 Hello and welcome to the session. This is Professor Farhad and the session we're going to look at activity based costing and we're going to look at an example. Now it's very helpful. Hello and welcome to the session. This is Professor Farhad and the session would look at ABC activity based costing and specifically I will work an example. Now it's very helpful if you do viewed the activity based costing explanation, although in this session I will go over the theory as I'm working the example but it's very important that you understand the theory, all the idea behind activity based costing. So to illustrate the point, the best way is to work an actual example. Now in this example I'm going to go through ABC. Then once I'm done with ABC, at the end I'm going to show you versus the traditional method. So I'm going to show you what would be the effect if we use the traditional method and you will see the difference between the two. But for now, just focus with ABC. So this we have the income statement for this company called Baxter battery. They have a million 50 million in sales. Direct labor of 15 million. I'm sorry direct labor of 12 million direct material of 15 million manufacturing overhead of 14 million. Total of 41 million cost a cost of goods sold gross margin is 5 million minus 41 and they have selling and administrative expensive 3 million selling to marketing and 6 million general and administrative a total net operating loss of 2 million. So this is their external financial statement or their financial statement using gap, which is that they use for the external purposes. At Baxter battery. Here's what we did. The ABC team selected the following activity cost pool measure. So what we did is we send people to to to to observe to observe our product. And by the way, we produce just kind of you need to know this. The company makes two type of automobile batteries. So they produce automobile batteries. One is the short start at which is a standard and one is a long life. It's a deluxe. So they use basically they have a regular battery and deluxe one. And usually ABC is a good way to illustrate when you have two type of product one is regular and one is deluxe. So let's take a look at what the ABC team collected from the facilities from the company's facilities. What they find out is the following activity. Consume resources one customer orders to design changes three order size customer relations and there was some cost they could not assign to anything. So they called it other. So let's look at the customer orders design changes and order sizes and how they define them customer orders. So what they did assigned all cost of resources that are consumed by taking and processing customer orders. So how much resources do we consume when we take a customer order. So that's one activity we believe it's consuming resources. Design changes assign all cost of resources consumed by customer requests design changes. So every time a customer request a design change how much money do we have to how much resources do we have to consume to comply with that design change order size. Assign all cost of resources consumed as a as a consequence of the number of unit produce and here the more unit we produce the bigger is the order size the more resources we consume and hopefully this makes sense. Customer relations assign all costs associated with maintaining relationship with the customer. So we need to stay in touch with the customer make sure the customer is happy serve the customer so on and so forth how much it's costing us to do so. And anything else that we could not fit in those four categories with it under other assigned all organization sustaining cost and unused capacity cost so anything that we could not fit into the other four clearly. Clearly defined activities. So the next thing we're going to do with we're going to assign cost to cost pool using the first stage allocation so let's go ahead and do so. So first we have to determine how much is our overhead cost so this is our overhead cost and remember for activity based costing for ABC. We include both manufacturing and non manufacturing overhead cost so it doesn't matter if it's manufacturing or non manufacturing as long as long as we can relate it to the product we're going to include it. So here's what's going to happen for the manufacturing and not manufacturing we have a total of 22 million so notice we have a total of 22 million right here let's break them down. We have indirect factory wages of 6 million factory equipment 3.5 factory factory utilities 2.5 factory building leases 2 million those are production which is end up to be 14 million. Administrative cost 4 million office equipment depreciation 9 administrative building lease is 1.1 million hold on a second aren't these considered basically period cost. Yes they are but for ABC we're going to try to allocate them to the cost itself to the product itself marketing we have marketing 1.5 and selling half a million. So those are all overhead costs so what happened to direct material and direct labor and shipping guess what those are traced directly to the product therefore we don't allocate them. Okay so notice here we have 22 million of cost where we are going to allocate now this 22 million once again it include both and I'm repeating myself that there's a reason because it's something you're not familiar with it include both manufacturing and non manufacturing cost. Now the next thing we're going to do is we're going to go out to