Activity based costing treats organization sustaining costs as

Chapter 7 Activity-Based Costing: A Tool to Aid Decision Making

LEARNING OBJECTIVES

After studying Chapter 7 , you should be able to:

· LO1 Understand activity-based costing and how it differs from a traditional costing system.

· LO2 Assign costs to cost pools using a first-stage allocation.

· LO3 Compute activity rates for cost pools.

· LO4 Assign costs to a cost object using a second-stage allocation.

· LO5 Use activity-based costing to compute product and customer margins.

· LO6 ( Appendix 7A ) Prepare an action analysis report using activity-based costing data and interpret the report.

· LO7 ( Appendix 7B ) Use activity-based costing techniques to compute unit product costs for external reports.

BUSINESS FOCUS: Managing Product Complexity

Managers often understand that increasing the variety of raw material inputs used in their products increases costs. For example, General Mills studied its 50 varieties of Hamburger Helper and concluded that it could lower costs by discontinuing half of them without alienating customers.Seagate studied seven varieties of its computer hard drives and found that only 2% of their parts could be shared by more than one hard drive. The engineers fixed the problem by redesigning the hard drives so that they used more common component parts. Instead of using 61 types of screws to make the hard drives, the engineers reduced the number of screws needed to 19. Eventually all Seagate products were designed so that 75% of their component parts were shared with other product lines.

Activity-based costing systems quantify the increase in costs, such as procurement costs, material handling costs, and assembly costs that are caused by inefficient product designs and other factors. ▪

Sources: Mina Kimes, “Cereal Cost Cutters,” Fortune, November 10, 2008, p. 24; Erika Brown, “Drive Fast, Drive Hard,” Forbes, January 9, 2006, pp. 92–96.

This chapter introduces the concept of activity-based costing which has been embraced by a wide variety of organizations including Charles Schwab, Citigroup, Lowe's, Coca-Cola, Conco Food Service, Banta Foods, J&B Wholesale, Fairchild Semiconductor, Assan Aluminum, Sysco Foods,Fisher Scientific International, and Peregrine Outfitters. Activity-based costing (ABC) is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” as well as variable costs. Activity-based costing is ordinarily used as a supplement to, rather than as a replacement for, a company's usual costing system. Most organizations that use activity-based costing have two costing systems—the official costing system that is used for preparing external financial reports and the activity-based costing system that is used for internal decision making and for managing activities.

This chapter focuses primarily on ABC applications in manufacturing to provide a contrast with the material presented in earlier chapters. More specifically, Chapters 3 and 4 focused on traditional absorption costing systems used by manufacturing companies to calculate unit product costs for the purpose of valuing inventories and determining cost of goods sold for external financial reports. In contrast, this chapter explains how manufacturing companies can use activity-based costing rather than traditional methods to calculate unit product costs for the purposes of managing overhead and making decisions. Chapter 6 had a similar purpose. That chapter focused on how to use variable costing to aid decisions that do not affect fixed costs. This chapter extends that idea to show how activity-based costing can be used to aid decisions that potentially affect fixed costs as well as variable costs.

Activity-Based Costing: An Overview

LEARNING OBJECTIVE 1

Understand activity-based costing and how it differs from a traditional costing system.

As stated above, traditional absorption costing is designed to provide data for external financial reports. In contrast, activity-based costing is designed to be used for internal decision making. As a consequence, activity-based costing differs from traditional cost accounting in three ways. In activity-based costing:

· 1. Nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis.

· 2. Some manufacturing costs may be excluded from product costs.

· 3. Numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measure of activity.

Each of these departures from traditional cost accounting practice will be discussed in turn.

Nonmanufacturing Costs and Activity-Based Costing

In traditional cost accounting, only manufacturing costs are assigned to products. Selling and administrative expenses are treated as period expenses and are not assigned to products. However, many of these nonmanufacturing costs are also part of the costs of selling, distributing, and servicing specific products. For example, commissions paid to salespersons, shipping costs, and warranty repair costs can be easily traced to individual products. In this chapter, we will use the term overhead to refer to nonmanufacturing costs as well as to indirect manufacturing costs. In activity-based costing, products are assigned all of the overhead costs—nonmanufacturing as well as manufacturing—that they can reasonably be supposed to have caused. In essence, we will be determining the entire cost of a product rather than just its manufacturing cost. The focus in Chapters 3 and 4 was on determining just the manufacturing cost of a product.

Manufacturing Costs and Activity-Based Costing

In traditional cost accounting systems, all manufacturing costs are assigned to products—even manufacturing costs that are not caused by the products. For example, in Chapter 3 we learned that a predetermined plantwide overhead rate is computed by dividing all budgeted manufacturing overhead costs by a measure of budgeted activity such as direct labor-hours. This approach spreadsall manufacturing overhead costs across products based on each product's direct labor-hour usage. In contrast, activity-based costing systems purposely do not assign two types of manufacturing overhead costs to products.

Manufacturing overhead includes costs such as the factory security guard's wages, the plant controller's salary, and the cost of supplies used by the plant manager's secretary. These types of costs are assigned to products in a traditional absorption costing system even though they are totally unaffected by which products are made during a period. In contrast, activity-based costing systems do not arbitrarily assign these types of costs, which are called organization-sustainingcosts, to products. Activity-based costing treats these types of costs as period expenses rather than product costs.

Additionally, in a traditional absorption costing system, the costs of unused, or idle, capacity are assigned to products. If the budgeted level of activity declines, the overhead rate and unit product costs increase as the increasing costs of idle capacity are spread over a smaller base. In contrast, in activity-based costing, products are only charged for the costs of the capacity they use—not for the costs of capacity they don't use. This provides more stable unit product costs and is consistent with the goal of assigning to products only the costs of the resources that they use. 1

1

Appendix 3A discusses how the costs of idle capacity can be accounted for as a period cost in an income statement. This treatment highlights the cost of idle capacity rather than burying it in inventory and cost of goods sold. The procedures laid out in this chapter for activity-based costing have the same end effect.

