Chapter 5: Activity-Based Costing: A Tool to Aid Decision Making
Benchmarking
A systematic approach to identifying the activities with the greatest room for improvement. --> Based on comparing the performance of one organization to another that's performing better. --> Another way to leverage the information in activity rates.
ABC provides alternative to the traditional plant-wide and departmental approaches to defining cost pools and selecting allocation bases, and does so through using:
MORE cost pools and UNIQUE measures of activity to better understand the costs of managing and sustaining product diversity.
General Ledgers:
The general ledger provides a record of each financial transaction that takes place during the life of an operating company. --> Usually classify costs within departments where the costs are incurred.
First-stage allocation in an ABC system:
Is the process of assigning functionally organized overhead costs derived from a company's general ledger to the activity cost pools --> Usually based on the results of interviews with employees who have first-hand knowledge of the activities. --> Interview employees & departmental managers EX: "What percentage of the available machine capacity is consumed by each activity such as the number of customer orders or the number of units processed?"
Activity-Based Costing (ABC): (3)
- A costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore "fixed" as well as variable costs - Designed to provide data for internal decision making -Ordinarily used as a supplement to, rather than a replacement for, a company's usual costing system.
Targeting Process Improvements
- Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements. - ABC activity rates can also provide valuable clues concerning where there is waste and the opportunity for improvement
Organization-Sustaining activities
- Are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. EX: Included heating the factory, cleaning executive offices, providing computer network (internet), arranging for loans, preparing annual reports to shareholders...etc.
ABC costing model overview
- Direct labor, direct materials, shipping cost are all traced directly to cost objects (products, customer orders, customers) - Overhead cost broken into customer orders, design changes, order size, customer relations, and other through first stage allocation which also overhead cost to each activity pool - Then each activity pool goes through second stage allocation using the activity rate to assign overhead cost to specific products and customers
STEP 3: Calculate activity rates
- First get the total activities for each cost pool that would be required to get the companys present product mix and serve its present customers (ex 10,000 customer orders, 4,000 design changes, 800,000 machine hours, 2,000 customers served) - then divide the total cost for each activity by the total activity levels to get the activity rate
Batch-level activities
- Performed each time a batch is handled or processes regardless of how many units are in a batch - Incurred once for each batch (or customer order) - Costs at this level depend on the number of batches processed. EX: placing purchase orders, setting up equipment, arranging for shipments)
Customer-level activities
- Relate to specific customers EX: includes activities such as sales calls, catalog mailing, and general technical support that are not tied to any specific product.
Product Margin
- Shows the profit from a product as a function of the products sales and the direct and indirect costs that the product causes - The first step in computing product margins is to gather each product's sales and direct cost data. - The second step in computing product margins is to incorporate the previously computed activity-based cost assignments pertaining to each product. - The third step in computing product margins is to deduct each product's direct and indirect costs from sales. - The product margins can be reconciled with the company's net operating income (use info in step 3 and less costs not assigned to products - customer relations and other)
STEP 2: Assign overhead costs to activity cost pools
- Use first-stage allocation - Each cost is allocated across the activity pools by multiplying it by the percentages.
Customer Margin Analysis:
- first step is gather sales and direct cost data - next incorporate previously computed activity-based cost assignments - third step is to compute customer margin by deducting all its direct and indirect costs from its sales
Unit-level activities
- performed each time a unit is produced - cost should be proportional to the number of units produced --> EX: Providing power to run processing equipment= unit level b/c power tends to be consumed in proportion to the # of units produced.
Allocating Overhead Cost To Products:
-ABC defines five levels of activity that largely do not relate to the volume of units produced. --> Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products
Product-level activities
-Relate to a specific products and typically must be carried out regardless of how many batches are run or units of product are produced or sold. --> EX: designing a product, advertising a product, and maintaining a product manager and staff
STEP 4: Assigning overhead to product
-Second stage allocation - Use the information provided for the company product and multiply the information given by the activity rate then add up the ABC total cost --> (Ex: if 600 orders use the activity rate for the customer orders activity pool, mutiply the activity rate by the activity (# of orders)) --> The amount of total overhead assigned to the product may not equal the total overhead costs because the product cost does not include customer relations (customer-level activity) and other activities (organization-sustaining activity) (if you added these costs to the amount allocated to products should equal the total overhead) - Do the same process for assigning costs to customers but use the customer related information (when talking about custom orders need to account for that in product design pool and when from one company account for 1 under customer relation pool)
Non-manufacturing costs in ABC: (2)
1. ABC costing uses non-manufacturing & manufacturing costs when calculating the entire cost of a project 2. Non-manufacturing costs relate to selling, distributing and servicing specific products
Two types of Non-manufacturing costs that ABC assigns:
1. All direct costs that can be traced to a product. Traces all direct non-manufacturing costs to individual products --> EX: commissions to salespersons, shipping costs, warranty repair costs 2. All indirect costs that are caused by products. Allocates indirect non-manufacturing costs to products whenever the products have presumably caused the costs to be incurred. *** With this, the need to distinguish between manufacturing & non-manufacturing costs disappear
The Activity-Based Costing Model: (4)
1. Cost Objects 2. Activities 3. Consumption Resources 4. Cost Products that generate activities, activities consume resources and these resources cause cost. EX: The greater # of sheets used to fill out production orders and the greater amount of time devoted to filling out such orders, the greater the cost.
