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Case: Traditional and Activity-Based Costing (ABC) Systems

Traditionally, job-order and process costing systems allocate indirect (support) costs in two stages:

1. To operating departments (first stage allocation) in proportion to the direct labor hours, or direct machine hours used by those departments.
2. The costs of the operating department are subsequently allocated to products (second stage allocation).

Such crude methods of allocating support costs are likely to distort product costing.

Traditional cost systems often under-estimate the cost of resources used in more complex products and over-estimate the costs of indirect resources required for standard products.

Activity-based cost (ABC) systems have been developed to reduce such cost distortions.

This case describes a transition by The Cooper Pen Company from a traditional costing system to Activity Based Costing (ABC).

Traditional Costing Systems: The Cooper Pen Company Cooper Pen, is a low cost producer of blue pens and black pens. Recently, Cooper Pen introduced red and purple pens, using same basic production technology, combined with more complex processes, selling at prices respectively 3% and 10% higher than black and blue According to cost estimates based on traditional costing, overall profitability for all pens decreased, but red and purple pens recorded higher profit margins than black and blue. Decision: Should Cooper Pen change its product mix so as to de emphasize blue and black and increase production of new specialty colored pens? Table 1: Profitability by Product (Traditional Costing) Blue Black Red Purple Total Units 50,000 40,000 9,000 1,000 100,000 Price $ 4.50 $ 4.50 $4.65 $4.95 Sales $225,000 $180,000 $41,850 $4,950 $451,800 Direct Materials 75,000 60,000 14,040 1,650 150,690 Direct Labor 30,000 24,000 5,400 600 60,000 Indirect Costs 90,000 72.000 16.2001 1.800 180,000 Tot. Mfg. Cost 195,000 | 156,000 35,640 4 ,050 | 390,690 S 30,000 $ 24,000 $6,210 Gross Margin GM S 900 $61,110 13.3% 13.3% 14.8% 18.2% 13.5% GM% of Sales Cooper's Traditional Production System Cooper operated for many years traditional production and cost systems: Major production stages at the factory: - Preparing and mixing the ink for the different color pens - Inserting the ink into the pens in a semi-automated process - Packing and shipping the pens in a manual stage - Operational Features - Production operations were mostly manual - Total indirect costs were less than direct labor costs Cooper's two standard products (blue and black pens) had similar production volumes and batch sizes Cooper's Traditional Cost Accounting System Cooper 'ases its plant as a single cost center for cost accumulation. - All indirect support costs of the plant were aggregated at the plant level into one cost pool and allocated to products based on each product's direct labor cost. Currently, the cost system's overhead (indirect costs) allocation (burden) rate was 300% of direct labor cost (i.e., indirect support costs were allocated at a rate of $3 per S1 of direct labor costs). Before the new pens were introduced, the overhead burden rate was only 200% of direct labor cost. Cooper's Change to a More Complex Production Environment Cooper observes the following major changes to a more complex production environment: Cooper's Change to a More Complex Production Environment Cooper observes the following major changes to a more complex production environment: Direct labor costs have decreased, and indirect costs have increased as a result of automation As specialty low-volume products, such as red and purple pens, were added Cooper's production system required more scheduling, more setups, more quality control, and a computerized system, to track orders and product specifications Making black ink is simpler: Cleaning residual blue ink from the previous run is not required if enough black ink was dumped in to cover it up Switching to red requires Cooper to stop production, and clean out all remnants of previous colors. Production of purple pens is more complex than black and blue, but less than red. Reason for Cost Distortions in Cooper's Traditional Costing Systems Cooper identifies the following main reasons for growing cost distortion. Cooper's traditional costing system uses the same burden rate for all pens in allocating indirect costs. This practice is based on the implicit assumption that the production systems for all pens are of about the same complexity. As a result, Cooper's traditional costing system would report essentially identical indirect costs per direct labor dollar unit for all pens, standard and specialty In reality, considerably more indirect and support resources are required per dollar of direct labor for the low-volume, newly designed red and purple pens than for the high-volume, standard blue and black pens. Hence, Cooper's traditional costing system over-allocates indirect costs to Blue and black pens, and under-allocates indirect costs to red and purple pens. sations & Bibliography Captions ABC Systems: General Procedures In general, Cooper decides to pursue the following