TUTORIAL -ABC TOTAL COST for a COST OBJECT

EXAMPLE: 1
Direct Cost (Labor Material)
Overhead Cost
+
Total Object Cost
Ir. Haery Sihombing/IP
Sihombing/IP
Pensyarah Pelawat
Fakulti Kejuruteraan Pembuatan
Universiti Teknologi Malaysia Melaka

TRADITIONAL COST ACCOUNTING TRADITIONAL COST ACCOUNTING

•Two products: Product A and Product B
„ Arbitrarily allocates to the cost objects

„ Total Company’s overhead is allocated o Product A : „ Product B:

„ 2 hours of direct labor
the products based on volume based „ 1 hours of direct labor

measure (e.g. labor hours, machine hours) (direct labor cost 1 *RM20/hour (direct labor cost 2 *RM20/ hour
=RM 20.00/hours)
20.00/hours) =RM 40.00/hours)
40.00/hours)

„ Assumption: relation between overhead „ Demand = 100 „ Demand = 950

and the volume based measure
TRADITIONAL COST ACCOUNTING ACTIVITY BASED COSTING

„ TOTAL OVERHEAD = RM 100,000.00 „ More Accurate Cost Management Methodology

„ TOTAL DIRECT LABOR = 2,000 Hours „ Focuses on indirect costs (overhead)
RM 100,000/2000 Hours = RM 50/ Hours „ Traces rather than allocates each expense
category to the particular cost object
„ Product A : 1 hours of direct labor „ Makes “indirect” expense “direct”
„ Product B : 2 hours of direct labor
„ TCA Overhead Allocation : A = RM 50/unit
B = RM 100/unit

ABC Basic Premise When To Use ABC

„ Cost objects consume activities „ Overhead is high
„ Activities consume resources „ Products are diverse: complexity,
„ This consumption of resources is what driver volume, amount of direct labor
costs „ Cost of errors are high
„ Understanding this relationship is critical to „ Competition is stiff
successfully managing overhead
 ABC Steps ABC Illustration

„ Identifies activities 1. INDENTIFY ACTIVITIES

„ Determine cost for each activity
„ Set-up
„ Determine cost drivers
„ Machining
„ Collect activity data
„ Receiving
„ Calculate product cost
„ Packing
„ Engineering

ABC Illustration ABC Illustration

2. DETERMINE ACTIVITY COST 3. DETERMINE COT DRIVERS

„ Set-up = RM 10,000 „ Set-up = Number of Setups
„ Machining = RM 40,000 „ Machining = Machining Hours
„ Receiving = RM 10,000 „ Receiving = Number of Receipt
„ Packing = RM 10,000 „ Packing = Number of Deliveries
„ Engineering = RM 30,000 „ Engineering = Engineering Hours
 ABC Illustration ABC Illustration

4. ACTIVITY DATA 5. PRODUCT COST CALCULATION

ACTIVITY Cost PRODUCT RM PRODUCT RM
(RM) A B „ Overhead for Product A =
Set-
Set-up 10,000 1 2,500 3 7,500 RM 24,500 : 100 = RM 245
Machining 40,000 100 2,000 1900 38,000
Receiving 10,000 1 2,500 3 7,500
Packing 10,000 1 2,500 3 7,500 „ Overhead for Product B =
Engineering 30,000 500 15,000 500 15,000
24,500 75,500
RM 75,000 : 950 = RM 79. 47

PRODUCT COST TCA Vs. ABC Undercosting & Overcosting

Cost for Product A :
Overhead TCA RM 50,00
Overhead ABC RM 245,00
Direct Cost TCA RM 20,00
Direct Cost ABC RM 20,00
TOTAL TCA RM 70,00
TOTAL ABC RM 265,00
EXAMPLE: 2
Cost for Product B :
Jose, Roberta, and Nancy order
Overhead TCA RM 100,00 separate items for lunch.
Overhead ABC RM 79.47 Jose’s order amounts to $14
Direct Cost TCA RM 40,00
Roberta consumed 30
Direct Cost ABC RM 40,00
Nancy’s order is 16
TOTAL TCA RM 140,00
TOTAL ABC RM 119,47
Total $60
What is the average cost per lunch?
 Undercosting & Overcosting Existing Single Indirect- Cost Pool System

EXAMPLE: 3
$60 ÷ 3 = $20 Kole Corporation manufactures a normal lens
(NL) and a complex lens (CL).
Kole currently uses a single indirect-cost rate
Jose and Nancy Roberta is job costing system.
are overcosted. undercosted. Cost objects: 80,000 (NL) and 20,000 (CL).