Steps for implementing ABC: (5)
1. Define activities, activity cost pools, and activity measures 2. Assign overhead costs to activity cost pools 3. Calculate activity rates 4. Assign overhead costs to cost objects using the activity rates and activity measures 5. Prepare management reports
Activity-Based Management (process improvements) involves focusing on activities to: (3)
1. Eliminate waste 2. Decrease processing time 3. Reduce defects.
Why do most companies not use ABC for external reporting? (4):
1. External reports are less detailed than internal reports. 2. It may be difficult to make changes to the company's accounting system. 3. ABC does not conform to GAAP. 4. Auditors may be suspect of the subjective allocation process based on interviews with employees.
Compute product margins using traditional cost system:
1. Gather each product's sales and direct cost data. 2. Compute the plant wide overhead rate (= total estimated manufacturing overhead/ total estimated machine-hours 3. Allocate MOH to each product (Machine hours x OH rate per machine-hour) 4. Compute the product margin (sales - direct materials - direct labor - MOH)
Product Margin Steps:
1. Gather each product's sales and direct cost data. 2. Incorporate the previously computed activity-based cost assignments pertaining to each product. 3. Deduct each product's direct and indirect costs from sales. --> Total Sales-Total Costs = Total Product Margin --> Product Margin - OH Costs not assigned to products = NOI OH Costs not assigned to products = Customer relations + Other
STEP 1: Define activities, activity cost pools, and activity measures
1. Identify the activities that will form the foundation for the system. --> A way to do this is interview people who work in OH departments and ask them to describe their major activities. Results in a long list of activities. --> Narrow down by combining similarities and activities on the appropriate level (unit, batch, etc.) EX: Classic Brass
How ABC differs from Traditional Absorption Costing: (3)
1. In ABC non-manufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis in traditional costing only. --> Manufacturing is applied (the definition of overhead is expanded to include all indirect costs manufacturing and non manufacturing) 2. Some manufacturing costs may be excluded from product cost in ABC costing, while all is used in traditional 3. In ABC, numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measure of activity
Limitations of ABC: (5)
1. More Costly--> Substantial resources required to implement and maintain. 2. Changes the rules of the game--> Resistance to unfamiliar numbers and reports. 3. Desire to fully allocate all costs to products--> leads to mistakes in pricing 4. Potential misinterpretation of unfamiliar numbers. 5. Does not conform to GAAP. Two costing systems may be needed.
Manufacturing Costs and ABC: Two types of man. OH costs that Activity-based costing doesn't assign:
1. Organization-sustaining costs→ Include costs such as factory security guards wages, the plant controller's salary, and the cost of supplies used by the plant manager's secretary. --> ABC treats them as period expenses rather than randomly assigning them to products. 2. Unused capacity costs→ Idle capacity costs --> Products are charged only for the cost of the capacity they use-- not for the cost of the capacity they don't use. **This provides a more stable unit product costs and is consistent with the goal of assigning to products only the costs of the resources that they use.
Makes sense to base overhead allocation on Direct Labor Hours and machine hours when:
1. Overhead costs and DLH are highly correlated 2. The goal of the OH allocation process is to prepare external financial reports.
STEP 5: Prepare management reports: Most common management reports are
1. Product profitability report 2. Customer profitability report --> These reports help companies channel their resources to their most profitable growth opportunities while at the same time highlighting products and customers that drain profits.
Characteristics of Successful ABC Implementations: (3)
1. Strong support from top managers → gets others to embrace the change 2. Link ABC Data to how people are evaluated and rewarded 3. Cross-functional team should be created to design and implement the ABC system.
Difference between ABC and Traditional product costs:
1. Traditional costing allocates all manufacturing overhead to products. --> ABC costing only assigns manufacturing overhead costs consumed by products to those products. 2. Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. --> ABC costing uses non-volume related allocation bases. 3. Traditional costing disregards selling and administrative expenses because they are assumed to be period expenses. --> ABC costing directly traces shipping costs to products and includes non-manufacturing overhead costs caused by products in the activity cost pools that are assigned to products.
The Two Most Common Cost Drivers:
1. Transaction drivers→ are simple counts of the number of times an activity occurs. = More commonly used in practice because take less time to perform EX: number of bills sent out to customers Often used in practice 2. Duration drivers→ measures the amount of time required to perform an activity. = More accurate measures of resource consumption, but take more effort to record. EX: the time spent preparing individual bills for customers.
ABC's Five levels of activity: (5)
1. Unit-Level activities 2. Batch-Level activities 3. Product-Level activities 4. Customer-Level activities 5. Organization-Sustaining-Level activities
Activity Measure (Cost Driver)
= An allocation base in an ABC system. -Also referred to as a Cost driver, because the activity measure should "drive" the cost being allocated - the two most common are transaction drivers and duration drivers
Activity Cost Pool
a "cost bucket" in which costs related to a single activity measure are accumulated
Second-Stage allocation
activity rates are used to apply overhead costs to products and customers
Activity
an event that causes the consumption of overhead resources