Financial Accounting and Accounting Standards

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The Islamic University of Gaza
Cost Accounting
Activity-Based Costing and Activity-Based
Management Dr. Hisham Madi
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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

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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

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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.

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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)

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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
  costs)
• 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,

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Cost Hierarchies

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

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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
  base.
• 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

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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
  jerseys

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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
  Products
• 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
  products.

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Implementing Activity-Based Costing

• Step 3 Select the Activities and Cost-Allocation
  Bases to Use for Allocating Indirect Costs to the
  Products
• 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
  cost
• 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
  products.

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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.

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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

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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
  regularly
• 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.

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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
  cost-drivers
• 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
  automation.
• Operations staff has substantial disagreement
  with the reported costs of manufacturing and
  marketing products and services

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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

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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.

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Activity-Based Management

• Design decisions
• Identifying new designs to reduce costs.
• Planning and managing activities

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ABC and Service/Merchandising Firms

• The overall objective of ABC in service firms is
  no different than it is in a manufacturing
  company
• 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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