Chapter 4 Notes Activity-Based Costing Systems Learning Objectives -- This chapter has eight learning objectives. 1. Describe how traditional costing could lead to undercosting or overcosting products. 2. Discuss the four ways used in activity-based costing system. 3. Identify the different level of resources and activities used in production processes. 4. Estimate the cost of activities and calculate a cost driver rate. 5. Assign activity costs to goods and services. 6. Analyze the profitability of products and customers. 7. Apply activity-based costing to service and merchandising. 8. Distinguish between activity-based costing, unit level costing, and ABC full costing of goods and services. <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 1 A. Activity-based costing (ABC) is a costing system __________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ 1. Production processes include ____________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 2 2. Business processes are _________________________ ____________________________________________ ____________________________________________ ____________________________________________ 3. ABC is applicable to all types of organizations -- manufacturing, merchandising, and service organizations. B. Different processes in an organization use resources differently. 1. Processes use ________________________________ ____________________________________________ a. Physical resources include ____________________ __________________________________________ b. Human resources refer to __________________ __________________________________________ __________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 3 C. An activity-based costing system _____________ __________________________________________ __________________________________________ __________________________________________ 2. By using the ABC framework, ____________________ ____________________________________________ ____________________________________________ ____________________________________________ a. What _____________________________________ __________________________________________ b. Does ______________________________________ __________________________________________ c. Does ___________________________________ __________________________________________ _________________________________________________________ ___________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 4 d. If ______________________________________ ________________________________________ ________________________________________ C. One very useful way to assess the need for resources and evaluate the use of resources _________________________ _________________________________________________ 1. Unit-level resources ____________________________ _____________________________________________ _____________________________________________ _____________________________________________ 2. Batch-level resources ___________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 5 _____________________________________________ _____________________________________________ 3. Product-level resources _________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ 4. Customer-level resources _______________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 6 5. Facility-level resources _________________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ Traditional cost systems use a volume-based approach to overhead cost allocation. As a result, __________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ D. Cost drivers can be either ____________________________ _________________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 7 1. Structural cost drivers determine (or drive) _________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ 2. Executional cost drivers determine ________________ _____________________________________________ _____________________________________________ _____________________________________________ E. Activities related to each of the five types of resources are described next. One note about these activities -- ________ _________________________________________________ _________________________________________________ _________________________________________________ 1. Unit-level activities are those activities _____________ ____________________________________________________________ ______________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 8 _____________________________________________ _____________________________________________ 2. Batch-level activities ___________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ 3. Product-level activities occur _____________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 9 4. Customer-level activities are performed ____________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ 5. Facility-level activities support ____________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 10 _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ F. Tracing resources to activities can be split into two stages. Stage 1 consists of _____________________________ _____________________________________________ Stage 2 consists of _____________________________ _____________________________________________ Stage 1 can be divided into four steps. (1) _______________________________________________ (2) _______________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 11 (3) _______________________________________________ _________________________________________________ (4) _______________________________________________ 1. Identify and classify activities. ____________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ a. A &quot;top-down&quot; approach relies _______________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 12 B. The &quot;interview or participative&quot; approach includes _________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 13 C. The &quot;recycling&quot; approach requires ____________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ Regardless of the approach used, the objective is to develop a list of the activities completed to achieve the goal (in this instance, making product or providing services). The next step after developing the list is to classify the list according to the activity level. Thus, each activity must be classified as unit, batch, product, customer, or facility-level. Use of resources must be <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 14 planned and organized in a way that maximizes the efficiency of operations. 