Activity-Based Costing and Activity-Based Management

Activity-Based Costing and
Activity-Based Management
Chapter 5
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5-1
Learning Objective 1
Explain undercosting
and overcosting of
products and services.
Undercosting and
Overcosting Example
Jose, Roberta, and Nancy order

separate items for lunch.
Jose’s order amounts to $14
Roberta consumed 30
Nancy’s order is 16
Total $60
What is the average cost per lunch?
Undercosting and
Overcosting Example
$60 ÷ 3 = $20
Jose and Nancy Roberta is

are overcosted. undercosted.
Present three guidelines for

refining a costing system.
Existing Single Indirect-
Cost Pool System Example
Kole Corporation manufactures a normal lens

(NL) and a complex lens (CL).
Kole currently uses a single indirect-cost rate
job costing system.
Cost objects: 80,000 (NL) and 20,000 (CL).
Normal Lenses (NL)

Direct materials $1,520,000
Direct mfg. labor 800,000
Total direct costs $2,320,000
Direct cost per unit: $2,320,000 ÷ 80,000 = $29
Complex Lenses (CL)

Direct materials $ 920,000
Direct mfg. labor 260,000
Direct cost per unit: $1,180,000 ÷ 20,000 = $59
INDIRECT-COST All
AllIndirect
IndirectCosts
Costs
POLL $2,900,000
$2,900,000
INDIRECT 50,000
50,000Direct
Direct
COST-ALLOCATION Manufacturing
Manufacturing
BASE Labor-Hours
Labor-Hours
$58 per Direct

Manufacturing
Labor-Hour
COST OBJECT: Indirect

IndirectCosts
Costs
NL AND CL
LENSES Direct
DirectCosts
Costs
DIRECT
COSTS
Direct
Direct
Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 10

Kole uses 36,000 direct manufacturing

labor-hours to make NL and 14,000 direct
manufacturing labor-hours to make CL.
How much indirect costs are allocated
to each product?

NL: 36,000 × $58 = $2,088,000
CL: 14,000 × $58 = $812,000
What is the total cost of normal lenses?
Direct costs $2,320,000 +
Allocated costs $2,088,000 = $4,408,000
What is the cost per unit?
$4,408,000 ÷ 80,000 = $55.10
What is the total cost of complex lenses?

Direct costs $1,180,000 + Allocated costs
$812,000 = $1,992,000
What is the cost per unit?
$1,992,000 ÷ 20,000 = $99.60

Normal lenses sell for $60 each and

complex lenses for $142 each.
Normal Complex
Revenue $60.00 $142.00
Cost 55.10 99.60
Income $ 4.90 $ 42.40
Margin 8.2% 29.9%

Refining a Costing System
Direct-cost tracing
Indirect-cost pools
Cost-allocation basis

1. Design of Products and Process

The Design Department designs the molds
and defines processes needed (details of
the manufacturing operations).

2. Manufacturing Operations
Lenses are molded, finished,
cleaned, and inspected.
3. Shipping and Distribution
Finished lenses are packed and
sent to the various customers.

Distinguish between the

traditional and the
activity-based costing
approaches to designing
a costing system.
Activity-Based Costing System
Fundamental Assignment to Other
Cost Objects Cost Objects
Activities Cost of:
• Product
• Service
Costs of Activities • Customer

A cross-functional team at Kole

Corporation identified key activities:
Design products and processes.
Set up molding machine.
Operate machines to manufacture lenses.
Maintain and clean the molds.

Set up batches of finished lenses for shipment.

Distribute lenses to customers.
Administer and manage all processes.

Activity
Indirect Cost Design Setup Shipping
Pool
Cost Parts- No. of

Allocation Square Setup No. of
feet Hours Shipments
Base
Product Lenses Lenses Lenses

Cost
Objects NL CL Other

NL CL
Quantity produced 80,000 20,000
No. produced/batch 250 50
Number of batches 320 400
Setup time per batch 2 hours 5 hours
Total setup-hours 640 2,000
Total setup costs are $409,200.

