Activity Based Costing (with full-length example)

In this video we're going to talk about activity-based costing which is sometimes abbreviated as ABC. So with ABC what we're looking at is non-direct costs. So when I say non-direct costs what we're ruling out, what we're not thinking about, is things like direct materials, direct labor. And the reason is that we can easily trace these costs to a product, to a division. It's not difficult for us to do that because they're direct costs. But when we think about non-direct costs, things that aren't as easily traceable, we basically come up with ways to try and allocate that overhead to products. And what we usually use are things like the number of machine hours or the number of labor hours. And we basically use these as proxies, as drivers of all of our non-direct costs. And we'll just think of, we'll just say for in general, we'll just talk about let's say our overhead. So when we think about our overhead, let's say we have five hundred thousand dollars in overhead. We just say, okay well how many labor hours did we have? And then we'll just divide that into this overhead figure. That'll give us an amount, a rate. That's our cost driver. And then we just go ahead and apply that to basically come up with ways to cost things out and kind of get into these non-direct costs. Now activity-based costing in that sense is no different. That it's not, we're not getting into these direct costs. We're still trying to kind of allocate costs. And activity-based costing is basically a different, more precise way of doing it than just simply looking at machine hours or labor hours. So it's more precise, but it also takes more information. It's actually more difficult to implement. So let's just jump into an example. So let's say in our example here that we've got, you've got a firm that is going to manufacture two products. So we've got two products. And let's say that these product lines, let's say you are really into the outdoors and hiking. And so you're going to make hiking packs. It's like the backpack that a hiker would wear. And then you will make tents. Those are the two things that you're going to make. So when we think about, okay, how will we go about implementing an ABC system? Let's say previously you used machine hours or something like that. That looks terrible. And now you want to use ABC. So first thing we need to do, and we can just think of this in terms of steps if you want. The first thing we need to do is identify kind of the activities that we're looking at, the activities that we're trying to allocate. And in this case, just to kind of make the example easier, I'm just going to say that what we're trying to allocate or spread out, we're just going to call it overhead. Now I could get into the specifics of this type of overhead and say, okay, this has to do with some equipment depreciation. It has to do with the janitor's salary. It has to do with these other things that have to do with the warehouse. And we could even say, okay, well, we're going to have manufacturing overhead. And then we're also just going to kind of have a separate thing where instead of this overhead, we also have another category of SG&A expenses. You can do whatever you want. Remember, we're doing costing and this isn't for external reports. This is just to produce useful information for managers to make decisions. So you can have costs that aren't seen as typical overhead costs like your SG&A or customer support costs in this figure, or you can break it out separately. Now I'm just going to lump it all here to make it easier for you to understand how to do activity-based costing. So let's say that we took a look and we said, well, you know what? We've got, in terms of our overhead, we've got $1,000,000. That's what we're looking at. This is manufacturing overhead. Some of the SG&A costs, we just lumped it all and we say overhead is $1,000,000. That's what we're dealing with. So what we want to do is now we've kind of got our activity here or what it is that we're going to be trying to spread across these different products here, our tents and our hiking packs. And so now we can say, okay, well, let's put this into cost pools. Let's take this $1,000,000 and let's put it into different pools. So what these cost pools are, let me just change colors here. So let's say here, I'll just put cost pools. Is there a heading? Which basically these are categories that kind of comprise, well, how was this $1,000,000 spent? And we'll say that some of it was spent on assembly. Some of it was spent on putting together the hiking packs, putting together the tents. We had to assemble those items before we could ship them out. And so we say that assembly is going to be one of these cost pools. Now, when you say we've got a cost pool here, you also need to say, okay, well, how would we measure that cost pool? How will we say that, okay, we're incurring some of that cost? What's a good driver for the assembly cost? And we'll just say, okay, our measure, let's put that over here. Our measure of this activity of this cost object here, we'll say that it's going to be the number of units produced, number of units produced. And here's a way to think about this and say, okay, if we produce more units, if we produce more