2. Select cost-driver bases. Consumption of resources generates costs. A cost-driver is __________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ ____________________________________________ A. Inappropriate cost-drivers __________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 15 ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ B. Assignment of unit-level costs _______________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 16 ________________________________________ 3. Measure costs of activities. In order to properly assign costs generated by an activity, ___________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ 4. Trace resource costs to activities. a. A method must be developed _______________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 17 ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ B. Summing up costs of the activities should be the next step in the process of developing activity-based rates. ______________________________ ________________________________________ ________________________________________ ________________________________________ C. Unutilized cost of capacity __________________ ________________________________________ ________________________________________ ________________________________________ G. The second stage in the process of assigning costs is to use the activity list and activity classifications obtained in <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 18 Stage 1 to develop cost-driver rates. As was the case with Stage 1, this stage can be broken into several steps. (1) ______________________________________________ _________________________________________________ _________________________________________________ (2) ______________________________________________ _________________________________________________ (3) ______________________________________________ _________________________________________________ (4) ______________________________________________ _________________________________________________ Using this activity-based approach results in cost assignments that reflects the true costs of products. This is in contrast to more traditional costing approaches that apply costs more generically to various products. 1. Condense the activity list developed in Stage 1. ______ _____________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 19 _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ 2. Choose appropriate cost-driver bases to use in assigning costs of the condensed activities. _________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 20 3. Identify the costs of the resources used for activities identified in the condensed list. ___________________ _____________________________________________ _____________________________________________ _____________________________________________ 4. Compute a rate for each cost-driver base identified. _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ H. Tracing costs of activities to products and services. Once the cost-driver rates are developed, costs can be assigned to products and services. Before costs can be assigned, ______ _________________________________________________ _________________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 21 _________________________________________________ 1. The unit-level ABC approach assigns costs using _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 22 2. The full cost ABC approach shows _________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ 3. The unit-level ABC costing approach differs from the full ABC costing approach in one critical way. ________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 23 4. Both unit-level cost information and full-costing information are useful to managers but for different reasons. A. Unit-level costing shows managers ___________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ B. Full costing information shows how an organization _____________________________ ________________________________________ ________________________________________ ________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 24 ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ ________________________________________ I. Product and customer profitability analyses are important because __________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ _________________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 25 1. Product profitability requires analysis of only those costs ________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ Looking at the product costs individually also allows managers to focus on the other, higher-level costs as a separate cost management issue. <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 26 2. Customer profitability analysis provides similar benefits. Customer costing occurs _________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ 