McGraw-Hill/Irwin

5-1
Activity-Based Costing
and Cost Management
Systems
Chapter Five
McGraw-Hill/Irwin
5-2
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 of 10,000 4 of 5,000 10 of 400
McGraw-Hill/Irwin
5-3
Traditional, Volume-Based
Product-Costing System
Additional information includes:
Mode I Mode II Mode III
Dire ct mate rials 50.00 $ 90.00 $ 20.00 $
Dire ct labor (hr/board) 3 4 2
Se tup time (hr/run) 10 10 10
Machine time (hr/board) 1 1.25 2
Mode I Mode II Mode III
Dire ct mate rials 50.00 $ 90.00 $ 20.00 $
Dire ct labor 60.00 80.00 40.00
Manufacturing ove rhe ad 99.00 132.00 66.00
Total 209.00 $ 302.00 $ 126.00 $
Manufacturing overhead is determined as follows
McGraw-Hill/Irwin
5-4
Traditional, Volume-Based
Product-Costing System
Mode I Mode II Mode III
Units produce d 10,000 20,000 4,000
Dire ct labor (hr/unit) 3 4 2
Total hours 30,000 80,000 8,000
Total hours re quire d 118,000
Budgeted manufacturing overhead $3,894,000
Budgeted direct-labor hours 118,000
= $33 per hour
Mode I Mode II Mode III
Dire ct labor (hr/unit) 3 4 2
Ove rhe ad rate pe r hour 33 $ 33 $ 33 $
Ove rhe ad pe r unit 99 $ 132 $ 66 $
McGraw-Hill/Irwin
5-5
Traditional, Volume-Based
Product-Costing System
With these product costs, Aerotech established
target selling prices (Cost 125%).
Mode I Mode II Mode III
Dire ct mate rials 50.00 $ 90.00 $ 20.00 $
Dire ct labor 60.00 80.00 40.00
Manufacturing ove rhe ad 99.00 132.00 66.00
Total 209.00 $ 302.00 $ 126.00 $
Mode I Mode II Mode III
Cos t pe r unit 209.00 $ 302.00 $ 126.00 $
Targe t s e lling price 261.25 377.50 157.50
209.00 x 1.25
McGraw-Hill/Irwin
5-6
Traditional, Volume-Based
Product-Costing System
Aerotech wishes to see what target selling
prices would be suggested when using
activity-based costing.
Lets see how ABC works.
McGraw-Hill/Irwin
5-7
Activity Based Costing System
(ABC)
ABC systems follow
a two-stage
procedure to
assign overhead
costs to products.
Assigning
overhead to
products is a
difficult process.
I agree!
McGraw-Hill/Irwin
5-8
Activity Based Costing System
(ABC)
ABC systems follow
a two-stage
procedure to
assign overhead
costs to products.
Lets begin
by identifying
our major
activities.
Stage One
Identify significant
activities and assign overhead
costs to each activity in
proportion to resources used.
McGraw-Hill/Irwin
5-9
Activity Based Costing System
(ABC)
ABC systems follow
a two-stage
procedure to
assign overhead
costs to products.
Overhead assigned to
activities are called
activity cost pools.
Stage Two
Identify cost drivers
appropriate to each activity
and allocate overhead to
the products.
McGraw-Hill/Irwin
5-10
Overhead Costs
Total budgeted cost = $3,894,000

Activity
Cost
Pools
Machinery
cost pool
$1,212,600
Setup
cost pool
$3,000
Engineering
cost pool
$700,000
Facility
cost pool
$507,400
Unit
Level
Batch
Level
Product-
Sustaining
Level
Facility
Level
Identification
of Activity
Cost Pools
Activity
must be
done on
each unit
produced.
Activity
performed
on each
batch
produced.
Activities needed to support
an entire product line
Activity required in order
for the production
process to occur.
McGraw-Hill/Irwin
5-11
Overhead Costs
Total budgeted cost = $3,894,000

Activity
Cost
Pools
Machinery
cost pool
$1,212,600
Setup
cost pool
$3,000
Engineering
cost pool
$700,000
Facility
cost pool
$507,400

