 Hello and welcome to this session. This is Professor Farhad and this session we're going to discuss activity-based costing. So activity-based costing, it's going to take us back to product costing. It's going to take us back to deal with overhead. Now I'm sure we know by now that the product consume direct labor, direct material, and manufacturing overhead. Now what we know as well that direct labor and direct material, they can easily be traced to the product. So let's assume this is the product. However, manufacturing overhead, what we said, we said it cannot be easily traced to the product. So what we do is we allocate, we allocated to the product based on some allocation base. And if you remember we said direct labor hours could be one of them, dollar amount of labor, or machine hours. Okay, and basically if you remember what I did is I said something like this, this is manufacturing overhead, and we're going to allocate this to the product based on some activity. We call this the predetermined overhead rate, and the way we compute the predetermined overhead rate is we take our estimated dollar amount of overhead, manufacturing overhead MOH, then we'll divide it by the activity level. Again, what's the activity level? Could be direct labor, dollar amount labor, or machine hours. Well, guess what? Remember this formula assumes or this method assumes that what's driving overhead is one activity, direct labor hours. Guess what? There's another way to look at manufacturing overhead, how we allocate manufacturing overhead. In a sense, that's incorrect. Are you saying, so why did I teach you this method? Well, because back in the old days what companies have is direct labor hours, dollar amounts, so it's easy to allocate overhead based on that. Now, in some companies they might use two drivers, so you could use two activity drivers rather than one. But we have a new method that we're going to learn about today. It's called activity-based costing, or ABC. This is what we're going to be learning about today. So ABC is going to be dealing with this issue. Before we discuss ABC in details, I would like to remind you whether you are an accounting student or a CPA candidate, and most likely that's who you are and that's why you are watching. I'm glad you have arrived. Please visit farhatlectures.com for additional resources such as lectures, multiple choice, true, false. I can help you whether you are an accounting student or studying for your CPA exam along your CPA review course. If you have not connected with me on social media, please do so, LinkedIn, YouTube, Instagram, Facebook, Twitter and Reddit. And here's what ABC disagrees with the prior model. The prior model basically said something like this. Resources, which is overhead, are consumed by the product. In other words, the product consumed the resources. The resources are manufacturing overhead. What ABC said, ABC looked at this from a different view. It says, well, guess what? We do have, we do spend resources and what consume resources are activities. Then the product consumed those activities. Hold on a second. Basically, we're back to resources going to activities and here resources go into activities. So what are we really doing here? What are we really doing? Well, we are making an assumption here and a very important assumption because what you're saying is, you might be asking yourself, well, we're going from resources to product. Let me put it in a different color. So this is the old, let me, let me, let me change my pen here. So this is the old model. This is the old model. And you're saying the old model resources goes to the product and this is the new model. And what you're telling me, resources end up being absorbed by the product. Of course it does. But what we are making, we are making the assumptions that not all products are created equal. It does make a difference because not product are created equal. Well, let's think about it. Well, some product are produced in large quantities. So some product produce in large quantities and some in small quantities. Okay, so we cannot read them the same. If you think about it, some product use many parts. So some product use many parts and some product use few parts. Okay. Well, some product, they have many options. Basically, we customize them. And some product have few options. So the point is, not all products are created equally. So if we take the resources and we use, we allocate them to the product directly, that's not true. We have to know how the product is consuming those resources and how it's consuming those resources based on the product itself, based on the product. In a sense, the old model is a little bit misleading. So how do we determine those activities? Well, here's what we can do. We can do, we can state and we can study our product, our manufacturing product and we can make certain observations. For example, some product consume activities on a unit level. Okay. So every time we produce one unit, some activities are consumed. Some product, they consume activities at a batch level. What does that mean? Batch level means it doesn't matter how many units we produce, we produce one or we produce 1,000 or 2,000 or 5,000. The cost is the same. What could be, so batch level, there's no, it ignores units. It doesn't, units are not really what matters. An example of it will be machine setup. So when we set up the machine to create a specific product, well, we spend one dollar amount, let's assume it costs us $500 to set up the machine to create this type of product. So once we spend this $500, we might produce one unit, 500 unit or 5,000 unit. The point is the frequency of the cost is only once. The frequency as the cost is only once and that's on the batch level. Certain activities, they are consumed on a product level. So certain resources are consumed on a product level. Well, what could be an example? Well, product level, it means no, no regards to batch level. So it ignores the batch level. Okay. What would be an example of it? And my wife work in this, my wife, my wife work with John, with Johnson and Johnson and she works in medical and medical equipment and what they do every once in a while, they