© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s...

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management

Eldenburg & Wolcott’s Cost Management, 1e Slide # 1

Cost ManagementMeasuring, Monitoring, and Motivating Performance

Prepared byPrepared byGail KaciubaGail Kaciuba

Midwestern State UniversityMidwestern State University

Chapter 7

Activity-Based Costing and Management



Chapter 7: Activity-Based Costing and Management

Learning objectives

• Q1: How is activity-based costing (ABC) different from traditional costing?

• Q2: What are activities and how are they identified?

• Q3: What process is used to assign costs in an ABC system?

• Q4: How are cost drivers selected for activities?

• Q5: What is activity-based management?

• Q6: What are the benefits, costs, and limitations of ABC and ABM?



Q1: Product Cost Cross Subsidization

• Sharing the bill at a restaurant is a good example!

• Inappropriate pooling of indirect costs and poor choices for cost drivers can lead to the incorrect costs of products or services.

• If one product is under-costed, then other products may be over-costed resulting in product cost cross subsidization.



Q1: Product Cost Cross Subsidization

• The dieters are subsidizing the other two diners.

• Suppose four people go out to dinner.• two people are on diets and eat lightly• two people order appetizers, large meals, & dessert

• If they share the bill equally, then all costs were considered indirect and the cost allocation base was number of diners.



Q1: Cost System Refinement

An existing cost system can be improved by

• increasing the number of costs tracked as direct

• increasing the number of indirect cost pools

• using a better cause-and-effect cost allocation base for each indirect cost pool



A company makes 2 products, Premium and Regular, with direct costs of $120 and $80, respectively. Each product requires 5 DL hours, and the overhead rate is $10/DL hour. However, the Premium product line is more difficult to produce and manage. It takes twice the number of engineering hours, four times the number of machine setups, and twice the hours in the machining department to get a full run of Premium out the door. Determine the traditional cost of each product and discuss.

Q1: Product Cost Cross Subsidization Example

Premium RegularDirect costs (DM+DL) $120 $80Overhead (5 hrs @ $10) 50 50

$170 $130

The use of a single indirect cost pool with direct labor hours as an allocation base does not appropriately reflect the

consumption of resources during production.

The use of a single indirect cost pool with direct labor hours as an allocation base does not appropriately reflect the

consumption of resources during production.



Q1: Activity-Based Costing (ABC)

• ABC is a method of cost system refinement.

• Indirect costs are divided into “sub-pools” of costs of activities.

• Activity costs are then allocated to the final cost objects using a cost allocation base (more commonly called cost drivers in ABC).

• Activities are measurable, making it more likely that cost drivers can be found so that a final cost object will absorb indirect costs in proportion to its use of the activity.



Q1: Traditional Costing vs. ABC

Product A

Product B

Product C

Traditional costing systems:

IndirectCosts

Direct Costs

Direct Costs

Direct Costs

Direct costs are traced to the

individual products.

The individual products are the final cost

objects.

Indirect costs are grouped into one (or a small number) of cost

pools; a cost allocation base assigns costs to the individual products



Q1: Traditional Costing vs. ABC

Activity-based costing systems:

IndirectCosts

Product A

Product B

Product C

Direct Costs

Direct Costs

Direct Costs

The individual products are the final cost objects & direct costs are traced to the individual products.

Indirect costs are assigned (traced &

allocated) to various pools of activity costs.

Activity 1

Activity 2

Activity 3

Activity costs are allocated to

products



Q1: ABC in Manufacturing ExampleAlphabet Co. makes products A & B. Product A is a low-volume specialty item and B is a high-volume item. Estimated factory- wide overhead is $800,000, and the number of DL hours for the year is estimated to be 50,000 hours. DL costs are $10/hour. Each product uses 2 DL hours. Compute the traditional cost of each product if Products A & B use $25 and $10 in direct materials, respectively.

First, compute the estimated overhead rate:

Estimated overhead rate = $800,000/50,000 hours = $16/hour.

Product A Product BDirect materials $25 $10Direct labor (2hrs @ $10) 20 20Overhead (2 hrs @ $16) 32 32

$77 $62



Q1: ABC in Manufacturing ExampleAlphabet Co. is implementing an ABC system. It estimated the costs and activity levels for the upcoming year shown below.

First, compute the estimated overhead rate for each activity:

Prod. A Prod. B Total Cost DriverMachine set-ups $200,000 3,000 2,000 5,000 # set-upsInspections 140,000 500 300 800 # inspectionsMaterials handling 80,000 400 400 800 # mat'l requistionsMachining dep't 320,000 12,000 28,000 40,000 # machine hoursQuality control dep't 60,000 600 150 750 # tests

$800,000

Estimated Activity LevelsEstimated Costs



Q1: ABC in Manufacturing Example

Machine set-ups $200,000 5,000 set-ups $40 /setupInspections 140,000 800 inspections $175 /inspectionMaterials handling 80,000 800 mat'l requistions $100 /requisitionMachining dep't 320,000 40,000 machine hours $8 /mach hrQuality control dep't 60,000 750 tests $80 /test

$800,000

Estimated Costs Overhead RateEstimated Activity

$40 /setup$175 /inspection$100 /requisition

$8 /mach hr$80 /test



Q1: ABC in Manufacturing ExampleAlphabet recently completed a batch of 100 As and a batch of 100 Bs. Direct material and labor costs were as budgeted. Information about each batch’s use of the cost drivers is given below. Compute the overhead allocated to each unit of A and B.