More
Cost
Pools
Unit
Level
Batch
Level
Product-
Sustaining
Level
Facility
Level
Identification
of Activity
Cost Pools
McGraw-Hill/Irwin
5-12
Receiving/Inspection
cost pool $200,000
Material-Handling
cost pool $600,000
Quality-Assurance
cost pool $421,000
Packaging/Shipping
cost pool $250,000
Machinery
cost pool
$1,212,600
Setup
cost pool
$3,000
Engineering
cost pool
$700,000
Facility
cost pool
$507,400
Unit
Level
Batch
Level
Product-
Sustaining
Level
Facility
Level
McGraw-Hill/Irwin
5-13
Various overhead
costs related
to machinery
Maintenance
Depreciation
Computer Support
Lubrication
Electricity
Calibration
Machinery Cost Pool
Total budgeted cost = $1,212,600
Activity
cost
pool
STAGE ONE
McGraw-Hill/Irwin
5-14
Calculate
the pool
rate
Budgeted Machinery Costs $1,212,600
Budgeted Machine Hours 43,000
$28.20/hour
Cost
Assignment
STAGE TWO
=
=
Mode I:
$28.20 per hr.
1 hr. per unit
$28.20 per unit
Mode II:
$28.20 per hr.
1.25 hr. per unit
$35.25 per unit
Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit
McGraw-Hill/Irwin
5-15
Calculation of
total setup cost
Setup Cost Pool
Total budgeted cost = $3,000
Activity
cost
pool
STAGE ONE
Total budgeted setup cost
$20 per hour
10 hr. per setup
$200 cost per setup
15 production runs
3,000 $ Total
McGraw-Hill/Irwin
5-16
Calculate
the pool
rate
Budgeted Setup Costs $3,000
Planned Production Runs 15 runs
$200 per run
Cost
Assignment
STAGE TWO
=
=
Mode I: (1 Run)
= $.02 per unit
$200 per run
10,000 units per run
Mode II: (4 Runs)
= $.04 per unit
$200 per run
5,000 units per run
Mode III: (10 Runs)
= $.50 per unit
$200 per run
400 units per run
McGraw-Hill/Irwin
5-17
Various overhead
costs related
to engineering
Engineering salaries
Engineering supplies
Engineering software
Depreciation
Engineering Cost Pool
Total budgeted cost = $700,000
Activity
cost
pool
STAGE ONE
McGraw-Hill/Irwin
5-18
Allocate based
on engineering
transactions
Cost
Assignment
STAGE TWO
Engineering Cost Pool
Total budgeted cost = $700,000
Mode I:
= $17.50 per unit
25% $700,000
10,000 units
Mode II:
= $15.75 per unit
45% $700,000
20,000 units
Mode III:
= $52.50 per unit
30% $700,000
4,000 units
McGraw-Hill/Irwin
5-19
Various overhead
costs related
to general
operations
Plant depr.
Plant mgmt.
Plant maint.
Property taxes
Insurance
Security
Facility Cost Pool
Total budgeted cost = $507,400
Activity
cost
pool
STAGE ONE
McGraw-Hill/Irwin
5-20
Calculate
the pool
rate
Budgeted Facilities Cost $507,400
Budgeted Direct-Labor Hours 118,000
$4.30/hour
Cost
Assignment
STAGE TWO
=
=
Mode I:
$4.30 per hr.
3 hr. per unit
$12.90 per unit
Mode II:
$4.30 per hr.
4 hr. per unit
$17.20 per unit
Mode III:
$4.30 per hr.
2 hr. per unit
$8.60 per unit
McGraw-Hill/Irwin
5-21
Product Cost from 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
Here are the new product costs so far . . .
McGraw-Hill/Irwin
5-22
Other Overhead Costs
Board Ove rhe ad % Units = Cos t/Unit
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
Receiving and Inspect ion Cost Pool
Board Ove rhe ad % Units = Cos t/Unit
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
Mat erial-Handling Cost Pool
Board Ove rhe ad % Units = Cos t/Unit
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
Qualit y-Assurance Cost Pool
Board Ove rhe ad % Units = Cos t/Unit
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
Packaging and Shipping Cost Pool
McGraw-Hill/Irwin
5-23
Board Ove rhe ad % Units = Cos t/Unit
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
Packaging and Shipping Cost Pool
Board Ove rhe ad % Units = Cos t/Unit
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
Qualit y-Assurance Cost Pool
Other Overhead Costs
Board Ove rhe ad % Units = Cos t/Unit
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
Receiving and Inspect ion Cost Pool
Board Ove rhe ad % Units = Cos t/Unit
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
Mat erial-Handling Cost Pool
$14.82
McGraw-Hill/Irwin
5-24
Product Cost from 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 $
These are the new product costs when
Aerotech uses ABC.
McGraw-Hill/Irwin
5-25
Product Diversity
Both original and ABC target selling prices are
based on (Cost 125%).
Mode I Mode II Mode III
Traditional cos ting 209.00 $ 302.00 $ 126.00 $
ABC cos ting 183.44 261.81 390.85
Original targe t s e lling price 261.25 377.50 157.50
ABC targe t s e lling price 229.30 327.26 488.56
[$209.00 1.25] [$183.44 1.25]
The selling price of Mode I and II are reduced
and the selling price for Mode III is increased.
McGraw-Hill/Irwin
5-26
Product Diversity
Can you identify any problems Aerotech is likely to
face as a result of this distortion?
Mode I Mode II Mode III
Traditional cos ting 209.00 $ 302.00 $ 126.00 $
ABC cos ting 183.44 261.81 390.85
Cos t dis tortion pe r unit 25.56 40.19 (264.85)
Units produce 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.
McGraw-Hill/Irwin
5-27
ABC: Some Key Issues
The Past
Small number of
products which did
not differ much in
required
manufacturing
support.
Labor was the
dominant element in
the cost structure.
The Present
Numerous products
with more and
complicated
production
requirements.
Labor is becoming an
ever smaller part
component of total
production costs.
McGraw-Hill/Irwin
5-28
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
Correlation
Cost of
Measurement
Behavioral
Effects
McGraw-Hill/Irwin
5-29
Homogeneous Activity Cost Pools
A homogeneous cost pool is a grouping of
overhead costs in which each cost component is
consumed in roughly the same proportion by
each product line.
A homogeneous cost pool
uses a single cost driver.
McGraw-Hill/Irwin
5-30
Transaction Costing
Activities
Paperwork
Usually
Result In
Transaction
processing
provides a
readily
measurable
gauge of
departmental
activity.
McGraw-Hill/Irwin
5-31
Storyboarding
A procedure used to develop a detailed
process flow chart, which visually
represents activities and the relationships
among activities.
Step
1
Step
2
Step
3
Step
4
These are the steps we
follow to build a
memory board.
McGraw-Hill/Irwin
5-32
Direct versus Indirect Costs
Volume-Based Costing
All production costs
except direct materials
and direct labor are
lumped together in
one overhead cost
pool.
Activity-Based Costing
An effort is made to
account for as many
costs as possible as
direct costs of
production.