tents, then we're going to incur more manufacturing overhead or we'll just say general overhead related to the assembly function. All right. So some of this million dollars is going to come down here and go into this cost pool. We don't know how much yet. We're going to get into that. Let's just finish going through our cost pool. So our second cost pool, we'll say, let's say it's a processing orders. Now you say, well, if you're asking yourself, where do we even come up with these cost pools? Where are you getting this? Well, this is something that's different to every organization. And so one organization might say, well, you know what, really this is trivial. We don't need to deal with that. So it's specific to the organization. And we're just saying, we've spoken with the managers and these are the cost pools they feel are most relevant. So we say processing orders. And then the measure, what drives the processing orders? Well, the number of orders, right? So if all else equal, if we have more orders, we're going to incur more costs related to processing those orders. So that kind of makes sense. And we just work our way through and say, the next thing, let's say there's customer support as a cost pool. You say, well, what is customer support? What are you talking about? Well, when you sell a product, you'll often have people complain about the quality and then they have to talk to somebody. Maybe there was a part that was defective and they call and get support staff. There's any number of reasons that a firm is going to incur costs relative to this customer support. And a good way of saying, okay, well, what's a measure for customer support? What might be something that drives it? Well, we can say the number of customers. So the more customers we have, the more people we might have or companies we might have calling us saying, hey, you know what, I'm not really happy with these tents that I received and so forth. So another cost pool, which is quite common, it's just to have a pool called other. Now with other, we're not going to have any measure. Basically, other is just saying, okay, these are things that we actually call them. There's a phrase for them. Some people call them organization sustaining activities. This might be something like, for example, let's say the lease on the factory, right? So we've got a lease on the factory to produce our tents and our hiking packs. And we say, you know what, that really doesn't fall into any of these cost pools. And we really don't even want to be assigning it to either the hiking pack division or the tent division anyways, because realistically, if we got rid of one of those products, we're still going to need the factory, right? So we just say, okay, well, we really just going to dump this in this other category because we don't really want to spread that cost. We just really want to be looking at these cost pools right here. This is what we feel is the best basis for comparison. So now that we've got our cost pools, what we need to do is say, okay, well, we need to take this million dollars and we need to spread it throughout these cost pools, right? So assembly is going to get some, processing is going to get some, customer support, and then other, they're all going to get some. And we say, well, how do we know, how do we go ahead and do that? Well, and again, this is where you think about it in terms of steps. This would be step two is now we assign that overhead to these cost pools, and we're going to do it by estimating a percentage of this overhead that relates to each one of these functions, each one of these cost pools. Now, how do you figure that out? Well, you're going to do interviews. You're going to do interviews with maybe some of the factory workers and you say, okay, how much of your time, what percent of your time would you say you end up dealing with assembly or with, you know, you start thinking about the overhead and say, okay, what is this, is this 90% of this has to do with assembly or is it 90% has to do with customer support? So you interview your staff and this is where kind of the subjective nature of ABC system comes into play. But ultimately you interview people and you find out and you say, okay, wait a minute, we've done a lot of checking. We think, okay, let me just, let me just write this out here. Let's say you say, okay, you know what, 50% of this we estimate has to do with, with assembly, right? So 50% has to do with assembly and then let's say 10% has to do with, with processing and then let's say you estimate 25% has to do, has to do with customer support and then 15% has to do with other, that's the lease on the factory or something. So I'm actually, I know this looks terrible penmanship here, so let me just scroll down and we'll, we'll make this a little better. So let's say here, we'll just write that out. So we've got assembly. So now we need to, so we've got, here's our pool. I'll just put pool and now we'll say the cost. We need to know the cost that is going to end up in this cost pool, on this cost pool and then the cost that is going to end up here, right here. We need to know that. So what we do is we say, okay, well, we've got 50% goes to assembly and then we've got a million dollars. So 50% of a million dollars is $500,000, right? So