the plant facility and study what we do study what we do. Okay so let's take a look at an example we had let's take a look at the example of indirect factory wages we have 6 million of indirect factory wages and what are indirect factory wages factories the supervisors people who are not working directly on the product. So how do they spend their time how do they spend their activities when they when they work for us here's what we can here's what we here's what we find out. Our indirect factory wages those people that are working on the product but not directly they spend 30% of their time on customer orders they spend wow substantial amount of their time figuring out the design change. Depending on how big is the size of order size but it seems they spend 20% of their time on the order size they spend 10% they still deal with customers and 10% we cannot define. Okay so this is how we are going to allocate their their six million dollars. Okay. Factory equipment depreciation on the customer orders. We think 20% is consumed on customer orders we can allocate 20% of it 10% of the design little bit maybe we need to make some minor changes for the factory when we change the design. 60% is the order size and this should make sense the bigger the order size the more we use the equipment. Notice here and hopefully now this is starting to make sense to you 0% of the factory equipment 0% of the factory equipment is allocated to customer relations right. Factory equipment don't deal with the customer in any way shape or form so notice what we did as we said this is 0% and hopefully this make it this is making sense to you. 10% is other we could not allocate note notice factory utilities 0% to customer orders. 10% to design changes that means if there's design changes we may have to consume more electricity 60% of factory for factory utilities is allocated to the order size. And 30% which is we don't know we could not really pinpoint it so notice factory utilities it's very hard to. It's mostly order size okay mostly order size and you could see the rest how they figure it out. For example here administrative building lease they just they said 100% others just to kind of show you some big ones. Selling expense notice selling expense here 70% of the selling expenses for customer relationship and hopefully this makes sense. That's where you spend your month that's what you spend your time and 20% of customer order so notice selling expenses. When do we incur selling expenses when we take orders and we will mean when we maintain the relationship with the customer so hopefully you understand how we're coming up with these percentages. Be careful. This is not a science this is at best an art. Okay, so how do we figure out those percentages we talk to those people we observe what people are doing will try to measure the activity of our facilities to determine how much they are consuming in the relationship to the orders. Now what we do is we'll start to allocate the money remember we allocated 6 million to the indirect wages and we said 30% of that is consumed by factory by customer orders. Therefore what we do is we take 6 million multiply by 30% we say of the 6 million 1.8 is allocated to the factory order to this cost pool. Then we said we have 3.5 million and equipment depreciation and we said 20% of it is consumed by customer orders, which is will take 3.5 million times 20%. And what we did now is we took the 6 million and we allocated to the various activities. We took the 3.5 million and factory equipment depreciation and we allocated it to the various activities notice we did not give anything to customer relation. And we did the same thing, we did the same thing for factory leases, we did the same thing for selling and remember we said the selling is mostly customer relation and customer orders right and makes sense hopefully it makes sense. So what we did is we took the dollar amount the cost pools and we put in each cost pool how much dollar amount should go there. For example, customer order pool is 4 million 550,000 design changes 3 million and 40,000 order size 5.2 million customer relation 3.5 million and 6.1 6 million 160 it's like for other it's doesn't really there's no clear cut way to do to do so. Notice the total of this is where the 22 million comes into place again. But notice of the 22 million 6 million is not really allocated to anything specifically and 6 million is a lot in relationship to 22 million. That's a substantial amount more than 25%, which is that's fine. That's fine. We can live with that but we're still going to be more accurate than direct labor. Now the next thing we're going to do we're going to compute an activity rate for cost pool. Now we know we know our cost pool. Let's see what the activities are. We're going to have 10,000 customer orders, 4,000 design changes, 80,000 machine hours and 2000 customers are served. How did we get this? We know based on the activities that we do on a yearly basis. So this is those are the activities. Okay. We have 10,000 customer orders. Now the next thing we're going to do is we're going to compute the activity rate. Remember, we allocated 4,520,000 customer orders. We have 10,000 customer orders. Go back to the prior screen 10,000 customer orders. It means every time we have an order, each order costs us $425. For design changes, we allocated 3 million and 40,000 at the cost pool. And we said we're going to have 4,000 design changes. Therefore, every time we process a design change