What is the setup cost per setup-hour?

$409,200 ÷ 2,640 hours = $155
What is the setup cost per
direct manufacturing labor-hour?
$409,200 ÷ 50,000 = $8.184

Allocation using direct labor-hours:
NL: $8.184 × 36,000 = $294,624
CL: $8.184 × 14,000 = $114,576
Total $409,200
Allocation using setup-hours:
NL: $155 × 640 = $ 99,200
CL: $155 × 2,000 = $310,000
Total $409,200
Describe a four-part
cost hierarchy.

Cost Hierarchies
A cost hierarchy is a categorization

of costs into different cost pools.
Cost drivers bases (cost-allocation bases)
Degrees of difficulty in determining
cause-and-effect relationships

Cost Hierarchies
ABC systems commonly use a
four-part cost hierarchy to
identify cost-allocation bases:
1. Output unit-level costs
2. Batch-level costs
3. Product-sustaining costs
4. Facility-sustaining costs
Output Unit-Level Costs
These are resources sacrificed

on activities performed on each
individual unit of product or service.
Energy
Machine depreciation
Repairs

Batch-Level Costs
These are resources sacrificed on

activities that are related to a group
of units of product(s) or service(s)
rather than to each individual unit
of product or service.
Setup-hours
Procurement costs
Product-Sustaining Costs
These are often called service-sustaining

costs and are resources sacrificed on
activities undertaken to support
individual products or services.
Design costs
Engineering costs

Facility-Sustaining Costs
These are resources sacrificed on

activities that cannot be traced to
individual products or services but
support the organization as a whole.
General administration
– rent – building security

Cost products or services using

activity-based costing.

Implementing
Activity-Based Costing
Step 1 Step 2
Identify cost objects. Identify the direct costs
of the products.
NL Direct material
CL Direct labor
Mold cleaning and
maintenance
Implementing
Cleaning and maintenance costs of

$360,000 are direct batch-level costs.
Why?
Because these costs consist of workers’
wages for cleaning molds after each
batch of lenses is run.

Implementing
Normal Lenses (NL)

Cost Hierarchy
Description Category
Direct materials Unit-level $1,520,000
Direct mfg. labor Unit-level 800,000
Cleaning and maint. Batch-level 160,000

Implementing
Complex Lenses (CL)

Cost Hierarchy
Description Category
Direct materials Unit-level $ 920,000
Direct mfg. labor Unit-level 260,000
Cleaning and maint. Batch-level 200,000

Implementing
Step 3
Select the cost-allocation bases to use for
allocating indirect costs to the products.
(1) (2) (3)
Activity Cost Hierarchy Total Costs
Design Product-sustaining $450,000
Setups Batch-level $409,200
Operations Unit-level $637,500
Implementing
Step 4
Identify the indirect costs associated
with each cost-allocation base.
Overhead costs incurred are assigned
to activities, to the extent possible, on
the basis of a cause-and-effect relationship.

Implementing
Step 5
Compute the rate per unit.
(1) (5)
NL CL Total
Setup-hours: 640 2,000 2,640
$409,200 ÷ 2,640 = $155

Implementing
Step 6
Compute the indirect costs allocated
to the products.
NL: $155 × 640 = $ 99,200
CL: $155 × 2,000 = 310,000
Total $409,200

Implementing
Step 7
Compute the costs of the products.
NL and CL would show three
direct cost categories.
1. Direct materials
2. Direct manufacturing labor
3. Cleaning and maintenance
Implementing
NL and CL would show six indirect cost pools.
1. Design
2. Molding machine setups
3. Manufacturing operations
4. Shipment setup
5. Distribution
6. Administration
Use activity-based
costing systems for
activity-based management.

