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Overview of Overview of Activity-Based Cost Systems Activity-Based Cost Systems

for Management Controlfor Management ControlACCT7320, Dr. C. BaileyACCT7320, Dr. C. Bailey

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IntroductionIntroduction

This presentation…This presentation…• describes how ABC systems help improve describes how ABC systems help improve

pricing and product mix decisions.pricing and product mix decisions.• illustrates how ABC assists in cost illustrates how ABC assists in cost

management decisions by improving management decisions by improving processes and product designs.processes and product designs.

Note: ABC concerns mainly Note: ABC concerns mainly indirectindirect (overhead) costs!(overhead) costs!

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Undercosting and OvercostingUndercosting and Overcosting

Product undercostingProduct undercosting::A product consumes a relatively high level of A product consumes a relatively high level of resources but is reported to have a relatively resources but is reported to have a relatively low total cost.low total cost.

Product overcosting:Product overcosting:A product consumes a relatively low level of A product consumes a relatively low level of resources but is reported to have a relatively resources but is reported to have a relatively high total cost.high total cost.

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Undercosting and OvercostingUndercosting and Overcosting

Irene, Roberta, and Nancy are three bank customers.Irene, Roberta, and Nancy are three bank customers. They require different They require different activitiesactivities from the bank: from the bank:

• Irene banks exclusively at the ATM.Irene banks exclusively at the ATM.• Roberta visits the teller daily to make deposits, Roberta visits the teller daily to make deposits,

withdrawalswithdrawals• Nancy deposits foreign currency as well as calling Nancy deposits foreign currency as well as calling

the branch frequently to ask currency rates.the branch frequently to ask currency rates.

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Undercosting and OvercostingUndercosting and Overcosting

Traditional allocation bases might apply Traditional allocation bases might apply branch overhead to accounts based on account branch overhead to accounts based on account balances or equal amounts per account.balances or equal amounts per account.

Irene (who never makes any demands on the Irene (who never makes any demands on the branch) will be branch) will be overovercosted and appear less costed and appear less profitable than she should.profitable than she should.

Roberta and Nancy may be Roberta and Nancy may be underundercosted and costed and appear more profitable than they are.appear more profitable than they are.

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Refining a Costing SystemRefining a Costing System

Guidelines for refining a costing system:Guidelines for refining a costing system:

Direct-cost tracing Direct-cost tracing – – Classify as many of the Classify as many of the total costs as direct costs as is economically total costs as direct costs as is economically feasible.feasible.

Indirect-cost poolsIndirect-cost pools – Expand the number of – Expand the number of cost pools until each of these pools is cost pools until each of these pools is homogeneous.homogeneous.

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Refining a Costing SystemRefining a Costing System

Cost-allocation basisCost-allocation basis –– Identify the preferred Identify the preferred cost-allocation cost-allocation basebase for each indirect-cost for each indirect-cost pool.pool.

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Activity-Based Costing SystemActivity-Based Costing System

ABC calculates the costs of individual ABC calculates the costs of individual activities and assigns costs to cost objects activities and assigns costs to cost objects such as products, services, or customers based such as products, services, or customers based on the on the activitiesactivities used to produce a product or used to produce a product or service, serve a customer, etc.service, serve a customer, etc.

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Two-Step Allocation Two-Step Allocation

Collect costs in general ledger and subsidiary Collect costs in general ledger and subsidiary accounts accounts (labor, material, services, deprec., etc)(labor, material, services, deprec., etc)

Identify activity centersIdentify activity centersAccumulate costs into activity center cost poolsAccumulate costs into activity center cost pools

• cost drivercost driverAllocate costs to products and servicesAllocate costs to products and services

• activity driveractivity driver

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Activity-Based Costing SystemActivity-Based Costing System

Cost of Activity AOther Indirect Costs of

product/svc (including other non-ABC items)

Cost of Product, Service, Customer

Fundamental Cost Objects: Labor, materials, etc. (All indirect to the

Product or Service)

Cost drivers

Activity driversOtherCostdrivers

Direct CostsTraced

Cost of Activity B, etc.

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Examples of ActivitiesExamples of Activities

Activities at a Video Rental Store:Activities at a Video Rental Store:

• Replace movies on shelvesReplace movies on shelves

• Ring sales:Ring sales:

Collect moneyCollect money

Sign receiptSign receipt

Give copyGive copy

• Accept reservations, Hold, Call customerAccept reservations, Hold, Call customer

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Activity AnalysisActivity Analysis

Value-added activityValue-added activity Increases worth of Increases worth of

product or service to a product or service to a customercustomer

Customer is willing to Customer is willing to pay forpay for

Non-value-added activityNon-value-added activity Increases time spent on product Increases time spent on product

or service but does not increase or service but does not increase worthworth

Unnecessary from customer Unnecessary from customer perspectiveperspective

Some can be eliminated without Some can be eliminated without affecting market value or affecting market value or qualityquality

Business-value-addedBusiness-value-added activities activities are essentialare essential

ABM

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Activities of a Activities of a Milk Truck Delivery PersonMilk Truck Delivery Person

ActivityActivity Cost DriverCost Driver

DrivingDriving Time; miles; area of townTime; miles; area of town

ShelvingShelving Time; number of packages;Time; number of packages;

categories of productscategories of products

PaperworkPaperwork Time; types of customerTime; types of customer

WaitingWaiting Type of customer?Type of customer?

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Cost HierarchiesCost Hierarchies

A cost hierarchy is a categorization of costs A cost hierarchy is a categorization of costs into different cost pools on the basis of the into different cost pools on the basis of the different types of cost drivers (cost-allocation different types of cost drivers (cost-allocation bases) or different degrees of difficulty in bases) or different degrees of difficulty in determining cause-and-effect relationships.determining cause-and-effect relationships.

