Implementing Activity-Based Costing

Learning Objective 5 Cost products or services using activity-based costing

• use cost rates for different activities to compute indirect costs of a product

Now that you understand the basic concepts of ABC, let’s see how Plastim’s managers develop an ABC system by refining the simple costing system. We will also compare the two systems, and identify the factors to consider when deciding whether to develop an ABC system.

Implementing ABC at Plastim

To implement ABC, Plastim’s managers follow the seven-step approach to costing and the three guidelines for refining costing systems (trace more costs as direct costs, increase the number of homogenous indirect-cost pools, and identify cost drivers of the costs in the cost pools). Exhibit 5-3 shows an overview of Plastim’s ABC system. Use this exhibit as a guide as you study the following steps, each of which is marked in Exhibit 5-3.

1. Step 1: IDENTIFY THE PRODUCTS THAT ARE THE CHOSEN COST OBJECTS. The cost objects are the 60,000 S3 and the 15,000 C5 lenses that Plastim will produce in 2020. Plastim’s managers want to determine the total costs and then the per-unit cost of designing, manufacturing, and distributing these lenses.
2. Step 2: IDENTIFY THE DIRECT COSTS OF THE PRODUCTS. The managers identify the following direct costs of the lenses because these costs can be easily and unambiguously traced to a specific mold and lens: direct material costs, direct manufacturing labor costs, and mold cleaning and maintenance costs.
3. Exhibit 5-5 shows the direct and indirect costs for the S3 and C5 lenses using the ABC system. The direct costs calculations appear on lines 6, 7, 8, and 9 in Exhibit 5-5. Plastim’s managers classify all other costs as indirect costs, as we will see in Exhibit 5-4.

1. Step 3: SELECT THE ACTIVITIES AND COST-ALLOCATION BASES TO USE FOR ALLOCATING INDIRECT COSTS TO THE PRODUCTS. Following guideline 2 (increase the number of homogenous indirect-cost pools) and guideline 3 (identify cost drivers of the costs in the cost pools) for refining a costing system (pages 156–157), Plastim’s managers identify six activities in order to allocate indirect costs to products: (1) design, (2) molding machine setup, (3) machine operations, (4) shipment setup, (5) distribution, and (6) administration. Exhibit 5-4, column 2, shows the cost hierarchy category, and column 4 shows the cost-allocation base and the budgeted total quantity of the cost-allocation base for each activity described in column 1.
2. Identifying the cost-allocation bases effectively defines the activity pools into which costs must be grouped in an ABC system. For example, rather than define the design activities of product design, process design, and prototyping as separate activities, Plastim’s managers group them as a combined “design” activity and form a homogenous design-cost pool. Why? Because the same cost driver—the complexity of the mold—drives the cost of each design activity. In contrast, the manufacturing department identifies two activity-cost pools—a molding machine setup-cost pool and a machine operations-cost pool—instead of a single manufacturing overhead cost pool, because each activity has a different cost driver: setup-hours for the molding machine setup-cost pool and machine-hours for the machine operations-cost pool.
3. Step 4: IDENTIFY THE INDIRECT COSTS ASSOCIATED WITH EACH COST-ALLOCATION BASE. In this step, Plastim’s managers try to assign budgeted indirect costs for 2020 to the activities identified in Step 3 (see Exhibit 5-4, column 3) on the basis of a cause-and-effect relationship between the identified cost-allocation base for an activity and the individual indirect costs. For example, all costs that have a cause-and-effect relationship to cubic feet of packages moved are assigned to the distribution-cost pool. Of course, the strength of the cause-and-effect relationship between the cost-allocation base and the cost of an activity varies across cost pools. For example, the cause-and-effect relationship between direct manufacturing labor-hours and administration activity costs, which, as we discussed earlier, is somewhat arbitrary, is not as strong as the relationship between setup-hours and setup activity costs, where setup-hours is the cost driver of setup costs.
4. Some indirect costs can be directly identified with a particular activity. For example, salaries paid to design engineers and depreciation of equipment used in the design department are directly identified with the design activity. Other indirect costs need to be allocated across activities. For example, on the basis of interviews or time records, manufacturing engineers and supervisors estimate the time they will spend on design, molding machine setup, and molding machine operations. If a manufacturing engineer spends 15% of her time on design, 45% of her time managing molding machine setups, and 40% of her time on molding operations, the company will allocate the manufacturing engineer’s salary to each of these activities in proportion to the time spent. Another example is rent costs that are allocated to activity-cost pools on the basis of square-feet area used by the different activities.
5. As you will see, most costs do not fit neatly into activity categories. Often, costs first need to be allocated to activities (Stage 1 of the two-stage cost-allocation model) before the costs of the activities can then be allocated to cost objects such as products (Stage 2).
6. The following table shows the assignment of indirect costs to the seven activities identified in Step 3. Recall that Plastim’s management accountants reclassify mold-cleaning costs as a direct cost because these costs can be easily traced to a specific mold and lens.