Cost Pools, Allocation Bases, and Activity-Based Costing

Throughout the 19th century and most of the 20th century, cost system designs were simple and satisfactory. Typically, either one plantwide overhead cost pool or a number of departmental overhead cost pools were used to assign overhead costs to products. The plantwide and departmental approaches always had one thing in common—they relied on allocation bases such as direct labor-hours and machine-hours for allocating overhead costs to products. In the labor-intensive production processes of many years ago, direct labor was the most common choice for an overhead allocation base because it represented a large component of product costs, direct labor-hours were closely tracked, and many managers believed that direct labor-hours, the total volume of units produced, and overhead costs were highly correlated. (Three variables, such as direct labor-hours, the total volume of units produced, and overhead costs, are highly correlated if they tend to move together.) Given that most companies at the time were producing a very limited variety of products that required similar resources to produce, allocation bases such as direct labor-hours, or even machine-hours, worked fine because, in fact, there was probably little difference in the overhead costs attributable to different products.

Then conditions began to change. As a percentage of total cost, direct labor began declining and overhead began increasing. Many tasks previously done by direct laborers were being performed by automated equipment—a component of overhead. Companies began creating new products and services at an ever-accelerating rate that differed in volume, batch size, and complexity. Managing and sustaining this product diversity required investing in many more overhead resources, such as production schedulers and product design engineers, that had no obvious connection to direct labor-hours or machine-hours. In this new environment, continuing to rely exclusively on a limited number of overhead cost pools and traditional allocation bases posed the risk that reported unit product costs would be distorted and, therefore, misleading when used for decision-making purposes.

Activity-based costing, thanks to advances in technology that make more complex cost systems feasible, provides an alternative to the traditional plantwide and departmental approaches to defining cost pools and selecting allocation bases. The activity-based approach has appeal in today's business environment because it uses more cost pools and unique measures of activity to better understand the costs of managing and sustaining product diversity.

In activity-based costing, an activity is any event that causes the consumption of overhead resources. An activity cost pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system. An activity measure is an allocation base in an activity-based costing system. The term cost driver is also used to refer to an activity measure because the activity measure should “drive” the cost being allocated. The two most common types of activity measures are transaction drivers and duration drivers. Transaction drivers are simple counts of the number of times an activity occurs, such as the number of bills sent out to customers. Duration driversmeasure the amount of time required to perform an activity, such as the time spent preparing individual bills for customers. In general, duration drivers are more accurate measures of resource consumption than transaction drivers, but they take more effort to record. For that reason, transaction drivers are often used in practice.

IN BUSINESS: GASTRONOMIC COST DRIVERS AT THE CLUB MED—BORA BORA

The Club Med—Bora Bora of Tahiti is a resort owned and operated by the French company Club Med. Most guests buy all-inclusive packages that include lodging, participation in the resort's many activities, a full range of beverages, and sumptuous buffet meals. The resort's guests come from around the world including Asia, North America, South America, and Europe. The international nature of the club's guests poses challenges for the kitchen staff—for example, Japanese breakfasts feature miso soup, stewed vegetables in soy sauce, and rice porridge whereas Germans are accustomed to cold cuts, cheese, and bread for breakfast. Moreover, the number of guests varies widely from 300 in the high season to 20 in the low season. The chefs in the kitchen must ensure that food in the correct quantities and variety are available to please the club's varied clientele. To make this possible, a report is prepared each day that lists how many Japanese guests, German guests, French guests, Polish guests, U.S. guests, and so forth, are currently registered. This information helps the chefs prepare the appropriate quantities of specialized foods. In essence, costs in the kitchen are driven not by the number of guests alone, but by how many guests are Japanese, how many German, how many French, and so on. The costs are driven by multiple drivers.

Source: Conversation with Dominique Tredano, Chef de Village (i.e., general manager), Club Med—Bora, Bora. For information about Club Med, see www.clubmed.com .

Traditional cost systems rely exclusively on allocation bases that are driven by the volume of production. On the other hand, activity-based costing defines five levels of activity—unit-level, batch-level, product-level, customer-level, and organization-sustaining—that largely do not relate to the volume of units produced. The costs and corresponding activity measures for unit-level activities do relate to the volume of units produced; however, the remaining categories do not. These levels are described as follows: 2

· 1. Unit-level activities are performed each time a unit is produced. The costs of unit-level activities should be proportional to the number of units produced. For example, providing power to run processing equipment would be a unit-level activity because power tends to be consumed in proportion to the number of units produced.

· 2. Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, tasks such as placing purchase orders, setting up equipment, and arranging for shipments to customers are batch-level activities. They are incurred once for each batch (or customer order). Costs at the batch level depend on the number of batches processed rather than on the number of units produced, the number of units sold, or other measures of volume. For example, the cost of setting up a machine for batch processing is the same regardless of whether the batch contains one or thousands of items.

· 3. Product-level activities relate to specific products and typically must be carried out regardless of how many batches are run or units of product are produced or sold. For example, activities such as designing a product, advertising a product, and maintaining a product manager and staff are all product-level activities.

· 4. Customer-level activities relate to specific customers and include activities such as sales calls, catalog mailings, and general technical support that are not tied to any specific product.

· 5. Organization-sustaining activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. This category includes activities such as heating the factory, cleaning executive offices, providing a computer network, arranging for loans, preparing annual reports to shareholders, and so on.

Many companies throughout the world continue to base overhead allocations on direct labor-hours or machine-hours. In situations where overhead costs and direct labor-hours are highly correlated or in situations where the goal of the overhead allocation process is to prepare external financial reports, this practice makes sense. However, if plantwide overhead costs do not move in tandem with plantwide direct labor-hours or machine-hours, product costs will be distorted—with the potential of distorting decisions made within the company.