for a customer, we're going to allocate $760 to that design change. Same thing with order size, 5.2 million. And order size is driven by machine hours. So we're going to spend $6.50 per machine hour. And for customer relation, we allocated 3 million and 80,000. We have 2,000 customers. So on average, each customer is costing us $1,540. And notice 6 million is we could not allocate to anything specifically. That's fine. Those are organization sustaining costs and will be assigned to product or customers will see how it goes. If it's too large, if it's a small, we just expense them. Just kind of get rid of them. So let's take a look now at what, how the cost work. Remember, material, labor and overhead goes directly to the cost object, the product. So it's no big deal here. Overhead. Remember, we have those. We're going to first start with the first allocation. Then the second allocation is find the activity rate. And this is what we did earlier. And the other will be unallocated. This is basically a picture of what we just did. And remember, the customer order was 4.25. The design change was 7.60 per design change. The machine hours is 6.50. And the customer, it's costing us $1,540 to maintain a customer. Okay. Now let's assign cost to cost object using the second stage allocation using Baxter battery. So this is what Baxter battery looks like. This is what the situation looks like. The sure start, the standard battery require no design resources. So notice we're not going to, they have no design. They don't, they don't get redesigned. So we allocate none for design. We have 800,000 batteries ordered with 4,000 separate orders. So we have 4,000 orders, 8,000 batteries, the number of unit. Each sure start require 36 minutes of machine hours, which is total time of 480,000. Because remember, we spend machine hours and at times 6.5. Long life require new design resources. And we're going to find out how much for each customer. We produce 400,000 of them. Notice half of the sure start with 6,000 separate orders. 4,000 custom design prepared. Well, we know how many design, custom design. We have 4,000 of those custom design versus none for the sure start. And each long life require 48 minutes of machine hours. That's a deluxe. Therefore it requires more time. And remember, we're going to multiply this by $6.50 per machine hours. So let's find our overhead cost for each battery using ABC. For the, which one is this? This is for the sure start for the sure start customer orders. We said we have 4,000 customer order and each customer order is 452. Therefore we're going to assign 1 million and 1,808,000 design changes, nothing. We don't have any design changes based on the order size. We have 480,000 unit times $6.50 per machine hour. So total overhead allocated the sure start is 4,925,000. And for the long life, we'll do the same thing. Notice the long life will have design changes, which is the long life did not. And what happened? We end up with 9,920,000. That's not assigned to anything. Not assigned to anything. Okay. Because the batteries don't consume the resources on that level. That's fine. Let's take a look at the next slide. Now let's take a look at a specific customer. Let's take a look at how Baxter batteries system work for just one of the 2,000 customer. Let's assume Acme Auto Parts who placed a total of 12 orders. So the orders are 12, 12 orders. Note that 4 orders are for long life for the deluxe and 8 orders are for the, for the long life and 4, and sorry. 4 orders for long life and obviously 8 are for the standard one sure start. And note that 4 orders for long life require design change. So the 4 orders for the long life require the design change. So each order for the short start for the regular one. This is for the regular one and 4 orders for the deluxe one of 50. They want 50 deluxe and 60 regular machine hours. Obviously 480 machine hours 480 short start require, which is because we have 8 times 60 equal to 480. So we have 480 units require 288 machine hours. The 200 long life, which is 4 orders times 50, which is 200, require 160 machine hours. So we're breaking down the machine hours. Let's take a look to see how much things are costing us in terms of overhead. So customer orders, we have 12 customer orders times 425. That's 5,422. We have 4 design changes for the deluxe one. Okay, we have 488 hours in between the two times 650. And this is one customer acne with multiply 15 40 by one. So the total overhead allocated to this customer is 12,916. So this is this is for one customer specifically. So this is how we find how much it's costing us per customer based on their order design changes order size in customer relation. So now let's take a look at the customer margin customer margin. So let's let's take a look at the big picture. Then we'll look at acne as a customer by itself. So the first step in computing the product margin is to gather each product sales and direct cost data. So this is the sales for the short start 31,300,000 for the long life 18,700,000 total sales as we saw from the beginning is 50 million. This is how much direct labor direct material and shipping costs that's directly allocated to short start. This is how much late material labor and overhead directly allocated to long life. And this is the total. Sorry, and this is the total. Now we're going to add the overhead. The overhead. How much did we assign to short start 1,808 1,808 for the customer order and for the design change 3 million 120 we computed