5: Activity-Based Costing

Look what’s overhead!

Chapter 5 Guided Practice Problems


5.1 Activity-Based Costing Background

5.1.1 When is Job-Order Costing Inaccurate?

The correct answer is always. Remember that absorbing overhead costs to jobs is a fiction. It’s only an approximation of what overhead costs a job is actually responsible for.

I have a better question. When is job-order costing most inaccurate?

At the end of chapter 4, I said that a company-wide PDOH rate can be inaccurate when different departments have different styles of overhead. One department might have a lot of machinery-related overhead. Another department might have a lot of labor-related overhead. To solve this we developed departmental PDOH rates. Kumbaya, problem solved.

Except that it’s not solved. Although department PDOH rates can account for how product units cause different overhead costs from department-to-department, it ignores variation in how product units cause different overhead costs within a department.

  • Different styles of product within a department. Even within a department different products might interact with overhead costs in different ways. One product might interact primarily with the department’s machinery. Another product might interact primarily with the department’s labor. If the firm has organizational reasons not to sub-divide departments any further than it already has, then using department PDOH rates won’t solve this problem. Overhead costs will be inaccurately applied to the two products.

Below I’ve created an example of this. It is a Powerpoint presentation turned into a video, with about 15 seconds on each slide (no narration). Of course, you can pause the video if it’s going too fast.

  • Different relationships between volume and overhead within a department. Some overhead costs are closely related to volume while others are not. For example, some overhead costs are incurred each time a batch is started. If one product is produced in batches of 10 units and another product is produced in batches of 10,000 units, then the majority of batch-related costs really belong to the 10-units-per-batch product—it probably has many, many more batch-starts. Volume, meaning overall product units produced, for these two products might be exactly the same. Traditional job-order costing ignores the non-volume-related batch costs by relying on volume-related drivers like direct labor hours or machine hours.

I’ve created a video for this one too. It’s shorter overall and relies on details from the first video. It also has about 15 seconds per slide (still no narration).

So, the answer is that job-order costing is most inaccurate when the firm has multiple products that are (1) different enough to interact with department overhead in significantly different ways or (2) have significant costs that are not volume-related (like batch-related costs).

5.1.2 Activity-Based Costing Differences, Solving Job-Order Costing Inaccuracies

The whole point of activity-based costing (ABC) is to refine overhead absorption to make job-order costing more accurate. This is especially useful for firms with products that interact in substantially different ways with overhead costs, either because there are multiple types of overhead costs within a department or because of significant non-volume-related costs.

Activity-based costing is very similar to job-order costing in a lot of ways. There are many permutations of ABC out there, of course. But the basic mainstream implementation of ABC follows much the same pattern you learned in Chapter 4: (1) product units are assigned any costs that can be directly traced to them, then (2) absorb overhead based on actual cost driver consumption and a pre-determined overhead rate.

But, of course, they are not the same thing. There’s a whole chapter’s worth of differences. ABC re-imagines come key aspects of the second step: overhead absorption. Here are three big differences between job-order costing and activity-based costing, based on ABC’s re-imagining of how to absorb overhead.

First, ABC uses unique terminology, which can lead to easily avoidable mistakes. Oftentimes, the new terms aren’t substantially different from terms covered in Chapter 4.

Second, firms using ABC subdivide overhead costs into sub-groups. Each sub-group of overhead costs is designed to capture a unique relationship between overhead costs and individual product units. Each sub-group of overhead costs uses a different cost driver to approximate its relationship. This is the main feature of ABC that makes it more accurate than job-order costing. These sub-groups can span multiple departments and/or capture sub-sections of overhead costs within a department. They are not limited by the company’s org chart.

Third, activity-based costing redefines all indirect costs (both overhead and SG&A) as “overhead” that can be applied to product units. This captures some SG&A costs that are actually related to individual product units, even if it is difficult to trace these costs to product lines. That said, ABC still uses an “other” sub-group of costs, which are not absorbed by product units and are instead expensed in the period they’re incurred. ABC just uses different criteria (different from traditional job-order costing) to decide which costs are product costs and which are period costs.

