Chapter 8

Activity-Based Costing A Tool to Aid Decision Making

Learning Objectives
LO1. LO2. LO3. LO4. LO5. LO6. LO7. Understand activity-based costing and how it differs from a traditional costing system. Assign costs to cost pools using a first-stage allocation. Compute activity rates for cost pools. Assign costs to a cost object using a second-stage allocation. Prepare a report showing activity-based costing margins from an activity view. Compare product costs computed using traditional and activity-based costing methods. (Appendix 8A) Prepare an action analysis report using activity-based costing data and interpret the report.

New in this Edition

New In Business boxes have been added. Many new exercises have been added to the end of chapter materials.

Chapter Overview
A. Background for the Instructor. A few general comments will help set the stage for the
chapter. 1. ABC and GAAP. Some ABC systems are used for external as well as for internal financial reports. However, in most cases, a companys ABC system is not integrated with the companys regular costing system. We agree with experts who argue against integrating the two systems because of their very different purposes. We have chosen to emphasize the use of activity-based costing as a decision-making tool, although a number of exercises and problems at the end of the chapter permit an instructor to explore the use of ABC as an alternative to traditional costing systems for external reporting. The ABC approach taken in the chapter. In practice activity-based costing comes in many variations. We have consciously combined the best elements from practice and have added some innovations of our own. As a consequence, the material in the chapter should be regarded as ABC as it should be rather than a description of ABC as it is commonly implemented in practice.

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B. Differences Between ABC and Traditional Costing. (Exercise 8-16) The product
costs computed in this chapter differ in major ways from the product costs in Chapters 2, 3, and 4 that describe traditional costing systems.

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Manufacturing costs in ABC. In the ABC system described in the chapter, some manufacturing costs are excluded from product costs. This treatment follows recommendations by Cooper and Kaplan and others. a. The chapter advocates excluding the costs of idle capacity from product costs, but without getting into the details of how this is done. It would be helpful, but not absolutely necessary, for your students to have read Appendix 3A, which goes into this subject in greater depth. b. We also exclude organization-sustaining costs from activity-based costing product costs. These costs will be discussed in more detail below. Basically, organizationsustaining costs are excluded from product costs because they are not caused by individual products and are not relevant in decisions concerning those products.

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Non-manufacturing costs in ABC. Strictly speaking, non-manufacturing costs are excluded from product costs under GAAP. However, to the extent that these costs are caused by specific products, excluding them results in misleading information for making decisions. It is true that these non-manufacturing costs can be deducted from product revenues in addition to unit product costs when decisions are made, but this is not always done. It is probably safer to build these costs right into product costs, which is the approach taken in this chapter. (Remember, these costs are to be used for making decisions, not valuing inventory and cost of goods sold.) Multiple overhead cost pools in ABC. Traditional overhead costing systems are described in Chapters 2, 3, and 4. In these traditional systems, an entire plant may have a single overhead cost pool or each production department may have a separate overhead cost pool. In nearly all cases, overhead costs are applied to products using either direct labor-hours, direct labor cost, or machine-hours. In activity-based costing, each major activity has its own separate overhead cost pool. An activity is any event that causes the consumption of resources. The activities tracked in the ABC system may cut across many departments and the measures of activity (i.e., allocation bases) may be quite different from the traditional allocation bases.

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C. Cost Hierarchy in Activity-Based Costing. (Exercises 8-8, 8-13, and 8-15.)

Thousands of activities are carried out in most organizations. It would not be practical to track all of them in an activity-based costing system. A great deal of simplification is necessary. Activities and their costs must be combined to reduce complexity and record-keeping requirements. One way to simplify is to group activities into a hierarchy. Activities, and their costs, can be combined within each level of the hierarchy into activity cost poolshopefully with minimal loss in accuracy. The cost hierarchy used in the text is not the only scheme that could be used, but it is reasonably comprehensive. The levels in the hierarchy are as follows: 1. 2. Unit-level activities. These activities are performed each time a unit is produced. For example, providing power to run processing equipment is likely to be a unit-level activity. Batch-level activities. These 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.

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Product-level activities. These activities relate to specific products and must be carried out regardless of how many batches or units of product are produced or sold. For example, designing a product, advertising a product, and maintaining a product manager and staff are all product-level activities. Customer-level activities. These activities relate to specific customers and include sales calls, catalog mailings, and general technical support not tied to any specific product. Organization-sustaining activities. These activities are carried out regardless of which products are produced, how many batches are run, or how many units are made. This category of activities includes cleaning executive offices, providing a computer network, arranging for loans, preparing annual reports to shareholders, and so on.

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D. Mechanics of Activity-Based Costing. (Exercises 8-9, 8-10, 8-11, 8-18, 8-20, and 816.) Exhibit 8-6 is a useful Exhibit for summarizing the mechanics of activity-based costing. You may want to refer to it frequently as you walk students through the steps of assigning costs using ABC. 1. Overview. Once the activity cost pools and their activity measures have been defined, costs are allocated to the activity cost pools. The costs in the activity cost pools are then divided by their activity measures to determine activity rates. (Activity rates are like the overhead rates of Chapter 3.) The activity rates are then used to assign costs to cost objects such as products and customers. For example, if a customer generates five orders and the activity rate for orders is $15 per order, then the customer would be assigned $75 in order costs. The mechanics are fundamentally no different from the mechanics covered in Chapter 3 for applying overhead to products. The main difference is that instead of one predetermined overhead rate, many activity rates are used. First-stage allocations. (Exhibits 8-13, 8-15, and 8-9.) The first stage in the allocation process is based on a table showing the distribution of resource consumption across activities for each category of cost in the companys bookkeeping system. For example, if indirect factory wages is one of the accounts in the companys bookkeeping system, the table would show what percentage of indirect wages is attributable to each of the activities in the companys ABC system. The text describes how interviews can be used to elicit these percentage distributions, but these percentage distributions are always given in all examples and problems. The first-stage allocation is accomplished by multiplying the total cost of each account by the percentages in its row in the table showing the distribution of resource consumption across activities. For example, if the table shows that 20% of indirect factory wages are attributable to processing batches, then 20% of the cost of indirect factory wages would be allocated to that activity cost pool. The end product of the first stage of the allocation process is a table showing how each cost such as indirect factory wages is divided up among activity cost pools. The Other activity cost pool. In the text one activity cost pool is usually labeled Other. Costs are allocated to this activity cost pool in the first stage of the allocation process but they are not subsequently allocated to products, customers, or other cost objects. This activity cost pool is supposed to capture costs of idle capacity and organization-sustaining costs that should not be allocated to cost objects because they are not caused by the cost objects. In practice, these costs are almost always allocated to cost

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objectsthe costs of idle capacity and organization-sustaining costs are seldom segregated from other costs. 4. Computation of activity rates. (Exhibit 8-5.) The total cost assigned to an activity cost pool in the first-stage allocation is divided by the total amount of activity for the cost pool to determine the activity rate for that cost pool. Each activity cost pool has its own activity rate. Second-stage allocations of costs to cost objects. (Exhibit 8-8.) The activity rates can be used to assign costs to any cost object. The activity rate is simply multiplied by the amount of activity for the cost object. Product and customer marginsactivity view. (Exhibit 8-9) Margins for products, customers, and other cost objects can be easily constructed using the costs in Exhibit 8-8. These costs are combined with whatever costs are directly traced to the cost object (for example, direct materials), and deducted from the sales attributable to the cost object. This is the conventional approach in activity-based costing.