procedures, common to most ABC Systems use the following procedures 1. Detailed analysis of the sequence of activities performed 2. Identification of the resources required for each activity 3. Estimation of the cost of performing each activity by pooling same activity costs into separate activity cost pools 4. Choice of the most appropriate cost driver for the costs of each activity 5. Determination of the level of the cost driver made available by the resources committed to each activity 6. Calculation of the activity cost driver rates for each activity cost pool by dividing the support costs in each pool of activity by the level of its respective activity cost driver 7. Applying the activity cost drivers rates to each activity cost pool to allocate activity support costs to cost objects. Activities and Activity Cost Drivers at Cooper's ABC Analysis of the activities identified the following major pen production and support activities performed at Cooper's. This was followed by the selection of the most appropriate cost drivers that drive the costs of these activities. The activities and the activity cost drivers used by Cooper for its ABC were: Table 2: Activities, Activity Cost Pools and Activity Cost Drivers ACTIVITY ACTIVITY COST DRIVER HANDLE PRODUCTION RUNS PRODUCTION RUNS SET UP MACHINES SETUP HOURS SUPPORT PRODUCTS NUMBER OF PRODUCTS RUN MACHINES MACHINE HOURS PROVIDE FRINGE BENEFITS LABOR DOLLARS Drocus e Show Notes Footnotes Entry Lookup Research Caption Citation - Bibliography Citations & Bibliography Cross-reference Captions Activity Cost Drivers Requirements per Product Unit and Total Cost Driver Levels for Each Activity. Based on the identified major activities & and selected cost drivers, Coopers ABC proceeds as follows: The quantities of cost drivers required for each pen are estimated The total quantities of each activity cost driver required for the production of planned quantities of all pens are estimated Costs related to each activity are identified and pooled into a cost pools Activity cost driver rates are calculated by dividing the activity cost in each activity cost pool by the total quantity of the respective activity cost driver. Activity cost driver rates are multiplied by the quantity of each activity cost driver used by each of the four pens to obtain the assigned (allocated) costs of each activity to each of the four pens . The profitability of each pen is estimated Table 3: Activity Cost Driver's Requirements per Product Unit & Total Cost Driver Levels for Each Activity Activity Cost Driver/unit Blue Black Purple Total DL hr/unit 0.02 0.02 0.02 2.000 Mach.hr/unit 0.1 0.1 10.000 0.1 Prod.runs 70 Setup time hr/run 14 Total setup hr 280 156 of products 1 1 D. Focus Red of products of Pens 550.000 40.000 9.000 1.000 2. Compute the activity Costs Assigned from Activity Cost Pools to the Cost Ohjects Table 5: Activity Costs Assigned from Activity Cost Pools to Cost Objects Black Red Purple Total blue Handle Production Runs Sef up machines Support Products Ram Machines Total Costs Traditional Costing Systems: The Cooper Pen Company Cooper Pen, is a low cost producer of blue pens and black pens. Recently, Cooper Pen introduced red and purple pens, using same basic production technology, combined with more complex processes, selling at prices respectively 3% and 10% higher than black and blue According to cost estimates based on traditional costing, overall profitability for all pens decreased, but red and purple pens recorded higher profit margins than black and blue. Decision: Should Cooper Pen change its product mix so as to de emphasize blue and black and increase production of new specialty colored pens? Table 1: Profitability by Product (Traditional Costing) Blue Black Red Purple Total Units 50,000 40,000 9,000 1,000 100,000 Price $ 4.50 $ 4.50 $4.65 $4.95 Sales $225,000 $180,000 $41,850 $4,950 $451,800 Direct Materials 75,000 60,000 14,040 1,650 150,690 Direct Labor 30,000 24,000 5,400 600 60,000 Indirect Costs 90,000 72.000 16.2001 1.800 180,000 Tot. Mfg. Cost 195,000 | 156,000 35,640 4 ,050 | 390,690 S 30,000 $ 24,000 $6,210 Gross Margin GM S 900 $61,110 13.3% 13.3% 14.8% 18.2% 13.5% GM% of Sales Cooper's Traditional Production System Cooper operated for many years traditional production and cost systems: Major production stages at the factory: - Preparing and mixing the ink for the different color pens - Inserting the ink into the pens in a semi-automated process - Packing and shipping the pens in a manual stage - Operational Features - Production operations were mostly manual - Total indirect costs were less than direct labor costs Cooper's two standard products (blue and black pens) had similar production volumes and batch sizes Cooper's Traditional Cost Accounting System Cooper 'ases its plant as a single cost center for cost accumulation. - All indirect support costs of the plant were aggregated at the plant level into one cost pool and allocated to products based on each product's direct labor cost. Currently, the cost system's overhead (indirect costs) allocation (burden) rate was 300% of direct labor cost (i.e., indirect support costs