5.2 Activity-Based Costing: How Does It Work?

5.2.1 Terminology

Overhead: any cost that is not directly traceable to individual product units (includes SG&A).

Activity cost pool: a sub-group of overhead costs that share a common relationship to product units. Sometimes this is just called a cost pool.

Activity driver: a cost driver that approximates the relationship between an activity cost pool and product units.

Activity rate: a PDOH rate for a particular activity driver and activity cost pool.

You can see why “activity” is in ABC’s name, since the word is used in just about every term!

The theory for ABC basically goes like this. A firm performs various activities to add value to the finished product, and each activity has a unique set of overhead costs associated with it. These overhead costs are that activity’s cost pool. A unique activity driver is theorized to approximate the relationship between each cost pool and each product unit.

5.2.2 Implementing ABC

The mechanical process of ABC takes place in two separate allocations. That means the firm moves costs twice.

First, the firm separates overhead costs into cost pools, moving them from where they actually originate into the cost pools. This is the first-stage allocation. Second, the firm applies costs from cost pools to individual product units based on each individual product unit’s consumption of the activity driver. This is the second-stage allocation.

At first blush this looks easy. The second step is basically the same procedure as job-order costing with department PDOH rates: applying overhead to individual product unites through multiple PDOH rates. The first step might also seem easy on the surface as well.

But it isn’t easy. Dun, dun, DUUUUUUN!!

See, determining which costs go to which cost pool—or even deciding which cost pools to create—is something that requires a lot of professional judgment and/or well-refined data.

Say a firm wants to implement ABC. It often contracts with a consulting firm that specializes in ABC. Some well-paid ABC consultants fly in, interview workers and managers, statistically measure overhead costs’ inter-relationships using various activity drivers, and attempt to balance the need for more cost pools (for increased accuracy) and the need for fewer cost pools (for parsimony).

Their time and expertise usually isn’t cheap, and most of that effort is time-intensive and expertise-intensive. Only then do you have cost pools to break costs up into. Then, you can start to do the first-stage allocation.

How?

5.3 Activity-Based Costing Example

Let’s assume the firm has three sources of overhead costs. These are all budgeted numbers.

Shop supplies ($50,000)

Machine maintenance workers’ wages ($120,000)

Miscellaneous administrative costs, e.g. CEO salary, office supplies ($85,000)

ABC consultants decide the firm performs effectively two activities that add value: machining and finishing. They create the following a table to express the relationship between overhead sources and these two activities. Of course, there’s also an “other” category, where the firm can place overhead costs that really do not relate to product units. So, I guess there are three activity cost pools in this example.

From this table, you multiply each percentage by the total budgeted cost to get the following table. The far-right column gives the cost that should be allocated to the three cost pools.

It is costly to (1) come up with the cost pools, (2) determine how much overhead cost goes into each cost pool, and (3) update the cost pools and first-stage allocation numbers over time. Thus ABC usually isn’t implemented by smaller firms or firms that don’t have especially inaccurate job-order costing numbers (see Section 5.1).

Once the firm has these budgeted cost pool numbers (the right-hand column in the table above), it divides those numbers by the respective budgeted activity drivers. For this example, let’s assume the two cost pools are based on the cost drivers of machine hours for the machining activity and batch-starts for the finishing activity.

The firm estimates it will have 5,000 machine hours next period and 500 batch-starts.

$137,250 budgeted machining cost pool / 5,000 budgeted machine hours = $27.45 per machine hour.

$46,500 budgeted finishing cost pool / 500 budgeted batch-starts = $93 per batch-start.

These are our two activity rates. The “other” category does not have an activity driver or activity rate and is considered a period cost.

As product units consume these resources (machine hours or batch-starts), overhead cost is allocated to those product units using these two activity rates. (The batch-level cost is most likely split evenly across all units in a batch.)

Let’s assume product unit OP57 consumes 6 machine hours, and is part of a batch of 50. The firm would allocate $164.70 in machining costs and $1.86 in finishing costs. Total overhead allocated to that product unit is $166.56.