IN BUSINESS: DINING IN THE CANYON

Western River Expeditions ( www.westernriver.com ) runs river rafting trips on the Colorado, Green, and Salmon rivers. One of its most popular trips is a six-day trip down the Grand Canyon, which features famous rapids such as Crystal and Lava Falls as well as the awesome scenery accessible only from the bottom of the Grand Canyon. The company runs trips of one or two rafts, each of which carries two guides and up to 18 guests. The company provides all meals on the trip, which are prepared by the guides.

In terms of the hierarchy of activities, a guest can be considered as a unit and a raft as a batch. In that context, the wages paid to the guides are a batch-level cost because each raft requires two guides regardless of the number of guests in the raft. Each guest is given a mug to use during the trip and to take home at the end of the trip as a souvenir. The cost of the mug is a unit-level cost because the number of mugs given away is strictly proportional to the number of guests on a trip.

What about the costs of food served to guests and guides—is this a unit-level cost, a batch-level cost, a product-level cost, or an organization-sustaining cost? At first glance, it might be thought that food costs are a unit-level cost—the greater the number of guests, the higher the food costs. However, that is not quite correct. Standard menus have been created for each day of the trip. For example, the first night's menu might consist of shrimp cocktail, steak, cornbread, salad, and cheesecake. The day before a trip begins, all of the food needed for the trip is taken from the central warehouse and packed in modular containers. It isn't practical to finely adjust the amount of food for the actual number of guests planned to be on a trip—most of the food comes prepackaged in large lots. For example, the shrimp cocktail menu may call for two large bags of frozen shrimp per raft and that many bags will be packed regardless of how many guests are expected on the raft. Consequently, the costs of food are not a unit-level cost that varies with the number of guests actually on a trip. Instead, the costs of food are a batch-level cost.

Source: Conversations with Western River Expeditions personnel.

2

Robin Cooper, “Cost Classification in Unit-Based and Activity-Based Manufacturing Cost Systems,”Journal of Cost Management, Fall 1990, pp. 4–14.

Designing an Activity-Based Costing (ABC) System

There are three essential characteristics of a successful activity-based costing implementation. First, top managers must strongly support the ABC implementation because their leadership is instrumental in properly motivating all employees to embrace the need to change. Second, top managers should ensure that ABC data is linked to how people are evaluated and rewarded. If employees continue to be evaluated and rewarded using traditional (non-ABC) cost data, they will quickly get the message that ABC is not important and they will abandon it. Third, a cross-functional team should be created to design and implement the ABC system. The team should include representatives from each area that will use ABC data, such as the marketing, production, engineering, and accounting departments. These cross-functional employees possess intimate knowledge of many parts of an organization's operations that is necessary for designing an effective ABC system. Furthermore, tapping the knowledge of cross-functional managers lessens their resistance to ABC because they feel included in the implementation process. Time after time, when accountants have attempted to implement an ABC system on their own without top-management support and cross-functional involvement, the results have been ignored.

IN BUSINESS: IMPLEMENTING ACTIVITY-BASED COSTING IN CHINA

Xu Ji Electric Company is publicly traded on China's Shen Zhen Stock Exchange. From 2001–2003, it successfully implemented an activity-based costing (ABC) system because top-level managers continuously supported the new system—particularly during a challenging phase when the ABC software encountered problems. The ABC adoption was also aided by Xu Ji's decision to drive the implementation using a top-down approach, which is aligned with the company's cultural norm of deferring to and supporting the hierarchical chain of command.

Xu Ji's experience is similar to Western ABC implementations that have consistently recognized the necessity of top-level management support. However, contrary to Xu Ji's experience, many Western managers do not readily support the top-down implementation of new management innovations in their organizations. They prefer to be involved in the decision-making processes that introduce change into their organizations.

Source: Lana Y.J. Liu and Fei Pan, “The Implementation of Activity-Based Costing in China: An Innovation Action Research Approach,” The British Accounting Review 39, 2007, pp. 249–264.

Classic Brass, Inc., makes two main product lines for luxury yachts—standard stanchions and custom compass housings. The president of the company, John Towers, recently attended a management conference at which activity-based costing was discussed. Following the conference, he called a meeting of the company's top managers to discuss what he had learned. Attending the meeting were production manager Susan Richter, the marketing manager Tom Olafson, and the accounting manager Mary Goodman. He began the conference by distributing the company's income statement that Mary Goodman had prepared a few hours earlier (see Exhibit 7–1 ):

EXHIBIT 7–1 Classic Brass Income Statement

· John: Well, it's official. Our company has sunk into the red for the first time in its history—a loss of $1,250.

· Tom: I don't know what else we can do! Given our successful efforts to grow sales of the custom compass housings, I was expecting to see a boost to our bottom line, not a net loss. Granted, we have been losing even more bids than usual for standard stanchions because of our recent price increase, but …

· John: Do you think our prices for standard stanchions are too high?

· Tom: No, I don't think our prices are too high. I think our competitors’ prices are too low. In fact, I'll bet they are pricing below their cost.

· Susan: Why would our competitors price below their cost?

· Tom: They are out to grab market share.

· Susan: What good is more market share if they are losing money on every unit sold?

· John: I think Susan has a point. Mary, what is your take on this?

· Mary: If our competitors are pricing standard stanchions below cost, shouldn't they be losing money rather than us? If our company is the one using accurate information to make informed decisions while our competitors are supposedly clueless, then why is our “bottom line” taking a beating? Unfortunately, I think we may be the ones shooting in the dark, not our competitors.

· John: Based on what I heard at the conference that I just attended, I am inclined to agree. One of the presentations at the conference dealt with activity-based costing. As the speaker began describing the usual insights revealed by activity-based costing systems, I was sitting in the audience getting an ill feeling in my stomach.

