Activity Based Costing – Glaser Health Products Case Essay
Activity Based Costing – Glaser Health Products Case
Glaser Health Products manufactures medical items for the health care industry. Production involves machining, assembly and painting. Finished units are then packed and shipped. The financial controller is interested to introduce an activity-based costing (ABC) system to allocate (or distribute) indirect costs to products. Indirect costs, as distinct from direct costs, cannot be unambiguously linked to specific products. The controller would like to calculate product costs based on ABC for planning and control, not inventory valuation. Under an ABC system, the allocation of costs to products is achieved through at least four analytical steps. Firstly, costs are grouped into activity levels.
Secondly, cost drivers are selected for each activity level to link activities with costs. Thirdly, for each activity level, a cost function is defined to arithmetically describe the relationship between cost drivers and costs. Finally, a unit allocated cost is calculated for each product (Schneider, 2012). This paper outlines a process for introducing an ABC system at Glaser. The paper is divided into six sections. The first section groups cost categories identified at Glaser by division. The second section groups cost categories by division and activity level. The third section identifies specific cost drivers for each activity level. The fourth section explains preliminary stage allocation. The fifth section explains primary stage allocation. The final section summarizes the main conclusions.
Cost Categories by Division
Glaser is organized into three functional divisions – Operations, Sales, and Administration. Operations is the only cost or activity center. Glaser recognizes 22 cost categories. These cost categories are grouped by division in Table 1, shown in the appendix.
Cost Categories by Division by Activity Level
The second step in an ABC system involves grouping costs based on the level of activity at which they are generated. An activity involves the movement or handling of any part, component, or finished product within the relevant organizational unit. The rationale for this grouping is that costs at each activity level are determined by different cost drivers. Four levels of activity are commonly recognized – unit, batch, product and facility level. Unit-level activities are the most granular level of activity. They are performed each time a sub-unit is produced. Unit-level activities are on-going and reflect basic production tasks. Direct labor or direct materials are examples. Costs of these activities mainly vary according to the number of units produced. Batch-level activities are relevant to batch (rather than continuous) production processes.
They are performed each time a batch of product sub-units is produced. Typical examples of these costs relate to machine setups, order processing, and materials han¬dling. Costs of these activities vary mainly according to the number of batches produced, not the number of units in each the batch. Product-level activities support production of each product. The costs of these activities vary mainly according to the number of separate product models. Examples include maintaining bills of materials, processing engineering changes, and product testing routines. Facility-level activities are common to a variety of different products and are the most difficult to link to individual product-specific activities. These activities sustain the production process at an overall production plant or facil¬ity. Examples include plant supervision, rental expense and other building occupancy costs. Some firms, including Glaser, choose not to allocate facility-level costs to product costs.
Based on these activity level distinctions, the 22 Glaser cost categories may be grouped by division and activity level as shown in Table 2. By way of digression, it is worth mentioning that as a broad generalization, unit-level activities tend to generate mainly variable costs while and facility-level activities tend to generate mainly fixed costs, although there can be exceptions. Activities in the other two activity levels tend to generate a mixture of variable and fixed (Hansen & Mowen, 2006).
Cost Drivers by Activity Level by Division
Cost drivers can be identified for each activity or cost category based on observation, discussions with management, simulations and statistical studies. The key is to determine the behavior of indirect costs with respect to activity or resource usage in each activity center (Leslie, 2009). These efforts have identified the eight cost drivers shown in Table 3. Direct labor assembly costs are, by their nature, directly traceable to individual products. Therefore the relevant cost driver for this cost is the number of Direct Assembly Labor Hours. The other 21 cost categories are indirect costs. At the unit activity level, electricity assembly costs are likely to vary with Direct Labor Hours, Assembly. Similarly, the three machining costs grouped at the unit-activity level are likely to vary with by the number of Direct Labor Hours, Machining. Secondly, at the batch activity level, paint cost is likely to vary mainly with the Number of Batches Processed. Painting activity is the only batch activity at Glaser.
Thirdly, at the product activity level, the two Operations costs are likely to vary mainly with the Number of Units Produced and the three Sales costs are also likely to vary mainly with the Number of Units Produced. Finally, at the facility-level, the five Operations costs are likely to vary mainly with the Number of Units Produced, the Square Feet of Building Space Used, Payroll Costs, the Number of Employees, and the Change in Number of Employees. The three Sales costs are also likely to vary mainly with the Number of Employees. The three Administration costs are likely to vary mainly with the Number of Employees, the Change in Number of Employees and the number of Square Feet of Space Used. In summary, eight separate cost drivers may be used by Glaser to link activities with indirect costs and finally allocate those costs to individual products. These cost drivers are summarized by activity level by division in Table 3.
Preliminary Stage Allocation
Direct costs can be linked immediately to a product without the need for a cost driver. This is not true for indirect costs. An indirect cost requires a cost driver to link that cost with an activity and finally a product (Kimmel, et. al., 2010, Chapter 5). The first step in allocating indirect costs to products is to complete a preliminary stage allocation. This involves allocating the support center costs to the activity centers. In the case of Glaser, there is only one activity center, Operations. The Glaser controller has decided that the ABC system implemented at Glaser should allocate all indirect cost categories to products except for the three Sales and three Administration categories classified as facility-level costs. The only non-activity center costs that need to be assigned are the three product-level Sales division costs. This allocation may best be demonstrated with an example as summarized by Table 4 provided in the appendix.
The table assumes Glaser produces two products, A and B, with 30,000 units of each product produced during the period. It also assumes that product-level Sales division costs total $300,000. Allocation of these non-activity center costs result in unit costs of $5 for Product A and $5 for Product B. These unit costs are identical at $5 because the number of units produced is equal at 30,000 units for Product A and 30,000 units for Product B. These non-activity center unit costs need to be added to unit costs derived from the primary stage allocation.
Primary Stage Allocation
In the primary stage allocation, activity center (that is, Operations division) costs are assigned to each of the two products. In the example summarized by Table 5, the 13 costs assigned to Operations totaled $2,041,000. Allocation of these costs based on the various cost drivers results in unit costs of $40.60 for Product A and $27.43 for Product B. Once the $5 non-activity center unit cost is added to each product, the total allocated unit cost is $45.60 and $32.43 for Product A and B respectively.
Accounting provides information about the financial health of a firm. That information is used by a variety of stakeholders and other interested parties including managers, investors, investment analysts, employees, suppliers, customers, financial journalists, and regulators. At the broadest level, the information is used to improve resource allocation. ABC is a good example of accounting data being used to raise resource efficiency. ABC allows management to methodically identify activities and resources used to produce a product. The system distributes indirect costs to individual products and in that way improves product costing and pricing which ultimately affects buying decisions by consumers and investment decisions by management and investors (Edmonds & McNair, 2012).
Finally, the Glaser controller decided that the ABC system at Glaser will not allocate all indirect cost categories to products. The three Sales and three Administration division cost categories classified as facility-level costs are excluded from the allocation process. To that extent, costs are not fully distribute or allocated to products. The excluded sales and
Administration costs must be recognized at some stage during the product price setting process otherwise those costs will not be recovered by the resultant product prices.
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