Existing Single Indirect- Cost Pool System Existing Single Indirect- Cost Pool System

Normal Lenses (NL) Complex Lenses (CL)

Direct materials $1,520,000 Direct materials $ 920,000
Direct mfg. labor 800,000 Direct mfg. labor 260,000
Total direct costs $2,320,000 Total direct costs $1,180,000
Direct cost per unit: $2,320,000 ÷ 80,000 = $29 Direct cost per unit: $1,180,000 ÷ 20,000 = $59
Existing Single Indirect- Cost Pool System Existing Single Indirect- Cost Pool System

INDIRECT-COST All Indirect Costs

POLL COST OBJECT: Indirect Costs
$2,900,000 NL AND CL
LENSES Direct Costs

INDIRECT 50,000 Direct

COST-ALLOCATION Manufacturing
BASE Labor-Hours
DIRECT
COSTS
$58 per Direct Direct
Manufacturing Direct
Manufacturing
Labor-Hour Materials Labor

Existing Single Indirect- Cost Pool System Existing Single Indirect- Cost Pool System

NL: 36,000 × $58 = $2,088,000

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?
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
Existing Single Indirect- Cost Pool System Existing Single Indirect- Cost Pool System

What is the total cost of complex lenses? Normal lenses sell for $60 each and
complex lenses for $142 each.
Direct costs $1,180,000 + Allocated costs
Normal Complex
$812,000 = $1,992,000
Revenue $60.00 $142.00
What is the cost per unit? Cost 55.10 99.60
$1,992,000 ÷ 20,000 = $99.60 Income $ 4.90 $ 42.40
Margin 8.2% 29.9%

Refining a Costing System Refining a Costing System

1. Design of Products and Process
The Design Department designs the molds and defines
Direct-cost tracing processes needed (details of the manufacturing operations).

2. Manufacturing Operations
Indirect-cost pools
Lenses are molded, finished, cleaned, and inspected.

Cost-allocation basis 3. Shipping and Distribution

Finished lenses are packed and sent to the various customers.
 Activity-Based Costing System Activity-Based Costing System

Fundamental Assignment to Other A cross-functional team at Kole

Cost Objects Cost Objects Corporation identified key activities:
Activities Cost of: Design products and processes.
• Product Set up molding machine.
• Service
Costs of Activities • Customer Operate machines to manufacture lenses.
Maintain and clean the molds.

Activity-Based Costing System Activity-Based Costing System

Activity
Indirect Cost Design Setup Shipping
Set up batches of finished lenses for shipment. Pool

Distribute lenses to customers.

Cost Parts- No. of
Allocation Square Setup No. of
Administer and manage all processes. Base feet Hours Shipments

Product Lenses Lenses Lenses

Cost
Objects NL CL Other
 Activity-Based Costing System Activity-Based Costing System

NL CL What is the setup cost per setup-hour?

Quantity produced 80,000 20,000
No. produced/batch 250 50 $409,200 ÷ 2,640 hours = $155
Number of batches 320 400 What is the setup cost per
Setup time per batch 2 hours 5 hours direct manufacturing labor-hour?
Total setup-hours 640 2,000 $409,200 ÷ 50,000 = $8.184
Total setup costs are $409,200.

