Activity-Based Costing and Activity-Based Management

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Activity-Based Costing andActivity-Based
Management

• Chapter 5

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Overview

• Over/under costing
• Reasons to allocate costs
• Criteria to guide allocation
• Refining a cost system
• ABC versus traditional cost systems
• Costs/Benefits of ABC
• ABC in service retail as well as mfg.

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• Explain undercosting
• and overcosting of
• products and services.

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Undercosting andOvercosting Example
Jose, Roberta, and Nancy order separate items for
lunch.
Joses order amounts to 14 Robertas order
30 Nancys order is
16 Total 60
What is the average cost per lunch?
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Undercosting andOvercosting Example
60 3 20
Jose and Nancy are overcosted.
Roberta is undercosted.
The use of broad averages to allocate costs (aka
peanut-butter costing) can lead to product-cost
cross-subsidization.
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Reasons to Allocate costs
There are many reasons for allocating costs
to cost objects.
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Purposes of Cost Allocation
1. To provide information for economic decisions
2. To motivate managers and other employees
3. To justify costs or compute reimbursement
4. To measure income and assets for reporting to
external parties
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Criteria to GuideCost-Allocation Decisions
Cause-and-effect Using this criterion, managers
identify the variable or variables that cause
resources to be consumed.
Benefits-received Using this criterion, managers
identify the beneficiaries of the outputs of the
cost object.
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Criteria to GuideCost-Allocation Decisions
Fairness or equity This criterion is often cited
on government contracts when cost allocations are
the basis for establishing a price satisfactory
to the government and its suppliers.
Ability to bear This criterion advocates
allocating costs in proportion to the cost
objects ability to bear them.
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Role of Dominant Criteria
Fairness and ability- to-bear are less frequently
used.
The cause-and-effect and the benefits- received
criteria guide most decisions related to cost
allocations.
Why?
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Refining a Costing System
More Direct-cost tracing
Indirect-cost pools (More homogeneous)
Better cost-allocation bases
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Activity-Based Costing System
Activity Indirect Cost Pool
Setup
Design
Shipping
No. of Setup Hours
No. of Shipments
Parts- Square feet
Cost Allocation Base
Lenses NL
Lenses CL
Lenses Other
Product Cost Objects
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Activity-Based Management
ABM describes management decisions that
use activity-based costing information to
satisfy customers and improve profits.
Product pricing and mix decisions
Cost reduction and process improvement decisions
Design decisions
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• Evaluate the costs and benefits of implementing
  activity-based costing systems.

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Benefits of ABC Systems(When the benefits of ABC
tend to be large)
Significant amounts of indirect costs
are allocated using only one or two cost pools.
All or most costs are identified as output
unit-level costs.
Products make diverse demands on resources
because of differences in volume, process steps,
batch size, or complexity.
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Benefits of ABC Systems
Products that a company is well-suited to make
and sell show small profits while products for
which a company is less suited show large profits.
Complex products appear to be very profitable and
simple products appear to be losing money.
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Benefits of ABC Systems
Operations staff have significant disagreements
with the accounting staff about the costs of
manufacturing and marketing products and
services. Operations staff may even keep their
own set of books!
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Limitations of ABC Systems
The main limitations of ABC are the measurements
necessary to implement the system.
ABC systems require management to estimate costs
of activity pools and to identify and measure
cost drivers for these pools.
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Limitations of ABC Systems
Activity-cost rates also need to be updated
regularly.
Very detailed ABC systems are costly to operate
and difficult to understand.
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ABC In Service andMerchandising Companies
The general approach to ABC in the service and
merchandising areas is very similar to the
approach in manufacturing.
Costs are divided into homogeneous cost pools and
classified as output unit-level, batch-level,
product- or service-sustaining, and
facility-sustaining costs.
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ABC In Service andMerchandising Companies
The cost pools correspond to key activities.
Costs are allocated to products or
customers using activity drivers or
cost-allocation bases that have a
cause-and-effect relationship with the cost in
the cost pool.
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End of Chapter 5(Thats all folks!)