those earlier. For the long life customer order we allocated. So this is the overhead. This is ABC cost assignment for the overhead. Okay. This is how much we assign overhead for long life. And this is the total. Now let's take a look at the product margin. It seems what's happening short start. We're making a profit on short start of 8,372 and we are incurring a loss on the long life 1,132,000. It seems you are making a profit on short start and long life is it's a loss. Now remember overall the company is incurring a loss because we still have 9,240,000. That's unassigned, unassigned what's unassigned. Okay. So therefore we get a loss of 2 million. Why? Because remember this is 7,240,000. This is the profit. Then we have to subtract the customer relation. We have to subtract other costs that's unassigned. So we have 9,240,000 unassigned. Therefore we end up with a loss of 2 million. But now what we know is short start is a profitable product. Long life is not a profitable product. So this is what ABC has shown us based on this data. Okay. So let's take a look now at ACME specifically ACME. ACME the sales for ACME auto parts was 29,200. Let's look at direct material. Direct material was 7,500. Direct labor 6,700 and shipping 1,700. Which are, those are directly traced to the ACME. For the overhead, remember we computed the overhead was customer order 5,424. Product design 3,040. Order size and customer relation. Let's see what the product margin is. The product margin or the customer margin is $354. What does this tells us? It tells us we are making a profit on this customer of $384. We're able to pinpoint how much we are making profit for customer. That's including the direct labor and direct material as well as overhead and any direct traceable cost. So that's important. It's very important to see this. Now we're going to switch. Now we're going to switch. I'm going to show you what would happen if we're using the traditional cost. What's the traditional cost system? Remember the traditional cost system is you would use one overhead allocation rate to allocate the overhead. So let's take a look at again at the same data. Sales does not change for each product. Direct material and direct labor does not change. So those are not changed. What's going to happen is this now. We're going to look at our manufacturing overhead which are only product costs. Not indirect costs. Only product costs. Only the product costs. Production costs. Not non-manufacturing, which is 14 million. And we're going to assume that machine hours is what's driving our overhead. So we're going to have one allocation rate, which is machine hours. So 14 million of overhead, estimated overhead costs divided by the driver or the allocation based off 800,000 machine hours. We find that $17.50 is our consumption rate of overhead, assuming we are using one overhead rate. So simply put, short start uses 800,000 hours, 800,000 times 0.6 per hour to produce it. So we use 480,000 machine hours and long life uses 320,000 machine hours, 320. So now we can find the overhead because we're going to take the machine hours times 1750. The machine hours times 1750. The machine hours times 1750. This is how much we allocate to short start and overhead 8.4 million. And this is how we allocate how much overhead 5.6 million to long life. So this is how the overhead allocated. Very easy notice. It took us maybe 15, 20 minutes to explain this, to explain ABC for the traditional cost. It took me like a couple of minutes. Just take the predetermined overhead rate. Take the predetermined overhead rate multiplied by the activity, which is machine hours. We find the overhead. Now let's take a look at our profitability using the traditional method. Under the traditional method, short start is only making 6.9 million. And guess what? Long life seems profitable. Notice this is the deluxe. Now it's profitable under the traditional method, which was not profitable when we did the ABC method. And this is basically going back to the previous lesson where I told you. The simple product, the product that doesn't consume new designs, doesn't consume fancy resources are subsidizing. So notice here, short start, it's more profitable than 6.9 million. And long life is making a loss. But under the traditional method, because we're only using machine hours, we're assuming they're basically, in a sense, they are produced the same way, which they're not. Long life require more design. Okay, therefore it should not be treated as short start. But under the traditional method, it's misleading. It shows both are profitable. Then we have to subtract 11 million of administrative costs. We're back to the 2 million. Obviously it doesn't matter. We're at a loss of 2 million. Okay. So notice here that we are at a, basically the traditional is misleading. Now let's take a look at a picture of those. Under the traditional method, short start is making 6.9. Long life is making 2.1. And we're going to say, oh, we're doing great. But under ABC, which is if we consider ABC superior, then we have a problem. Short start is making more profit. It's making 1.4 million, 1 million, 472,000 more in profit. And long life is incurring a loss. We are off 3.2 million costing the long life. Okay. So the traditional cost over cost the short start. It's showing us it's costing us more for the short start and it's not. And report a lower profit for this product. We're thinking short start is not a good thing. On the contrary, according to ABC, short start