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Activity-Based Costing

Activity-Based Costing. Key Concepts. Costs. Life cycle First Operating & Maintenance Disposal Sunk Future Opportunity Direct Indirect Overhead Fixed Variable. Cost Structure for Manufacturing. Direct material Direct labor Sum is prime costs Indirect material

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Activity-Based Costing

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  1. Activity-Based Costing Key Concepts rd

  2. Costs • Life cycleFirstOperating & MaintenanceDisposalSunkFutureOpportunityDirectIndirectOverheadFixedVariable rd

  3. Cost Structure for Manufacturing • Direct material • Direct labor Sum is prime costs • Indirect material • Indirect labor Factory overhead • Fixed and miscellaneous Sum is cost of goods made • General and administrative • Selling Sum is cost of good sold • Profit Sum is selling price rd

  4. Cost Estimating • What cost components must be estimated? • First component ~ equipment, delivery, installation insurance, training • Elements – Direct labor and materials, maintenance • What approach to cost estimation will be applied? • Bottom-up, design-to-cost or top-down • How accurate should estimates be? • ROMs ~  20% of actual costs, Detail  5% • What estimation techniques will be used? • Unit, cost indices, learning curves, capacity, analogy rd

  5. Cost Estimation • Cost component • estimates • Cost • Estimates Required price Bottom-Up Required price Top-Down DTC rd

  6. Unit Method • CT = U x N • Cost of operating a car (43 cents / mile) • Cost to bury fiber cable ($30K / mile) • Cost to construct a parking space in parking garage $4500 • Cost to construct Interstate highway ($6.2 M /mile) • Cost of house construction ($225 /ft2) rd

  7. Total Cost Estimate rd

  8. Cost Indexes • Cost index is a ratio of the cost of something today to its cost sometime in the past. • CPI ~ Consumer Price Index rd

  9. Cost Capacity • C2 = C1 (Q2 /Q1)x (It /I0) • The total cost for a digester with a flow rate of ½ MGD was $1.7M in 2000. Estimate the cost for a flow rate of 2 MGD. The cost index in 2000 of 131 is now 225 and the exponent x = 0.14 for the range flow 0.2 to 40 MGD. • C2 = 1,700,000 * (2/0.5)0.14 (225/131) • = $3,546,178. • Component Size Range Exponent • Activated sludge plant 1-100 MGD 0.84 • Aerobic digester 0.2-40 MGD 0.14 • …. … … rd

  10. Cost Estimating Relationships • Factor Method (Hans J. Lang) • CT = h x CE • Total cost = factor times cost of major equipment where h is usually used as 4. • Delivered equipment cost is $1.55M imply a total cost of • 4 * $1.55M = $6.2M • Factor method can be broken down into direct and indirect costs. h = 1 + => CT = [CE(1 + )](1 + fd) rd

  11. Learning Curve • TN = T1 Nb where N is unit number, T1 is cost or time for first item, TN is the cost or time for the Nth unit and b is the slope of the learning curve in decimal. • b = (Log learning-rate 2) = Ln L / Ln 2 • Unit Hours Cumulative(sim-lc 100 10 90) 1 100.00 100.00 • 2 90.00 190.00 • 3 84.62 274.62 • 4 81.00 355.62 • 5 78.30 433.92 • 6 76.16 510.08 • 7 74.39 584.47 • 8 72.90 657.37 • 9 71.61 728.98 • 10 70.47 799.45 rd

  12. Learning Curve Example • To build 25 FEMA test units took 200 hours for the first one. The direct and indirect labor costs average $50.hour and 80% learning curve is assumed. Estimate the total labor cost for the 25 units. (sim-lc 200 25 80) • Unit Hours Cumulative Unit Hours Cumulative 1 200.00 200.00 16 81.92 1784.03 • 2 160.00 360.00 17 80.34 1864.36 • 3 140.42 500.42 18 78.87 1943.24 • 4 128.00 628.42 19 77.51 2020.75 • 5 119.13 747.55 20 76.24 2096.99 • 6 112.34 859.88 21 75.05 2172.04 • 7 106.90 966.78 22 73.94 2245.98 • 8 102.40 1069.18 23 72.89 2318.87 • 9 98.59 1167.77 24 71.90 2390.76 10 95.30 1263.07 25 70.96 2461.72TC = 2461.72 * 50 = $123,086 • 11 92.42 1355.50 • 12 89.87 1445.37 • 13 87.58 1532.95 • 14 85.52 1618.47 • 15 83.64 1702.11 rd

  13. Indirect Cost (Overhead) • Traditional Overhead = Estimated total indirect cost • Estimated basis level • Allocation Basis Indirect Cost Category • Direct labor hours Machine shop, human resources, supervision • Direct labor cost Machine shop, supervision, accounting • Machine hours Utilities, IT network servers • Cost of materials Purchasing, receiving, inspection • Space occupied Taxes, utilities, bldg maintenance • Amount consumed Utilities, food services • Number of items Purchasing, receiving, inspection • Number of accesses Software • Number of inspections Quality assurance rd

  14. Blanket Rate • Example • Blanket indirect cost rate = total expected indirect costs • total estimated materials costs • Automated vs. non-automated could cause discrepancy with low value items mixed with high value items resulting in over-accumulating of indirect costs for -lower value items. rd

