AGENDA

Difference between ABC and Traditional

AF3112 Costing Approach
MANAGEMENT ACCOUNTING 2 Design and Implementation of ABC Costing
System
Activity-Based Costing Limitations of ABC

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Activity Based Costing (ABC) Traditional Costing Systems

vs. ABC
The objective of ABC is a
Traditional cost systems were created
activity-based costing good supplement
is to understand to our traditional
cost system
when manufacturing processes were
overhead and the I agree!
profitability of labor intensive.
products and A single company-wide overhead rate
customers.
based on, say direct labor hours may be
used to allocate overhead to products in
these labor intensive processes.

3 4
Traditional Costing Systems Traditional Costing Systems
vs. ABC (cont’d) vs. ABC (cont’d)
Job1 Job2 Now, the company introduces automated
Labor Hours 2 6 machinery. Total overhead rises from $120 to
OH allocation $420, while the labor time needed for Job2 falls
Overhead will be allocated to jobs using direct labor from 6 hours to 1 hour. Now allocate the $420
hours. If total overhead is $120, how much will be OH to the two jobs.
allocated to each job? Job1 Job2
Labor Hours 2 1
Job1 Job2 OH allocation 280 140
Labor Hours 2 6
OH allocation $30 $90
Do you see the problem with traditional
Why? 5
costing system? 6

Traditional Costing Systems How Costs are Treated Under

vs. ABC (cont’d) Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
The automation process benefits only
Job2. But most of the additional
Manufacturing Nonmanufacturing
overhead cost resulted from automation costs costs
was allocated to Job1.

Some
Mo
Clearly it is NOT a reasonable costing s t,
not but

All
a ll
method. We need look for another cost
Traditional ABC
driver. product costing product costing
ABC system makes it possible.
ΠABC assigns both types of costs to products.
 ABC does not assign all manufacturing costs to products.
7 8
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
ABC differs from traditional cost accounting in five ways.
1. ABC assigns both manufacturing and nonmanufacturing

Level of complexity
costs to products. Traditional cost systems assign only Ž ABC uses more cost
Activity–Based
manufacturing costs to products. However, ABC Costing pools.
systems can assign sales commissions, shipping costs, ABC cost pools are created to
Departmental
and warranty repair costs to specific products. correspond to the activities
Overhead performed in an organization that
2. ABC systems do not assign all manufacturing costs to Rates cause the consumption of
products, while traditional cost systems do assign all overhead resources. The total
Plantwide
manufacturing costs to products. ABC only assigns a number of ABC cost pools will
Overhead definitely exceed one and it is
cost to a product if decisions concerning that product Rate likely to exceed the number of
will cause changes in the cost. departments within a company
Number of cost pools since more than one activity is
often performed within each
department.
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How Costs are Treated Under

Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways. The most commonly used allocation base
in traditional costing is direct labor hours (or sometimes
Volume machine hours). Direct labor hours work well when
Allocation Bases

measures overhead increases as direct labor hours increase.

Bases usually plus other
Number of

rely solely on bases. Problems:

volume 1. In many processes, overhead is increasing while
measures. direct labor is decreasing.
2. Variety and complexity of products is increasing.

Solutions:
ABC uses volume as well as other allocation bases
Traditional Costing ABC (such as customer relation activities, customer order,
 ABC uses more allocation bases. lighting and heating etc.) not related to the volume of
11 production. 12
How Costs are Treated Under
Activity–Based Costing Designing an ABC System
“Best practice” ABC differs from traditional costing in five ways.

Traditional Costing ABC Cost Objects Activities

The predetermined Products are charged (e.g., products)
overhead rate is based for the costs of
on budgeted activity. capacity they use – not
This results in applying for the costs of Consumption
all overhead costs capacity they don’t use.
of Resources
including unused, or Unused capacity costs
idle capacity costs to are treated as period
products. expenses.
Cost
 ABC bases level of activity on capacity.
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ŒIdentify and Define Activities

Designing an ABC System and Activity Cost Pools

Steps for Implementing ABC

ΠIdentify and define activities and An Activity Cost Pool $$
activity cost pools. $
in the ABC system is a $ $
 Trace costs to activities and cost “bucket” in which costs $
objects. associated with a single
Ž Assign costs to activity cost pools. activity measure are
 Calculate activity rates. accumulated.
 Assign costs to cost objects.
‘ Prepare management reports.

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ŒIdentify and Define Activities
and Activity Cost Pools Cost / Activities Hierarchies
Unit-level costs
l Cost of activities performed on each individual unit of product/service
Unit-Level Cost Batch-Level Cost l E.g. machine operation costs (such as cost of energy consumed)
Batch-level costs
l Cost of activities related to a batch of units of a product/service
l E.g. machine setup costs ( such cost cannot be avoided by producing one less unit)
Cost Hierarchies Product-sustaining costs
Cost of activities undertaken to support individual products/services regardless of the
Categorize different cost pools based l
number of units/batches produced
on types of cost drivers. l E.g. product design costs, research and development expenses
Facility-sustaining costs
l Costs of activities that cannot be traced to individual products/services but that
support the organization as a whole
Product-sustaining Facility-sustaining l Difficult to find good cause-and-effect relationship to output, so some companies
Cost deduct the entire sum against operating income
Cost l E.g. top management compensation, security and janitorial costs

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ŒIdentify and Define Activities ŒIdentify and Define Activities

and Activity Cost Pools and Activity Cost Pools
At Classic Brass, the ABC team, selected the
Two types of activity measures: following activity cost pools and activity
measures:

Transaction Duration
driver driver

Simple count A measure

of the number of of the amount
times an activity of time needed
occurs. for an activity.