Indirect
Costs
McGraw-Hill/Irwin
5-33
Indicators of Need for ABC
Line managers do not
believe the product
costs reports
Marketing does not
use costs reports for
pricing decisions
Product-line profit
margins are hard
to explain
Sales are increasing,
but profits are declining.
Some products that
have reported high
profit margins are not
sold by competitors
Direct labor is a
small percentage
of total costs
McGraw-Hill/Irwin
5-34
Optimal Product-Costing System
High
High
Low
Low
Cost
Information
System
Accuracy
Optimal
system
Total Cost
Design, implementation
and maintenance costs
Cost of
inferior
decisions
resulting
from
inaccurate
information.
McGraw-Hill/Irwin
5-35
Cost Management Systems

Measure the cost of resources consumed.
Identify and eliminate non-value-added costs.
Determine the efficiency and effectiveness of
all major activities.
Identify and evaluate new activities that can
improve future performance.
Objectives
McGraw-Hill/Irwin
5-36
Non-Value-Added Costs
Suppose our production process looks like this:
Storage
Time
Waiting
Time
Process
Time
Move
Time
Inspection
Time
VA NVA NVA NVA NVA
VA = Valued-added activity
NVA = Non-value-added activity
McGraw-Hill/Irwin
5-37
Non-Value-Added Costs
VA = Valued-added activity
NVA = Non-value-added activity
Our goal is to reduce or eliminate the non-value-added activities.
Storage
Time
Waiting
Time
Process
Time
Move
Time
Inspection
Time
VA NVA NVA NVA NVA
McGraw-Hill/Irwin
5-38
ABC in the Service Industry
Implementation
Problems
High proportion of
facility-level costs
Activities tend to
be nonrepetitive
human tasks.
McGraw-Hill/Irwin
5-39
End of Chapter 5
This is
real value-added
time!