TUTORIAL -ABC TOTAL COST for a COST OBJECT · PDF fileTOTAL COST for a COST OBJECT Direct Cost...

TUTORIAL TUTORIAL --ABCABC

Ir. Haery Ir. Haery SihombingSihombing/IP/IPPensyarah Pelawat

Fakulti Kejuruteraan PembuatanUniversiti Teknologi Malaysia Melaka

TOTAL COST for a COST OBJECTTOTAL COST for a COST OBJECT

Direct CostDirect Cost (Labor Material)(Labor Material)

Overhead CostOverhead Cost

++

Total Object CostTotal Object Cost

EXAMPLE: 1

TRADITIONAL COST ACCOUNTINGTRADITIONAL COST ACCOUNTING

Arbitrarily allocates to the cost objectsArbitrarily allocates to the cost objects

Total CompanyTotal Company’’s overhead is allocated o s overhead is allocated o

the products based on volume based the products based on volume based

measure (measure (e.g. labor hours, machine hourse.g. labor hours, machine hours))

Assumption: relation between overhead Assumption: relation between overhead

and the volume based measureand the volume based measure

Product A :Product A :1 hours of direct labor1 hours of direct labor

(direct labor cost 1 *RM20/hour(direct labor cost 1 *RM20/hour

=RM =RM 20.00/20.00/hours)hours)

Demand = 100Demand = 100

TRADITIONAL COST ACCOUNTINGTRADITIONAL COST ACCOUNTING

Product B:Product B:2 hours of direct labor2 hours of direct labor

(direct labor cost 2 *RM20/ hour (direct labor cost 2 *RM20/ hour

=RM =RM 40.0040.00/hours)/hours)

Demand = 950Demand = 950

•Two products: Product AProduct A and Product BProduct B

TOTAL OVERHEAD = RM 100,000.00TOTAL OVERHEAD = RM 100,000.00

TOTAL DIRECT LABOR = 2,000 HoursTOTAL DIRECT LABOR = 2,000 Hours

RM 100,000/2000 Hours = RM 50/ HoursRM 100,000/2000 Hours = RM 50/ Hours

Product A :Product A : 1 hours of direct labor1 hours of direct labor

Product B :Product B : 2 hours of direct labor2 hours of direct labor

TCA Overhead Allocation : TCA Overhead Allocation : AA = RM = RM 50/unit50/unit

BB = RM = RM 100/unit100/unit

TRADITIONAL COST ACCOUNTINGTRADITIONAL COST ACCOUNTING ACTIVITY BASED COSTINGACTIVITY BASED COSTING

More Accurate Cost Management MethodologyMore Accurate Cost Management Methodology

Focuses on indirect costs (overhead)Focuses on indirect costs (overhead)

Traces rather than allocates each expense Traces rather than allocates each expense

category to the particular cost objectcategory to the particular cost object

MakesMakes ““indirectindirect”” expenseexpense ““directdirect””

ABC Basic PremiseABC Basic Premise

Cost objects consume activitiesCost objects consume activities

Activities consume resourcesActivities consume resources

This consumption of resources is what driver This consumption of resources is what driver

costscosts

Understanding this relationship is critical to Understanding this relationship is critical to