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E. Activity Rates and Activity-Based Management. (Exercise 8-10.) Activity rates (i.e.,
the cost per unit of activity) can be useful to managers in targeting business process improvements. If activity rates are available from other organizations, an unusually high cost for carrying out a particular activity can signal room for improvement. Also, if similar activities are carried out at different locations within the same organization, activity rates can help identify which locations are most efficient. The methods used at the most efficient locations can then be applied to other locations.

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The Impact on Product Costs of Adopting an ABC System. (Exercise 8-21.) Unit product costs are different under activity-based costing and traditional cost systems for a number of reasons. First, some manufacturing costs (i.e., the costs of idle capacity and organizationsustaining costs) are excluded from product costs under the activity-based costing approach described in the text. Second, some non-manufacturing costs are included in product costs under activity-based costing. These two differences affect the total amount of cost allocated to products. However, even if these differences are ignored or suppressed, the unit product costs will still differ between activity-based costing and traditional costing systems. For example, if a company switches to activity-based costing for external financial reports, the total costs allocated to products will remain the same, but the pattern of allocation will differ. The biggest changes in product costs from switching to an ABC system occur when the ABC system includes batch or product-level costs. In this case, costs ordinarily shift from highvolume products to low-volume products. Consequently, the total and per unit costs of the highvolume products decrease and the total and per unit costs of the low-volume products increase. When overhead costs are shifted from one product to another, a given dollar amount is implicitly subtracted from the total cost of one product and added to the total cost of the other product. Since the total cost of all products remains the same, what is taken away from one product must be added to another product. However, the effects on unit costs are not symmetrical. The perunit costs of the low-volume products must go up more than the per-unit costs of the highvolume products go down. G. Appendix 8A: ABC Action Analysis. (Exercises 8-12, 8-19, and 8-21) The
conventional ABC analysis discussed in the chapter has some important drawbacks for decision-making. Most importantly, with a product margin analysis such as the one shown

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in Exhibit 8-9, it is unclear who is actually responsible for a cost. For example, if a product is dropped because of a negative margin, it is unclear who would be responsible for actually carrying out reductions in costs. An activity cost pool may contain costs from many departments. If a product is dropped, the activities associated with the product will presumably disappear, but will the costs? If it is unclear who would be responsible for reducing the costs, no one may actually take any action. This is particularly true for personnel costs. What manager will voluntarily give up personnel if there is no accountability? Be sure to reinforce the idea that the costs assigned to a product, customer, or whatever in an activity-based costing system are relevant in a decision only if the costs would actually change if the decision were taken. For example, in a product drop decision, the costs of resources are relevant only if spending would decrease as a result of the decision or the resources would be redeployed to more profitable uses. In the latter case, this means that the resources would have to be redeployed to the constraint. An action analysis report makes it much clearer what costs are likely to be relevant in a decision and who in the organization would be responsible for the cost if an action is taken. Unfortunately, preparing an action analysis report requires considerably more work than the more conventional analysis. 1. Activity rates. (Exhibit 8A-2) The action analysis approach differs from the conventional ABC approach beginning with the computation of the activity rates. In the conventional analysis, a single activity rate is computed for each activity cost pool. In an action analysis, a rate is computed for each cost category within an activity cost pool. Looking at Exhibit 8A-2, only the rates at the bottom of the Exhibit would be computed in a conventional analysis. In an action analysis, the entire table is filled out. Second-stage allocations. (Exhibit 8A-3) In an action analysis, an entire matrix of costs is computed rather than just a total cost for each activity cost pool. Looking at Exhibit 8A-3, only the costs at the bottom of the Exhibit would be computed in a conventional analysis. In an action analysis, the entire table is filled out by multiplying activities by the activity rates in each cell. The conventional activity analysis. From the action analysis cost matrix in Exhibit 8A-3, it is easy to construct the conventional activity analysis report showing product margins. Just take the totals from the bottom of the cost matrix. Note that these costs are identical to the costs computed earlier in the chapter in Exhibit 8-8. However, using the row totals from Exhibit 8A-3, it is possible to look at the margins of products and other cost objects from a different perspective. Instead of abstract labels like order processing costs for the various activity cost pools, the costs are labeled using the account titles from the companys bookkeeping system. This makes it clear what the costs actually consist of and who in the organization would be responsible for taking action if a decision is made. Ease of adjustment codes. (Exhibit 8A-4) Some costs, such as direct materials, are much easier to adjust than other costs, such as the total wages of experienced supervisors. As a consequence, some costs are more likely to be relevant in a decision than others. The ease of adjustment codes provide a way of assisting managers in making these distinctions. a. Green. These costs adjust automatically to changes in activity without any management action. Examples include direct materials and the cost of power to run machines.

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b. Yellow. These costs could, in principle, be adjusted to changes in activity, but management action would be required. Direct labor is usually such a cost, as are many discretionary expenses. c. Red. These costs would be very difficult to adjust to changes in activity and management action would be required. Examples include time-based depreciation and many salaries. 5. Action analysis report. (Exhibit 8A-5) The action analysis report combines the cost information from the row totals in Exhibit 8A-3 with the ease of adjustment codes in Exhibit 8A-4. This report makes it much clearer where costs would need to be adjusted in the organization as the result of an action, who would be responsible for the change in costs, and which costs are likely to be relevant and which costs are likely to be irrelevant in decisions. Such an action analysis report is not the final step in the decision-making process. Further analysis, such as illustrated in Chapter 13, would be necessary before making any major decision.

