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Financial Accounting and Accounting Standards


Activity-Based Costing and Activity-Based Management Dr. Hisham Madi Activity-Based Costing Systems Activity-based costing (ABC) refines a costing system by ... – PowerPoint PPT presentation

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Title: Financial Accounting and Accounting Standards

The Islamic University of Gaza
Cost Accounting
Activity-Based Costing and Activity-Based
Management Dr. Hisham Madi
Activity-Based Costing Systems
  • Activity-based costing (ABC) refines a costing
    system by identifying individual activities as
    the fundamental cost objects.
  • An activity is an event, task, or unit of work
    with a specified purposefor example, designing
    products, setting up machines, operating
    machines, and distributing products.
  • ABC systems identify activities in all functions
    of the value chain, calculate costs of individual
    activities, and assign costs to cost objects such
    as products and services

Activity-Based Costing Systems
  • ABC systems identify activities in all functions
    of the value chain, calculate costs of individual
    activities, and assign costs to cost objects such
    as products and services

Cost Hierarchies
  • A cost hierarchy categorizes various activity
    cost pools on the basis of the different types of
    cost drivers, or cost-allocation bases.
  • ABC systems commonly use a cost hierarchy with
    four levelsoutput unit-level costs, batch-level
    costs, product-sustaining costs, and
    facility-sustaining coststo identify
    cost-allocation bases that are cost drivers of
    the activity cost pools.

Cost Hierarchies
  • Output unit-level costs
  • are the costs of activities performed on each
    individual unit of a product or service.
  • These costs increase as the number of units
    produced increases.
  • Machine operations costs (such as the cost of
    energy, machine depreciation, and repair) related
    to the activity of running the automated molding
    machines are output unit-level costs.
  • They are output unit-level costs because, over
    time, the cost of this activity increases with
    additional units of output produced (or
    machine-hours used)

Cost Hierarchies
  • Batch-level costs
  • are the costs of activities related to a group of
    units of a product or service rather than each
    individual unit of product or service.
  • Setup machine, shipment setup.
  • Indirect setup cost increase with setup hours and
    number of shipments
  • Product-sustaining costs (service-sustaining
  • are the costs of activities undertaken to support
    individual products or services regardless of the
    number of units or batches produced
  • Design costs are an example of this type of cost.
  • Design costs depend largely on the time designers
    spend on designing and modifying the product,

Cost Hierarchies
  • Product research and development costs, costs of
    making engineering changes, and marketing costs
    to launch new products.

Cost Hierarchies
  • Facility-sustaining costs
  • are the costs of activities that cannot be traced
    to individual products or services but that
    support the organization as a whole.
  • Examples of this type of cost include general
    administration, rent, and building security.
  • These costs usually lack a cause-and-effect
    relationship between the cost and the allocation
  • This lack of a cause-and-effect relationship
    causes some companies not to allocate these costs
    to products and instead to deduct them as a
    separate lump-sum amount from operating income

Cost Hierarchies
  • Companies may achieve greater accuracy in
    overhead cost allocation by recognizing these
    four different levels of activities and, from
    them, developing specific activity cost pools and
    their related cost drivers.
  • Once a company has classified its activities and
    identified the related resources, managers may
    discover that some manufacturing overhead costs
    can be traced directly to products.
  • An example of a traceable manufacturing overhead
    cost at CC Sports is the cost of operating the
    chenille machine. This cost, includes
    depreciation and indirect materials, is directly
    traceable to the award jackets because the
    chenille machine is used only to produce award
    jackets, and should not be allocated to pants and

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Implementing Activity-Based Costing
  • Step 1 Identify the products that are the chosen
    cost objects
  • The cost objects are the 60,000 S3 and the 15,000
    CL5 lenses that Plastim will produce in 2011
  • Step 2 Identify the direct costs of the products
  • Step 3 Select the Activities and Cost-Allocation
    Bases to Use for Allocating Indirect Costs to the
  • Plastim identifies six activities(a) design, (b)
    molding machine setups, (c) machine operations,
    (d) shipment setup, (e) distribution, and (f)
    administrationfor allocating indirect costs to

Implementing Activity-Based Costing
  • Step 3 Select the Activities and Cost-Allocation
    Bases to Use for Allocating Indirect Costs to the
  • Analysis of the activities performed to
    manufacture a product or provide a service
  • The system assigns overhead costs directly to the
    appropriate activity cost pool.
  • For example, rather than define the design
    activities of product design, process design, and
    prototyping as separate activities, Plastim
    defines these three activities together as a
    combined design activity and forms a
    homogeneous design cost pool.

