First stage allocation in activity based costing

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

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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.

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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