· Mary: Honestly John, I have been claiming for years that our existing cost system is okay for external reporting, but it is dangerous to use it for internal decision making. It sounds like you are on board now, right?

· John: Yes.

· Mary: Well then, how about if all of you commit the time and energy to help me build a fairly simple activity-based costing system that may shed some light on the problems we are facing?

· John: Let's do it. I want each of you to appoint one of your top people to a special “ABC team” to investigate how we cost products.

Like most other ABC implementations, the ABC team decided that its new ABC system would supplement, rather than replace, the existing cost accounting system, which would continue to be used for external financial reports. The new ABC system would be used to prepare special reports for management decisions such as bidding on new business.

The accounting manager drew the chart appearing in Exhibit 7–2 to explain the general structure of the ABC model to her team members. Cost objects such as products generate activities. For example, a customer order for a custom compass housing requires the activity of preparing a production order. Such an activity consumes resources. A production order uses a sheet of paper and takes time to fill out. And consumption of resources causes costs. The greater the number of sheets used to fill out production orders and the greater the amount of time devoted to filling out such orders, the greater the cost. Activity-based costing attempts to trace through these relationships to identify how products and customers affect costs.

EXHIBIT 7–2 The Activity-Based Costing Model

As in most other companies, the ABC team at Classic Brass felt that the company's traditional cost accounting system adequately measured the direct materials and direct labor costs of products because these costs are directly traced to products. Therefore, the ABC study would be concerned solely with the other costs of the company—manufacturing overhead and selling and administrative costs.

The team felt it was important to carefully plan how it would go about implementing the new ABC system at Classic Brass. Accordingly, it broke down the implementation process into five steps:

Steps for Implementing Activity-Based Costing:

· 1. Define activities, activity cost pools, and activity measures.

· 2. Assign overhead costs to activity cost pools.

· 3. Calculate activity rates.

· 4. Assign overhead costs to cost objects using the activity rates and activity measures.

· 5. Prepare management reports.

Step 1: Define Activities, Activity Cost Pools, and Activity Measures

The first major step in implementing an ABC system is to identify the activities that will form the foundation for the system. This can be difficult and time-consuming and involves a great deal of judgment. A common procedure is for the individuals on the ABC implementation team to interview people who work in overhead departments and ask them to describe their major activities. Ordinarily, this results in a very long list of activities.

The length of such lists of activities poses a problem. On the one hand, the greater the number of activities tracked in the ABC system, the more accurate the costs are likely to be. On the other hand, a complex system involving large numbers of activities is costly to design, implement, maintain, and use. Consequently, the original lengthy list of activities is usually reduced to a handful by combining similar activities. For example, several actions may be involved in handling and moving raw materials—from receiving raw materials on the loading dock to sorting them into the appropriate bins in the storeroom. All of these activities might be combined into a single activity called material handling.

When combining activities in an ABC system, activities should be grouped together at the appropriate level. Batch-level activities should not be combined with unit-level activities or product-level activities with batch-level activities and so on. In general, it is best to combine only those activities that are highly correlated with each other within a level. For example, the number of customer orders received is likely to be highly correlated with the number of completed customer orders shipped, so these two batch-level activities (receiving and shipping orders) can usually be combined with little loss of accuracy.

At Classic Brass, the ABC team, in consultation with top managers, selected the following activity cost pools and activity measures:

Activity Cost Pools at Classic Brass

Activity Cost Pool

Activity Measure

Customer orders

Number of customer orders

Product design

Number of product designs

Order size

Machine-hours

Customer relations

Number of active customers

Other

Not applicable

The Customer Orders cost pool will be assigned all costs of resources that are consumed by taking and processing customer orders, including costs of processing paperwork and any costs involved in setting up machines for specific orders. The activity measure for this cost pool is the number of customer orders received. This is a batch-level activity because each order generates work that occurs regardless of whether the order is for one unit or 1,000 units.

The Product Design cost pool will be assigned all costs of resources consumed by designing products. The activity measure for this cost pool is the number of products designed. This is a product-level activity because the amount of design work on a new product does not depend on the number of units ultimately ordered or batches ultimately run.

The Order Size cost pool will be assigned all costs of resources consumed as a consequence of the number of units produced, including the costs of miscellaneous factory supplies, power to run machines, and some equipment depreciation. This is a unit-level activity because each unit requires some of these resources. The activity measure for this cost pool is machine-hours.

The Customer Relations cost pool will be assigned all costs associated with maintaining relations with customers, including the costs of sales calls and the costs of entertaining customers. The activity measure for this cost pool is the number of customers the company has on its active customer list. The Customer Relations cost pool represents a customer-level activity.

The Other cost pool will be assigned all overhead costs that are not associated with customer orders, product design, the size of the orders, or customer relations. These costs mainly consist of organization-sustaining costs and the costs of unused, idle capacity. These costs will not be assigned to products because they represent resources that are not consumed by products.

It is unlikely that any other company would use exactly the same activity cost pools and activity measures that were selected by Classic Brass. Because of the amount of judgment involved, the number and definitions of the activity cost pools and activity measures used by companies vary considerably.

The Mechanics of Activity-Based Costing

LEARNING OBJECTIVE 2

Assign costs to cost pools using a first-stage allocation.

Step 2: Assign Overhead Costs to Activity Cost Pools

Exhibit 7–3 shows the annual overhead costs (both manufacturing and nonmanufacturing) that Classic Brass intends to assign to its activity cost pools. Notice the data in the exhibit are organized by department (e.g., Production, General Administrative, and Marketing). This is because the data have been extracted from the company's general ledger. General ledgers usually classify costs within the departments where the costs are incurred. For example, salaries, supplies, rent, and so forth incurred in the marketing department are charged to that department. The functional orientation of the general ledger mirrors the presentation of costs in the absorption income statement in Exhibit 7–1 . In fact, you'll notice the total costs for the Production Department in Exhibit 7–3 ($1,000,000) equal the total manufacturing overhead costs from the income statement in Exhibit 7–1 . Similarly, the total costs for the General Administrative and Marketing Departments in Exhibit 7–3 ($510,000 and $300,000) equal the marketing and general and administrative expenses shown in Exhibit 7–1 .