re-engineer the product. So the engineers, they will sit down and they will re-engineer, you know, some product that goes into the spine and to the hip into the knee. It's medical devices. So what they do is they incur that cost once. So they may incur, for example, $300,000 to re-engineer a product. But it doesn't matter how many times they produce the product in terms of batch level. It doesn't matter how many units of that product they produce. The product level is only consumed once. So this is product engineering level or basically product level. An example will be re-engineering the product. It's only once. It doesn't matter how many batches we set up. It doesn't matter how many units we produce. And certain costs, certain costs, we will call them, they're called facility level, facility level. Well, those facility levels, it doesn't matter how many units, batches, product, it just, we're going to consume those on a facility-wide level. So notice, this new system ignores direct labor hours, if we're using direct labor hours. In a sense, if we only use direct labor hours, direct labor hours, in a sense, it becomes little bit, little bit confusing, not confusing, misleading to the product, misleading to the product. Why? Because activities comes in different intervals. What we assume in the old level is every time we spend direct labor hour, okay, assuming we're using direct labor hour, we are spending money. It doesn't have to be the case and we're spending the money equally for all product. That's not the same. Well, it's easy. It's an easy method. I mean, tell you the truth, it's easy. It's very easy to use that method, but it's not true at all. It's very convenient because we have the data, direct labor hours, because we need to pay our employees, we keep direct labor hours. So that's easy to keep, but not very misleading. And what happened is this. Under those circumstances, here's what happened. If we have a simple product, the simple product, it's what's going to happen, it's going to, we're going to over-cost the simple product. If we have a simple product to produce, it's going to be over-cost. Why? Because it's going to be treated as if we are producing a difficult or a complex product. And the complex product is treated the same way as a simple product. Therefore, it's, we under-cost them. So we think it's costing us less. So say it in another way. The simple product, the simple product, the easy product to produce, easy product are subsidizing the complex product. So the easy product are subsidizing the complex product. Why? Because we're allocating more dollar amount, more dollar amount to the simple product. Why? Because we're treating both the same. We're treating that direct labor is the only thing that's driving the cost. That's the old model. So that's why the old model is not accurate. So let's take a picture. So let's look at the old model one more time. The old model, we have factory overhead here, and it goes to the product through some activity. And we're going to consider that activity direct labor hours. Let's take a look at the new model. The new model, let's assume this is the new model, we have factory overhead. This is the dollar amount. And by the way, also ABC, it's not only factory overhead, we'll try to do the same thing for admin cost. So the admin cost also, we're going to be using the same theory for the admin cost, which we'll illustrate in a moment. So we do an activity-based costing. We'll try to study what activities are consuming our product. What activities are consuming our products. And we call this stage one. So on stage one, so the way we do stage one, is we go out there and we ask our employees, we ask the people on the frontline, we either ask them, observe them, just study, study what they do. And we find out that they are working with, they have activity one, that's what they do. They have activity two, and they have activity three. So three activities, they have three activities, one, two, and three. So this is at this stage. So this is what they do. Okay, for example, here they are, one activity is to unload the trucks. One activities is to assemble the product, just unloading, assembling, I'm just making this up, then painting the product. So those are the three activities. What we do is we take the dollar amount and we'll start to see, well, not a dollar amount, we'll wait for now. So those are the activities. Now we'll do the same thing for the admin costs. The admin costs, we'll try to find activities for the admin. Activity A and activity B. For example, activity A is, I don't know, sales invoices. How do we process sales invoices for the people and for our customers? And activity B, how do we pay our suppliers account spable? So this is how we're administration spend time, either on sales invoice to build our customers or to pay our bills. So the activity is basically the same. Then what we do now, we'll go through a stage two process. Now what we do is we, let's assume we have a million, let's make it 900,000 here. And I'm just going to make this 900,000 divisible by three. And for simplicity, that's not the case. I'm going to, I'm going to, I'm going to spread this equally. So 300,000 for unloading, 300,000 for assembling and 300,000 for painting. Then what we do on the next stage, we'll find a rate for the port. So we basically divide the 300,000 by how many trucks do we, do we unload? Okay, let's assume we unload 300 trucks. So basically what we say, we say 300,000 divided by 300 trucks. So every truck we need to unload, it will cost us $1,000. Okay, that's the activity period. Then we'll find an activity for the assembling and activity for the painting, so on and so forth. So this is what we are doing. We are trying to find a relationship in between what is consuming our resources. Okay, so every time we need to unload a truck, we said unloading is 300,000. We unload 300 trucks. Every time we unload a truck, we consume $1,000 of resources. Okay, and we'll do the same thing for the other. So this is basically an overview of activity-based costing. Now let's take a look at some terms that you need to be familiar with, and let's take a look basically at a summary of everything