Chapter 5 - Activity Based Costing

Activity-Based Costing

A costing approach that assigns costs to cost objects based on the activities performed for the cost objects.

Cost Driver

A factor that causes or relates to a change in the cost of an activity

Resource Consumption Cost Driver

A measure of the amount of resources consumed by an activity

Product Cost Cross Subsidization

A strategy where support for a product comes from the profits generated by another product. This is usually done to attract customers to a newly introduced product by giving them a lower price. The low price is sustained by the earnings of another product sold by the same company.

Create relative information for managers.

ABC Systems are designed to...

Competitive Advantage

Accurate cost information leads to...?

Second Stage of ABC Procedure

Activity costs are assigned to cost objects using activity consumption cost drivers.

Resource Demands of the Cost Object

Actual resource consumption of the product or service. - What is the resource consumption of Product A vs Product B? - What are the resources consumed by the accounting department?

Resource

An economic element needed or consumed in performing activities

Indicated Cost

An output. The number that the accounting system produces. Ex: To produce product A, it costs $20,000

Two Stage Cost Assignment

Assigns resource costs to activity cost pools and then to cost objects.

1. Better profitability measures 2. Better decision making 3. Process improvement 4. Improved planning 5. Cost of unused capacity

Benefits of Activity Based Costing

Low-Value Added Activity

Consumes time, resources, or space, but add little to satisfying customer needs. Ex: Setting up, waiting, moving, reworking, repairing, storing, inspecting

Low-Value-Added Activity

Consumes time, resources, or space, but adds little to satisfying customer needs.

Improves accuracy

Direct cost tracing...

First Stage of ABC Procedure

Direct materials and labor are assigned to cost objects; overhead costs are assigned to activities using resource consumption cost drivers.

Operational ABM

Enhances operational efficiency and asset utilization and lowers costs; its focuses are on doing things right and performing activities more efficiently. Use activity analysis, business process improvement, TQM, and performance measurement.

Strategic ABM

Focuses on choosing appropriate activities for the operation, eliminating nonessential activities, and selecting the most profitable customers. Use process design, customer profitability analysis, and value chain analysis.

While one could safely say that the ABC system provides an improved assignment of the overhead costs to the two products, the term "accuracy" tends to be regarded as a measure of how close the numbers are to some accepted target, but the target value is not known. It must be remembered that allocations are needed because direct assignment of cost to products is not possible and that all allocations are dependent upon subjective management decisions. The new costs reflect the decisions made with regard to the number of cost pools, the actual assignment of costs to those cost pools, and the selection of the cost drivers for each cost pool. If, for example, number of setups rather than number of setup hours was used to assign overhead from the machine setup pool, the cost of each product may have been different, thereby making it difficult to say that any ABC system is entirely accurate. The resulting values can only be evaluated with respect to those generated under some other system.

How are ABC Systems more accurate than the volume based system currently in use?

By linking uses of resources to activities and linking activity costs to products, services or customers.

How do ABC systems differ from volume based costing systems?

- Increased direct-cost tracing - Better allocation of service-department costs (Chap. 7) - ABC—even better methods for allocating indirect costs (Chap. 5)

How do we improve cost-system accuracy?

• Increased direct-cost tracing • Better allocation of service-department costs (Chap. 7) Direct, Step, or Reciprocal Method • ABC—even better methods for allocating indirect costs (Chap. 5) • Alternatives and strategies for better allocating costs to products, customers and services. • ABC is better than the Reciprocal Method

How do we improve cost-system accuracy?

Dysfunctional decisions and sub-optimization.

Inaccurate cost information leads to...?

High-Value-Added Activity

Increases the value of the product or service to the customers

High-Value Added Activity

Increases the value of the product or service to the customers. Ex: Designing product, processing, delivering product.

Activity Based Management

Manages resources and activities to improve the value of products or services to customers and increase the firm's competitiveness and profitability. Management can identify ways to improve operations, reduce costs, or increase value to customers, all of which can enhance the firm's competitiveness.

Activity Consumption Cost Driver

Measures how much of an activity a cost object uses

Batch-Level Activity

Performed for each batch or group of products or services

Unit Level Activity

Performed for each unit of the cost object

Strategic (Managerial) Objective of Cost Accounting Systems

Produce cost data that reflect the resource demands/resource consumption of a firm's cost objects [services it provides, products it produces, customers it serves, etc.]"

Coarse

Rough estimate

Activity

Some specific task or action of work done

Facility Level Activity

Supports operations in general

Product-Level Activity

Supports the production of a specific product or service

Theory Underlying ABC

Theory Underlying ABC • Products cause Activities......Activities cause Costs - Identifying which of the major activities and costing them - What's the cost of doing an inspection? Thus, ABC's underlying philosophy can be summed up as: - Build up Product costs by: - Assigning Costs to Activities - Then Assigning Activities to Products

1. Identify resource costs and activities 2. Assign resource costs to activities 3. Assign activity costs to cost objects

What are the 3 steps in developing an ABC system?

1. ABC system defines cost pools as activities rather than production plant or department cost centers. 2. The cost drivers that the ABC system uses to assign activity costs to cost objects are drivers based on an activity performed for the cost object.

What are the two ways that ABC systems differ from volume based systems?