successfully managing overheadsuccessfully managing overhead

When To Use ABCWhen To Use ABC

Overhead is highOverhead is high

Products are diverse: complexity, Products are diverse: complexity,

volume, amount of direct laborvolume, amount of direct labor

Cost of errors are highCost of errors are high

Competition is stiffCompetition is stiff

ABC StepsABC Steps

Identifies activitiesIdentifies activities

Determine cost for each activityDetermine cost for each activity

Determine cost driversDetermine cost drivers

Collect activity dataCollect activity data

Calculate product costCalculate product cost

ABC IllustrationABC Illustration

SetSet--upup

MachiningMachining

ReceivingReceiving

PackingPacking

EngineeringEngineering

1. INDENTIFY ACTIVITIES1. INDENTIFY ACTIVITIES

SetSet--upup

MachiningMachining

ReceivingReceiving

PackingPacking



2. DETERMINE ACTIVITY COST2. DETERMINE ACTIVITY COST

= RM 10,000= RM 10,000

= RM 40,000= RM 40,000

= RM 10,000= RM 10,000

= RM 10,000= RM 10,000

= RM 30,000= RM 30,000


3. DETERMINE COT DRIVERS3. DETERMINE COT DRIVERS

SetSet--upup

MachiningMachining

ReceivingReceiving

PackingPacking


= Number of Setups= Number of Setups

= Machining Hours= Machining Hours

= Number of Receipt= Number of Receipt

= Number of Deliveries= Number of Deliveries

= Engineering Hours= Engineering Hours


4. ACTIVITY DATA4. ACTIVITY DATA

75,50075,50024,50024,500

15,00015,00050050015,00015,00050050030,00030,000EngineeringEngineering

7,5007,500332,5002,5001110,00010,000PackingPacking

7,5007,500332,5002,5001110,00010,000ReceivingReceiving

38,00038,000190019002,0002,00010010040,00040,000MachiningMachining

7,5007,500332,5002,5001110,00010,000SetSet--upup

RMRMPRODUCTPRODUCT

BB

RMRMPRODUCTPRODUCT

AA

CostCost

(RM)(RM)

ACTIVITYACTIVITYOverhead for Product A =Overhead for Product A =

RM 24,500 : 100 = RM RM 24,500 : 100 = RM 245245

Overhead for Product B =Overhead for Product B =

RM 75,000 : 950 = RM RM 75,000 : 950 = RM 79. 4779. 47


5. PRODUCT COST CALCULATION5. PRODUCT COST CALCULATION

PRODUCT COST TCA Vs. ABCPRODUCT COST TCA Vs. ABC

OverheadOverhead TCATCA RMRM 50,0050,00

OverheadOverhead ABCABC RMRM 245,00245,00

Direct Cost Direct Cost TCATCA RMRM 20,0020,00

Direct Cost Direct Cost ABC ABC RMRM 20,0020,00

TOTAL TOTAL TCATCA RMRM 70,0070,00

TOTAL TOTAL ABCABC RMRM 265,00 265,00

OverheadOverhead TCA TCA RMRM 100,00100,00

OverheadOverhead ABCABC RMRM 79.4779.47

Direct Cost Direct Cost TCATCA RMRM 40,0040,00

Direct Cost Direct Cost ABC ABC RMRM 40,0040,00

TOTAL TOTAL TCATCA RMRM 140,00140,00

TOTAL TOTAL ABC ABC RMRM 119,47 119,47

Cost for Product A : Cost for Product A : Cost for Product B :Cost for Product B :

Undercosting & Undercosting & OvercostingOvercosting

Jose, Roberta, and Nancy order

separate items for lunch.

Jose’s order amounts to $14

Roberta consumed 30

Nancy’s order is 16

Total $60

What is the average cost per lunch?

EXAMPLE: 2

$60 ÷ 3 = $20

Jose and Nancy

are overcosted.

Roberta is

undercosted.

Undercosting & Undercosting & OvercostingOvercosting Existing Single IndirectExisting Single Indirect-- Cost Pool SystemCost Pool System

Kole Corporation manufactures a normal lens

(NL) and a complex lens (CL).

Kole currently uses a single indirect-cost rate

job costing system.

Cost objects: 80,000 (NL) and 20,000 (CL).

EXAMPLE: 3

Normal Lenses (NL)

Direct materials $1,520,000

Direct mfg. labor 800,000

Total direct costs $2,320,000

Direct cost per unit: $2,320,000 ÷ 80,000 = $29

Existing Single IndirectExisting Single Indirect-- Cost Pool SystemCost Pool System

Complex Lenses (CL)

Direct materials $ 920,000

Direct mfg. labor 260,000

Total direct costs $1,180,000

Direct cost per unit: $1,180,000 ÷ 20,000 = $59


All Indirect Costs$2,900,000

50,000 DirectManufacturingLabor-Hours

INDIRECT-COST

POLL

INDIRECT

COST-ALLOCATION

BASE

$58 per DirectManufacturing

Labor-Hour


Indirect Costs

Direct Costs

COST OBJECT:

NL AND CL

LENSES

DIRECT

COSTS

Direct

Materials

DirectManufacturing

Labor


Kole uses 36,000 direct manufacturing

labor-hours to make NL and 14,000 direct

manufacturing labor-hours to make CL.