EXHIBIT 7–3 Annual Overhead Costs (Both Manufacturing and Nonmanufacturing) at Classic Brass

Three costs included in the income statement in Exhibit 7–1 —direct materials, direct labor, and shipping—are excluded from the costs shown in Exhibit 7–3 . The ABC team purposely excluded these costs from Exhibit 7–3 because the existing cost system can accurately trace direct materials, direct labor, and shipping costs to products. There is no need to incorporate these direct costs in the activity-based allocations of indirect costs.

Classic Brass's activity-based costing system will divide the nine types of overhead costs in Exhibit 7–3 among its activity cost pools via an allocation process called first-stage allocation. The first-stage allocation in an ABC system is the process of assigning functionally organized overhead costs derived from a company's general ledger to the activity cost pools.

First-stage allocations are usually based on the results of interviews with employees who have first-hand knowledge of the activities. For example, Classic Brass needs to allocate $500,000 of indirect factory wages to its five activity cost pools. These allocations will be more accurate if the employees who are classified as indirect factory workers (e.g., supervisors, engineers, and quality inspectors) are asked to estimate what percentage of their time is spent dealing with customer orders, with product design, with processing units of product (i.e., order size), and with customer relations. These interviews are conducted with considerable care. Those who are interviewed must thoroughly understand what the activities encompass and what is expected of them in the interview. In addition, departmental managers are typically interviewed to determine how the nonpersonnel costs should be distributed across the activity cost pools. For example, the Classic Brass production manager would be interviewed to determine how the $300,000 of factory equipment depreciation (shown in Exhibit 7–3 ) should be allocated to the activity cost pools. The key question that the production manager would need to answer is “What percentage of the available machine capacity is consumed by each activity such as the number of customer orders or the number of units processed (i.e., size of orders)?”

IN BUSINESS: ABC HELPS A DAIRY UNDERSTAND ITS COSTS

Kemps LLC, headquartered in Minneapolis, Minnesota, produces dairy products such as milk, yogurt, and ice cream. The company implemented an ABC system that helped managers understand the impact of product and customer diversity on profit margins. The ABC model “captured differences in how the company entered orders from customers (customer phone call, salesperson call, fax, truck-driver entry, EDI, or Internet), how it packaged orders (full stacks of six cases, individual cases, or partial break-pack cases for small orders), how it delivered orders (commercial carriers or its own fleet, including route miles), and time spent by the driver at each customer location.”

Kemps’ ABC system helped the company acquire a large national customer because it identified “the specific manufacturing, distribution, and order handling costs associated with serving this customer.” The ability to provide the customer with accurate cost information built a trusting relationship that distinguished Kemps from other competitors. Kemps also used its ABC data to transform unprofitable customers into profitable ones. For example, one customer agreed to accept a 13% price increase, to eliminate two low-volume products, and to begin placing full truckload orders rather than requiring partial truckload shipments, thereby lowering Kemps’ costs by $150,000 per year.

Source: Robert S. Kaplan and Steven R. Anderson, “Time-Driven Activity-Based Costing,” Harvard Business Review, November 2004, pp. 131–139.

The results of the interviews at Classic Brass are displayed in Exhibit 7–4 . For example, factory equipment depreciation is distributed 20% to Customer Orders, 60% to Order Size, and 20% to the Other cost pool. The resource in this instance is machine time. According to the estimates made by the production manager, 60% of the total available machine time was used to actually process units to fill orders. This percentage is entered in the Order Size column. Each customer order requires setting up, which also requires machine time. This activity consumes 20% of the total available machine time and is entered under the Customer Orders column. The remaining 20% of available machine time represents idle time and is entered under the Other column.

EXHIBIT 7–4 Results of Interviews: Distribution of Resource Consumption across Activity Cost Pools

Exhibit 7–4 and many of the other exhibits in this chapter are presented in the form of Excel spreadsheets. All of the calculations required in activity-based costing can be done by hand. Nevertheless, setting up an activity-based costing system on a spreadsheet or using special ABC software can save a lot of work—particularly in situations involving many activity cost pools and in organizations that periodically update their ABC systems.

We will not go into the details of how all of the percentages in Exhibit 7–4 were determined. However, note that 100% of the factory building lease has been assigned to the Other cost pool. Classic Brass has a single production facility. It has no plans to expand or to sublease any excess space. The cost of this production facility is treated as an organization-sustaining cost because there is no way to avoid even a portion of this cost if a particular product or customer were to be dropped. (Remember that organization-sustaining costs are assigned to the Other cost pool and are not allocated to products.) In contrast, some companies have separate facilities for manufacturing specific products. The costs of these separate facilities could be directly traced to the specific products.

Once the percentage distributions in Exhibit 7–4 have been established, it is easy to allocate costs to the activity cost pools. The results of this first-stage allocation are displayed in Exhibit 7–5 . Each cost is allocated across the activity cost pools by multiplying it by the percentages in Exhibit 7–4 . For example, the indirect factory wages of $500,000 are multiplied by the 25% entry under Customer Orders in Exhibit 7–4 to arrive at the $125,000 entry under Customer Orders in Exhibit 7–5 . Similarly, the indirect factory wages of $500,000 are multiplied by the 40% entry under Product Design in Exhibit 7–4 to arrive at the $200,000 entry under Product Design in Exhibit 7–5 . All of the entries in Exhibit 7–5 are computed in this way.

