Activity Based Costing

Notes to Chapter 7
 Examples
Split a restaurant bill
Split profit in a partnership
Allocate cost to products
Cost of a degree program?
What is cost of an international student?
What is the cost of an auditing student?
What is the cost of a cand. merc. student?
Multi-product firms are found everywhere.
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 Indirect cost Classic Pen
Classic Pen was a low cost producer of pens. They had a profit
margin of at least 20% of revenue
Five years ago the firm started producing red pens
Same production technology
Could be sold at a premium price 3% higher than the two other types of
pens
Last year purple was added
Profit margin 10% higher
The controller of Classic Pen was disappointed by the result from
last quarter
The controller pondered if Classic Pen should continue to introduce new pens
instead of focusing on the blue and black
The production manager pointed out the influence of the new types on the
production

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 Indirect cost Classic Pen

The costing system of Classic Pen was simple:

All indirect costs were aggregated at factory level and allocated
to products based upon the direct labor cost
At this time the overhead rate was 300% of direct labor cost
Before new types of pens were introduced the overhead rate
was only 200% of direct labor cost
Classical Pen uses only one cost center
This would not change even if several cost centers were
introduced. The biases in the production costs would
remain.

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 Indirect cost Classic Pen
Blue Black Red Purple Total
Units 50.000 40.000 9.000 1.000 100.000
Price 4,50 4,50 4,65 4,95
Sales 225.00 180.000 41.850 4.950 451.800
Materials 75.000 60.000 14.040 1.650 150.690
Labor 30.000 24.000 5.400 600 60.000
Overhead 90.000 72.000 16.200 1.800 180.000
Total man. 195.000 156.000 35.640 4.050 390.690
cost.
Oper.inc 30.000 24.000 6.210 900 61.110

return. % 13,3% 13,3% 14,8% 18,2% 13,5%

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 Indirect cost Classic Pen
Before:
Production primarily manual
Total indirect cost were less that the direct labor cost
Classic Pens two products were identical with respect to volume
and batch size
Direct labor cost and indirect cost has decreased due to
automation
As low volume products were introduced the result was
increased demand for:
Increased planning
More setups of machines
More quality control
Computers to keep track of jobs and product specifications

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 Indirect cost Classic Pen
Same physical output, same cost of material

The firm has approximately

Property taxes, security cost and heating cost which are unchanged
Much higher indirect and support costs due to the larger and more
diversified product mix and more complex production

One unit of the high volume standard product (blue or black) uses
approximately the same amount of direct labor as one unit of red or
purple

The traditional costing system would fundamentally report identical

costs for the standard and special products, independent of production
volume
The use of indirect and support activities by the special products are
higher that the use by the standard products
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 Indirect cost Classic Pen
ABC at Classic Pen - Analysis of the cost structure:
Indirect labor
50% of the indirect labor costs are caused by what the controller
called handling of production batches
40% of the indirect labor cost were caused by th physical change
from one color to another and were called setup costs
10% of the time was used to an activity which the controller labeled
support activities
Computer costs
20% allocated to support activities,
This is an activity which is already found in the catalogue of
activities as it was used to account for the 4 products
80% of computer resources were used to produce batches and are
closely related to handling of production batches

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 Indirect cost Classic Pen
Activity Cost
Driver Blue Black Red Purple Total**
DL h/unit 0,02 0,02 0,02 0,02 2.000
Mach. h/unit 0,1 0,1 0,1 0,1 10.000

Prod. series 70 65 50 15 200

Setup 4 2,4 5,6 5,6 --
time/batch
Tot.setup.hours 280 156 280 84 800
# products 1 1 1 1 4

**Volume 50.000 40.000 9.000 1.000

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 Indirect cost Classic Pen

Indirect labor IT Depreciation Maintenance Energy

50% 40% 10%

80% 20%

Support
Handling Setup Operation
activities

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 Indirect cost Classic Pen
Three categories of indirect cost remained:
Machine depreciation
Machine maintenance
Energy for running the machines
These costs were incurred to maintain the
production capacity for the production of pens.
The Controller calls the production activities
running the machines

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 Indirect cost Classic Pen

Identification of cost hierarchy

Four activities which explain the indirect cost at Classic
Pen represents three levels in the cost hierarchy:

Activity Cost hierarchy

Running machines Unit level
Handling of batches Batch level
Setups of machines Batch level
Product sustaining Product

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 Indirect cost Classic Pen

Cost-driver rates Aktivity- Aktivity- Driver Rate

cost driver quantity

Handling 66.000 #Batches 200 330 pr

prod.batches batch
Setups of mach 33.600 #Setup hours 800 42 pr setup
hour
Product sustain 14.400 # Products 4 3.600 pr
product
Running 42.000 # Machine 10.000 4,20 per
machines hours machine ht
156.000
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 Indirect cost Classic Pen
Assigned IPO
Blue Black Red Lilla Total**
Handling
prod.batches 23.100 21.450 16.500 4.950 66.000
Setups of 11.760 6.552 11.760 3.528 33.600
machines
Product 3.600 3.600 3.600 3.600 14.400
sustain
Running 21.000 16.800 3.780 420 42.000
machines
Total cost
assigned 59.460 48.402 35.640 12.498 156.000