then we take $500,000 and put it here in the assembly, right? That's just saying that of that overhead, that big bucket, we're going to dump it into a smaller bucket here and say, okay, assembly. Now I'm just going to bring with us our activity measure. If you remember that we said that we had, we're going to look at the number of units. We're going to say, we're going to, here, let me just, I'll scroll back up for you to see that. Where did we have it? Oh, it's right here. Okay. So we said we're going to measure this with the number of units for assembly. So now I'll just bring that down and now we say, okay, well, as we're doing this, we'll just say, well, how many units are we budgeting for this year? How many units are we expecting to sell? Well, let's say it's 20,000. So we'll just collapse this all into one step. We've got our cost pool over here, assembly. We're saying, okay, of that million of overhead, 50% or 500,000 belongs with assembly and we're expecting 20,000 units that we're actually going to assemble. So why I've got all that will become important in a minute. Let me just figure out what we've got for the next one, which is processing. So we'll say here we've got processing. Now we need to know the cost for processing. So we say, well, we've got 10% of that million. Remember that million right here? Say 10% applies to processing. So that's going to be $100,000. So I put 100,000 here. Now I remember processing, we say it's based on the number of orders. Well, how many orders are we expecting? Okay. Well, we talked to the sales department and we talked to somebody and they said, well, we're expecting 1,000 orders. So then we put in 1,000 orders. So next up is our customer support. So just call this support and we need to know the cost for this. So we say, okay, it's 25% that we estimated of that million. So that means that we're going to have 250,000 gets dumped in the support bucket, right? Now we add the number of customers was our measure for support. So we're going to, let's say that we have 200 customers and we're expecting to have 200 customers. And then in our other category, that's just 15% of that million. Let me scroll down a bit. So other is going to be 150,000. And here we don't have an activity because it's just, we're not measuring it. We're just saying it, we actually don't want to consider it. So now if you add all this up, you're going to get to a million, right? So we basically just took that million and we spread it across these cost pools, right? That's all we did here. So now let's go down. And now if you notice that, okay, we've got our cost pool, we've got the cost and we've got the activity. What we can do is a really convenient thing, which we can just say, okay, let's take the total cost and divide it by the number of units or the number of orders customers for each one. It's different, but you get the idea. We're taking this column and dividing it by here. So, and that'll give us our rate. We'll just call it our act, our activity rate. Okay. So let me change up here so I don't have to keep having the same. So we take the 500,000 divided by 20,000 units, and that's going to give us $25 a unit, $25 a unit. Okay. Now we take the 100,000, the processing costs, and divide it by 1,000 orders. And that's going to give us $100 in order. Okay. Now we take the 250,000 support costs, divide it by the 200 customers that we we're expecting to have. That's going to give $1,250 in cost per customer. And again, we don't have a rate for other, because we're just going to, we're not even going to consider that with our ABC system. So what, what we really got here, if you notice, we've got three rates, right? Now this isn't all that different from before when we used to do, we take our machine hours and our labor hours and divide that into our manufacturing overhead and get some kind of plant-wide overhead rate. But now what we're doing is we're saying, hey, there's really a lot that's driving that overhead. You know, we've got some assembly going on here. We've got processing the orders. We've got some customer support. And really we don't want to just take one rate for the whole plant and just say, that's going to tell us about overhead. We've got three different rates here, right? So it's going to allow us to be more precise when we're actually pinning down of that million dollars in that overhead bucket, what applies to tents and what applies to our hiking packs. So now that we've got these rates, we can do a lot of things with that. Right now, what I'm just going to do is, is I'm actually going to break it out by hiking packs and by tents, right? So let me change colors here again. How about purple? Okay. So let's say that, and we'll just, you know, if we think of this in terms of steps, you know, we now, we started in step one, we define what our activities were, the cost pools, the measures. And then step two, we assign the overhead to cost pools based on, you know, employee interviews, talking with people. Then we calculated the rates, right? That was the last thing we did. And now we can use those rates to assign overhead to cost objects. So let's say we want to know the costs for the hiking packs division or product line, and then we've got the tents. So we say, let's just assume that we