  15. Economic Value Added (EVA) • EVA ~ adding value to the shareholders • looks at the difference between net operating profit and the cost of capital. rd

  16. Activity Based Cost (ABC) Accounting • Rate sensitive to value added is a production hour rate method. • Using more than one basis led to the ABC method. • Factory costs are the sum of the costs of goods. • Automation advances result in decreased direct hours. • Once 35% to 45% of final cost due to labor; now 5 to 15% • Indirect cost comprise as much as 35% to 45% of total cost rd

  17. Four Key Concepts • Activity accounting ~ decomposes into a cause-and-effect rationale of how activities results in outputs • Cost Drivers ~ an event that affects cost/performance of a group of related activities. Number of machine hours, engineering change notices, purchase orders • Direct traceability ~ attributing costs to products or processes that consume resources • Non-value-added costs • ABC identify and place a cost on the activities performed so that management can determine desired changes rd

  18. Example • XYZ makes 2 models Qt = 50K each Model A • Direct material cost $2,800,600Direct labor cost $ 350,000Direct labor hours 35,000  $7MModel BDirect material cost $ 1,500,000Direct labor cost $ 250,000Direct labor hours 25,000  $5M • Total Manufacturing overhead costs $12,000,000 • Traditional (volume-based absorption) costing systemCost rate = Total Overhead Costs / Total Direct Labor Hours • = 12M / 60K hours = $200 per direct labor hour Allocated overhead 35K hours * $200 = $7M Model A => $10,150,600Allocated overhead 25K hours * $200 = $5M Model B => $6,750,000 • Total costs for 50K units $10,150,600/50K = $203 A and $135 B … continued  rd

  19. Activity-based Costing DataSix Main Activities for Manufacturing Activity $ Costs Cost Driver Budgeted RateProduction $8M # of machine hrs 200K hoursEngineering 1M # ECO 40K orders Material Handling 1M # of material moves 60K movesReceiving 800K # of batches 500 batchesQuality Assure 800K # of inspections 20K inspectionsPack & Ship 400K # of products 100K products rd

  20. ABC Driver Rates for Models A & B Activity Model A Model B Production 50K hours 150K hoursEngineering 15K orders 25K ordersMaterial Handling 20K moves 40K movesReceiving 150 batches 350 batchesQuality Assurance 6K inspections 14K inspectionsPack & ship 50K products 50K products rd

  21. EVA Example NOPAT Net Operating Profit After Taxes rd

  22. ABC for XYZ • Applied Activity Rate Model A Model BProduction $40/machine hr $2M $6MEngineering $25/ECO $375K $625KMaterial Hand $16.67/move $333,400 $666,600Receiving $1,600/batch $240,000 $560,000QA $40/inspection $240,000 $560,000Pack & Ship $4 / product $200,000 $200,000 • Total Overhead Costs $3,388,400 $8,611,600 • Direct material cost $2,800,600 $1.5M Direct labor costs $350,000 $250KTotal costs $6,539K$10,361,600 Cost per unit $130.78 $207.23 • Cost per unit (traditional) $203 $135 • $12M = $3,388,400 + $8,611,600Example: Production consumes 50K + 150K = 200K machine hours. $8M/200K = $40/machine hr. rd

  23. Activity-based Costing vs. Traditional(Volume-based absorption VBC) Model A is less expensive to make than Model B.\ Traditional based cost estimates on Model A being responsible for more overhead costs than B using direct labor hours as its base. In reality Model B incurs more overhead because of difference in number of transactions. rd

  24. ABC Example • A firm with 4 plants used traditional methods for business travel. See table below. Last year $500K in travel expenses were distributed at a rate of $500K/29,100 = $17.18 / employee. A switch to ABC was considered. rd

  25. Travel Voucher Basis 500,000, 500 = $1000/voucher rd

  26. Problem • If the processing cost decreases by a constant 4% every time the output is doubled, the slope parameter of the learning curve is closest to: • -0.009 b) -0.059 c) 0.991 d) -1.699 • (Log 0.96 2)  -0.058894 rd

  27. Problem • The cost of a robot is $80K and the cost for one with twice the capacity is $120K. The value of the exponent in the cost-capacity equation is closest to • 0.51 b) 0.58 c) 0.62 d) 0.69 • C2 = C1 (Q2 /Q1)x (It /I0) • 120 = 80*2x • x = 0.58496 rd

  28. Problem • Delivered equipment costs $650K with direct cost factor 1.82 and indirect cost factor 0.31. The total plant cost estimate is approximately • $2,034,500 b) $1,734,500 • $1,384,500 d) $1,183,000 • TC = (1 + 1.82 + 0.31) * 650K = $2,034,500 rd

  29. Problem • Police want to allocate indirect cost for speed monitoring of 3 toll roads. An allocation basis that may not be reasonable is • Miles of toll road monitored • Average number of cars patrolling per hours • Amount of car traffic per section of toll road • Cost to operate a car. rd

  30. Problem • First one took 24.5 seconds to paint with a 95% learning rate. How long to paint the 10th one? • 20.7 seconds b) 0.46 seconds • 2.75 seconds d) 15.5 seconds • T10 = 24.5 * 10 (Log 0.95 2) • = 20.66 sec. rd

  31. Problem • Cost of capital is 12%. Consider the two firms below. • Which seems better? Firm B, but Firm A is better. rd

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