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Assignment Materials
Assignment Exercise 8-1 Exercise 8-2 Exercise 8-3 Exercise 8-4 Exercise 8-5 Exercise 8-6 Exercise 8-7 Exercise 8-8 Exercise 8-9 Exercise 8-10 Exercise 8-11 Exercise 8-12 Exercise 8-13 Exercise 8-14 Exercise 8-15 Exercise 8-16 Exercise 8-17 Exercise 8-18 Exercise 8-19 Exercise 8-20 Exercise 8-21 Problem 8-22 Problem 8-23 Problem 8-24 Problem 8-25 Problem 8-26 Problem 8-27 Problem 8-28 Problem 8-29 Problem 8-30 Case 8-31 Case 8-32 Case 8-33 Case 8-34 Topic ABC cost hierarchy................................................................ First-stage allocation.............................................................. Compute activity rates........................................................... Compute ABC product costs.................................................. Product and customer profitability analysis........................... Contrasting traditional and ABC product costs...................... (Appendix 8A) Preparing an action analysis report................ Cost hierarchy........................................................................ First-stage allocations............................................................ Computing and interpreting activity rates.............................. Second-stage allocation to an order........................................ (Appendix 8A) Second-stage allocation to an order using the action analysis approach.............................................. Activity measures................................................................... Computing ABC product costs.............................................. Cost hierarchy and activity measures..................................... Calculating and interpreting activity-based costing data........ Activity-based costing as an alternative to traditional product costing.................................................................. Second-stage allocation and margin calculations................... (Appendix 8A) Second-stage allocation and margin calculations using the action analysis approach................. Comprehensive activity-based costing exercise..................... (Appendix 8A) Comprehensive activity-based costing exercise............................................................................. Activity-based costing as an alternative to traditional product costing.................................................................. (Appendix 8A) Activity rates and activity-based management...................................................................... Evaluating the profitability of services................................... (Appendix 8A) Evaluating the profitability of services using an action analysis approach............................................... Activity-based costing as an alternative to traditional product costing.................................................................. Activity-based costing and bidding on jobs........................... Second-stage allocations and product margins....................... (Appendix 8A) Second-stage allocations and product margins.............................................................................. Activity-based costing as an alternative to traditional product costing.................................................................. Activity-based costing and pricing......................................... Contrasting activity-based costing and traditional costing..... (Appendix 8A) Comprehensive activity-based costing case. . Activity-based costing as an alternative to traditional product costing.................................................................. Level of Difficulty Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Medium Medium Medium Medium Medium Medium Medium Medium Medium Difficult Difficult Difficult Difficult Suggested Time 10 min. 15 min. 10 min. 10 min. 30 min. 30 min. 20 min. 10 min. 10 min. 20 min. 10 min. 30 min. 10 min. 20 min. 15 min. 30 min. 45 min. 15 min. 45 min. 30 min. 60 min. 60 min. 45 min. 45 min. 75 min. 60 min. 45 min. 20 min. 30 min. 45 min. 90 min. 90 min. 120 min. 90 min.

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Essential Problems: Problem 8-22 or Problem 8-26, Problem 8-24, Problem 8-27, Problem 8-28 Supplementary Problems: Problem 8-30, Case 8-31, Case 8-32, Case 8-34 Linked Exercises: Exercise 8-10 should be assigned only if Exercise 8-9 is also assigned. Exercise 8-12 should only be assigned if Exercise 8-11 is assigned. Appendix 8A Essential Problems: Problem 8-23, Problem 8-25, Problem 8-29 Appendix 8A Supplementary Problems: Case 8-33

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Chapter 8 Lecture Notes Helpful Hint: Before beginning the lecture, show students the seventh and eighth segments from the second tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. These segments introduce students to many of the concepts discussed in chapter 8. The lecture notes reinforce the concepts in the video. Chapter theme: This chapter introduces students to activity-based costing (ABC) which is a tool that has been embraced by a wide variety of service, manufacturing, and non-profit organizations. 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. It is ordinarily used as a supplement to, rather than as a replacement for, the companys usual costing system. How costs are treated under activity-based costing A. Best practice ABC differs from traditional cost accounting in five ways:
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ABC assigns both manufacturing and nonmanufacturing costs to products. Traditional cost systems only assign manufacturing costs to products.

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1. For example, ABC systems can assign sales 4 5

commissions, shipping costs, and warranty repair costs to specific products.

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ABC systems do not assign all manufacturing costs to products, while traditional cost systems do assign all manufacturing costs to products. 1. This is because ABC only assigns a cost to a product if decisions concerning that product will cause changes in the cost.

Helpful Hint: Emphasize that ABC systems that are used to support internal decision making do not need to conform to GAAP. Therefore, while GAAP requires treating S, G & A as a period expense and it requires assigning all manufacturing costs to products, ABC systems can assign S, G & A expenses to products and they can exclude manufacturing costs from product costs where appropriate.
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ABC uses more cost pools than traditional cost systems which often use a single plantwide overhead pool or just one overhead pool per department. 1. ABC cost pools are created to correspond to the activities performed in an organization that cause the consumption of overhead resources. a. The total number of ABC cost pools will definitely exceed one (as in the plantwide approach) and it is likely to exceed the number of departments
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departmental approach) since more

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than one activity is often performed within each department. In Business Insights The insights revealed by creating a larger number of cost pools as in an ABC system can change the focus of a managers attention. For example: ABC Changes the Focus (page 317) Euclid Engineering makes parts and components for automobile manufacturers. As a result of its ABC study, its managers realized that the company was spending more on launching new products than on direct labor expenses to produce existing products. Product development and launch expenses were 10% of expenses whereas, direct labor costs were only 9%. Rather than focusing on reducing direct labor costs, managers turned their attention to reducing product launch costs. Euclids ABC information was shared with customers who used the detailed breakdown of the costs of design and engineering activities to compare the cost of product design features with the increase in functionality offered by those features. Peddling to Oblivion (page 319) Claudia Post started a small bicycle-messenger service, Diamond Courier, in Philadelphia. Her business eventually expanded to include truck deliveries, airfreight services, a parts-distribution
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subpoenas and prepared court filings.