EXHIBIT 7–5 First-Stage Allocations to Activity Cost Pools

Now that the first-stage allocations to the activity cost pools have been completed, the next step is to compute the activity rates.

Step 3: Calculate Activity Rates

LEARNING OBJECTIVE 3

Compute activity rates for cost pools.

The activity rates that will be used for assigning overhead costs to products and customers are computed in Exhibit 7–6 . The ABC team determined the total activity for each cost pool that would be required to produce the company's present product mix and to serve its present customers. These numbers are listed in Exhibit 7–6 . For example, the ABC team found that 400 new product designs are required each year to serve the company's present customers. The activity rates are computed by dividing the total cost for each activity by its total activity. For example, the $320,000total annual cost for the Customer Orders cost pool (which was computed in Exhibit 7–5 ) is divided by the total of 1,000 customer orders per year to arrive at the activity rate of $320 per customer order. Similarly, the $252,000 total cost for the Product Design cost pool is divided by the totalnumber of designs (i.e., 400 product designs) to determine the activity rate of $630 per design. Note that an activity rate is not computed for the Other category of costs. This is because the Other cost pool consists of organization-sustaining costs and costs of idle capacity that are not allocated to products and customers.

EXHIBIT 7–6 Computation of Activity Rates

The rates in Exhibit 7–6 indicate that on average a customer order consumes resources that cost $320; a product design consumes resources that cost $630; a unit of product consumes resources that cost $19 per machine-hour; and maintaining relations with a customer consumes resources that cost $1,470. Note that these are average figures. Some members of the ABC design team at Classic Brass argued that it would be unfair to charge all new products the same $630 product design cost regardless of how much design time they actually require. After discussing the pros and cons, the team concluded that it would not be worth the effort at the present time to keep track of actual design time spent on each new product. They felt that the benefits of increased accuracy would not be great enough to justify the higher cost of implementing and maintaining the more detailed costing system. Similarly, some team members were uncomfortable assigning the same $1,470 cost to each customer. Some customers are undemanding—ordering standard products well in advance of their needs. Others are very demanding and consume large amounts of marketing and administrative staff time. These are generally customers who order customized products, who tend to order at the last minute, and who change their minds. While everyone agreed with this observation, the data that would be required to measure individual customers’ demands on resources were not currently available. Rather than delay implementation of the ABC system, the team decided to defer such refinements to a later date.

Before proceeding further, it would be helpful to get a better idea of the overall process of assigning costs to products and other cost objects in an ABC system. Exhibit 7–7 provides a visual perspective of the ABC system at Classic Brass. We recommend that you carefully go over this exhibit. In particular, note that the Other category, which contains organization-sustaining costs and costs of idle capacity, is not allocated to products or customers.

EXHIBIT 7–7 The Activity-Based Costing Model at Classic Brass

Step 4: Assign Overhead Costs to Cost Objects

LEARNING OBJECTIVE 4

Assign costs to a cost object using a second-stage allocation.

The fourth step in the implementation of activity-based costing is called second-stage allocation. In the second-stage allocation , activity rates are used to apply overhead costs to products and customers. First, we will illustrate how to assign costs to products followed by an example of how to assign costs to customers.

The data needed by the ABC team to assign overhead costs to Classic Brass's two products—standard stanchions and custom compass housings—are as follows:

Standard Stanchions

· 1. This product line does not require any new design resources.

· 2. 30,000 units were ordered during the year, comprising 600 separate orders.

· 3. Each stanchion requires 35 minutes of machine time for a total of 17,500 machine-hours.

Custom Compass Housings

· 1. This is a custom product that requires new design resources.

· 2. There were 400 orders for custom compass housings. Orders for this product are placed separately from orders for standard stanchions.

· 3. There were 400 custom designs prepared. One custom design was prepared for each order.

· 4. Because some orders were for more than one unit, a total of 1,250 custom compass housings were produced during the year. A custom compass housing requires an average of 2 machine-hours for a total of 2,500 machine-hours.

Notice, 600 customer orders were placed for standard stanchions and 400 customer orders were placed for custom compass housings, for a total of 1,000 customer orders. All 400 product designs related to custom compass housings; none related to standard stanchions. Producing 30,000 standard stanchions required 17,500 machine-hours and producing 1,250 custom compass housings required 2,500 machine-hours, for a total of 20,000 machine-hours.

IN BUSINESS: HOW MUCH DOES IT COST TO HANDLE A PIECE OF LUGGAGE?

It costs an airline about $15 to carry a piece of checked luggage from one destination another. The activity “transporting luggage” consists of numerous sub-activities such as tagging bags, sorting them, placing them on carts, transporting bags planeside, loading them into the airplane, and delivering them to carousels and connecting flights.

A variety of employees invest a portion of their labor hours “transporting luggage” including ground personnel, check-in agents, service clerks, baggage service managers, and maintenance workers. In total, labor costs comprise $9 per bag. Airlines also spend millions of dollars on baggage equipment, sorting systems, carts, tractors, and conveyors, as well as rental costs related to bag rooms, carousels, and offices. They also pay to deliver misplaced bags to customers’ homes and to compensate customers for lost bags that are never found. These expenses add up to about $4 per bag. The final expense related to transporting luggage is fuel costs, which average about $2 per bag.

Many major airlines are charging $15 each way for one checked bag and $25 each way for a second checked bag. United Airlines expects to collect $275 million annually for its first and second bag fees.

Source: Scott McCartney, “What It Costs an Airline to Fly Your Luggage,” The Wall Street Journal, November 25, 2008, p. D1 and D8.

Exhibit 7–8 illustrates how overhead costs are assigned to the standard stanchions and custom compass housings. For example, the exhibit shows that $192,000 of overhead costs are assigned from the Customer Orders activity cost pool to the standard stanchions ($320 per order × 600orders). Similarly, $128,000 of overhead costs are assigned from the Customer Orders activity cost pool to the custom compass housings ($320 per order × 400 orders). The Customer Orders cost pool contained a total of $320,000 (see Exhibit 7–5 or 7–6) and this total amount has been assigned to the two products ($192,000 + $128,000 = $320,000).