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ŒIdentify and Define Activities When Possible, Directly Trace Overhead
and Activity Cost Pools Costs to Activities and Cost Objects

Customer Orders - assigned all costs that are

consumed by taking and processing customer orders.
Product Designs - assigned all costs consumed by
designing products.
Order Size - assigned all costs consumed as a
consequence of the number of units produced.
Customer Relations – assigned all costs associated
with maintaining relations with customers.
Other – assigned all overhead costs that are not
associated with the other cost pools.

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ŽAssign Costs to Activity Cost ŽAssign Costs to Activity Cost

Pools Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined
(usually after interviewing the employees).

Indirect factory wages $500,000

Percent consumed by customer orders X 25%
$125,000
**Not included because they are directly traced to customer orders.
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ŽAssign Costs to Activity Cost ŽAssign Costs to Activity Cost
Pools Pools

Factory equipment depreciation $300,000

Percent consumed by customer orders X 20%
$ 60,000
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Calculate Activity Rates Calculate Activity Rates

The ABC team determines that Classic
Brass will have these total activities for
each activity cost pool . . .
l 1,000 customer orders,
l 200 new designs,

l 20,000 machine-hours,
l 100 customer relations activities.

Now the team can compute the individual

activity rates by dividing the total cost for
each activity by the total activity levels. 27 28
Activity-Based Costing at Classic Brass Activity-Based Costing at Classic Brass

Direct Direct Shipping Direct Direct Shipping

Overhead Costs Overhead Costs
Materials Labor Costs Materials Labor Costs

First-Stage Allocation

Traced Traced Traced

Order Customer Product Customer
Other
Size Orders Design Relations

Cost Objects: Cost Objects:

Products, Customer Orders, Customers Products, Customer Orders, Customers
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Activity-Based Costing at Classic Brass Assigning Costs to Cost Objects

Direct Direct Shipping Let’s take a look at how our system works
Overhead Costs
Materials Labor Costs for just one customer – Windward Yachts.
First-Stage Allocation Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours.
3. Selling price is $34 each.
Order Customer Product Customer
Other 4. Direct materials total $2,110.
Size Orders Design Relations
5. Direct labor totals $1,850.
6. Shipping costs total $180.
Second-Stage Allocations
Custom Compass Housing (requires new design)
$/MH $/Order $/Design $/Customer 1. One order during the year.
2. Each housing required 4 machine-hours.
3. Selling price is $650 each.
Cost Objects: 4. Direct materials total $13.
Unallocated
Products, Customer Orders, Customers 5. Direct labor totals $50.
31 6. Shipping costs total $25. 32
Assigning Costs to Cost Objects ‘Prepare Management Reports
Standard Stanchions
Sales $ 13,600
Cost:
Direct materials $ 2,110
Direct labor 1,850
Shipping costs 180
Customer orders 630
Product design -
Order size 3,800 8,570
Product margin $ 5,030
Custom Compass Housing
Sales $ 650
Cost:
Direct materials $ 13
Direct labor 50
Shipping costs 25
In this example, the customer-level cost is assigned to Customer orders 315
Product design 1,285
customers directly; it is not assigned to products.
Order size 76 1,764
33 Product margin $ (1,114)
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‘Prepare Management Reports Product Margins

Traditional Cost Accounting System
Customer Profitability Analysis

400 units x 0.5 MH/unit x $50/MH = $10,000

Predetermined manufacturing $1,000,000

= = $50/MH
overhead rate 20,000 MH
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Differences Between ABC and Differences Between ABC and Traditional
Traditional Product Costs Product Costs at Classic Brass
Reason 1 Reason 3
l Traditional: l Traditional:
l Assigns only manufacturing costs to products. l Assigns design costs to both products based on
l ABC machine hours.
l Assigns BOTH manufacturing and non-manufacturing l ABC
costs to products. l Assigns design costs to a product only if product
Reason 2 design work is required.
l Traditional Reason 4
l Assigns all manufacturing costs to products. l Traditional
l ABC l Assigns customer order costs (a batch-level cost),
l Not to assign all manufacturing costs to products, using a unit-level allocation base, i.e. machine hours.
such as facility-sustaining manufacturing costs (i.e. l ABC
factory building leasing) 37
l Assigns batch-level costs using a batch-level driver 38

Characteristics of Successful Activity-Based Costing and

ABC Implementations External Reporting
Most companies do not use ABC for external reporting
because . . .
1. External reports are less detailed than internal reports in
the sense that individual product costs are not reported.
External reports only disclose cost of goods sold and
Strong top
ending inventory.
management support
Link to evaluations 2. It may be difficult to make changes to the company’s
and rewards accounting system.
3. ABC does not conform to GAAP. It excludes some
organization-sustaining manufacturing costs and includes
some non-manufacturing costs in its product cost
calculations. These cost system design attributes don’t
Cross-functional comply with GAAP.
involvement
4. Auditors may be suspect of the subjective allocation
39 process based on interviews with employees. 40
The Non-GAAP Issue ABC Limitations

Substantial resources Resistance to

Product and Company required to implement unfamiliar numbers
For each Profitability and maintain. and reports.
product line
Total product revenue Desire to fully Potential
<Total product cost> allocate all costs misinterpretation of
Net product margin to products. unfamiliar numbers.
<Organizational/facility-level costs>
Company profit or loss Does not conform to
This is Not GAAP. Two costing
GAAP systems may be needed.
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End of Topic

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