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 Within three years Diamond was booking $3.1 million dollars in annual sales and had 40 bike messengers, an office staff of 25 employees, and about 50 independent drivers. However, the company was losing money! An ABC analysis revealed that the average cost of a bike delivery, including overhead, was $9.24, but she was charging only $4.60. She decided to drop the bicycle messenger service and concentrate on other profitable lines of business. Further analysis later led to closing down the airfreight and parts-distribution divisions. Today, 13 years after making its first local messenger delivery, the company now known as the Diamond Transportation Group is a leading national provider of transportation logistics management.
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ABC uses more allocation bases than traditional cost systems which rely solely on volume as the base for allocating overhead costs. 1. The most common allocation bases in traditional cost systems are direct labor hours and machine hours. a. These bases work correctly when changes in the quantity of the base are correlated with changes in the overhead costs being assigned using the base. b. Relying exclusively on these bases to assign overhead costs to products has come under increased scrutiny since,
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and overhead costs have been moving

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in opposite directions and the variety of products produced by companies has increased. 2. ABC systems often use direct labor hours, machine hours, or other unit-level allocation bases to assign the portion of overhead costs that move in tandem with the volume of production. However, unlike traditional systems, ABC also uses additional allocation bases that are not related to the volume of production to assign overhead costs that are not correlated with volume. In Business Insights ABC systems usually include a larger number of allocation bases than traditional cost systems. For example: Shedding Light on Product Profitability (page 315) Reichhold, Inc., a leading supplier of synthetic materials, adopted ABC to shed light on the profitability of its various products. Reichholds prior cost system used one allocation base, reactor hours, to assign overhead costs to products. The ABC system uses four additional activity measures preprocess preparation hours, thintank hours, filtration hours, and waste disposal costs per batch to assign overhead costs to products. Reichhold has rolled out ABC to all 19 of its North American plants to help improve decision making.
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ABC systems may base the level of activity for each cost pool on the capacity of the activity rather than the budgeted level of activity which is always used in traditional cost systems. 1. Using the budgeted level of activity to compute a predetermined overhead rate results in unused capacity costs being assigned to products. 2. Using activity capacity to compute predetermined overhead rates isolates unused capacity costs as a period expense rather than assigning them to products.

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Designing an activity-based costing (ABC) system B. Characteristics of a successful ABC implementation:

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There should be strong top management support. 1. Without leadership from top management, some managers may not see any reason to change. 2. Without top management support, the ABC implementation will be seen as unimportant.

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There should be cross-functional involvement. 1. Since ABC affects people across departments, it should involve these people
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and be fully supported by them. If the accounting department alone attempts to impose ABC on others, skepticism and resistance are inevitable. 2. A well designed ABC system requires intimate knowledge of many parts of an organization. This knowledge can only be learned from employees familiar with the various parts of an organizations operations. ABC data should be linked to how people are evaluated and rewarded. 1. If traditional non-ABC data continues to be used to evaluate employee performance, it sends the signal that ABC data is unimportant and can even be ignored. C. The activity-based costing model
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Cost objects such as products generate activities. 1. For example, a customer order generates the need to complete the activity of preparing a production order.

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Performing activities consumes resources. 1. For example, preparing a production order uses a sheet of paper and it takes time to fill out.

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The consumption of resources causes costs. 1. For example, the greater the number of sheets of paper used to prepare a production order and the greater the amount of time devoted to preparing the production order, the greater the cost.

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D. Steps for implementing ABC (provide an overview of all five steps)

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Identify and define activities and activity cost pools (The activities are often identified and defined by interviewing the employees that work in the respective overhead departments. The lengthy list of activities that emerges from this process is usually reduced to a handful by combining similar activities.)

Helpful Hint: The cost-benefit concept should be reviewed when discussing the number of activities to track in an ABC system. 14 1. A common framework for combining activities in manufacturing companies is as follows: a. Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment would be a unit-level activity. b. Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch.
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For example, setting up equipment and shipping customer orders are batch-level activities. c. Product-level activities relate to specific products and must be carried out regardless of how many batches are run or units produced and sold. For example, designing or advertising a product would be product-level activities. d. Customer-level activities relate to specific customers and are not tied to any specific product. For example, sales calls and catalog mailings would be customer-level activities. e. 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. For example, heating a factory and cleaning executive offices are organization-sustaining activities. 2. When combining these activities, they should be grouped together at the appropriate level. Batch-level activities should not be combined with unit-level activities, and so on. Furthermore, activities should only be combined within a level if they are highly correlated with each other.

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3. Each combined group of activities forms what is called an activity cost pool which is defined as a bucket that accumulates costs related to a single allocation base. In an ABC system the term allocation base is replaced by the term activity measure, or the term cost driver is also used. Two types of activities measures include: a. Transaction driver a simple count of the number of times that an activity occurs. This is the least accurate type of activity measure. b. Duration driver measures the amount of time needed to perform an activity. This is more accurate than a transaction driver, but it takes more effort to record. Helpful Hint: Revisit the cost-benefit concept by explaining that transaction drivers are more prevalent in practice than duration drivers because the data is much easier to obtain. The additional accuracy provided by duration drivers often times does not pass the cost-benefit test. 4. In the Classic Brass example from the textbook, the ABC team selected the five activity cost pools and corresponding activity measures as shown. a. The definition for each of the activity cost pools is as shown.
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Whenever possible, directly trace overhead costs to activities and cost objects.

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1. The manufacturing and nonmanufacturing overhead costs for Classic Brass are as shown. a. Notice, the shipping costs can be directly traced to customer orders. The remainder of the overhead costs will be assigned to customer orders using the ABC cost pools. In Business Insights The ABC implementation steps that we are discussing apply not only to manufacturing companies, such as Classic Brass, but to all types of organizations. For example: The Virtual Bakery (page 324) Super Bakery, Inc. founded by former Pittsburgh Steelers running back Franco Harris, supplies donuts and other baked goods to schools, hospitals, and other institutions. The companys master baker develops products, and then the company formulates and produces the appropriate dry mixes from ingredients it has purchased. All other activities such as baking, warehousing and shipping are outsourced. As much as possible, actual costs are traced to individual customer accounts. The remaining costs of the company are assigned to customer accounts using the following four activity cost pools with corresponding activity measures shown in parentheses: Advertising, trade shows, and bonds (projected number of cases sold), Order department (number of orders), Sales management (time spent in each sales territory,)