Product unit OP106, however, consumes 2 machine hours and is part of a batch of 3 product units. The firm would allocate $54.90 in machining costs and $31 in finishing costs, for a total overhead allocation of $85.90.

Typically, most product units receive at least some overhead cost from each cost pool. But if the firm’s products are different enough to justify using ABC, then the amounts allocated from each cost pool probably vary significantly from product line to product line and from product unit to product unit.

5.4 Activity-Based Management

5.4.1 What is Activity-Based Management?

Activity-based costing more accurately measures unit cost. In Chapter 1, I said managers want to know who or what is responsible for costs the firm incurs, because then they can better maximize future profitability (it allows them to say “more of that!” and “less of that!”).

Therefore, the result of ABC’s increased accuracy is that managers can make an array of decisions better. This includes the decisions covered in Chapters 2 and 3. It also includes some new ones. When managers take advantages of ABC’s more accurate picture of costs to make improves decision making is called activity-based management.

5.4.2 Non-Volume-Related Overhead Costs

To fully understand the scope of activity-based management, I need to expand on my earlier description of activity-based costing.

At the beginning of the chapter, I illustrated the difference between volume-related and non-volume-related costs by pointing out that batch-related costs are not strictly volume-related. There are other types of costs that are not volume-related. ABC usually splits up overhead costs at several levels. (Direct materials and direct labor are product unit-level costs by definition.)

  1. Product Unit-level: overhead costs that are driven by volume. For example, factory supplies, nuts and bolts, machine lubricant, maintenance overtime, a portion of utilities, etc.
  2. Batch-level: overhead costs that are driven by batches produced. For example, equipment testing, cleaning, and set-up, batch transportation across factory floor, purchase order placement, etc.
  3. Product Line-level: overhead costs driven by producing a particular product line. For example, research, development, and product testing, product launch (including advertising), some manager/supervisor salaries, some administrative staff salaries, etc. This can also include costs driven by customer maintenance and loyalty, such as overhead costs from sales calls, account maintenance, and loyalty programs. This level can also include design costs and engineering salaries. Some companies break out these costs as a separate level.
  4. Organization-sustaining-level: overhead costs driven by being in business, in general. For example, some administrative costs, information technology costs, accounting and reporting,

All levels listed above, except the first, tend to be non-volume-related.

Think about it. If all you know about a firm is that it has high volume, does that mean the firm always has a lot of batch starts, product lines, and customers. What if all you knew was that the firm has low volume? Does that firm always have few batch starts, product lines, and customers?

The answer is no. A firm can easily have low volume and still have a lot of batch starts (i.e. small batches), product lines (i.e. a range of specialized product lines), and customers (i.e. a lot of small customer accounts). And vice versa.

You need to understand the full array of non-volume-related overhead costs if you’re going to understand the power of activity-based management in the below decisions.

5.4.3 Customer Profitability Analysis

Firms using ABC should better know the true profitability of each customer too, mainly because the firm has a better picture of the type of batch-level and product line-level overhead costs each customer is causing the firm to incur.

As an example, Build Boise, Inc. produces custom software in the western United States. The firm uses activity-based costing and wants to compare the profitability of two customers: Stewart’s, LLC and Brickhaven International. Build Boise, Inc. uses five activity cost pools based on four activities: research, design, quality, and other.

As shown below, the two customers of interest use Build Boise’s services in unique ways. Neither requires a new product version, but they do require varying levels of re-design (i.e. design activity) and quality control (i.e. quality activity). This is in addition to each customer’s direct costs, in the form of licensed portions of Build Boise’s software.

In the below table, I apply job-order costing and activity-based costing to estimates of these two customers’ profitability. Under job-order costing Stewart’s, LLC is more profitable than Brickhaven International, and both seem to be profitable. Under ABC the picture comes into better focus. Stewart’s, LLC is not only less profitable than Brickhaven International but unprofitable altogether.

Build Boise, Inc. would most likely respond to this new information by negotiating for a more profitable contract from Stewart’s, LLC. If that does not work, the firm might be better off dropping them as a customer.

