MBA 649 Strategic Managerial Accounting & Control

Week 3

Chapter 5 Activity-based Costing and Management

Dr. Yijing Jiang

Department of Accountancy
Upcoming Tutorial
 TA: Hussam Al Maleh (Sam)
 Time:
 Wednesday Jan 25th, 9:30 – 11:30 am
 Friday Jan 27th, 6:00 – 8:00 pm
 Location: MB 6.240
 Zoom link in Tutorial Schedule file
 Topics covered:
 Chapter 3 job-order costing
 Chapter 5 activity-based costing
 Materials:

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Agenda
 Chapter 5 Activity-Based Costing

 [Break ~15 mins]

 In-Class Case Analysis: Survey Masters

 (A part of) Chapter 6 Cost Behavior

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Next Week
 Data Workshop – Cost Estimation and Regression Analysis
 Download and install R & RStudio:
 R for Windows: https://cran.r-project.org/bin/windows/base/
 R for Mac: https://cran.r-project.org/bin/macosx/

 RStudio (RStudio Desktop Free version):

https://www.rstudio.com/products/rstudio/download/

 A short video (~4 mins) on downloading & installation:

https://www.youtube.com/watch?v=0Qu7Jg1Jw5A
Recap of Chapters 2 & 3
Purchases

BB Raw Materials EB
Inventory

DL MOH
DM
BB EB
Work-in-process
Inventory
Cost of goods
manufactured
BB Finished Goods EB
Inventory

Cost of Goods
Sold (COGS)
 Recap of Chapters 2 & 3

Job No. 1 completed Job No. 2 completed

January 1st: December 31st:

The managers estimate The managers calculate
MOH for the entire year. actual MOH and make
adjustments.
The managers allocate The managers allocate
estimated MOH to Job 1. estimated MOH to Job 2.

• Allocating MOH:

Predetermined Budgeted manufacturing overhead cost

=
Rate Budgeted amount of cost driver

Overhead applied = Estimated rate × Actual activity

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What is a Cost Driver?
 A cost driver is a characteristic of an event or activity that results in the
incurrence of costs

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What is a Good Cost Driver?
 A good cost driver:
 Directly and accurately causes changes in the cost
 Can be conveniently measured

E.g., Allocating JMSB indirect costs to programs:

• Bad cost drivers: number of students
• Better cost drivers: courses offered
• How about: using supporting staffs’ time allocation to each
program as the cost driver?
o Might not be conveniently measured.
o There might be behavioral effects.

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 Activity-Based Costing:
Why We Need It?

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 Q: If both factories use machine hours as the
An Example single cost driver to allocate overhead, what will
happen to the prices of blue pens?

Plant A Plant B

Product: blue ballpoint pens Product: blue, red, black, purple,

yellow, green, … ballpoint pens
Annual production: 1 million
• 1 million blue pens (100%) Annual production: 1 million pens
• 500,000 blue pens (50%)
• 10,000 red pens (1%)
Compare product costs in Plant A & B:
• 50,000 black pens (5%)
• Direct labor & direct material costs: similar •
10,000 purple pens (1%)
• Machine setup? • ……
• Client order processing / customer relations?
• Materials ordering / materials handling?
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Activity-Based Costing is better when…
 The products are diversified
 The overhead costs are high

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 Activity-Based Costing

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What is Activity-based Costing (ABC)?
 An approach to the costing and monitoring of activities
 Resources are assigned to activities
 Activities are assigned to cost objects

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Why Do We Need ABC?

• What should a product or process cost?

• What are the non-value-adding activities that contribute to its current cost?
• If a distribution channel or market is unprofitable, where can the company
reduce costs to make it profitable?
• If the company eliminates an unprofitable product or customer, how much
will it save in costs?
• What can the company do during the design and engineering stages to
avoid unnecessary costs?

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 DRONZE INC.