3. ABC is a useful tool for estimating the costs of new products. _______________________________________ _______________________________________________ _______________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 27 _______________________________________________ _______________________________________________ <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 28 Chapter 4 Problem 1 Customer profitability Arman Printing has two types of customers; those with large orders and those with small orders. Arman has determined that marketing cost amounts to approximately $36,000. This amount is currently allocated based on sales volume. Sales to small customers amounted to $80,000 and those to large customers has amounted to $120,000. Cost of sales is approximately 60% of net sales. A total of 200 orders were placed last year for a total ordering cost of $8,000. Only 30 of these orders were for the large orders. Billing costs around $9,000 for the period for 300 invoices issued. 240 of invoices were for small-order customers. Warehousing cost amounted to $4,000. The warehouse handled 4,000 packages - about of which was for small-order customers. The balance of the marketing cost was for use of company vehicles. The drivers report that 2/3 of the cost and distance traveled has been for servicing small customers. Required: Determine a) profit or loss by customer type under the traditional method, b) profit or loss using ABC costing. <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 29 Solution to Problem 1: a) Income Statement under traditional costing Small C Sales Cost of sales Gross profit Marketing costs Income b) Large C Total Income Statement - Using ABC Costing Small C Sales Cost of sales Gross profit Marketing costs: Ordering # Ordering $ Billing Billing # $ Large C Total Warehousing # Warehousing $ Shipping Shipping # $ Total marketing Operating income <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 30 Problem 2 Traditional Costing Shortcomings Saba Signs produces approximately one thousand signs each period. The signs which vary in size and intricacies are sold anywhere between 10 to $325 for each piece. The overhead is estimated to amount to $160,000 assuming a direct labor cost of $80,000, and a total of 4,000 machine hours. Here is some general data on the signs make up for this period: Item Number of DL $ per signs job Small signs 6,000 $5 Mach. Hrs. per job 1/4th of an hour of an hour Material cost $6 Medium 4,000 $8 $10 size Large size 2,000 $12 One hour $25 Required: Determine a) the predetermined overhead rate based on direct labor cost, b) cost per job using budgeted overhead and direct labor cost for allocation purposes, c) determine cost for each job, and d) total cost for each category of products using normal costing. Solution to problem 2: a) Predetermined overhead rate based on DL $: $160,000 / $80,000 = $2 per direct labor dollar Item Small size Medium size Large size Total DM $ 6.00 $ 10.00 $ 25.00 DL $ 5.00 $ 8.00 $ 12.00 OH $ 10.00 $ 16.00 $ 24.00 TOTAL $ 21.00 $ 34.00 $ 61.00 QTY 6,000 4,000 2,000 $ $ $ $ AMOUNT 126,000.00 136,000.00 122,000.00 384,000.00 <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 31 Problem 3: LO: 1 Repeat problem 2 using machine hours as the allocation base. Solution to problem 3: a) Predetermined overhead rate based on machine hours: $160,000 / 4,000 = $40 Machine time needed: hour, hour, one hour for the sizes below respectively: Item Small size Medium size Large size Total DM $ 6.00 $ 10.00 $ 25.00 DL $ 5.00 $ 8.00 $ 12.00 OH $ 10.00 $ 20.00 $ 40.00 TOTAL $ 21.00 $ 38.00 $ 77.00 QTY 6,000 4,000 2,000 $ $ $ $ AMOUNT 126,000.00 152,000.00 154,000.00 432,000.00 <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 32 Problem 4: LO: 1 Repeat problem 2 assuming that 50% of overhead costs are related to direct labor and the balance are related to machine hours. Solution to problem 4: a) Predetermined overhead rates: Labor-related overhead: (160,000/2)/80,000 = $1 per labor dollar Machine related overhead: (160,000/2)/4,000 = $20 per machine hour Item Small size Medium size Large size Total DM $ 6.00 $ 10.00 $ 25.00 DL $ 5.00 $ 8.00 $ 12.00 L. OH $ 5.00 $ 8.00 $ 12.00 M. OH $ 5.00 $ 10.00 $ 20.00 TOTAL $ 21.00 $ 36.00 $ 69.00 QTY 6,000 4,000 2,000 AMOUNT $ 126,000.00 $ 144,000.00 $ 138,000.00 $ 408,000.00 <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 33 Problem 5: LO: 2 Repeat problem 2 assuming that 20% of overhead costs are batch related, and there were 60 batches for small and midsize, and 40 batches for the large size group. The balance of overhead is to be equally divided between labor-related and machine-related costs. Comment on the disparity in costs that you see between problems 2, 3, 4, and 5. Solution to problem 5: a) Predetermined overhead rates: Labor-related overhead: (160,000 * .40)/80,000 = .80 Machine-related overhead: (160,000 * .40)/4,000= 18 Batch-level related overhead (160,000 * .20)/160 = 200 Item DM Small size $ 6.00 Medium size $ 10.00 Large size $ 25.00 Total DL $ 5.00 $ 8.00 $ 12.00 L. OH $ 4.00 $ 6.40 $ 9.60 M. OH $ 4.50 $ 9.00 $ 18.00 B. OH $ 2.00 $ 3.00 $ 4.00 TOTAL $ 19.50 $ 33.40 $ 64.60 QTY 6,000 4,000 2,000 AMOUNT $ 117,000.00 $ 133,600.00 $ 129,200.00 $ 379,800.00 Using different allocation bases provides different results. It is important to find the association between the costs and cost drivers to be able to arrive at the most accurate costs. Particularly in a competitive environment where margins are low, having a better handle on costs and margins is important for future viability of the firm. <a href="/keyword/cost-accounting/" >cost accounting</a> - Chapter 4 Notes Page 34