Build Boise, Inc. can also trace this unprofitability to its cause: the intensive design work required by Stewart’s, LLC. They consume 1,000 engineer hours, a fifth of the annual budget for engineer hours. Build Boise, Inc. can use this information to identify other likely unprofitable customers or to screen unprofitable potential customers. It might re-evaluate how much it is willing to customize software for customers. Or it might try to re-design its processes or offerings to reduce the cost of engineer hours.

5.4.4 Product Mix and Process Improvement Analysis

Analysis very similar to the above might help Build Boise, Inc. improve (1) the products and product mix it offers or (2) the processes it uses to provide these products. Let’s look at an example of each of these. (I’ll use the same activity cost pools and rates for Build Boise, Inc., shown above).

5.4.4.1 Product Mix Analysis

First, Build Boise, Inc. might changes its product offerings or product sales mix. (Decisions to change product offerings or product sales mix overlap so much that I consider them together in this section). Consider the following scenario for Build Boise, Inc. Based on the sales department’s projections, the firm could re-mix three of its most popular products into three alternative configurations, i.e. re-mixes.

(I simply assume the same number of bundles are sold in each scenario, so I can evaluate the profit of these re-mixes on a per bundle basis.)

Because the firm has ABC information on these three products, can easily evaluate the profitability of each of these re-mix scenarios. Notice that I omit overhead costs relates to the research activity. That’s because this decisions does not involve dropping any of these product lines, as a whole, meaning the cost of annual versions for each product will stay the same.

Now, let’s consider additional possible mixes that drop one or more of the products being offered. For this calculation I include research activity costs and the number of bundles sold, so I can evaluate the re-mix scenarios on a total profit basis (as opposed to the profit-per-bundle basis used above).

5.4.4.2 Process Improvement Analysis

Second, ABC can help the firm evaluate potential improvements to its processes. Process improvements can cost a lot. ABC information can often give the firm more accurate information about the profitability of these improvements.

For example, look at three different improvements below (relevant original items highlighted in blue, with changes highlighted in orange). Improvement #1 reduces direct costs. Improvement #2 streamlines quality checks, reducing cost per customer install. Improvement #3 involves hiring better engineering staff, reducing how many engineer hours each product consumes.

5.4.5 Pricing Decisions

5.4.5.1 General Pricing Decisions

Pricing philosophy varies from firm to firm. Some firms look to the market to set the price (more on this in Chapter 8). A lot of other firms price their products based on how much they cost the firm. This is actually a more traditional view. Many prices have to be set in markets where the price is less than clear, or over a time-horizon that makes it economically risky to rely on current market prices.

ABC can improve prices set on product cost because it can improve the firms understanding of product. Specifically, ABC improves the portion of the firm’s pricing policy that hinges on overhead. This is especially important for a common type of cost-based pricing.

5.4.5.2 Cost-Plus Contracts

Prices based on product cost often use full absorption cost (which thus includes applied overhead) plus a fixed profit margin (as a percentage) or a fixed unit profit (as a dollar amount). Long-term contracts are often made on this basis. These are called cost-plus contracts because the firm is reimbursed for costs, plus a little extra as profit.

Cost-plus contracts are used because long-term project costs can be difficult to estimate beforehand. They also have the advantage of mitigating some perverse incentives. Setting a fixed overall contract amount, as opposed to a cost-plus contract, can motivate the seller to cut costs in an unacceptable way, since this will maximize short-term profits.

For cost-plus contracts, overhead reimbursement is the trickiest part. Direct costs, by definition, are relatively easy to trace and reimburse. Fixed profit margins or dollar amounts are also relatively calculate and are determined by negotiation at the beginning of the contract. Overhead costs, though, can be a source of disagreement because they are only applied to individual product units. How much overhead each product unit is actually responsible for cannot realistically be known.

Therefore much of the work in negotiating a cost-plus contracts involves measuring and negotiating over the selling firm’s overhead rate. Activity-based costing can improve these measurements and negotiations. The buying firm has more peace of mind that applied overhead amounts are not arbitrary. The selling firm has more peace of mind that it will be fairly reimbursed for overhead costs it really has incurred.