Ch 7 - Activity-Based Costing: A Tool to Aid Decision Making

Organization-sustaining activities

Activities that are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. (p. 276)

Why are there two stages of allocation in activity-based costing?

In activity-based costing, costs must irst be allocated to activity cost pools and then they are allocated from the activity cost pools to products, customers, and other cost objects.

Customer-level activities

Activities that are carried out to support customers, but that are not related to any specific product. (p. 276)

Batch-level activities

Activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in the batch. The amount of resource consumed depends on the number of batches run rather than on the number of units in the batch. (p. 275)

Unit-level activities

Activities that are performed each time a unit is produced. (p. 275)

Product-level activities

Activities that relate to specific products that must be carried out regardless of how many units are produced and sold or batches run. (p. 276)

When activity-based costing is used, why do manufacturing overhead costs often shift from high-volume products to low-volume products?

In traditional cost systems, product- level costs are indiscriminately spread across all products using direct labor-hours or some other allocation base related to volume. As a consequence, high-volume products are assigned the bulk of such costs. If a product is responsible for 40% of the direct labor in a factory, it will be assigned 40% of the manufacturing overhead cost in the factory—including 40% of the product-level costs of low- volume products. In an activity-based costing system, batch-level and product- level costs are assigned more appropriately. This results in shifting product-level costs back to the products that cause them and away from the high- volume products. (A similar efect will be observed with batch-level costs if high- volume products are produced in larger batches than low-volume products.)

Activity cost pool

A "bucket" in which costs are accumulated that relate to a single activity mea- sure in an activity-based costing system. (p. 275)

Activity-based costing (ABC)

A costing method based on activities that is designed to provide managers with cost information for strategic and other decisions that potentially affect capac- ity and therefore fixed as well as variable costs. (p. 273)

Activity-based management (ABM)

A management approach that focuses on managing activi- ties as a way of eliminating waste and reducing delays and defects. (p. 296)

Duration driver

A measure of the amount of time required to perform an activity. (p. 275)

Action analysis report

A report showing what costs have been assigned to a cost object, such as a product or customer, and how difficult it would be to adjust the cost if there is a change in activity. (p. 295)

Transaction driver

A simple count of the number of times an activity occurs. (p. 275)

Benchmarking

A systematic approach to identifying the activities with the greatest potential for improvement. (p. 296)

How can the activity rates (i.e., cost per activity) for the various activities be used to tar- get process improvements?

Activity rates tell managers the average cost of resources consumed to carry out a particular activity such as processing purchase orders. An activity whose average cost is high may be a good candidate for process improvements. Benchmarking can be used to identify which activities have unusually large costs. If some other organization is able to carry out the activity at a signiicantly lower cost, it is reasonable to suppose that improvement may be possible.

In what fundamental ways does activity-based costing differ from traditional costing methods such as job-order costing as described in Chapter 3?

Activity-based costing difers from traditional costing systems in a number of ways. In activity-based costing, nonmanufacturing as well as manufacturing costs may be assigned to products. And, some manufacturing costs—including the costs of idle capacity—may be excluded from product costs. An activity-based costing system typically includes a number of activity cost pools, each of which has its unique measure of activity. These measures of activity often difer from the allocation bases used in traditional costing systems.

Activity measure

An allocation base in an activity-based costing system; ideally, a measure of the amount of activity that drives the costs in an activity cost pool. (p. 275)

Activty

An event that causes the consumption of overhead resources in an organization. (p. 275)

Why is the first stage of the allocation process in activity-based costing often based on interviews?

Because people are often involved in more than one activity, some way must be found to estimate how much time they spend in each activity. The most practical approach is often to ask employees how they spend their time. It is also possible to ask people to keep records of how they spend their time or observe them as they perform their tasks, but both of these alternatives are costly and it is not obvious that the data would be any better. People who know they are being observed may change how they behave.

What types of costs should not be assigned to products in an activity-based costing system?

Organization-sustaining costs, customer-level costs, and the costs of idle capacity should not be assigned to products. These costs represent resources that are not consumed by the products.

Why is the activity-based costing described in this chapter unacceptable for external financial reports?

The activity-based costing approach described in the chapter is probably unacceptable for external inancial reports for two reasons. First, activity-based product costs, as described in this chapter, exclude some manufacturing costs and include some nonmanufacturing costs. Second, the irst-stage allocations are based on interviews rather than veriiable, objective data.

Second-stage allocation

The process by which activity rates are used to apply costs to products and customers in activity-based costing. (p. 285)

First-stage allocation

The process by which overhead costs are assigned to activity cost pools in an activity-based costing system. (p. 281)

Why are top management support and cross-functional involvement crucial when attempting to implement an activity-based costing system?

Top managers provide leadership that is needed to properly motivate all employees to embrace the need to implement ABC. Top managers also have the authority to link ABC data to the employee evaluation and reward system. Cross-functional employees are also important because they possess intimate knowledge of operations that is needed to design an efective ABC system. Tapping the knowledge of cross-functional employees also lessens their resistance to ABC because they feel included in the implementation process.

What are unit-level, batch-level, product-level, customer-level, and organization-sustaining activities?

Unit-level activities are performed for each unit that is produced. Batch-level activities are performed for each batch regardless of how many units are in the batch. Product-level activities must be carried out to support a product regardless of how many batches are run or units produced. Customer-level activities must be carried out to support customers regardless of what products or services they buy. Organization-sustaining activities are carried out regardless of the company's precise product mix or mix of customers.

Why is direct labor a poor base for allocating overhead in many companies?

When direct labor is used as an allocation base for overhead, it is implicitly assumed that overhead cost is directly proportional to direct labor. When cost systems were originally developed in the 1800s, this assumption may have been reasonably accurate. However, direct labor has declined in importance over the years while overhead has been increasing. This suggests that there is no longer a direct link between the level of direct labor and overhead. Indeed, when a company automates, direct labor is replaced by machines; a decrease in direct labor is accompanied by an increase in overhead. This violates the assumption that overhead cost is directly proportional to direct labor. Overhead cost appears to be driven by factors such as product diversity and complexity as well as by volume, for which direct labor has served as a convenient measure.