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and, Research and development (hours of R&D for each product line).
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Assign costs to activity cost pools (this is also called first-stage allocation) 1. The cross-functional employee interviews resulted in the resource allocations as shown. Notice: a. The indirect factory workers allocated 25% of their time to the customer orders activity, 40% of their time to the product design activity, 20% of their time to the order size activity, 10% of their time to customer relations, and 5% of their time to the other activity. b. 100% of the factory building lease is allocated to the other activity. Since Classic Brass has a single production facility that it does not plan to contract or expand the lease cost is an unavoidable organization-sustaining cost. c. The shipping costs have no corresponding allocation percentages. This is because the shipping costs will be directly traced to customer orders. 2. Once the percentage allocations have been determined, it is a simple matter to assign costs to activity cost pools. a. For example, the indirect factory wages assigned to the customer orders activity ($125,000) was computed by multiplying the total amount of
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indirect factory wages ($500,000) by the percentage of time that indirect factory workers spent on this activity (25%). b. As another example, the factory equipment depreciation assigned to the customer orders activity ($60,000) was computed by multiplying the total amount of factory equipment depreciation ($300,000) by the percentage of time that the factory equipment was used to support this activity (20%). c. The complete grid of first-stage allocations would be as shown. Calculate activity rates 1. The Classic Brass ABC team determined activity levels for each activity as shown. This information enabled the team to compute ABC rates for each activity by dividing the total cost in each activity cost pool by the respective quantity of the activity measure. a. The activity rate for each cost pool is as shown. For example, the customer orders activity cost pool has an activity rate of $315 per order. Importantly, this is an average figure. b. Notice, the other cost pool does not have an activity rate. This is because these organization-sustaining costs will not be assigned to customer orders.
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2. Before proceeding, lets get a visual perspective of the Classic Brass ABC system. a. The direct materials, direct labor and shipping costs were directly traced to customer orders. b. The first-stage allocation process assigned the remaining overhead costs to five activity cost pools. c. Then, activity measures were identified, activity levels were determined, and activity rates were computed for each activity. These rates will be used in the next step to assign overhead costs to customer orders.
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Assign costs to cost objects (this is also called second stage allocation) 1. For each activity cost pool, the amount of activity consumed by the product (or customer) is multiplied by the activity rate to arrive at the amount of overhead cost applied to the product (or customer). a. For example, lets look at the following data for one Classic Brass customer (Windward Yachts) that bought two products (standard stanchions and custom compass housings). b. The second stage allocations show that $630 from the customer orders pool and $3,800 from the order size pool were assigned to the standard stanchions. Similarly, $315 (from the
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customer orders pool), $1,285 (from the product design pool), and $76 (from the order size pool) were assigned to custom compass housings. xvii. Prepare management reports 1. Two management reports that can be prepared include a product margin report and a customer margin report. a. The product margin is calculated by deducting directly traceable costs and ABC costs from sales. Notice, the product margins for standard stanchions and custom compass housings are $5,030 and $(1,114), respectively. b. The customer margin ($241) is calculated by subtracting the customerlevel costs ($3,675) from the combined product margins for both products ($3,916). In Business Insights Preparing management reports can provide key insights that enable managers to target their most profitable customers. For example, consider trends in the banking industry as well as the experiences of FedEx: Finding that Golden Top 20% (page 330) According to Meridien Research of Newton, Massachusetts, 20% of a banks customers generate about 150% of its revenue. Conversely,

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30% of a banks customers drain 50% of its profits. Customer relationship management software coupled with ABC can enable companies to prepare management reports that help them identify which customers are in that golden top 20%. Meridien Research estimates that large commercial banks are increasing their spending on customer profitability systems by 14% a year with total annual expenditures exceeding $6 billion dollars. Culling the Customer List (page 335) FedEx classifies its customers as the good, the bad, and the ugly based on their profitability. The good can expect a phone call if their shipping volume falters, which can head off defections before they occur. As for the bad those who spend but are expensive to the company FedEx is turning them into profitable customers in many cases by charging higher shipping prices. As for the ugly, FedEx was quoted as saying We just dont market to them anymore. E. Comparison of traditional and ABC product costs xviii. Product margins computed using the traditional cost system 34 1. Continuing with the Classic Brass example, assume that the company uses a plantwide

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predetermined overhead rate based on machine hours. In this case: a. The predetermined overhead rate would be $50 per machine hour. b. The manufacturing overhead assigned to stanchions and the compass housing would be $10,000 and $200, respectively. c. The product margins for stanchions and compass housings would be $(360) and $387, respectively.
xix.

The differences between ABC and traditional product costs 1. The product margins for the traditional system are dramatically different from the ABC system for four reasons: a. The traditional system spreads product design costs across both products based on machine hours. The ABC system assigned product design costs to a product only if it required product design work. b. The traditional cost system assigns customer order costs, a batch-level cost, using a unit-level allocation base, namely machine hours. The ABC system assigns these batch-level costs using a batch-level activity measure. c. The traditional system assigns only manufacturing costs to the products. The ABC system also assigns nonmanufacturing costs to products.
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d. The traditional system assigns all manufacturing costs to products. The ABC system does not assign organization-sustaining manufacturing costs to the products. 2. Generally speaking, when batch-level and product-level costs are present, ABC will shift costs from high volume products produced in large batches to low volume products produced in small batches. This cost shifting will usually have its greatest impact on the per unit cost of the low volume products. Helpful Hint: A simple example can be used to illustrate the impact of ABC systems on product costs when batch-level costs are involved. Suppose two products are each run in one batch a year and the cost of setting up a batch is $100 for either product. Other data follow: A B Total Units ......... 80 20 DLH/ unit.. x 1 x 1 Total DLHs 80 20 100 The two batches a year cost a total of $200 to set up. If DLHs are used to allocate the setup costs, the overhead rate would be $2 per DLH or $2 per unit for either product A or product B. However, in an ABC system, $100 will be allocated to product A and $100 to product B. Consequently, the batch setup costs would be $1.25 per unit for product A and $5.00 per unit for product B. ABC systems tend to reduce the per-unit costs of high-volume products and increase the per-unit
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costs of low-volume products, but the impact is more dramatic on the low-volume products. F. Targeting process improvements
xx.

Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvement, to actually improve processes, and to reduce costs. While the theory of constraints approach discussed in Chapter 1 is a powerful tool for targeting process improvement efforts, the activity rates computed in ABC can also provide valuable clues concerning where there is waste and the opportunity for improvement. 1. Benchmarking can be used to compare an organizations activity rates with standards of performance that are external to the organization.

xxi.

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G. Activity-based costing and external reports

xxii.

There are four reasons why most companies do not use ABC for external reporting purposes: 1. External reports are less detailed than internal reports in the sense that individual product costs are not reported. External reports only disclose cost of goods sold and ending inventory. Therefore, if some products are undercosted and others are
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overcosted, the errors tend to cancel each other out when the product costs are added together. 2. It is often very difficult to change a companys accounting system because it is deeply embedded within complex computer programs that have evolved over many years. 3. An ABC system, such as the one described in the chapter, does not conform to generally accepted accounting principles (GAAP). a. It excluded some organizationsustaining manufacturing costs and it included some nonmanufacturing costs in its product cost calculations. These cost system design attributes do not comply with GAAP. 4. Auditors are likely to be uncomfortable with cost allocations that are based upon interviews with the companys personnel. This type of subjective data can be easily manipulated by management. H. The limitations of activity-based costing
xxiii.