How much indirect costs are allocated

to each product?


NL: 36,000 × $58 = $2,088,000

CL: 14,000 × $58 = $812,000

What is the total cost of normal lenses?

Direct costs $2,320,000 +

Allocated costs $2,088,000 = $4,408,000

What is the cost per unit?

$4,408,000 ÷ 80,000 = $55.10


What is the total cost of complex lenses?

Direct costs $1,180,000 + Allocated costs

$812,000 = $1,992,000

What is the cost per unit?

$1,992,000 ÷ 20,000 = $99.60


Normal lenses sell for $60 each and

complex lenses for $142 each.

Normal Complex

Revenue $60.00 $142.00

Cost 55.10 99.60

Income $ 4.90 $ 42.40

Margin 8.2% 29.9%


Refining a Costing SystemRefining a Costing System

Direct-cost tracing

Indirect-cost pools

Cost-allocation basis

Refining a Costing SystemRefining a Costing System

1. Design of Products and Process

The Design Department designs the molds and defines

processes needed (details of the manufacturing operations).

2. Manufacturing Operations

Lenses are molded, finished, cleaned, and inspected.

3. Shipping and Distribution

Finished lenses are packed and sent to the various customers.

ActivityActivity--Based Costing SystemBased Costing System

Fundamental

Cost Objects

Activities

Costs of Activities

Assignment to Other

Cost Objects

Cost of:

• Product

• Service

• Customer


A cross-functional team at Kole

Corporation identified key activities:

Design products and processes.

Set up molding machine.

Operate machines to manufacture lenses.

Maintain and clean the molds.


Set up batches of finished lenses for shipment.

Distribute lenses to customers.

Administer and manage all processes.


No. ofSetupHours

Lenses

NL

Lenses

CL

Lenses

Other

CostAllocationBase

ProductCostObjects

No. ofShipments

Parts-Square

feet

SetupDesign ShippingActivityIndirect CostPool


NL CL

Quantity produced 80,000 20,000

No. produced/batch 250 50

Number of batches 320 400

Setup time per batch 2 hours 5 hours

Total setup-hours 640 2,000

Total setup costs are $409,200.


What is the setup cost per setup-hour?

$409,200 ÷ 2,640 hours = $155

What is the setup cost per

direct manufacturing labor-hour?

$409,200 ÷ 50,000 = $8.184


Allocation using direct labor-hours:

NL: $8.184 × 36,000 = $294,624

CL: $8.184 × 14,000 = $114,576

Total $409,200

Allocation using setup-hours:

NL: $155 × 640 = $ 99,200

CL: $155 × 2,000 = $310,000

Total $409,200

Cost HierarchiesCost Hierarchies

A cost hierarchy is a categorization

of costs into different cost pools.

Cost drivers bases (cost-allocation bases)

Degrees of difficulty in determining

cause-and-effect relationships

Cost HierarchiesCost Hierarchies

ABC systems commonly use a

four-part cost hierarchy to

identify cost-allocation bases:

1. Output unit-level costs

2. Batch-level costs

3. Product-sustaining costs

4. Facility-sustaining costs

Output UnitOutput Unit--Level CostsLevel Costs

These are resources sacrificed

on activities performed on each

individual unit of product or service.

Energy

Machine depreciation

Repairs

BatchBatch--Level CostsLevel Costs

These are resources sacrificed on

activities that are related to a group

of units of product(s) or service(s)

rather than to each individual unit

of product or service.

Setup-hours

Procurement costs

ProductProduct--Sustaining CostsSustaining Costs

These are often called service-sustaining

costs and are resources sacrificed on

activities undertaken to support

individual products or services.