EXHIBIT 7–8 Assigning Overhead Costs to Products

Exhibit 7–8 shows that a total of $952,000 of overhead costs is assigned to Classic Brass's two product lines—$524,500 to standard stanchions and $427,500 to custom compass housings. This amount is less than the $1,810,000 of overhead costs included in the ABC system. Why? The total amount of overhead assigned to products does not match the total amount of overhead cost in the ABC system because the ABC team purposely did not assign the $367,500 of Customer Relations and $490,500 of Other costs to products. The Customer Relations activity is a customer-level activity and the Other activity is an organization-sustaining activity—neither activity is caused by products. As shown below, when the Customer Relations and Other activity costs are added to the $952,000 of overhead costs assigned to products, the total is $1,810,000.

Next, we describe another example of second-stage allocation—assigning activity costs to customers. The data needed by Classic Brass to assign overhead costs to one of its customers—Windward Yachts—are as follows:

Windward Yachts

· 1. The company placed a total of three orders.

· a. Two orders were for 150 standard stanchions per order.

· b. One order was for a single custom compass housing unit.

· 2. A total of 177 machine-hours were used to fulfill the three customer orders.

· a. The 300 standard stanchions required 175 machine-hours.

· b. The custom compass housing required 2 machine-hours.

· 3. Windward Yachts is one of 250 customers served by Classic Brass.

Exhibit 7–9 illustrates how the ABC system assigns overhead costs to this customer. As shown in Exhibit 7–9 , the ABC team calculated that $6,423 of overhead costs should be assigned to Windward Yachts. The exhibit shows that Windward Yachts is assigned $960 ($320 per order × 3 orders) of overhead costs from the Customer Orders activity cost pool; $630 ($630 per design × 1 design) from the Product Design cost pool; $3,363 ($19 per machine-hour × 177 machine-hours) from the Order Size cost pool; and $1,470 ($1,470 per customer × 1 customer) from the Customer Relations cost pool.

EXHIBIT 7–9 Assigning Overhead Costs to Customers

With second-stage allocations complete, the ABC design team was ready to turn its attention to creating reports that would help explain the company's first ever net operating loss.

Step 5: Prepare Management Reports

LEARNING OBJECTIVE 5

Use activity-based costing to compute product and customer margins.

The most common management reports prepared with ABC data are product and customer profitability reports. These reports help companies channel their resources to their most profitable growth opportunities while at the same time highlighting products and customers that drain profits. We begin by illustrating a product profitability report followed by a customer profitability report.

The Classic Brass ABC team realized that the profit from a product, also called the product margin,is a function of the product's sales and the direct and indirect costs that the product causes. The ABC cost allocations shown in Exhibit 7–8 only summarize each product's indirect (i.e., overhead) costs. Therefore, to compute a product's profit (i.e., product margin), the design team needed to gather each product's sales and direct costs in addition to the overhead costs previously computed. The pertinent sales and direct cost data for each product are shown below. Notice the numbers in the total column agree with the income statement in Exhibit 7–1 .

Standard Stanchions

Custom Compass Housings

Total

Sales

$2,660,000

$540,000

$3,200,000

Direct costs:

 Direct materials

$905,500

$69,500

$975,000

 Direct labor

$263,750

$87,500

$351,250

 Shipping

$60,000

$5,000

$65,000

Having gathered the above data, the design team created the product profitability report shown in Exhibit 7–10 . The report revealed that standard stanchions are profitable, with a positive product margin of $906,250, whereas the custom compass housings are unprofitable, with a negative product margin of $49,500. Keep in mind that the product profitability report purposely does not include the costs in the Customer Relations and Other activity cost pools. These costs, which total $858,000, were excluded from the report because they are not caused by the products. Customer Relations costs are caused by customers, not products. The Other costs are organization-sustaining costs and unused capacity costs that are not caused by any particular product.

EXHIBIT 7–10 Product Margins—Activity-Based Costing

The product margins can be reconciled with the company's net operating loss as follows:

Next, the design team created a customer profitability report for Windward Yachts. Similar to the product profitability report, the design team needed to gather data concerning sales to Windward Yachts and the direct material, direct labor, and shipping costs associated with those sales. Those data are presented below:

Windward Yachts

Sales

$11,350

Direct costs:

 Direct material costs

$2,123

 Direct labor costs

$1,900

 Shipping costs

$205

IN BUSINESS: IS ACTIVITY-BASED COSTING STILL BEING USED?

Researchers surveyed 348 managers to determine which costing methods their companies use. The table below shows the percentage of respondents whose companies use the various costing methods to assign departmental costs to cost objects such as products.

Departments

Costing Method

Research and Development

Product and Process Design

Production

Sales and Marketing

Distribution

Customer Service

Shared Services

Activity-based

13.0%

14.7%

  18.3%

17.3%

    17.2%

21.8%

 23.0%

Standard 1

17.6%

20.7%

  42.0%

 18.1%

28.4%

 18.5%

 23.0%

Normal 2

4.6%

 8.6%

    9.9%

     7.9%

  6.0%

  8.1%

   5.6%

Actual 3

23.1%

25.0%

  23.7%

23.6%

26.7%

 16.9%

 15.9%

Other

1.9%

 0.9%

    0.0%

   0.8%

  0.9%

      1.6%

   2.4%

Not allocated

39.8%

30.2%

    6.1%

32.3%

20.7%

33.1%

 30.2%

1Standard costing is used for the variance computations in Chapter 10 .

2Normal costing is used for the job-order costing computations in Chapter 3 .

3Actual costing is used to create the absorption and variable costing income statements in Chapter 6 .