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Cost HierarchiesCost Hierarchies

ABC systems commonly use a four-part cost ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases:hierarchy to identify cost-allocation bases:

1 Output unit-level costOutput unit-level cost

2 Batch level costsBatch level costs

3 Product- (or service-)sustaining costsProduct- (or service-)sustaining costs

4 Facility-sustaining costsFacility-sustaining costs

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Output Unit-Level Costs...Output Unit-Level Costs...

are resources sacrificed on activities are resources sacrificed on activities performed on each individual unit of product performed on each individual unit of product or service.or service.

• EnergyEnergy

• Machine maintenance, repairs Machine maintenance, repairs (depreciation?)(depreciation?)

• LaborLabor

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Batch-Level Costs...Batch-Level Costs...

are resources sacrificed on activities that are are resources sacrificed on activities that are related to a related to a group of unitsgroup of units of product or service of product or service

• Setup hours to run a batchSetup hours to run a batch

• Procurement costs of placing an orderProcurement costs of placing an order

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Product-Sustaining...Product-Sustaining...

or service-sustaining, costs are resources or service-sustaining, costs are resources sacrificed on activities to sacrificed on activities to support individual support individual products or servicesproducts or services..

• Design costsDesign costs

• Engineering costsEngineering costs

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Facility-Sustaining Costs...Facility-Sustaining Costs...

are resources sacrificed on activities that are resources sacrificed on activities that cannot be traced to individual products or cannot be traced to individual products or services but support the services but support the organization as a organization as a whole.whole.

• General administrationGeneral administration

• RentRent

• Building securityBuilding security

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Decision Usefulness of Cost HierarchiesDecision Usefulness of Cost Hierarchies

Different levels of cost drivers:Different levels of cost drivers:LevelLevel Useful for Decisions Such As…Useful for Decisions Such As…Output-unitOutput-unit Shall we increase production, and at what price? Shall we increase production, and at what price?

BatchBatch How often should we produce batches? How often should we produce batches?

What base amount must we charge to set up a What base amount must we charge to set up a “run”, “run”, regardless of the number a customer wants made? regardless of the number a customer wants made?

Product/Service-Sustaining Should we continue to offer this service/product?Product/Service-Sustaining Should we continue to offer this service/product?

Facility-SustainingFacility-Sustaining Shall we continue in business or dissolve it? Shall we continue in business or dissolve it?

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Major Differences,Major Differences,Traditional Costing vs. ABCTraditional Costing vs. ABC

Typical SystemTypical System ABCABCOne or a few indirect One or a few indirect Many pools Many pools

cost poolscost pools Application base Application base maymay Base more likely a Base more likely a be a true cost driverbe a true cost driver true cost driver true cost driver Application base oftenApplication base often Bases likely to be Bases likely to befinancial (direct labor cost, non-financial (# of parts,financial (direct labor cost, non-financial (# of parts, direct material cost, etc)direct material cost, etc) number of operations, number of operations,

hours of testing, etc.)hours of testing, etc.)

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Indicators that ABC Systems Indicators that ABC Systems May be AppropriateMay be Appropriate

significant amounts of indirect costs are significant amounts of indirect costs are allocated using only one or two cost pools.allocated using only one or two cost pools.

all or most costs are identified as output unit-all or most costs are identified as output unit-level costs (unlikely to be true!).level costs (unlikely to be true!).

products make diverse demands on resources products make diverse demands on resources because of differences in volume, process because of differences in volume, process steps, batch size, or complexity.steps, batch size, or complexity.

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Indicators that ABC Systems May be Appropriate, Indicators that ABC Systems May be Appropriate, continued...continued...

products that a company is well-suited to products that a company is well-suited to make and sell show small profits while make and sell show small profits while products for which a company is less suited products for which a company is less suited show large profits.show large profits.

complex products appear to be very profitable complex products appear to be very profitable and simple products appear to be losing and simple products appear to be losing money.money.

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Indicators that ABC Systems May be Appropriate, Indicators that ABC Systems May be Appropriate, continued…continued…

operations staff have significant disagreements operations staff have significant disagreements with the accounting staff about the costs of with the accounting staff about the costs of manufacturing and marketing products and manufacturing and marketing products and services.services.

automation makes it difficult to assign automation makes it difficult to assign overhead to products using direct labor or overhead to products using direct labor or machine hoursmachine hours

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Criticisms of ABCCriticisms of ABC

Significant amount of time and cost to Significant amount of time and cost to implementimplement

Must overcome barriers to changeMust overcome barriers to changeDoes not conform to GAAPDoes not conform to GAAPDoes not promote total quality managementDoes not promote total quality management

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ABC In Service And ABC In Service And Merchandising CompaniesMerchandising Companies

The general approach to ABC in the service The general approach to ABC in the service and merchandising areas is very similar to and merchandising areas is very similar to the approach in manufacturing.the approach in manufacturing.

Costs are divided into homogeneous cost Costs are divided into homogeneous cost pools and classified as output unit-level, pools and classified as output unit-level, batch level, product, or service-sustaining batch level, product, or service-sustaining and facility sustaining costs.and facility sustaining costs.

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ABC In Service And ABC In Service And Merchandising CompaniesMerchandising Companies

The cost pools correspond to key activities.The cost pools correspond to key activities.Costs are allocated to products or customers Costs are allocated to products or customers

using activity drivers or cost-allocation bases using activity drivers or cost-allocation bases that have a cause-and-effect relationship with that have a cause-and-effect relationship with the cost in the cost pool.the cost in the cost pool.

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EndEnd