Financial Accounting and Accounting Standards

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The Islamic University of Gaza
Cost Accounting
CHAPTER 4 Activity-Based Costing
and Activity-Based Management Dr. Hisham Madi
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Background

• Historically, firms produced a limited variety of
  goods and at the same time, their indirect costs
  were relatively small.
• Indirect (or overhead) costs were a relatively
  small percent- age of total costs.
• Using simple costing systems to allocate costs
  broadly was easy, inexpensive, and reasonably
  accurate.
• Plantwide Overhead Rate
• Total Estimated Overhead /Total Estimated Base
• Obtain total of all overhead costs to be
  allocated.
• Determine best base direct labor hours,
  machine hours, etc.
• This rate is used to allocate overhead costs to
  all products

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Background

• The end-result
• Products using fewer resources are overcosted and
  products using more resources are undercosted.
• However, as product diversity and indirect costs
  have increased, broad averaging has resulted in
  greater inaccuracy of product costs
• Different products consume activities at
  different rates, traditional costing does not
  recognize these differences

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Over and Undercosting-defined

• Consider the cost of a restaurant bill for four
  colleagues who meet monthly to discuss business
  developments.
• The restaurant bill for the most recent meeting
  is as follows
• 27 is the average cost per diner.
• This cost-averaging approach treats each diner
  the same
• When costs are averaged across all four diners,
  both Emma and Matthew are overcosted, James is
  undercosted, and Jessica is accurately costed.

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Over and Undercosting-defined

• Broad averaging can lead to undercosting or
  overcosting of products or services
• Product undercostinga product consumes a high
  level of resources but is reported to have a low
  cost per unit (Jamess dinner)
• Product overcostinga product consumes a low
  level of resources but is reported to have a high
  cost per unit (Emmas dinner).

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Over and Undercosting-defined

• What are the strategic consequences of product
  undercosting and overcosting
• Undercosted products will be underpriced and may
  even lead to sales that actually result in losse
  sales bring in less revenue than the cost of
  resources they use.
• Overcosted products lead to overpricing, causing
  these products to lose market share to
  competitors producing similar products.

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Cross-subsidization

• When a company has a situation in which
  undercosting or overcosting of products occurs
  due to broad averaging of costs, this is referred
  to as product-cost cross-subsidization
• if a company undercosts one of its products, it
  will overcost at least one of its other products.
  
• Product-cost cross-subsidization is very common
  in situations in which a cost is uniformly
  spread meaning it is broadly averagedacross
  multiple products without recognizing the amount
  of resources consumed by each product

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Cross-subsidization

• In the restaurant-bill example
• The amount of cost cross-subsidization of each
  diner can be readily computed because all cost
  items can be traced as direct costs to each diner
  
• If all diners pay 27, Emma is paying 12 more
  than her actual cost of 15. She is cross-
  subsidizing James who is paying 15 less than his
  actual cost of 42.

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Cross-subsidization

• When the resources represented by indirect costs
  are used by two or more diners, we need to find a
  way to allocate costs to each diner
• Consider, for example, a 40 bottle of juice
  whose cost is shared equally
• Each diner would pay 10 (40 4)
• Suppose Matthew drinks 2 glasses of juice while
  Emma, James, and Jessica drink one glass each for
  a total of 5 glasses
• Allocating the cost of the bottle of Juice on the
  basis of the glasses of Juice that each diner
  drinks would result in Matthew paying 16 (40
  2/5) and each of the others 8 (40 1/5).
• In this case, by sharing the cost equally, Emma,
  James, and Jessica are each paying 2 (10 8)
  more and are cross-subsidizing Matthew who is
  paying 6 (16 10) less for the wine he
  consumes

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Simple Costing System Using a Single
Indirect-Cost Pool
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Simple Costing System Using a Single
Indirect-Cost Pool
Step 1 Identify the Products That Are the Chosen
Cost Objects. The cost objects are the 60,000
simple S3 lenses and the 15,000 complex CL5
lenses that Plastim will produce in 2011 Step 2
Identify the Direct Costs of the Products.
Plastim identifies the direct costs direct
materials and direct manufacturing laborof the
lenses. Step 3 Select the Cost-Allocation Bases
to Use for Allocating Indirect (or Overhead)
Costs to the Products Plastim uses direct
manufacturing labor-hours as the only allocation
base to allocate all manufacturing and
nonmanufacturing indirect costs to S3 and CL5.
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Simple Costing System Using a Single
Indirect-Cost Pool
Step 4 Identify the Indirect Costs Associated
with Each Cost-Allocation Base. Because Plastim
uses only a single cost-allocation base, Plastim
groups all budgeted indirect costs of 2,385,000
for 2011 into a single overhead cost pool Step
5 Compute the Rate per Unit of Each
Cost-Allocation Base.
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Simple Costing System Using a Single
Indirect-Cost Pool
Step 6 Compute the Indirect Costs Allocated to
the Products. Plastim expects to use 30,000
total direct manufacturing labor-hours to make
the 60,000 S3 lenses and 9,750 total direct
manufacturing labor-hours to make the 15,000 CL5
lenses Step 7 Compute the Total Cost of the
Products by Adding All Direct and Indirect Costs
Assigned to the Products
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Refining a Costing System

• A refined cost system reduces the use of broad
  averages for assigning costs of resources to cost
  objects
• Reasons for Refining a Costing System
• Increase in product diversity. The growing demand
  for customized products has led to product
  diversity with the result that products and
  services demand differing quantities of resources
  
• Increase in indirect costs. With product and
  process technology, companies have experienced a
  decrease in direct costs (especially direct
  labor) with a resulting increase in indirect
  costs
• Competition in product markets. Markets have
  become more competitive, forcing managers to
  obtain more accurate cost information to help
  them make strategic decisions, such as pricing
  and product mix

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Refining a Costing System

• Three guidelines are presented for refining a
  costing system
• Direct-cost tracing. Identify as many direct
  costs as is economically feasible.
• This guideline aims to reduce the amount of costs
  classified as indirect, thereby minimizing the
  extent to which costs have to be allocated,
  rather than traced
• Indirect-cost pools. Expand the number of
  indirect-cost pools until each pool is more
  homogeneous
• All costs in a homogeneous cost pool have the
  same or a similar cause- and-effect (or
  benefits-received) relationship with a single
  cost driver that is used as the cost-allocation
  base

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Refining a Costing System

• For example,
• a single indirect-cost pool containing both
  indirect machining costs and indirect
  distribution costs that are allocated to products
  using machine-hours
• This pool is not homogeneous because
  machine-hours are a cost driver of machining
  costs but not of distribution costs, which has a
  different cost driver, number of shipments
• If, instead, machining costs and distribution
  costs are separated into two indirect-cost pools
  (with machine-hours as the cost-allocation base
  for the machining cost pool and number of
  shipments as the cost-allocation base for the
  distribution cost pool), each indirect-cost pool
  would become homogeneous.

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Refining a Costing System

• Cost-allocation bases.
• The cost driver serves as the cost allocation
  base for each homogeneous indirect-cost pool

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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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