Activity-Based Costing System Cost Hierarchies

Allocation using direct labor-hours:

NL: $8.184 × 36,000 = $294,624 A cost hierarchy is a categorization
CL: $8.184 × 14,000 = $114,576 of costs into different cost pools.
Total $409,200 Cost drivers bases (cost-allocation bases)
Allocation using setup-hours: Degrees of difficulty in determining
NL: $155 × 640 = $ 99,200 cause-and-effect relationships
CL: $155 × 2,000 = $310,000
Total $409,200
 Cost Hierarchies Output Unit-Level Costs

ABC systems commonly use a

These are resources sacrificed
four-part cost hierarchy to
on activities performed on each
identify cost-allocation bases:
individual unit of product or service.
1. Output unit-level costs
Energy
2. Batch-level costs
Machine depreciation
3. Product-sustaining costs
Repairs
4. Facility-sustaining costs

Batch-Level Costs Product-Sustaining Costs

These are resources sacrificed on These are often called service-sustaining

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
costs and are resources sacrificed on
activities undertaken to support
individual products or services.
Design costs
Engineering costs
 Implementing
Facility-Sustaining Costs
Activity-Based Costing

Step 1 Step 2
These are resources sacrificed on
activities that cannot be traced to Identify cost objects. Identify the direct costs
individual products or services but of the products.
support the organization as a whole.
NL Direct material
General administration CL Direct labor
– rent – building security Mold cleaning and
maintenance

Implementing Implementing
Activity-Based Costing Activity-Based Costing

Cleaning and maintenance costs of Normal Lenses (NL)

$360,000 are direct batch-level costs. Cost Hierarchy
Why? Description Category
Direct materials Unit-level $1,520,000
Because these costs consist of workers’
Direct mfg. labor Unit-level 800,000
wages for cleaning molds after each
Cleaning and maint.Batch-level 160,000
batch of lenses is run.
Total direct costs $2,480,000
 Implementing Implementing
Activity-Based Costing Activity-Based Costing
Step 3
Complex Lenses (CL) Select the cost-allocation bases to use for
Cost Hierarchy allocating indirect costs to the products.
Description Category
(1) (2) (3)
Direct materials Unit-level $ 920,000
Activity Cost Hierarchy Total Costs
Direct mfg. labor Unit-level 260,000
Design Product-sustaining $450,000
Cleaning and maint.Batch-level 200,000
Setups Batch-level $409,200
Total direct costs $1,380,000
Operations Unit-level $637,500

Implementing Implementing
Activity-Based Costing Activity-Based Costing
Step 4 Step 5
Identify the indirect costs associated Compute the rate per unit.
with each cost-allocation base. (1) (5)
Overhead costs incurred are assigned NL CL Total
to activities, to the extent possible, on Setup-hours: 640 2,000 2,640
the basis of a cause-and-effect relationship. $409,200 ÷ 2,640 = $155
 Implementing Implementing
Activity-Based Costing Activity-Based Costing
Step 6 Step 7
Compute the indirect costs allocated Compute the costs of the products.
to the products. NL and CL would show three
NL: $155 × 640 = $ 99,200 direct cost categories.
CL: $155 × 2,000 = 310,000 1. Direct materials
Total $409,200
2. Direct manufacturing labor
3. Cleaning and maintenance

Implementing ABC and Department

Activity-Based Costing Indirect-Cost Rates

NL and CL would show six indirect cost pools.

Many companies have evolved their
1. Design costing system from using a single
2. Molding machine setups cost pool to using separate indirect-cost
3. Manufacturing operations rates for each department:

4. Shipment setup Design

5. Distribution Manufacturing

6. Administration Distribution
 ABC and Department
SUMMARY of ABC APPOACH
Indirect-Cost Rates
„ ABC is more accurate cost management system
than Traditional Cost Accounting (TCA)
Why?
„ Traditional Cost Accounting (TCA) is unable to
Because the cost drivers of resources in each calculate the “true” of a product
department or subdepartment differ from the
single, company-wide, cost-allocation base.
ABC systems are a further refinement of
department costing systems.

Benefits of ABC Systems Benefits of ABC Systems

Significant amounts of indirect costs are

allocated using only one or two cost pools. Products that a company is well-suited to
make and sell show small profits while
All or most costs are identified
products for which a company is less
as output unit-level costs.
suited show large profits.
Products make diverse demands on
Complex products appear to be very
resources because of differences in
profitable and simple products
volume, process steps, batch size,
appear to be losing money.
or complexity.
 Benefits of ABC Systems
Operations staff have significant
disagreements with the accounting
staff about the costs of manufacturing
and marketing products and services.
Limitations of ABC Systems
Activity-cost rates also need to be
updated regularly.
Very detailed ABC systems are costly
to operate and difficult to understand.
Limitations 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.