100 BsMachine set-ups 60 10Inspections 10 2Materials handling 4 2Machining dep't 240 120Quality control dep't 3 1

100 As

Overhead allocated: 100 As 100 BsMachine set-ups $2,400 $400Inspections 1,750 350Materials handling 400 200Machining dep't 1,920 960Quality control dep't 240 80Overhead for batch $6,710 $1,990

Overhead per unit $67.10 $19.90



Q1: ABC in Manufacturing ExampleCompute the total cost of each product and compare it to the costs computed under traditional costing.

Traditional costing assigned $77 to a unit of Product A and $62 to a

unit of Product B.

Traditional costing assigned $77 to a unit of Product A and $62 to a

unit of Product B.

Prod A Prod BDirect material $25.00 $10.00Direct labor 20.00 20.00Overhead 67.10 19.90Total $112.10 $49.90

• The only difference between the two costing systems is that Product A is assigned more overhead costs under ABC.

• The additional overhead assigned to Product A reflects Product A’s consumption of resources.



Q2: What are Activities and How are They Identified?

The ABC cost hierarchy includes the following activities:

• organization-sustaining

• facility-sustaining

• customer-sustaining

• product sustaining

• batch-level

• unit-level



Q2: ABC Cost Hierarchy ExampleSome of the costs incurred by the Dewey Chargem law firm are listed below. This firm specializes in immigration issues and family law. For each cost, identify whether the cost most likely relates to a(n) (1) organiz-ation-sustaining, (2) facility-sustaining, (3) customer-sustaining, (4) product-sustaining, (5) batch-level, or (6) unit-level activity and explain your choice.

Cost Cost Hierarchy LevelBookkeeping softwareSalary for partner in charge of family lawOffice suppliesSubscription to family law update journalTelephone charges for local callsLong distance telephone chargesWindow washing serviceSalary of receptionist



Q3: What Process is Used to Assign Costs in an ABC system?

• Identify the relevant cost object. • Identify activities, and group homogeneous

activities. • Assign costs to the activity cost pools. • Choose a cost driver for each activity cost

pool. • Calculate an allocation rate for each

activity cost pool. • Allocate activity costs to the final cost

object.



Q4: How Are Cost Drivers Selected for Activities?

• For each activity, determine its place in the ABC cost hierarchy.

• Look for drivers that have a good cause-and-effect relationship with the activities’ costs.

• Use a reasonable driver when there is no cause-and-effect relationship.



• ABM is the process of using ABC information to evaluate opportunities for improvements in an organization.

Q5: Activity-Based Management (ABM)

• Examples include managing & monitoring

• customer profitability• product and process design • environmental costs• quality• constrained resources



• Activities can be defined so that different costs of servicing customers are accumulated.

Q5: ABM & Customer Profitability

• Examples include

• analyzing the types of bank transactions used by various categories of customers

• comparing the costs of servicing insurance contracts sold to married versus single individuals

• comparing the costs of different distribution channels



• Activities can be defined so that the costs of stages of production or of a business process are accumulated.

Q5: ABM & Product/Process Improvements

• Examples include• determining the costs of non-value-added

activities so the most costly can be reduced or eliminated

• changing the steps in the accounts payable function to reduce the number of personnel

• determining the most costly stages of product development so that the time to market is reduced



• Activities can be defined so that types of environmental costs are accumulated.

Q5: ABM & Environmental Costs

• Examples include

• capturing the costs of contingent liabilities for waste disposal site remediation

• comparing the cost of recycling packaging to the cost of disposal

• computing the costs of treating different kinds of emissions



• Activities can be defined so that categories of costs of managing quality are accumulated.

Q5: ABM & Quality Costs

• Common categories of quality costs are

• costs of prevention activities

• costs of appraisal activities

• costs of production activities

• costs of postsales activities



• Benefits• more accurate product cost information• employees focus attention on activities• measurement of the costs of activities and business

processes

Q6: Benefits & Costs of ABC and ABM

• Costs• ABC systems are difficult to design and maintain• more information must be captured • decision makers may not use the information

appropriately



• Judgment is required when determining activities.

Q6: Uncertainties in ABC and ABM Implementation

• Judgment is required when selecting cost drivers.

• Denominator levels for cost drivers are estimates.

• ABC information includes unitized fixed costs, so decision makers must use ABC information correctly.

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s...

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