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Implementing Activity-Based Costing
  • Step 4 Identify the Indirect Costs Associated
    with Each Cost-Allocation Base
  • Plastim assigns budgeted indirect costs for 2011
    to activities, to the extent possible, on the
    basis of a cause-and-effect relationship between
    the cost-allocation base for an activity and the
  • The company must identify the cost drivers for
    each cost pool.
  • The cost driver must accurately measure the
    actual consumption of the activity by the various

Implementing Activity-Based Costing
  • To achieve accurate costing, a high degree of
    correlation must exist between the cost driver
    and the actual consumption of the overhead costs
    in the cost pool.
  • The strength of the cause-and-effect relationship
    between the cost-allocation base and the cost of
    an activity varies across cost pools.
  • For example, the cause-and-effect relationship
    between direct manufacturing labor-hours and
    administration activity costs is not as strong as
    the relationship between setup-hours and setup
    activity costs.

Implementing Activity-Based Costing
  • Step 5 Compute the Rate per Unit of Each
    Cost-Allocation Base
  • Budgeted Indirect cost rate
  • Step 6 Compute the Indirect Costs Allocated to
    the Products
  • Step 7 Compute the Total Cost of the Products by
    Adding All Direct and Indirect Costs Assigned to
    the Products

Total Budgeted Indirect Cost
Budgeted quantity of cost allocation base
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ABC vs. Simple Costing Schemes
  • ABC systems trace more costs as direct costs
  • ABC systems create homogeneous cost pools linked
    to different activities
  • For each activity-cost pool, ABC systems seek a
    cost-allocation base that has a cause-and-effect
    relationship with costs in the cost pool
  • ABC is generally perceived to produce superior
    costing figures due to the use of multiple
    drivers across multiple levels

Costs and limitations of an ABC system
  • ABC can be expensive to use
  • The increased cost of identifying multiple
    activities and applying numerous cost drivers
    discourages many companies from using ABC.
  • Activity cost rates also need to be updated
  • As ABC systems get very detailed and more cost
    pools are created, more allocations are necessary
    to calculate activity costs for each cost pool.
    This increases the chances of misidentifying the
    costs of different activity cost pools.

When to Use ABC
  • How does a company know when to use ABC?
  • Indirect costs are significant in proportion to
    direct costs and use only one or two
  • Product lines differ greatly in volume and
    manufacturing complexity.
  • Product lines are numerous and diverse, and they
    require differing degrees of support services
  • The manufacturing process or the number of
    products has changed significantlyfor example,
    from labor-intensive to capital-intensive due to
  • Operations staff has substantial disagreement
    with the reported costs of manufacturing and
    marketing products and services

Activity-Based Management
  • The process of using activity-based costing
    information to manage a businesss activities,
    and thus its costs.
  • is a method of management decision making that
    uses activity-based costing information to
    improve customer satisfaction and profitability

Activity-Based Management
  • A method of management that uses ABC as an
    integral part in critical decision-making
    situations, including
  • Pricing and product-mix decisions
  • Cost reduction and process improvement decisions
  • Reduce costs by improving the way work is done
    without compromising customer service or the
    actual or perceived value (usefulness) customers
    obtain from the product or service
  • Eliminate activities that consume resources but
    do not contribute to the value of the product non
    value added.

Activity-Based Management
  • Design decisions
  • Identifying new designs to reduce costs.
  • Planning and managing activities

ABC and Service/Merchandising Firms
  • The overall objective of ABC in service firms is
    no different than it is in a manufacturing
  • That objective is to identify the key activities
    that generate costs and to keep track of how many
    of those activities are performed for each
    service provided
  • Health Care
  • Banking
  • Telecommunications
  • Retailing
  • Transportation

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