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 Indirect cost Classic Pen
Profitability
Blue Black Red Lilla Total**
Sales 225.000 180.000 41.850 4.950 451.800
Materials 75.000 60.000 14.040 1.650 150.690
Labor 30.000 24.000 5.400 600 60.000
40% 12.000 9.600 2.160 240 24.000
Support 59.460 48.402 35.640 12.498 156.000
Total
prod.cost 176.460 142.002 57.240 14.988 390.690
Operating 48.540 37.998 (15.390) (10.038) 61.110
income
B.M. % 21,6% 21,1% -36,8% -202,8% 13,5%

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Assigning service department costs
to activities
Untraceable or common costs
Rough estimates of product cost
This is estimation by means of allocation
Cause and effect relationship
Link cost to activities
How are the activities using resources
What type of measures do we have
Fixed or variable costs
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 Ingredients
Aggregate cost pools
LLAs
Allocation

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Example

18
Impressionist

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20
ABC Definitions

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 Indirect cost Classic Pen

Indirect labor IT Depreciation Maintenance Energy

50% 40% 10%

80% 20%

Support
Handling Setup Operation
activities

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 Activity cost drivers
Unit level activities
Batch level activities
Product sustaining activities
Customer sustaining activities

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 Activity cost drivers
Transaction drivers
Duration drivers
Intensity drivers

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Problem 7.15
 Problem 7.15

OV1 = 750,000 + 0.4 DL

OV2 = 200,000 + 0.2 DM + 1.5T
OV3 = 750,000
OV4 = 1,500 S
Problem 7.15
Problem 7.15
Problem 7.15
 Problem 7.15
q 2500 2500 2400
UCI 170 630 1392
UCabc 216 631 1343
q 5000 500 5200
UCI 141 558 1221
UCabc 171 562 1192
q 2500 0 0
UCI 778 0 0
UCabc 778 0 0
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Problem 7.15
The Firms Technology

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 The Firms Technology

Factor inputs z1,z8

Production f,g,h
Output q = (q1, ,qn)

z5 z6

z3 h z4
z7 z8

f g q = (q1,,qn)
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Account structure

34
 Marginal costs

Impressionists estimation:

35
 Marginal costs
The Modernisms estimation:

36
Example 7.3

37
Example 7.3

38
Example 7.3 Modern School

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41
K 200
q12 q22
Solution : K = 200, L1 = = 50, L2 = = 200
200 200
Total cost = 100* 200 + 150*50 + 175* 200
MC1 = 150, MC2 = 350
 Marginal costs
The marginal cost have a linear structure

The ABC cost results in marginal cost

The Impressionist School leads to different
product cost

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 Problem 7.8

8. unit versus marginal cost

Return to Example 7.3 and focus on the constant
returns to scale case of = = .5. Determine
total cost, marginal cost of each product, unit cost
of each product under the impressionism school,
and unit cost of each product under the
modernism school for each of the following output
pairs: q = [3, 8], q = [8, 3] and q = [10, 10]. Also
determine the corresponding percentage
estimation errors.

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Example 7.3

45
Example 7.3

46
Example 7.3 Modern School

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 Problem 7.8 Product one
Example 7.3

q1 q2 TC MC UCt UCabc
7 9 632.33 47.60 54.99 47.60

3 8 408.70 47.60 58.39 47.60

8 3 480.50 47.60 50.58 47.60

10 10 808.37 47.60 53.89 47.60

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 Problem 7.8 Product two
Example 7.3
q1 q2 TC MC UCt UCabc
7 9 632.33 33.24 27.49 33.24
3 8 408.70 33.24 29.19 33.24
8 3 480.50 33.24 25.29 33.24
10 10 808.37 33.24 26.95 33.24

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 Problem 7.9

9. unit versus marginal cost

Repeat the above for the mixed case of = .55

and = .45.

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 Problem 7.9
Product one non-linear
Example 7.3

q1 q2 TC MC UCt UCabc

3 8 418.73 57.54 59.82 54.50

8 3 549.08 59.49 57.80 56.28
10 10 899.24 60.81 59.95 57.41

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Ex 7.9 Product two non-linear

q1 q2 TC MC UCt UCabc

3 8 418.73 31.97 29.91 31.90

8 3 549.08 33.03 28.90 32.94
10 10 899.24 32.73 29.97 32.51

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 Decreasing Returns
Marginal Cost for Product 1

Marginal cost for product 1: MC1

53
 Decreasing Returns
Marginal Cost for Product 2

Marginal cost product 2

54
 Decreasing Returns
Impressionism Error for First product

55
 Decreasing Returns
Impressionism Error for Second product

56
 Decreasing Returns
ABC Error for First Product

57
 Decreasing Returns
ABC Error for second Product

58
 Increasing Returns
Impressionisms Error for First Product

59
 Increasing Returns
Impressionisms error for second product

60
 Increasing Returns
ABC Error for First Product

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 Increasing Returns
ABC Error for Second Product

62
 Mixed Returns
Impressionisms error for second product

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 Mixed Returns
Impressionisms error for second product

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 Mixed Returns
ABC Error for First Product

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 Mixed Returns
ABC Error for Second Product

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 Errors
Error is the norm
Errors are functions of the accounting system
Different accounting systems produce different
errors
Which department
Which product
Where to put errors
Where in the organization is precision
important?
Portfolio of errors
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 Conclusion
ABC costing allows fine tuning of accounting
system to technology
Is usable in a service organization
Requires more data collection
Assumes linearity in
Use of production factors
Cost functions
Allocation of errors
Theory of second best
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