that I said. So the first thing in ABC, non-manufacturing as well, manufacturing cost may be assigned to a product. So no, manufacturing cost, of course it's assigned to the product, but non-manufacturing cost also is assigned to product under ABC. So ABC, notice ABC, ABC, let me change my pen back to red, ABC, and this is important, it assign both manufacturing and non-manufacturing cost. The traditional system, the traditional system, only manufacturing cost is assigned to the product. Okay, so ABC can assign sales commission, shipping cost, and warranty repair to a specific product, which is much more accurate. Now you know exactly how much it's costing you. Okay, some manufacturing costs might be executed as well. So ABC executes organization sustaining costs and idle capacity costs from product costs. So certain costs also we execute because they're not really going to the cost directly. So what do we do with those? We just simply expense them. Okay, so each ABC cost will have its unique measure of activity, while traditional costs usually use one level of activity, direct labor. Direct labor and machine hours correctly are correctly, direct labor and machine hours work correctly when changes in the quantity of the base are correlated with changes in the overhead being assigned using the base. So if that's the case, if direct labor and machine hours are true, are true drivers, then that's fine. But often, often time that's not the case. So this method, this old method, it's being phased out. It's being phased out. Traditional costing system rely exclusively on allocation based that are driven by volume of production. ABC on the other level is the defined five levels, which as I already discussed, five at four and the fourth is customer. The discuss five level of activities that largely do not relate to the volume of units. So it's basically rather than looking at the volume, we look at the unit level activity, batch level activity, product level activity, organizational sustaining level activity, and the one I did not discuss is customer level activity, which one we work and exercise, I will show you customer level. That means how much does it cost us to serve a customer? For example, how much does it cost us to handle a complaints and how many complaints are we going to have? How many, how much does it cost us to to to service a customer over the phone? Then we'll assign some money to that pool. So manufacturing companies typically combine those activities into five classification, and those are the classification. What is an activity? An activity is an event that causes the consumption of the overhead resources, unloading the trucks. What is activity cost pool? Remember, we're going to put those and we're going to put we're going to put so many in those activities. Those are the cost pool. Those are the cost bucket in which costs related to a single activity measures are accumulated. And we would look at a picture of this. So the activity measure, okay, an allocation base and an activity based costing system, the term cost driver used to refer to an activity measure. So what is driving our cost is the activity measure, and we put the money in that activity level. So we have two common types of activity measure. Certain activity measures are transaction driven, simple count of the number of activities we do. And some are time driven. How much time do we spend on the activity what consumes the activity? And this is going to wrap up the whole picture. Direct labor, direct material and shipping cost are traced directly to the cost object. Now we have to deal with the overhead cost. Also shipping costs could be traced directly. That's easy. Every time we ship a product, we do it separately. Now overhead cost, we're going to break it down into basically remember the first stage, stage one, first stage. This is basically where we put the words, our activity, customer orders, design changes, order size, customer relation, and this is other. Other means when something doesn't fit anywhere, we put it under other than what we do. Now the overhead cost, we go through a second step, then we allocate dollar amount per order. So we have a dollar amount here. Let's assume again a million dollar. And let's assume it's 200,000 each. Again, the reason I used 200,000 just to illustrate the point, 200k, 200k, and 200k. Then what we do is find customer orders. For example, per customer order for every order, let's assume we process 200,000 orders. Again, to keep it simple, 200,000 dollar divided by 200,000 order, it's going to cost us $1 per order. So for overhead, for this product, every time we process an order, we add $1 of overhead. Then for design change, we allocated 200,000. Let's assume, let's make it the design change, we do four design changes. So 200,000, it's very expensive to do a design change divided by four. Every time we do a design change for a product, every time we do a design change, it's going to cost us $50,000 per design change. We're selling a very expensive product here. But the point is, this is how we allocate it. This is how we allocate the overhead to the cost based on the activity. For example, if a product doesn't need any design changes, guess what? Then it's not going to cost us much. We don't cost it high. But this is a good point to show you that what drives overhead is the actual activity, not direct labor hours. And here, if it's, remember, the fifth one, the other, what we do is not allocated. It means we expense it. We just don't want to bother with it. We would get expense. And this is basically the overall picture. This is what we're trying to say is the overhead is allocated through some sort of an activity. And this is basically an introduction. I hope it's a good introduction. You got the point about activity-based costing. Now, the only way to kind of get your hands, get your head around this is to work maybe one or two examples, some multiple choice questions, which we will work some just for illustration. Now make sure you read your book. Complete your homework. If you're studying for your CPA, you're studying for your CMA, activity-based costing is tested on both exams. Study hard. It's worth it.