is a better product for us. The traditional cost under cost the long life. It's showing us it's not costing us much to produce the long life, which is that's not good because it's showing us a higher profit. Well, indeed in reality, it's not. So why is there the differences between the two? Let's summarize. There are really three reasons. Three reasons why the reported product margin differ between the two. One, ABC costing only assign manufacturing overhead costs consumed by the product. So only assign those. Traditional costing assign all manufacturing overhead costs. So ABC says, if only the product is consuming the overhead, we allocate the overhead. It's not consuming the manufacturing overhead. We don't allocate it. Traditional said, no, no, no, we have to assume all manufacturing overhead. Not manufacturing, only manufacturing, but all of it. So one more time, let me show you this. We have manufacturing overhead. MOH. ABC says not all of it, some and none. So some of it is used and some of it not used, not used, depending if it's consuming. This is ABC. Under the traditional method, the old method, I call it the old traditional MOH. All MOH, all goes to the product. Under the ABC, some of it goes to the product. That's one difference. Traditional costing allocate all manufacturing overhead using a volume base allocation, volume basically on the volume. The more you produce of it, the more I would allocate to you. ABC uses activity, non-volume. So what happened in the traditional method, if a product is consuming a lot of electricity and we're using electricity, it will appear and if it's costing us more. Although, if we do activity-based costing, maybe other things are costing us more, not that activity itself. As we just saw in this battery example, where the design, we did not have to design the short start. Therefore, we did not allocate any cost to it. So traditional uses volume, ABC uses non-volume, some activity, that's another discrepancy. Also, traditional costing disregards selling and administrative because they are period cost. So traditional costs say, I'm not going to be using my selling expenses as part of my product cost. ABC traces shipping to product to include non-manufacturing overhead cost caused by the product and the activity cost pool that are assigned to the product. Simply put, selling expenses are included. We are allowed to put selling expenses as long as we can trace it to the product. Under the traditional, that's not included. That's also created a difference between the two. So many companies do not use ABC for external reporting. Why? Many reasons. For one thing, it doesn't comply with GAP because, remember, period cost cannot be a product cost. External reporting are less detailed than internal, so guess what? We're not going to give you how we produce the product. It's therefore ABC is very detailed. It may give you a competitive advantage. It may be difficult to make changes to the company's accounting system. ABC is complex. It's very complex. And sometime you may think this is the activity, then the next year you may change the activity. So it's not easy to just keep changing your accounting system. And last but not least, auditor may be suspect of this subjective allocation process based on interviews with employees. Now, you have your ABC system. And if you're using it for external reporting purposes, then guess what? The auditor is going to review it. And all hell is going to break loose when the auditor disagree with your judgment about what's consuming your resources. Because remember, it's a judgment. You are, you as a company determining those activities based on your experience. Now, here comes an auditor that may not have enough experience in the industry or may have too much experience, or they may not know how to allocate the cost. And they're going to question all those subjective allocation that you made for the activities. So it creates a lot of problems. That's why it's, it's used ABC in a sense. It's used as a supplemental supplemental method to price the product or to cost the product. So there are five limitation of ABC. One, the first one is to require substantial resources to implement and maintain. So it's costly. And you have to review it on a regular basis to desire to fully allocate all costs to product. Now also some, some product may not be allocable. So it will try to kind of any cost that we have will try to put it into the product if they can. That's that there's some little bit of bias there does not conform with gap. So if you have ABC, you have to have two costing system because you have another one that allocate only product costs for potential misinterpretation of unfamiliar numbers. Now you are, you are, you are introducing new numbers to your employees, new numbers to management. There could be some misinterpretation and resistance, unfamiliar numbers and report. You are adding more reports, more numbers, and you are creating more, not prep tape, just more, maybe more noise for some people. It may be very beneficial, but for some people, ABC may just be a noise and it's not needed and it's creating more work for us. It could be. I'm not saying it is. I'm just saying this is there's always resistance for new systems. And this is basically in a nutshell an example and a benefit slash disadvantages of ABC. If you have any questions, any comments by all means email me or see me in class. If you're studying for your CPA or your CMA exam study how it's worth it this time.