The results show that 18.3% of respondents use ABC to allocate production costs to cost objects and 42% use standard costing for the same purpose. ABC is used by at least 13% of respondents within all functional departments across the value chain. Many companies do not allocate nonproduction costs to cost objects.

Source: William O. Stratton, Denis Desroches, Raef Lawson, and Toby Hatch, “Activity-Based Costing: Is It Still Relevant?” Management Accounting Quarterly, Spring 2009, pp. 31–40.

Using these data and the data from Exhibit 7–9 , the design team created the customer profitability report shown in Exhibit 7–11 . The report revealed that the customer margin for Windward Yachts is $699. A similar report could be prepared for each of Classic Brass's 250 customers, thereby enabling the company to cultivate relationships with its most profitable customers, while taking steps to reduce the negative impact of unprofitable customers.

EXHIBIT 7–11 Customer Margin—Activity-Based Costing

Comparison of Traditional and ABC Product Costs

The ABC team used a two-step process to compare its traditional and ABC product costs. First, the team reviewed the product margins reported by the traditional cost system. Then, it contrasted the differences between the traditional and ABC product margins.

Product Margins Computed Using the Traditional Cost System

Classic Brass's traditional cost system assigns only manufacturing costs to products—this includes direct materials, direct labor, and manufacturing overhead. Selling and administrative costs are not assigned to products. Exhibit 7–12 shows the product margins reported by Classic Brass's traditional cost system. We will explain how these margins were calculated in three steps. First, the sales and direct materials and direct labor cost data are the same numbers used by the ABC team to prepare Exhibit 7–10 . In other words, the traditional cost system and the ABC system treat these three pieces of revenue and cost data identically.

EXHIBIT 7–12 Product Margins—Traditional Costing System

Second, the traditional cost system uses a plantwide overhead rate to assign manufacturing overhead costs to products. The numerator for the plantwide overhead rate is $1,000,000, which is the total amount of manufacturing overhead shown on the income statement in Exhibit 7–1 . The footnote in Exhibit 7–1 mentions that the traditional cost system uses machine-hours to assign manufacturing overhead costs to products. The Order Size activity in Exhibit 7–6 used 20,000 machine-hours as its level of activity. These same 20,000 machine-hours would be used in the denominator of the plantwide overhead rate, which is computed as follows:

Because 17,500 machine-hours were worked on standard stanchions, this product line is assigned$875,000 (17,500 machine-hours × $50 per machine-hour) of manufacturing overhead cost. Similarly, the custom compass housings required 2,500 machine-hours, so this product line is assigned $125,000 (2,500 machine-hours × $50 per machine-hour) of manufacturing overhead cost. The sales of each product minus its cost of goods sold equals the product margin of $615,750 for standard stanchions and $258,000 for custom compass housings.

Notice, the net operating loss of $1,250 shown in Exhibit 7–12 agrees with the loss reported in the income statement in Exhibit 7–1 and with the loss shown in the table beneath Exhibit 7–10 . The company's total sales, total costs, and its resulting net operating loss are the same regardless of whether you are looking at the absorption income statement in Exhibit 7–1 , the ABC product profitability analysis depicted on page 289, or the traditional product profitability analysis in Exhibit 7–12 . Although the “total pie” remains constant across the traditional and ABC systems, what differs is how the pie is divided between the two product lines. The traditional product margin calculations suggest that standard stanchions are generating a product margin of $615,750 and the custom compass housings a product margin of $258,000. However, these product margins differ from the ABC product margins reported in Exhibit 7–10 . Indeed, the traditional cost system is sending misleading signals to Classic Brass's managers about each product's profitability. Let's explain why.

The Differences between ABC and Traditional Product Costs

The changes in product margins caused by switching from the traditional cost system to the activity-based costing system are shown below:

The traditional cost system overcosts the standard stanchions and consequently reports an artificially low product margin for this product. The switch to an activity-based view of product profitability increases the product margin on standard stanchions by $290,500. In contrast, the traditional cost system undercosts the custom compass housings and reports an artificially high product margin for this product. The switch to activity-based costing decreases the product margin on custom compass housings by $307,500.

The reasons for the change in reported product margins between the two costing methods are revealed in Exhibit 7–13 . The top portion of the exhibit shows each product's direct and indirect cost assignments as reported by the traditional cost system in Exhibit 7–12 . For example, Exhibit 7–13 includes the following costs for standard stanchions: direct materials, $905,500; direct labor, $263,750; and manufacturing overhead, $875,000. Each of these costs corresponds with those reported in Exhibit 7–12 . Notice, the selling and administrative costs of $875,000 are purposely not allocated to products because these costs are considered to be period costs. Similarly, the bottom portion of Exhibit 7–13 summarizes the direct and indirect cost assignments as reported by the activity-based costing system in Exhibit 7–10 . The only new information in Exhibit 7–13 is shown in the two columns of percentages. The first column of percentages shows the percentage of each cost assigned to standard stanchions. For example, the $905,500 of direct materials cost traced to standard stanchions is 92.9% of the company's total direct materials cost of $975,000. The second column of percentages does the same thing for custom compass housings.

EXHIBIT 7–13 A Comparison of Traditional and Activity-Based Cost Assignments

There are three reasons why the traditional and activity-based costing systems report different product margins. First, Classic Brass's traditional cost system allocates all manufacturing overhead costs to products. This forces both products to absorb all manufacturing overhead costs regardless of whether they actually consumed the costs that were allocated to them. The ABC system does not assign the manufacturing overhead costs consumed by the Customer Relations activity to products because these costs are caused by customers, not specific products. It also does not assign the manufacturing overhead costs included in the Other activity to products because these organization-sustaining and unused capacity costs are not caused by any particular product. From an ABC point of view, assigning these costs to products is inherently arbitrary and counterproductive.