This discussion will be on the differences between simple or
traditional based costing and an activity-based costing system. So let's
first look at a simple example here. We have three roommates David, Matt, and
Brian and they're currently sharing all the cost of living together equally at
$900 per month, but they're not all participating in the
activities of living together equally, like eating, watching TV, and using the
internet. So the three roommates call a meeting to discuss the allocation of
these costs to each roommate and here in this spreadsheet you can see how
those cost or how each roommate is using up those activities. Some are not using
any of the activity, but yet they're getting charged for those activities. So
it's probably not a fair way to do this. So this is our first little look at the
difference between a simple costing system where we just split the cost
equally in actual and an actual activity-based costing system where it's
more accurately placing cost with the users of those costs and this of course
is called an activity-based costing system. Which allocates cost based on the
activity that causes the cost. The goal of activity-based costing is to allocate
those indirect cost more accurately to our jobs so that we can get a clearer
picture of what each product cost to manufacture. This allows our managers to
make better decisions for our company. So let's look at this simple DVD
manufacturing company here and we have panel A which is a traditional system
and we have panel B which is an activity-based costing system. So let's
first look at panel A which is our simple or traditional costing system. So
we start with our manufacturing overhead and we want to allocate this overhead
to our products. So as we know we currently pick a an allocation base in
this case we have picked direct labor cost to be our allocation base and we're
using direct labour costs to allocate all of our manufacturing overhead to our
Excel DVDs and our specialty DVDs. Which are our products, but one or more of
those products may not use direct labor cost as the true cost driver. So we may
not be getting a true look now what each one of those products are really costing
us and one may be subsidizing the other. Which we'll get to in a later
conversation and if we look at the ABC costing system, we are going to take
manufacturing overhead and then we determine activities that our products
go through. Here we've determined that each DVD goes through set up, DVD burning,
and case assembly, and in this case each product went through each activity. There
may be some times where one product will go through two activities and the other
product may go through three different activities, but in this case both
products go through all three activities and then we have a cost driver for each
activity and you'll notice that cost driver does not necessarily have to be
the same thing for each activity. For setups, we determine the cost driver is
number of batches. For DVD burning, we determine the cost driver or the cost or
the allocation base for DVD burning, is the number of machine hours, and for case
assembly, we determined that the number of inserts were driving the cost there.
So let's look at an example. We have Blake and Rosco. They're college friends,
they're planning a skiing trip to Aspen before the new year and they
estimated the following costs for the trip. So they think they're, that they're
estimating, their total estimated costs are going to be $1,210.
$600 being for food, $210 being for skiing and
$400 being for lodging, and they determined that there's a cost
driver for each one of these activities. For food, the cost driver is pounds of
food eaten. For skiing, it's number of lift tickets and for lodging it's the
number of nights stayed. Well Blake suggest that the cost be shared equally.
So we're going to calculate the amount each person would pay if we shared the
cost equally. So to do this we're going to take the total estimated cost and we're
going to divide that by the number of products. In this case we're talking
about people because people are using up these cost and we have two people. So the
amount that's going to be allocated to each person is $605
each. Well Roscoe may not think this is very fair because he plans to
stay in the room and not ski. So Roscoe suggests that each type of costs be
allocated to each person based on the cost driver listed above, in other words
we're going to use an activity-based costing here. So using the allocation for
each person, calculate the amount that each person would pay based on his own
consumption of the activity. Well the first thing we have to do in
activity-based costing is we have to determine a rate. So part one is to
calculate the rate for each activity. So the first activity was food. The total
cost of the food, the total cost was $600 and if you look up here we said that or
Blake anticipates eating 20 pounds of food and Roscoe anticipates eating 30
pounds of food. So we want to know what the total amount of food is going to be?
In this case is going to be 50 pounds of food. So we're going to come back down
here and our food is going to be the $600 divided by the estimated total
amount of food eaten which is 50 pounds. That will give us our allocation rate
per pound of food which in this case is $12 per pound. So for each pound eaten by
Blake and Roscoe they will pay $12 in cost. We're going to do the same thing
for both of the other two activities. Skiing we see that our cost for skiing
is going to be $210 and the total amount of tickets is 3. 3 plus
zero is three. So three tickets. We find that our rate per ticket is $70,
and the last activity is lodging and we determined that that estimated
cost was going to be $400 total for the trip and each
person is going to stay two nights for a total of four nights. So we can find that
our allocation rate for lodging will be would be $100 per night. The second
step is to allocate the costs to each product, in this case our product is
people. So we have Blake and we have Roscoe, for food Blake we go back up here,
Blake is going to eat 20 pounds of food. So we're going to take our rate which we
determined to be twelve pounds or $12 per pound. So $12
times is 20 pounds of food. He is going to cover $240 of that cost. Roscoe,
so we keep the same rate is still $12 per pound, Roscoe is going to eat
thirty pounds of food. So the amount of cost allocated to him for food will be
$260. We move on to skiing.
Our rate for skiing was $70 per ticket times 3 is $210 ok, and Roscoe our rate is
still $70 per ticket, but he's not going to buy any tickets,
so his cost for lift tickets is 0 and our last activity is lodging, and we
determined that our lodging rate was $100 per night and if you look back up
at our spreadsheet information, we see that each person is going to stay 2
nights each. So each person will cover $200 in lodging costs.