Activity-Based Management
ABM describes management decisions that use

activity-based costing information to satisfy
customers and improve profits.
Product pricing and mix decisions
Cost reduction and process improvement decisions
Design decisions

Product Pricing and
Mix Decisions
ABC gives management insight into the cost

structures for making and selling diverse products.
It provides more accurate product cost
information and more detailed information
on costs of activities and the drivers of those costs.

Cost Reduction and Process
Improvement Decisions
Manufacturing and distribution personnel use

ABC systems to focus on cost-reduction efforts.
Managers set cost-reduction targets in terms of
reducing the cost per unit of the cost-allocation base.

Design Decisions
Management can identify and evaluate new designs

to improve performance by evaluating how product
and process designs affect activities and costs.
Companies can work with their customers to
evaluate the costs and prices of alternative designs.

Compare activity-based costing

systems and department-
costing systems.

ABC and Department
Indirect-Cost Rates
Many companies have evolved their

costing system from using a single
cost pool to using separate indirect-cost
rates for each department:
Design
Manufacturing
Distribution
ABC and Department
Indirect-Cost Rates
Why?
Because the cost drivers of resources in each
department or subdepartment differ from the
single, company-wide, cost-allocation base.
ABC systems are a further refinement of
department costing systems.

Evaluate the costs and benefits

of implementing activity-based
costing systems.

Benefits of ABC Systems
Significant amounts of indirect costs are
allocated using only one or two cost pools.
All or most costs are identified
as output unit-level costs.
Products make diverse demands on
resources because of differences in
volume, process steps, batch size,
or complexity.
Products that a company is well-suited to

make and sell show small profits while
products for which a company is less
suited show large profits.
Complex products appear to be very
profitable and simple products
appear to be losing money.
Operations staff have significant

disagreements with the accounting
staff about the costs of manufacturing
and marketing products and services.

Limitations of ABC Systems
The main limitations of ABC are the

measurements necessary to
implement the system.
ABC systems require management
to estimate costs of activity pools
and to identify and measure cost
drivers for these pools.
Limitations of ABC Systems
Activity-cost rates also need to be

updated regularly.
Very detailed ABC systems are costly
to operate and difficult to understand.

ABC In Service and
Merchandising Companies
The general approach to ABC in the

service and merchandising areas is very
similar to the approach in manufacturing.
Costs are divided into homogeneous cost
pools and classified as output unit-level,
batch-level, product- or service-sustaining,
and facility-sustaining costs.
ABC In Service and
Merchandising Companies
The cost pools correspond to key activities.

Costs are allocated to products or customers
using activity drivers or cost-allocation
bases that have a cause-and-effect
relationship with the cost in the cost pool.

End of Chapter 5

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Activity-Based Costing and

Jose, Roberta, and Nancy order

Jose and Nancy Roberta is

Present three guidelines for

Kole Corporation manufactures a normal lens

Normal Lenses (NL)

Complex Lenses (CL)

$58 per Direct

COST OBJECT: Indirect

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 10

Kole uses 36,000 direct manufacturing

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 11

What is the total cost of complex lenses?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 13

Normal lenses sell for $60 each and

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 14

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 15

1. Design of Products and Process

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 16

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 17

Distinguish between the

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 19

A cross-functional team at Kole

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 20

Set up batches of finished lenses for shipment.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 21

Cost Parts- No. of

Product Lenses Lenses Lenses

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 22

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 23

What is the setup cost per setup-hour?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 24

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 26

A cost hierarchy is a categorization

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 27

These are resources sacrificed

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 29

These are resources sacrificed on

These are often called service-sustaining

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 31

These are resources sacrificed on

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 32

Cost products or services using

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 33

Cleaning and maintenance costs of

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 35

Normal Lenses (NL)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 36

Complex Lenses (CL)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 37

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 39

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 40

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 41

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 44

ABM describes management decisions that use

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 45

ABC gives management insight into the cost

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5 - 46

Manufacturing and distribution personnel use