Design costs

Engineering costs

FacilityFacility--Sustaining CostsSustaining Costs

These are resources sacrificed on

activities that cannot be traced to

individual products or services but

support the organization as a whole.

General administration

– rent – building security

ImplementingImplementing

ActivityActivity--Based CostingBased Costing

Identify cost objects.

NL

CL

Identify the direct costs

of the products.

Direct material

Direct labor

Mold cleaning and

maintenance

Step 1Step 1 Step 2Step 2



Cleaning and maintenance costs of

$360,000 are direct batch-level costs.

Why?

Because these costs consist of workers’

wages for cleaning molds after each

batch of lenses is run.



Normal Lenses (NL)Cost Hierarchy

Description CategoryDirect materials Unit-level $1,520,000Direct mfg. labor Unit-level 800,000Cleaning and maint.Batch-level 160,000Total direct costs $2,480,000



Complex Lenses (CL)Cost Hierarchy

Description CategoryDirect materials Unit-level $ 920,000Direct mfg. labor Unit-level 260,000Cleaning and maint.Batch-level 200,000Total direct costs $1,380,000



Select the cost-allocation bases to use for

allocating indirect costs to the products.

(1) (2) (3)

Activity Cost Hierarchy Total Costs

Design Product-sustaining $450,000

Setups Batch-level $409,200

Operations Unit-level $637,500

Step 3



Identify the indirect costs associated

with each cost-allocation base.

Overhead costs incurred are assigned

to activities, to the extent possible, on

the basis of a cause-and-effect relationship.

Step 4Step 4



Compute the rate per unit.

(1) (5)

NL CL Total

Setup-hours: 640 2,000 2,640

Step 5

$409,200 ÷ 2,640 = $155



Compute the indirect costs allocated

to the products.

NL: $155 × 640 = $ 99,200

CL: $155 × 2,000 = 310,000

Total $409,200

Step 6



Compute the costs of the products.

NL and CL would show three

direct cost categories.

Step 7

1. Direct materials

2. Direct manufacturing labor

3. Cleaning and maintenance



NL and CL would show six indirect cost pools.

1. Design

2. Molding machine setups

3. Manufacturing operations

4. Shipment setup

5. Distribution

6. Administration

ABC and DepartmentABC and Department

IndirectIndirect--Cost RatesCost Rates

Many companies have evolved their

costing system from using a single

cost pool to using separate indirect-cost

rates for each department:

Design

Manufacturing

Distribution

ABC and DepartmentABC and Department

IndirectIndirect--Cost RatesCost Rates

Why?

Because the cost drivers of resources in each

department or subdepartment differ from the

single, company-wide, cost-allocation base.

ABC systems are a further refinement of

department costing systems.

SUMMARY of ABC APPOACHSUMMARY of ABC APPOACH

ABC is more accurate cost management system ABC is more accurate cost management system

than Traditional Cost Accounting (TCA)than Traditional Cost Accounting (TCA)

Traditional Cost Accounting (TCA) is unable to Traditional Cost Accounting (TCA) is unable to

calculate the calculate the ““truetrue”” of a productof a product

Benefits of ABC SystemsBenefits of ABC Systems

Significant amounts of indirect costs are

allocated using only one or two cost pools.

All or most costs are identified

as output unit-level costs.

Products make diverse demands on

resources because of differences in

volume, process steps, batch size,

or complexity.


Products that a company is well-suited to

make and sell show small profits while

products for which a company is less

suited show large profits.

Complex products appear to be very

profitable and simple products

appear to be losing money.


Operations staff have significant

disagreements with the accounting

staff about the costs of manufacturing

and marketing products and services.

Limitations of ABC SystemsLimitations of ABC Systems

The main limitations of ABC are the

measurements necessary to

implement the system.

ABC systems require management

to estimate costs of activity pools

and to identify and measure cost

drivers for these pools.

Limitations of ABC SystemsLimitations of ABC Systems

Activity-cost rates also need to be

updated regularly.

Very detailed ABC systems are costly

to operate and difficult to understand.

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