were allocated at a rate of $3 per S1 of direct labor costs). Before the new pens were introduced, the overhead burden rate was only 200% of direct labor cost. Cooper's Change to a More Complex Production Environment Cooper observes the following major changes to a more complex production environment: Cooper's Change to a More Complex Production Environment Cooper observes the following major changes to a more complex production environment: Direct labor costs have decreased, and indirect costs have increased as a result of automation As specialty low-volume products, such as red and purple pens, were added Cooper's production system required more scheduling, more setups, more quality control, and a computerized system, to track orders and product specifications Making black ink is simpler: Cleaning residual blue ink from the previous run is not required if enough black ink was dumped in to cover it up Switching to red requires Cooper to stop production, and clean out all remnants of previous colors. Production of purple pens is more complex than black and blue, but less than red. Reason for Cost Distortions in Cooper's Traditional Costing Systems Cooper identifies the following main reasons for growing cost distortion. Cooper's traditional costing system uses the same burden rate for all pens in allocating indirect costs. This practice is based on the implicit assumption that the production systems for all pens are of about the same complexity. As a result, Cooper's traditional costing system would report essentially identical indirect costs per direct labor dollar unit for all pens, standard and specialty In reality, considerably more indirect and support resources are required per dollar of direct labor for the low-volume, newly designed red and purple pens than for the high-volume, standard blue and black pens. Hence, Cooper's traditional costing system over-allocates indirect costs to Blue and black pens, and under-allocates indirect costs to red and purple pens. sations & Bibliography Captions ABC Systems: General Procedures In general, Cooper decides to pursue the following procedures, common to most ABC Systems use the following procedures 1. Detailed analysis of the sequence of activities performed 2. Identification of the resources required for each activity 3. Estimation of the cost of performing each activity by pooling same activity costs into separate activity cost pools 4. Choice of the most appropriate cost driver for the costs of each activity 5. Determination of the level of the cost driver made available by the resources committed to each activity 6. Calculation of the activity cost driver rates for each activity cost pool by dividing the support costs in each pool of activity by the level of its respective activity cost driver 7. Applying the activity cost drivers rates to each activity cost pool to allocate activity support costs to cost objects. Activities and Activity Cost Drivers at Cooper's ABC Analysis of the activities identified the following major pen production and support activities performed at Cooper's. This was followed by the selection of the most appropriate cost drivers that drive the costs of these activities. The activities and the activity cost drivers used by Cooper for its ABC were: Table 2: Activities, Activity Cost Pools and Activity Cost Drivers ACTIVITY ACTIVITY COST DRIVER HANDLE PRODUCTION RUNS PRODUCTION RUNS SET UP MACHINES SETUP HOURS SUPPORT PRODUCTS NUMBER OF PRODUCTS RUN MACHINES MACHINE HOURS PROVIDE FRINGE BENEFITS LABOR DOLLARS Drocus e Show Notes Footnotes Entry Lookup Research Caption Citation - Bibliography Citations & Bibliography Cross-reference Captions Activity Cost Drivers Requirements per Product Unit and Total Cost Driver Levels for Each Activity. Based on the identified major activities & and selected cost drivers, Coopers ABC proceeds as follows: The quantities of cost drivers required for each pen are estimated The total quantities of each activity cost driver required for the production of planned quantities of all pens are estimated Costs related to each activity are identified and pooled into a cost pools Activity cost driver rates are calculated by dividing the activity cost in each activity cost pool by the total quantity of the respective activity cost driver. Activity cost driver rates are multiplied by the quantity of each activity cost driver used by each of the four pens to obtain the assigned (allocated) costs of each activity to each of the four pens . The profitability of each pen is estimated Table 3: Activity Cost Driver's Requirements per Product Unit & Total Cost Driver Levels for Each Activity Activity Cost Driver/unit Blue Black Purple Total DL hr/unit 0.02 0.02 0.02 2.000 Mach.hr/unit 0.1 0.1 10.000 0.1 Prod.runs 70 Setup time hr/run 14 Total setup hr 280 156 of products 1 1 D. Focus Red of products of Pens 550.000 40.000 9.000 1.000 2. Compute the activity Costs Assigned from Activity Cost Pools to the Cost Ohjects Table 5: Activity Costs Assigned from Activity Cost Pools to Cost Objects Black Red Purple Total blue Handle Production Runs Sef up machines Support Products Ram Machines Total Costs