1. Step 5: COMPUTE THE RATE PER UNIT OF EACH COST-ALLOCATION BASE. Exhibit 5-4, column 5, summarizes the calculation of the budgeted indirect-cost rates using the budgeted total quantity of each cost-allocation base from Step 3 and the total budgeted indirect costs of each activity from Step 4.
2. Step 6: COMPUTE THE INDIRECT COSTS ALLOCATED TO THE INDIVIDUAL PRODUCTS. Exhibit 5-5 shows total budgeted indirect costs of $1,153,953 allocated to the simple lens and $961,047 allocated to the complex lens. Follow the budgeted indirect-cost calculations for each lens in Exhibit 5-5. For each activity, Plastim’s operations personnel budget the total quantity of the cost-­allocation base that will be used by each type of lens (recall that Plastim operates at capacity). For example, lines 15 and 16 in Exhibit 5-5 show that of the 2,000 total setup-hours, the S3 lens is budgeted to use 500 hours and the C5 lens 1,500 hours. The budgeted indirect-cost rate is $150 per setup-hour (Exhibit 5-4, column 5, line 5). Therefore, the total budgeted cost of the setup activity allocated to the S3 lens is $\mathrm{\$}\text{75,000}\mathrm{\hspace{0.17em}}(500\hspace{0.17em}\text{setup‐hours}\times 150\hspace{0.17em}\text{pre\hspace{0.17em}setup‐hour})$ and to the C5 lens is $\$\text{225,000}\hspace{0.17em}(\text{1,500}\hspace{0.17em}\text{setup‐hours}\times 150\hspace{0.17em}\text{per\hspace{0.17em}setup‐hour}).$ The budgeted setup cost per unit equals $\$1.25\hspace{0.17em}(\$\text{75,000}÷\text{60,000}\hspace{0.17em}\text{units})$ for the S3 lens and $\mathrm{\$}15(\mathrm{\$}\text{225,000}÷\text{15,000}\hspace{0.17em}\text{units})$  for the C5 lens.
3. Next consider shipment setup costs. Plastim supplies its S3 and C5 lenses to two different Giovanni plants. One of these is an international plant in Mexico. Preparing for these shipments is more time consuming than preparing shipments to the local plant in Indiana because of additional documents related to customs, taxes, and insurance. The following table shows the budgeted number of shipments of S3 and C5 lenses to each plant.

1. Each shipment to the Mexico plant requires 12.5 hours of the shipment department personnel’s time, while each shipment to the Indiana plant requires half that time, 6.25 hours. The following table indicates the budgeted shipping setup-hours for the S3 and C5 lenses.

1. The budgeted indirect-cost rate is $54 per shipment setup-hour (Exhibit 5-4, column 5, line 7). Therefore, lines 21 and 22 in Exhibit 5-5 show that the total budgeted cost of the shipment setup activity allocated to the S3 lens is $\$\text{40,500}\hspace{0.17em}(750\hspace{0.17em}\text{shipment\hspace{0.17em}setup‐hours}\times \$54\hspace{0.17em}\text{per\hspace{0.17em}shipment\hspace{0.17em}setup‐hour})$ and to the C5 lens is $\$\text{40,500}\hspace{0.17em}(750\hspace{0.17em}\text{shipment\hspace{0.17em}setup‐hours}\times \$54\hspace{0.17em}\text{per\hspace{0.17em}shipment\hspace{0.17em}setup‐hour}).$ Budgeted setup cost per unit equals $\$0.67\hspace{0.17em}(\$\text{40,500}÷\text{60,000\hspace{0.17em}units})$ for the S3 lens and $\$2.70\hspace{0.17em}(\$\text{40,500}÷\text{15,000\hspace{0.17em}units})$ for the C5 lens.
2. Costing for shipment setups using shipment setup-hours as the cost driver is another example of time-driven activity-based costing (TDABC) because available time is used to allocate the costs in the activity pool. TDABC allows Plastim’s managers to account for the varying complexity in the shipments of S3 and C5 lenses. Notice that if Plastim had ignored the complexity of different shipments and allocated costs to lenses based only on the number of shipments, it would have calculated a budgeted indirect-cost rate of $405 per shipment in Exhibit 5-4 $(\$\text{81,000}÷200\hspace{0.17em}\text{shipment})$ Using this rate the total budgeted cost of the shipment setup activity allocated to the S3 lens is $\$\text{44,550}\hspace{0.17em}(110\hspace{0.17em}\text{shipments}\times \$405\hspace{0.17em}\text{per\hspace{0.17em}shipment})$ and to the C5 lens is $\$\text{36,450}\hspace{0.17em}(90\hspace{0.17em}\text{shipments}\times \$54\hspace{0.17em}\text{per\hspace{0.17em}shipment}).$ The budgeted setup cost per unit equals $\$0.74\hspace{0.17em}(\$\text{44,550}÷\text{60,000}\hspace{0.17em}\text{units})$ for the S3 lens and $\$2.43\hspace{0.17em}(\$\text{36,450}÷\text{15,000}\hspace{0.17em}\text{units})$ for the C5 lens. Using the number of shipments, rather than shipment setup-hours, as the cost driver would overcost the simple S3 lens and undercost the complex C5 lens.
3. Step 7: COMPUTE THE TOTAL COST OF THE PRODUCTS BY ADDING ALL DIRECT AND INDIRECT COSTS ASSIGNED TO THE PRODUCTS. Exhibit 5-5 presents the product costs for the simple and complex lenses. The direct costs are calculated in Step 2, and the indirect costs are calculated in Step 6. The ABC system overview in Exhibit 5-3 shows three direct-cost categories and six indirect-cost categories. The budgeted cost of each lens type in Exhibit 5-5 has nine line items, three for direct costs and six for indirect costs. The differences between the ABC product costs of S3 and C5 calculated in Exhibit 5-5 highlight how each of these products uses different amounts of direct and indirect costs related to each of the activities.

We emphasize two features of ABC systems. First, these systems identify all costs used by products, whether the costs are variable or fixed in the short run. Thus, ABC systems lend themselves to making long-run strategic decisions where managers want revenues to exceed total costs. Otherwise, a company will make losses and will be unable to continue in business. Second, recognizing the hierarchy of costs is critical when allocating costs to products. Management accountants use the cost hierarchy to first calculate the total costs of each product. They then derive per-unit costs by dividing total costs by the number of units produced.