
Product Cost from ABC
These are the new product costs when Aerotech uses
ABC.

Mode I Mode II Mode III

Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Machinery 28.20 35.25 56.40
Setup 0.02 0.04 0.50
Engineering 17.50 15.75 52.50
Facilities 12.90 17.20 8.60
Other 14.82 23.57 212.85
Total $ 183.44 $ 261.81 $ 390.85

5-19
Distorted Product Costs
Both original and ABC target selling prices are based
on (Cost × 125%).

Mode I Mode II Mode III

Tradition al cos tin g $ 209.00 $ 302.00 $ 126.00
AB C cos tin g 183.44 261.81 390.85

Origin al targe t s e llin g price 261.25 377.50 157.50

AB C targe t s e llin g price 229.30 327.26 488.56

The selling price of Mode I and II are decreased,

while the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]
5-20
 Distorted Product Costs
Can you identify any problems Aerotech is likely to
face as a result of this distortion?
Mode I Mode II Mode III
Tradition al cos tin g $ 209.00 $ 302.00 $ 126.00
AB C cos tin g 183.44 261.81 390.85
Cos t dis tortion pe r u n it 25.56 40.19 (264.85)
U n its produ ce d 10,000 20,000 4,000
Total cos t dis tortion 255,600 803,800 (1,059,400)

Traditional costing understates the cost

of complex, low volume products.

5-21
Two Key Points

A
A large
large proportion
proportion of of non-
non- Product
Product diversity
diversity
unit-level
unit-level activities
activities When
When thethe consumption
consumption
A
A unit-level
unit-level cost
cost driver,
driver, such
such ratios
ratios differ
differ widely
widely
as
as direct
direct labor,
labor, machine
machine
hours, between
between activities,
activities, no
no
hours, or
or throughput,
throughput, willwill
not
not be
be able
able to
to assign
assign the
the costs
costs
single
single cost
cost driver
driver will
will
of
of non-unit-level
non-unit-level activities
activities accurately
accurately assign
assign the
the
accurately.
accurately. resulting
resulting overhead
overhead costs.
costs.

5-22
Cost Drivers
A characteristic of an event or activity that results in
the incurrence of costs. In selecting a cost driver,
we must consider . . .

Degree of Behavioral
Correlation Effects

Cost of
Measurement

5-23
COLLECTING ABC DATA
INTERVIEWS AND PAPER TRAILS - The information
for ABC systems initially comes from interviews with
employees in the support departments and a review of each
department’s records.

STORYBOARDING - A procedure used to develop a

detailed process flow chart, which visually represents activities
and the relationships among activities.

MULTIDISCIPLINARY ABC PROJECT TEAMS – To

gather information from all facets of an organization’s
operations, it is essential to involve personnel from a variety of
functional areas. A typical ABC project team includes
ACCOUNTING, FINANCE, PRODUCTION, OPERATIONS,
ENGINEERS, MARKETING, etc.
5-24
Activity-Based Management

The use of
ABC costing
information
to help
management
make decisions
5-25
Activity-Based Management
Activity-based costing establishes relationships
between overhead costs and activities so that
we can better allocate overhead costs.
Activity-based management focuses
on managing activities to reduce costs.

5-26
Two-Dimensional ABC and Activity-
Based Management

Activities

5-27
Two-Dimensional ABC and Activity-
Based Management
Cost Assignment View

Resource
Resource costs
costs

Activities

Cost
Cost Objects
Objects
5-28
Two-Dimensional ABC and Activity-
Based Management
Cost Assignment View

Resource
Resource costs
costs
Process View
Activity Analysis Activity Evaluation

Root
Root Activity
Activity Performance
Performance
Causes
Causes Triggers
Triggers Activities Measures
Measures

Cost
Cost Objects
Objects
5-29
Elimination of Non-Value-Added Costs
Activities

Non-value-
added
activities
Unnecessary Necessary

Reduce or Continually Evaluate

Eliminate
and Improve 5-30
Using ABM to Eliminate Non-Value-
Added Activities and Costs
1. Identify Activities.
2. Identify Non-Value-Added Activities.
3. Understand Activity Linkages, Root Causes, and
Triggers.

Inspect
Inspect Rework
Rework
Specify
Specify Select
Select Receive
Receive Produce
Produce finished
finished defective
defective
parts
parts vendor
vendor parts
parts goods
goods goods
goods products
products

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.

5-31
Using ABM to Eliminate Non-Value-
Added Activities and Costs

Process time

Inspection time Storage time

Move time Waiting time

5-32
Customer Profitability Analysis

Customer profitability analysis uses

activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.

5-33
Customer Profitability Analysis
Required
special
packaging
Orders Demand
small fast
quantities service

Often
Orders
changes
frequently
orders

A costly customer
5-34
Customer Profitability Analysis
Cost Drive
Customer-Related Activities Cost Driver Base Rate
Order processing Purchase orders $ 150
Sales contacts (phone calls, faxes, etc.) Contacts 100
Sales visits Visits 1,000
Shipment processing Shipments 200
Billing and collection Invoices 160
Design/engineering change orders Design changes 4,000
Special packaging Units packaged 40
Special handling Units handled 60

A
A company
company maymay use
use these
these customer
customer
related
related costs
costs to
to help
help determine
determine the
the
profitability
profitability of
of each
each customer.
customer.

5-35
Customer Profitability Analysis
Customer Profitability
Cumulative Operating Income as a % of Total

125.0%

100.0%
Operating Income

75% of actual operating income

75.0%

50% of actual operating income

50.0%

25% of actual operating income

25.0%

0.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

5-36