Dronze Inc. produces three product lines of high-quality drones for

recreational and light commercial use:
• DZ-Standard
• DZ-Deluxe
• DZ-Ultimate

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 DRONZE INC. Planned Annual Production
DZ-Standard DZ-Deluxe DZ-Ultimate

Number of units 10,000 8,000 2,000

Production runs 80 runs @ 125 units 80 runs @ 100 units 40 runs @ 50 units

Direct materials $100 $120 $180

Direct labor $180 (9 hours *$20) $220 (11 hours*$20) $260 (13 hours*$20)

Machine hours per 10 12 17

product unit
Total machine hours 100,000 96,000 34,000

Overhead cost is allocated by direct labor hours:

• Total budgeted overhead: $4,896,000
• Total budgeted direct-labor hours: 204,000 hours
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“Volume-based costing system”
• Traditional
• Typical for manufacturing companies

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Trouble of Dronze Inc.
 Dronze Inc. pricing policy: 120% of the full product cost

DZ-Standard DZ-Deluxe DZ-Ultimate

Product cost $496.00 $604.00 $752.00

Target selling price 😱 $595.20 😱 $724.80

😀 $902.40

Actual current price $585.00 $705.00 $940.00

• Standard and Deluxe sell below target price, while Ultimate sell above
• Should Dronze Inc. market for Ultimate, and increase the sales revenue of
Ultimate?

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 Activity-based Costing
 Stage one: identify significant activities and assign overhead costs to each
activity in proportion to resources used

Total budgeted overhead cost

Unit level Batch level Product-sustaining level Facility

level
• Indirect materials • Designing of • Factory-related
• Machine-related production process
costs
• Setup
• Material handling
• Quality assurance
• Packing/shipping

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Activity-based Costing
 Stage two: identify cost drivers to each activity, and allocate overhead to
products

Total budgeted overhead cost

Unit level Batch level Product-sustaining level Facility

level

COST DRIVER

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Selecting Cost Drivers
 A cost driver is a characteristic of an event or activity that results in the
incurrence of costs
 3 factors in selecting cost drivers:
1. Degree of correlation
2. Cost of measurement
3. Behavioral effects
o E.g., for material-handling costs, selecting the number of material moves as
the cost driver may have a desirable behavioral effect of inducing managers to
reduce the number of times materials are moved, thereby reducing material-
handling costs
Selecting Cost Drivers

Activities Cost drivers

Packing and shipping
Production runs

Setup
Machine hours

Materials handling
Shipments
Quality assurance
Inspection hours
Machine maintenance

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Dronze Inc.’s Activities and Cost Drivers

Activity Cost Driver

Machine related Machine hours
Setup Production runs
Material handling Production runs
Purchasing Purchase orders
Quality assurance Inspection hours
Packing & shipping Shipments
Engineering design Engineering hours
Facility Machine hours

Next:
1. Determine the correlation between cost drivers and activity costs  allocation rate
2. Measure the actual amount of cost drivers for each product

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ABC – Allocation of Costs

(1). Calculate allocation rate (3). Calculate activity costs

for the activity allocated to each product

(2). Measure the actual

amount of cost driver for
each product

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ABC – Allocation of Costs
Standard Deluxe Ultimate
Machine related $540,000 $518,400 $183,600
Setup $84,000 $84,000 $42,000
Purchasing $100,000 $96,000 $104,000
Material handling $136,000 $136,000 $68,000
Quality assurance $40,000 $40,000 $30,000
Packing & shipping $120,000 $96,000 $48,000
Engineering design $50,000 $40,000 $40,000
Facility $1,000,000 $960,000 $340,000
TOTAL OVERHEAD $2,070,000 $1,970,400 $855,600
Number of products 10,000 8,000 2,000
OVERHEAD PER $207.00 $246.30 $427.80
UNIT

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 ABC – Allocation of Costs

DZ-Standard DZ-Deluxe DZ-Ultimate

Direct Labor $180.00 $220.00 $260.00

Direct Materials $100.00 $120.00 $180.00

Overhead $207.00 $246.30 $427.80

Total Product Cost $487.00 $586.30 867.60

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 Comparing ABC and Volume Based (Traditional) Costing