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Implementing an ABC system requires substantial resources. The benefits of increased cost accuracy may not outweigh the implementation costs.

xxiv. ABC systems produce numbers, such as product margins, that are at odds with the numbers produced by traditional cost systems. Managers are not accustomed to managing
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their operations using these numbers; hence, ABC inevitably faces resistance. This underscores the importance of having top management support for and cross-functional involvement with the ABC implementation.
xxv.

In practice, most managers insist on fully allocating all costs to products. The ABC system described in this chapter does not conform to this preference. ABC systems do not automatically identify the relevant costs for particular decisions; therefore, ABC data can be easily misinterpreted and must be used with care when making decisions. Costs assigned to products, customers, and other cost objects are only potentially relevant. Most organizations use ABC as a supplement to rather a replacement for their existing cost system. Maintaining two cost systems is costlier than maintaining just one system and it may cause confusion about which set of numbers is to be relied on.

xxvi.

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xxvii.

In Business Insights While ABC has been adopted by many organizations, it is not always the best solution for a companys needs. Furthermore, there is evidence to suggest that interest in ABC is leveling off.

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Sometimes ABC Isnt the Best Solution (page 338) Bertch Cabinet Manufacturing, Inc. makes highquality wooden cabinets, marble tops, and mirrors for bathrooms and kitchens. The company experimented with ABC but found that it was too difficult to set up and maintain such a complex costing system. For example, 21 separate operations are required to make a single raised panel cabinet door. The costs of keeping track of each of these operations would far exceed any conceivable benefit. The company adopted a variation of variable costing that is used in the theory of constraints. 70% of its direct labor cost was classified as variable and the rest was fixed. This system was easier to build, maintain, and understand than an ABC system. The Survey Says (page 339) Three professors from the United Kingdom studied ABC adoption trends within their country across a five year time span. The professors initial survey results are based on responses from 352 of the U.Ks largest companies, while the follow-up survey results obtained five years later are based on responses from 177 of the U.Ks largest companies. The professors summarized their findings by saying that their results are indicative of no growth in the popularity of ABC, and are consistent with both a leveling off in interest in it and the adoption of it over the five year period that was the focus of the study.

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I. Appendix 8A: ABC action analysis

xxviii.

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A conventional ABC analysis does not identify potentially relevant costs. An action analysis report can help in this regard because it shows what costs have been assigned to a cost object and it indicates how difficult it would be to adjust those costs in response to changes in the level of activity. 1. Constructing an action analysis report begins with the first-stage allocation process. In addition to computing an overall activity rate for each activity cost pool, an activity rate is computed for each type of overhead cost that is consumed supporting a given activity. a. Lets revisit the stage-one allocations from the Classic Brass example that we discussed earlier. b. Rather than computing one activity rate for each activity cost pool as was done previously (see the bottom of the slide for these rates), an activity rate is computed for each type overhead cost (or for each cell in the matrix). For example, the customer orders activity has six activity rates that sum to the total of $315 from the conventional ABC analysis. 2. Similarly, the second-stage allocation process requires assigning product costs by each type of overhead cost.

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a. In the Classic Brass illustration, there are, for example, six activity cost assignments from the customer orders activity to the standard stanchions. These six assignments total $630 as in the conventional ABC analysis. Notice, the total ABC costs assigned to standard stanchions are $4,430 which is the same as in the conventional ABC analysis. b. As another example, there are four assignments from the product design activity to the custom compass housing. These four assignments total $1,285 as in the conventional ABC analysis. Notice, the total ABC costs assigned to the custom compass housing is $1,676 which is the same as in the conventional ABC analysis. 3. The third step in preparing an action analysis report is to label each cost using an ease of adjustment code. a. Green costs adjust more or less automatically to changes in activity level without any action by managers. For example, direct materials cost would automatically change in response to changes in activity level without management action. b. Yellow costs can be adjusted to changes in activity level, but it would
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require management action to realize the change in cost. For example, direct and indirect labor may be classified as yellow costs because management action would be required to hire or layoff employees. c. Red costs can be adjusted to changes in activity level only with a great deal difficulty and with management intervention. For example, a factory building lease would be a red cost because it would be very difficult and expensive to break the lease. 4. The fourth step is to calculate green, yellow, and red margins. a. For example, the green, yellow, and red margins for the custom compass housing would be $612, $(1,018), and $(1,114), respectively. In this example, before managers would decide to eliminate the custom compass product line, they would need to commit to taking management action where required to reduce costs or redeploy resources.

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Chapter 8 Transparency Masters

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TM 8-1 AGENDA: Activity-Based Costing (ABC) 1. 2. 3. 4. 5. 6. 7. 8. The activity-based costing model. Differences between traditional costing and activity-based costing. Steps for implementing activity-based costing. The ABC cost hierarchy. An example of activity-based costing. Contrasting traditional costing and activity-based costing product costs. Typical impacts on product costs from implementing activitybased costing. (Appendix 8A) Action analysis report

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TM 8-2 ACTIVITY-BASED COSTING MODEL

Cost Objects (e.g., products, customers, orders)

Activities

Consumption of Resources

Cost

The emphasis is on decision-making and managing activities, not on assigning costs to products for external financial reports.

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TM 8-3 DIFFERENCES BETWEEN TRADITIONAL COSTING AND ACTIVITY-BASED COSTING In traditional costing systems: All manufacturing costs are assigned to products whether or not they are caused by the products. Nonmanufacturing costs are not assigned to productseven those nonmanufacturing costs that are caused by the products. The entire facility may have only one overhead cost pool and a single measure of activity such as direct labor-hours. Predetermined overhead rates are based on estimated costs at the budgeted or expected level of activity. In activity-based costing: Nonmanufacturing costs, as well as manufacturing costs, may be assigned to products. Some manufacturing costs may be excluded from product costs. There are a number of overhead cost pools, each of which has its own unique measure of activity. The allocation bases (i.e., measures of activity) often differ from those used in traditional costing. The activity rates (i.e., overhead rates) may be based on the level of activity at capacity rather than on the budgeted or expected level of activity.

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TM 8-4 STEPS FOR IMPLEMENTING ACTIVITY-BASED COSTING 1. 2. 3. 4. 5. 6. Identify and define activities and activity pools. Wherever possible, directly trace overhead costs to activities and cost objects. Allocate costs to activity cost pools. Calculate activity rates. Assign costs to cost objects using the activity rates and activity measures. Prepare management reports.