say, okay, well, we're going to, we sell 10,000 units of hiking packs and we're going to sell 10,000 tents. So 10,000 of each, right? So now this is actually going to be pretty simple. So this is our, now the reason I put, so units here, we're actually going to think of first our assembly, right? So actually, let me, let me write that down here. You can see that assembly be our first one. I should have put that in there. My apologies. So 10,000 units, what is that going to lead to in cost? Well, we have that $25 a unit. So for each, each of these is going to be $250,000. Change again. So $250,000 is the cost. When we look at 250,000, we have 10,000 units of tents, 10,000 units, 10,000 units of hiking packs. And so that's going to lead, basically we're splitting this 500,000 is going to end up going half over here and then half over here with the tents. And another way of looking at it is just that $25 a unit. So we're producing the same amount of units for each, but now let's make things a little, little bit more interesting. So now let's get into the processing, processing. So even though they have the same number of units, let's just say that when we look at the processing, remember it's the number of orders. Well, let's say that we have 700, 700 orders for hiking packs, and then we only have 300 orders for tents. So now we take this rate that we calculated and we multiply it by the number of orders. So it's a, it's a hundred dollars in order, right? So we take 700 times a hundred dollars, and that's going to give us 70,000. Now over here, we take the 300 orders times a hundred dollars in order. That's going to give us 30,000. Now we can go and say, well, we need to look at support next. So we'll take the customer support and remember that the number of customers was what we, what we looked at as our measure there. So let's say that we have 150 customers buying things for our, for our hiking packs. So that's 150. And then we have 50 customers for our tents. And now we can go ahead and look at the cost. And we said, well, it's $1,250 a customer. That's our rate. So $1,250 times $150, that's going to give us $187,500. Now that $1,250 times 50 customers is going to give us $62,500. Now again, we just, we don't worry about the other because we're not trying to assign that cost to the hiking packs or to the tent division. We're actually going to ignore that. We don't believe that that's, that's relevant. So now we can add up the costs for each of these divisions. So we say, I'm going to change colors again. So we've got, I believe we've got $507,500 here. And then over here, we're going to have $342,500. That's our total cost. Now again, remember these costs do not include direct materials, direct labor, right? So you don't want to base your entire decision and say, well, we want to get rid of this one product line or something just simply because of this. This is one input into the cost of the hiking packs and the tents. So when we think about this, we think, okay, well, what's going on here? We have the same number of units for each one, but we end up with these different cost totals. And it looks like that we say, okay, well, our hiking packs, they're being ordered more frequently and by a larger number of customers. So basically because of that, because we have more customers who decide maybe they're making smaller orders instead of one large order. Because of that, it's actually costing us more money, even though, see this, we're costing us over $150,000 more in terms of that overhead bucket. Because even though we're doing the same number of units, because of this, this discrepancy between 700 orders here, 300. So basically the tents, even though it's the same number of units, it's a lot less hassle in terms of these two items. And so it's actually costing us less when we just look at that overhead bucket. Now, another thing to think about is if you take this number and this number and add them together, it does not equal a million dollars. And you might say, hey, that's weird. Why is that not equal a million? Because remember, we started with a million in that overhead bucket. Well, the reason is that we didn't want to account for that other, right, that lease on the factory or whatever it was. So that's okay that these two numbers do not equal that number right there. So that's fine. And so ABC, important takeaway is that ABC is nice. It helps us kind of get a better idea of what the specific costs and cost drivers are for the hiking packs divisions and the tent division. Instead of just lumping the million dollars into just one big bucket and just saying, okay, we're going to come up, look at the number of machine hours, and then just take one plant-wide overhead rate and just apply that to the entire, both divisions. We're instead taking multiple rates based on these different cost pools that we identified by talking with our employees to see what is really driving the costs that are in that million. And then we identified those rates and then we apply them to get our total costs for the hiking packs and the tent division. And then we can go ahead and look at our direct costs, direct materials, and direct labor, put that together with these costs. And then we really have an accurate view of what the cost is for each division.