Activity-Based Cost Systems

CHAPTER
5

Product costing systems start by assigning direct labor and direct

materials costs to products.
For both materials and labor, cost accountants or industrial engineers
perform the following computations:
1. Calculate the cost per unit (pound, kilogram, or square meter) of
each material used by a product and the cost per hour of each type
of direct labor that processes the product.
2. For each unit of product made, determine the quantity (number
of pounds, kilograms, or square meters) of each type of material
used and the quantity (number of hours) required for each type of
labor.
3.For each labor and material type, multiply the cost per unit (or
hour) by the quantities used per product, as shown by the following
equations:
Materials cost/unit = Quantity of materials/unit of output
Cost per materials unit
Labor cost/unit = Quantity of labor hours/unit of output
Cost per labor hour
4. Add up all of the individual materials and labor costs to obtain the
total labor and materials cost of each product unit.
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 The

main focus of our attention in this chapter is on the

assignment of indirect expenses to products.
Indirect expenses include:
the costs of operating machines,
scheduling,
quality control,
purchasing,
maintenance,
supervision, and
general factory support (including building depreciation,
insurance, utilities, and housekeeping).
Indirect expenses are also called shared or common costs
since they support the production of all products and they are
not easily traced to individual products in the simple way that
direct materials and direct labor costs are.
3

 Companies

producing a more varied and complex

mix of products have higher costs than companies
producing only a narrow range of products.
Complex, diverse product lines require more
support (overhead) costs than simple, narrow
product lines.
Each different variation (model, style, color, etc.)
may require a variety of special activities:
1. Separate engineering drawings, specifications,
and testing.
2. Separate production capability (production lines,
machinery, workers with different skills.)
3. Special materials, along with inventories and
material control systems.

Madison Dairy Ice cream

Example

Consider one ice cream manufacturing plant at Madison

Dairy. The plant originally produced just two products,
vanilla and chocolate ice cream, and enjoyed profit
margins in excess of 15% of sales. Several years ago, the
plant manager had seen opportunities to expand the
business by extending the product line into new flavors
that earned premium selling prices. Madison had
introduced strawberry ice cream, which required the
same basic production
technology but could be sold at prices that were 10%
higher than vanilla and chocolate. Last year, the
company introduced mocha-almond ice cream, which it
sold at an even higher price.
5

Madison Dairy Ice cream

Example

With the increase in product variety

came an increase in the plants
overhead costs. These costs were
allocated to products based on their
direct labor content. Currently, the
rate was 240% of direct labor dollars.
Results of one month were
disappointing
(Next slide).
6

Madison Dairy Ice cream

Example

Madison Dairy Ice cream

Example
Difficulties

started when the strawberry flavor was

introduced. More changeovers had to be made to stop
production of vanilla or chocolate, empty the vats, clean out
all remnants of the previous flavor, and then start the
production of the strawberry flavor. Making chocolate was
simplethey didnt even have to clean out the residual from
the previous run if they just dumped in enough chocolate
syrup to cover it up. For strawberry, however, even small
traces of other flavors create quality problems. And because
mocha-almond contains nuts, to which many people have
severe allergic reactions, they have to do a complete
sterilization of the vat after every mocha production run.
they are also spending a lot more time on purchasing and
scheduling activities and just keeping track of where they
stand on existing, backlogged, and future orders.

Madison Dairy Ice cream

Example

The manager of Madison Dairy wondered why she

could not assign indirect expense costs to products in
the same way that standard cost systems assign
materials and labor costs to products. That is, why
couldnt she obtain the cost of using each unit of
overhead or indirect resource, and the quantity of
each indirect resource used by each product the
plant produced?
Thus, Time-Driven Activity Based Costing

Time-Driven Activity Based Costing (TDABC)

Time-driven activity based costing (TDABC)
requires estimating two parameters:
1.The first parameter is the capacity cost rate for
each type of indirect resource.

The capacity cost rate for a resource is

computed by dividing its cost by the
practical capacity it supplies.
E.g Salary per month divided by number
of hours worked per month.

10

Time-Driven Activity Based Costing (TDABC)

2. The second parameter is an estimation of how
much of each resources capacity is used by the
activities performed to produce the various
products and services.
With estimates of these two parameters for each
resource and product, the cost assignment is
performed as follows:
Cost of using resource i by product j =
Capacity cost rate of resource i Quantity of
capacity of resource i used by product j
11

EXAMPLE
Take an indirect production employee who specializes in
changing over machines from one product to the other.
The employees total compensation is $4,800 per month.
The employee has about 120 hours available to perform
changeovers each month.
The setup employees capacity cost rate is $40 per
hour ($4,800 per month/120 hours per month).
Consider now a product that is produced 3 times during
the month, with the setup time for each production run
taking 1.5 hours. The product uses 4.5 hours of this
indirect production employees time and would be
assigned $180 of cost ($40/hour 4.5 hours) this month
for use of this indirect employees time.
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Madison Dairy Ice cream