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TM 8-5 COST HIERARCHY 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. Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. Costs at the batch level do not depend on the number of units produced, the number of units sold, or other unit-level measures of volume. Product-level activities relate to specific products and typically must be carried out regardless of how many batches or units of product are produced or sold. 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. Organization-sustaining activities are carried out regardless of which products are produced, how many batches are run, or how many units are made.

2.

3.

4.

5.

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TM 8-6 THE CLASSIC BRASS EXAMPLE

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

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TM 8-7 THE CLASSIC BRASS EXAMPLE (contd)

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TM 8-8 THE CLASSIC BRASS EXAMPLE (contd)

Exhibit 8-2 Annual Overhead Costs (both Manufacturing and Nonmanufacturing) at Classic Brass
Production Department: Indirect factory wages...................... Factory equipment depreciation......... Factory utilities................................. Factory building lease....................... Shipping costs*.................................... General Administrative Department: Administrative wages and salaries..... Office equipment depreciation........... Administrative building lease............. Marketing Department: Marketing wages and salaries............ Selling expenses............................... Total overhead cost.............................. *Shipping costs are traced directly to customer orders. 400,000 50,000 60,000 250,000 50,000 $500,000 300,000 120,000 80,000 $1,000,000 40,000

510,000

300,000 $1,850,000

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TM 8-9 THE CLASSIC BRASS EXAMPLE (contd)

Exhibit 8-3 Results of Interviews Customer Orders

25% 20% 0% 0%

Production Department: Indirect factory wages.................. Factory equipment depreciation..... Factory utilities............................. Factory building lease................... Shipping costs* General Administrative Department: Administrative wages and salaries. Office equipment depreciation....... Administrative building lease......... Marketing Department: Marketing wages and salaries........ Selling expenses...........................

Activity Cost Pools Product Customer Design Order Size Relations

40% 0% 10% 0% 20% 60% 50% 0% 10% 0% 0% 0%

Other
5% 20% 40% 100%

Total
100% 100% 100% 100%

15% 30% 0% 20% 10%

5% 0% 0% 10% 0%

10% 0% 0% 0% 0%

30% 25% 0% 60% 70%

40% 100% 45% 100% 100% 100% 10% 100% 20% 100%

*Shipping costs are directly traced to customer orders.

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TM 8-10 THE CLASSIC BRASS EXAMPLE (contd)

Exhibit 8-4 First-Stage Allocations to Activity Cost Pools Activity Cost Pools Customer Product Order Customer Orders Design Size Relations
Production Department: Indirect factory wages.................. $125,000 $200,000 $100,000 Factory equipment depreciation..... 60,000 0 180,000 Factory utilities............................. 0 12,000 60,000 Factory building lease................... 0 0 0 Shipping costs* General Administrative Department: Administrative wages and salaries. Office equipment depreciation....... Administrative building lease......... 60,000 15,000 0 20,000 0 0 40,000 0 0 120,000 12,500 0 160,000 22,500 60,000 400,000 50,000 60,000 $50,000 0 0 0

Other
$25,000 60,000 48,000 80,000

Total
$500,000 300,000 120,000 80,000

Marketing Department: Marketing wages and salaries........ 50,000 25,000 0 150,000 25,000 250,000 Selling expenses........................... 5,000 0 0 35,000 10,000 50,000 Total.............................................. $315,000 $257,000 $380,000 $367,500 $490,500 $1,810,000 *Shipping costs are directly traced to customer orders.

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TM 8-11 THE CLASSIC BRASS EXAMPLE (contd)

Exhibit 8-5 Computation of Activity Rates Activity Cost Pools Customer orders Product design Order size Customer relations Other (a) (b) (a) (b) Total Cost Total Activity Activity Rate $315,000 1,000 orders $315 per order $257,000 200 designs $1,285 per design $380,000 20,000 MHs $19 per MH $367,500 100 customers $3,675 per customer Not applicable $490,500 Not applicable

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TM 8-12 THE CLASSIC BRASS EXAMPLE (contd)

Exhibit 87 Data Concerning the Products Ordered by Windward Yachts

Standard Stanchions 1. This is a standard design that does not require any new design resources. 2. Four hundred units were ordered during the year, comprising two separate orders. 3. Each stanchion required 0.5 machine-hour, for a total of 200 machine-hours. 4. The selling price per unit was $34, for a total of $13,600. 5. Direct materials for 400 units totaled $2,110. 6. Direct labor for 400 units totaled $1,850. 7. Shipping costs for the two orders totaled $180. Custom Compass Housing 1. This is a custom product that requires new design resources. 2. There was only one order for a single unit during the year. 3. The compass housing required 4 machine-hours. 4. The selling price was $650. 5. Direct materials were $13. 6. Direct labor was $50. 7. Shipping costs were $25.

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TM 8-13 THE CLASSIC BRASS EXAMPLE (contd)

Exhibit 8-8 Computation of Overhead Costs Activity Cost Pools (a) Activity Rate (b) Activity
2 orders 0 designs 200 MHs Not applicable

(a) (b) ABC Cost

$630 $0 $3,800

Standard Stanchions Customer orders $315 per order Product design $1,285 per design Order size $19 per MH Customer relations $3,675 per customer Custom Compass Housing Customer orders $315 per Product design $1,285 per Order size $19 per Customer relations $3,675 per

order design MH customer

1 order 1 design 4 MHs Not applicable

$315 $1,285 $76

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TM 8-14 THE CLASSIC BRASS EXAMPLE (contd)

Exhibit 8-9 Product Profitability Analysis Standard Stanchions $13,600

$2,110 1,850 180 630 0 3,800 $

Sales (from Exhibit 8-7) Costs: Direct materials (from Exhibit 8-7) Direct labor (from Exhibit 8-7) Shipping costs (from Exhibit 8-7) Customer orders (from Exhibit 8-8) Product design (from Exhibit 8-8) Order size (from Exhibit 8-8) Product margin

Custom Compass Housing $ 650

13 50 25 315 1,285 76

8,570 $ 5,030

1,764 $(1,114)

Customer Profitability AnalysisWindward Yachts Product margins of products ordered by Windward Yachts: Standard stanchion product margin (see above)................... $5,030 Custom compass housing product margin (see above).......... (1,114) Total product margins........................................................... 3,916 Less: Customer relations overhead (from Exhibit 8-5).............. 3,675 Customer margin.................................................................. $ 241

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TM 8-15 THE CLASSIC BRASS EXAMPLE (contd)

Exhibit 8-10 Standard Stanchions $13,600 Custom Compass Housing $650

$ 13 50 200

Sales (from Exhibit 8-7) Cost: Direct materials (from Exhibit 8-7) $ 2,110 Direct labor (from Exhibit 8-7) 1,850 Manufacturing overhead (see below) 10,000 13,960 Product margin* $ (360)

263 $387

In the traditional costing system used at Classic Brass, manufacturing overhead is applied based on machine-hours. The predetermined rate is $50 per machine-hour, determined as follows: Predetermined manufacturing = Total estimated manufacturing overhead overhead rate Total estimated machine-hours = $1,000,000 20,000 machine-hours

= $50 per machine-hour Referring back to Exhibit 7, the standard stanchions require 200 machinehours in total and the custom compass housing requires 4 machine-hours. Therefore, $10,000 (= 200 machine-hours $50 per machine-hour) of manufacturing overhead would be charged to the standard stanchions and $200 (= 4 machine-hours $50 per machine-hour) to the custom compass housing. *In a traditional costing system, the product margins do not include any nonmanufacturing costs such as shipping costs.