Market Price: $585.00 $705.00 $940.00

DZ-Standard DZ-Deluxe DZ-Ultimate

😱 😱 😀
Product cost – volume-based costing $496.00 $604.00 $752.00

Target price – volume-based costing $595.20 $724.80 $902.40

(costs x 120%)
Product cost – ABC $487.00 $586.30 $867.80

Target price – ABC

(costs x 120%) 😀 $584.40
😀 $703.56
😱 $1041.36

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Cost Distortion
 Cost Distortion: improper assignment of costs among a company’s products,
segments, etc.

Two Key Points:

1. A large proportion of non-unit-level activities
• A unit-level cost driver, such as direct labor or machine hours, will not
assign the costs of non-unit-level activities accurately.

2. Product diversity
• When the consumption ratios differ widely between activities, no
single cost driver will accurately assign the resulting overhead costs.

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In-Class Problem
 Whitestone Company produces two subassemblies, JR-14 and RM-13, used in
manufacturing trucks. The company is currently applies overhead based on direct-labor
hours.
 To Switch to ABC, Whitestone has accumulated cost pool information for this year, as
shown in the spreadsheet. This information is based on a product mix of 5,000 units of
JR-14 and 5,000 units of RM-13.
 On January 1, 20x2, Whitestone is planning to increase the prices of JR-14 to $355 and
RM-13 to $455.
 Material prices are not expected to increase in 20x2.
 Direct material usage is expected to decrease by 10% in 20x2 (assuming no impact on
overhead costs).
 In addition, direct labor wage will increase by 8 percent, and all manufacturing
overhead costs will increase by 6 percent.
 Due to the nature of the manufacturing process, the company does not have any
beginning or ending raw materials and work-in-process inventories.

 Budget for current year (20X1) is in the spreadsheet.

 Projected finished goods inventory level for next year is in the spreadsheet.

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In-Class Problem

1. Prepare a table showing for each product line the estimated 20x2 product cost.
2. Prepare a budgeted statement showing the gross margin for Whitestone Company for
20x2, using activity-based costing. The statement should show each product and a total
for the company.

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 Discussions of
Activity-Based Costing

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Traditional and ABC – A Comparison

Traditional Costing Activity-based Costing

Cost Pools One or a limited number Many, to reflect different
activities
Applied Rate Volume based Activity based
Suited For? Labor intensive, low overhead Diverse products, high overhead
Benefits Simple, inexpensive Accurate product costing

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ABC Implementation Challenges
 The implementation of ABC involves a tremendous job of data collection
 The employees are often reluctant as their activities will be measured under
ABC
 The design and implementation should be the responsibility of a cross-
functional team, which normally includes:
 Accounting, finance, IT, marketing, production, and engineering departments
 Can be costly to manage the ABC system

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ABC Merits
 ABC system provides accurate costing of products / services.
 Assists in decision making – pricing strategy, adding/dropping a line of products,
etc.
 The in-depth study of overhead costs under ABC makes all wastages visible.
Thus, better control over product costs.
 ABC system, through accurate measure of activities and costs, supports
performance evaluation and management.

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 Activity-Based Management

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Activity-Based Management
 Using activity-based costing information to support organizational strategy,
improve operations, and manage costs is called activity-based management

“What gets measured, gets managed.”

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Using ABM to Identify Non-Value-Added Activities and Costs

1. Identify activities.
2. Identify non-value-added activities.
3. Understand activity linkages, root causes, and triggers.
4. Establish performance measures.
5. Report non-value-added costs.
 Customer Profitability Analysis

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Customer Profitability Analysis
 Customer profitability analysis uses activity-based costing to determine the
activities, costs, and profit associated with serving particular customers

Requires
special
packaging
Orders
small Demands
quantities fast
service
A costly customer

Often Orders
changes frequently
orders

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Customer Profitability Analysis

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