Calculating Resource Capacity Cost Rates

Indirect Labor
Assume Madison Co. had 7 production
employees who did both the actual
work of producing the ice cream as well
as all of the production support work.
The standard cost accounting system
treated the employees as direct labor
when they ran the production process
and indirect when they did
everything else.
13

Calculating Resource Capacity Cost Rates

Indirect Labor
Madison Co. paid production employees a fixed salary per month
of $3,724. Lee (The manager) added the fringe benefits of 25%
(equal to $931) to obtain the total monthly compensation of
$4,655 per production employee.
For an average month, she estimated that an employee came to
work on about 19 days. Employees were paid for 8 hours of work
per day, but not all that time was available for productive work.
Breaks, training, and meetings consumed about 1 hour per day of
employees time, leaving 7 hours per day available for work.
Thus, each employee was available for 133 hours of work each
month, leading to the following calculation:
Cost rate per employee = $4,655 per month/133 hours per month
= $35 per hour
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Calculating Resource Capacity Cost Rates

Machinery ($15,400)
The ice cream factory had two identical production lines. It leased all
of the machinery on the lines from an outside supplier, and had total
current monthly lease payments of $15,400.
The production machines were available every working day of the
month, or about 22 days per month. The company operated with one
daily 8 hour shift. Normal preventive maintenance and minor repairs
were performed for 1hour each day, leaving 7 hours available for
productive work on each production line.
Thus the total available capacity per machine line was 22 days 7
hours per day or 154 hours per month. With 2 machine lines, the
plant had machine time available for 308 hours each month. Thus,
Cost rate for machines = $15,400 per month/308 hours per month
= $50 per machine hour

15

Calculating Resource Time Usage per Product

Determine the quantity of time that each product used of each
production resource (indirect labor and machines).
Indirect Labor Time
The demand for indirect labor time came from three sources.
1) Indirect labor scheduled production runs, did the
purchasing for a production run, prepared the materials and
brought materials to the production line just before a
production run. They also inspected the initial output from the
production run to ensure that it met the product specifications.
The manager assigned an industrial engineer to observe this
process over a period of several weeks; he reported back that
the time required to order materials, schedule, and prepare
for ONE production run was about 4 hours, and this time
was independent of which flavor was being produced or the
size of the production run.

16

Calculating Resource Time Usage per Product

Indirect Labor Time
2) Employees also performed the changeovers from one
product to another. Industrial engineers had already
established time standards for these changeovers:
Product
Changeover Time
Vanilla
2.0 hours
Chocolate
1.0 hour
Strawberry
2.5 hours
Mocha-almond
4.0 hours
3 employees worked as a team to perform each
changeover so the setup time for a new batch of vanilla
ice cream required 6 hours of indirect labor time (3
employees working for 2 hours on the setup).
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Calculating Resource Time Usage per Product

Indirect Labor Time
3) Employees also performed productsustaining activities each month for each flavor.
(These activities included maintaining and
updating the products bill of materials and
production process on the computer system,
monitoring and maintaining a minimum supply of
raw materials and finished goods inventory for
each product, improving the production process,
and performing recipe changes based on
customer feedback). This activity took about 9
hours per month for each product.
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Calculating Resource Time Usage per Product

Indirect Labor Time
The Manager summarized the demand for
indirect labor by each product with the following
time equation:
Indirect labor time/product = (4 hours +
product changeover time) Number of
production runs + 9
For example, if the Vanilla flavor had 10
production runs in a month, its total usage of
indirect labor time would be:
Vanilla indirect labor time = (4+ 6) 10 + 9 =
109 hours
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Calculating Resource Time Usage per Product

Indirect Labor Time
The total demands for indirect labor are summarized below:

20

Calculating Resource Time Usage per Product

Machinery Time
Machines were either producing products or being set up to
produce the next batch of products.
The time equation to estimate machine usage was:
Machine time per product = Product run time + Product
changeover time
= (Product volume (gallons) Run time/gallon) +
(Product changeover time Number of runs)
For example, if Vanilla had 10 production runs producing
8,000 gallons in a month, with processing time of 26 machine
hours per 1,000 gallons, its hours of machine usage were:
Vanilla machine time =
(8000gallons 26hrs/1000gallon) + 2 10 = 228 hours
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Calculating Product Cost and Profitability

Lee had now developed all of the informationcapacity
cost rates for each resource and capacity demands on
resources by each productthat she needed to calculate
accurate product costs.
She summarized the production data for the four products
from the recent month as shown below:

22

Calculating Product Cost and Profitability

Lee next entered the production data into the two time equations for
indirect production labor time and machine time to obtain the
resource demand for the four products, as shown below:

23

Calculating Product Cost and Profitability

Lee calculated the costs for each product by multiplying
the resource usage times in Preceding table by each
resources capacity cost rate, shown in the last column.
She summarized the results in the product profit and loss
statements shown below:

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Calculating Product Cost and Profitability

Lee was initially surprised by the results

reported. She saw that the products
previously thought to be the most
profitable, (strawberry and mochaalmond), were actually the least profitable
and in fact had enormous losses as a
percentage of sales. Conversely, vanilla
and chocolate, previously thought to be
breakeven, were actually profitable with
profit margins greater than 10% of sales.
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Calculating Product Cost and Profitability

Reasons for the reversals in profit rankings.
1.Vanilla and chocolate were produced in long production runs,
so their use of indirect labor and machine setup time were
small compared to actual production volumes.
2. Mocha-almond, had small production runs; its use of indirect
labor and machine setup time exceeded the quantity of direct
labor and machine run time for the product.
3.Despite mocha-almond having a unit price that was more
than 15% higher than vanilla or chocolate, its price failed, by a
large amount, to pay for the cost of its use of indirect labor and
machine setup time.
In general, the new costing approach clearly revealed that
the revenues from sales of the specialty strawberry and
mocha-almond flavors failed to cover all of the expenses
associated with their production.
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 Managers may use insights from activity-based cost

analysis to improve operations, such as by
1.reducing setup times or
2.reducing the times required to do purchasing and
scheduling for production orders.
Managers may also use their new insights to justify:
1.price increases for unprofitable products,
2.impose minimum order sizes, and
3.make decisions on the desired product mix.

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 The use of actual driver quantities can lead to

distortions in product costs simply because of the
difference between the capacity of the resource
supplied and used.
Practical capacity should be used as a denominator to
avoid distortions induced by the cost of unused
capacity.
Excess capacity should not be arbitrarily assigned to
the products produced during the period. However,
excess capacity costs should not be ignored. They
should be managed, if possible, by increasing the
volume of profitable business or reducing the supply of
unused resources.

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Exercise 5-17

29

Exercise 5-17
5-17 Halifax Brass Company manufactures pumps and valves and uses a time-driven activitybased cost (TDABC) system. Last year, Halifax recorded the following data for assigning
manufacturing overhead costs to its products:

Halifax also developed the following information on revenues and costs other than
manufacturing overhead:
Total revenues
$890,000
Total direct labor cost
$120,000
Total direct materials cost
$90,000
SG&A expenses
$100,000
Required
(a) Using the companys TDABC system, how much manufacturing overhead cost will be
assigned to pumps? How much will be assigned to valves?
(b) What is the companys net income? (Assume the company sells the entire amount of the
products it produces.)

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Exercise 5-20

31

Exercise 5-20
CAN Company sells multiple products and uses a time-driven ABC system.
The companys products must be wrapped individually before shipping. The
packaging and shipping department employs 25 people. Each person works
22 days per month on average. Employees in this department work an eighthour shift that includes a total of 90 minutes for breaks and a meal. The full
compensation, including fringe benefits, for each packaging and shipping
employee is $3,575 per month.
Required
(a) Using the principles discussed in this chapter and time-driven ABC, what
is the rate per hour for each packaging and shipping employee at CAN?
(b) On average, it takes one packaging and shipping employee 16 minutes to
prepare a package and label, independent of the number or types of items in
the shipment, plus 9 minutes per item to bubble wrap and pack it in the
carton. Using CANs time-driven ABC system, what is the packaging and
shipping cost assigned to Order A/32, which consisted of 120 items?

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Exercise 5- 25

33

Exercise 5- 25
Garber Company uses a traditional activity-based costing
system to assign $600,000 of committed resource costs for
customer service on the basis of the following information
gathered from interviews with customer service personnel:

Required
(a) Compute the activity cost driver rates using this system.

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Exercise 5- 25
Required

(b) Suppose instead that Garber uses time-driven ABC to

assign the $600,000 of committed resource costs to the
three activities. Compute the time-driven activity cost
driver rates, assuming 10,000 hours of useful work and
the unit time estimates that follow:

35

Exercise 5- 25
(c) Suppose that the quantities of activities this period are
8,000 customer orders, 400 customer complaints, and 450
credit checks. Using the information and activity cost
driver rates developed in part b, determine the cost
assigned to each of the activities and the estimated hours
of unused capacity as well as the associated cost. What
actions might managers take after evaluating such
information?

36

Exercise 5- 25
(d) Suppose that in the next time period, the
quantities of activities change to 8,500 customer
orders, 350 customer complaints, and 500 credit
checks. Using the information and activity cost
driver rates developed in part b, determine the
cost assigned to each of the activities and the
estimated hours of unused capacity as well as the
associated cost.

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Exercise 5- 29

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-END-

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