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TM 8-16 CONTRASTING ACTIVITY-BASED COSTING AND TRADITIONAL COSTING Exhibits 8-8 and 8-10 can be used to develop the following analysis:

Stanchions: Direct materials Direct labor Manufacturing overhead* Nonmanufacturing overhead Shipping costs Total cost Number of units ordered Unit product cost Custom Compass Housing: Direct materials Direct labor Manufacturing overhead* Nonmanufacturing overhead Shipping costs Total cost Number of units ordered Average cost per unit

Traditional $ 2,110 1,850 10,000

$13,960 400 $34.90

ABC $2,110 1,850 3,770 660 180 $8,570 400 $21.43

13 50 1,313 363 25 $ 1,764 1 $1,764.00 $

Traditional $ 13 50 200
263 1 $263.00 $

ABC

*Indirect factory wages, factory utilities, factory equipment depreciation, and factory building.

Administrative wages and salaries, office equipment depreciation, marketing wages and salaries, selling expenses, and administrative building lease.

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TM 8-17 TYPICAL IMPACT ON PRODUCT COSTS FROM IMPLEMENTING ABC Adopting activity-based costing usually results in shifting manufacturing overhead costs from high-volume products (e.g., stanchions) to lowvolume products (e.g., custom compass housing). The per unit costs of the low-volume products increase and the per unit costs of the high-volume products decrease because of better assignment of batch-level and product-level costs. The effects are not symmetricalthe dollar effect on the per unit costs of the low-volume products is usually larger. Note: The product costs from the activity-based costing system described here would not be acceptable for external financial reports. Excludes some manufacturing costs (i.e., costs of idle capacity and organization-sustaining costs) Includes some nonmanufacturing costs. Relies on subjective interview data.

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TM 8-18 APPENDIX 8A: ABC ACTION ANALYSIS Many decisions involve changes in activity, for example: If a product or customer is dropped, all of the activities associated with that product or customer can be avoided. Changes in prices affect sales volume, which in turn affects activity. Process improvements often result in decreases in redundant and nonvalue-added activities. A change in activity does not necessarily result in a change in cost. Many costs (i.e., the costs of salaried employees) must be managed up or down as a result of a change in activity. An action analysis report helps decision-makers by: Distinguishing between costs that are easy to adjust to changes in activity and those that are difficult to adjust. Identifying where cost adjustments would have to be made in the organization.

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TM 8-19 APPENDIX 8A: ABC ACTION ANALYSIS

Exhibit 8A-2 Computation of the Activity Rates for the Action Analysis Report Activity Cost Pools Customer Product Order Customer Orders Design Size Relations
Total activity.................................. 1,000 orders 200 20,000 100 product machine- active designs hours customers $1,000 0 60 0 100 0 0 125 0 $1,285 $5 9 3 0 2 0 0 0 0 $19 $500 0 0 0 1,200 125 0 1,500 350 $3,675

Production Department: Indirect factory wages.................. Factory equipment depreciation..... Factory utilities............................. Factory building lease................... General Administrative Department: Administrative wages and salaries. Office equipment depreciation....... Administrative building lease......... Marketing Department: Marketing wages and salaries........ Selling expenses........................... Total (conventional ABC analysis)....

$125 60 0 0 60 15 0 50 5 $315

Note: Activity rates are not computed for the Other cost pool because these are costs of idle capacity and organization-sustaining costs that are not allocated to products and other cost objects.

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TM 8-20 APPENDIX 8A: ABC ACTION ANALYSIS

Exhibit 8A-3 Action Analysis Cost Matrix for the Custom Compass Housing Activity Cost Pools Customer Product Order Orders Design Size
Total activity.................................. 1 order 1 4 product machinedesign hours $1,000 0 60 0 100 0 0 125 0 $1,285 $20 36 12 0 8 0 0 0 0 $76 $1,145 96 72 0 168 15 0 175 5 $1,676

Total

Production Department: Indirect factory wages.................. Factory equipment depreciation..... Factory utilities............................. Factory building lease................... General Administrative Department: Administrative wages and salaries. Office equipment depreciation....... Administrative building lease......... Marketing Department: Marketing wages and salaries........ Selling expenses........................... Total (conventional ABC analysis)....

$125 60 0 0 60 15 0 50 5 $315

Note: The activity rates for the Customer Relations cost pool are applied to customers, not products.

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TM 8-21 APPENDIX 8A: ABC ACTION ANALYSIS

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TM 8-22 APPENDIX 8A: ABC ACTION ANALYSIS

Exhibit 8A-5 Action Analysis of the Custom Compass Housing

Sales (from Exhibit 8-7)................................................ Green costs: Direct materials (from Exhibit 8-7)............................... $ Shipping costs (from Exhibit 8-7)................................. Green margin............................................................... 13 25 $ 650

38 612

Yellow costs: Direct labor (from Exhibit 8-7)..................................... 50 Indirect factory wages (from Exhibit 8A-3)................... 1,145 Factory utilities (from Exhibit 8A-3)............................. 72 Administrative wages and salaries (from Exhibit 8A-3). . 168 Office equipment depreciation (from Exhibit 8A-3)....... 15 Marketing wages and salaries (from Exhibit 8A-3)........ 175 Selling expenses (from Exhibit 8A-3)........................... 5 Yellow margin Red costs: Factory equipment depreciation (from Exhibit 8A-3)..... Factory building lease (from Exhibit 8A-3).................... Administrative building lease (from Exhibit 8A-3).......... Red margin.................................................................. 96 0 0

1,630 (1,018)

96 $(1,114)

Question: Do you think all of the above costs would be eliminated if jobs like the custom compass housing were no longer accepted? What impact would dropping such jobs have on follow-on sales and other sales from these customers?

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