ACC 315 Chapter 5: Activity-Based Costing

Main cost and limitation of an ABC system

Measurements necessary to implement it

Why did companies historically use simple costing systems (traditional)?

Overhead was a small component of costs and a single cost driver accurately reflected how overhead resources were used

What is the term for costing that broadly averages or spreads the cost of resources uniformly to cost objects?

Peanut-butter costing

Which cost hierarchy is product design in?

Product-sustaining

ABC systems help managers to evaluate the effect of current product and process designs on activities and costs and to identify new designs to _______ costs

Reduce

Value chain of activities

Research and Development Product Design Production Marketing Distribution Customer Service

Homogeneous cost pool

All costs in a homogeneous cost pool have the same or a similar cause-and-effect relationship with a single cost driver that is used as the allocation base

The cost hierarchy helps us choose what?

Allocation bases

Describe four signs that help indicate when ABC systems are likely to provide the most benefits.

"Tell-tale" signs that indicate when ABC systems are likely to provide the most benefits are as follows: 1. Significant amounts of indirect costs are allocated using only one or two cost pools. 2. All or most indirect costs are identified as output-unit-level costs (i.e., few indirect costs are described as batch-level, product-sustaining, or facility-sustaining costs). 3. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity. 4. Products that a company is well suited to make and sell show small profits, whereas products that a company is less suited to produce and sell show large profits. 5. Operations staff has significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.

Describe four levels of a cost hierarchy.

(i) Output unit-level costs: costs of activities performed on each individual unit of a product or service. (ii) Batch-level costs: costs of activities related to a group of units of products or services rather than to each individual unit of product or service. (iii) Product-sustaining costs or service-sustaining costs: costs of activities undertaken to support individual products or services regardless of the number of units or batches in which the units are produced. (iv) Facility-sustaining costs: costs of activities that cannot be traced to individual products or services but support the organization as a whole.

From a purely product costing standpoint, department and activity indirect-cost rates will also result in the same product costs if...

1. A single activity accounts for a sizable fraction of the department's cost 2. Significant costs incurred on different activities but each activity has same cost-allocation base 3. Significant costs incurred on different activities with different cost-allocation bases within a department but different products use resources from the different activity areas in the same proportions

Using department indirect-cost rates to allocate costs to products results in similar information as activity cost rates if...

1. A single activity accounts for a sizable proportion of the department's costs OR 2. Significant costs are incurred on different activities within a department, but each activity has the same cost driver and therefore allocation base

What is one of the best tools for refining a costing system?

Activity-based costing

Guidelines for refining a cost system

1. Direct-cost tracing ---ID as many direct costs as economically feasible and reduce the amount of costs classified as indirect 2. Indirect-cost pools ---Expand the number of indirect-cost pools until each pool is more homogeneous 3. Cost-allocation bases ---Whenever possible, managers should use the cost driver as the allocation base

Reasons for refining a cost system (4)

1. Increase in product diversity ---Customized products use different amounts of resources 2. Increase in indirect costs with different cost drivers ---More indirect costs and less direct costs because of computers 3. Competition in product markets ---Need more accurate cost information 4. Advances in information technology

Main costs and limitations of an ABC system

1. Many calculations required to determine costs of products and services --------Activity-cost rates need to be updated regularly --------Detailed system increases opportunity for error 2. Allocation bases used for which data readily available rather than preferred allocation bases

Telltale sings when an ABC system is likely to provide the most benefits

1. Significant amounts of indirect costs are allocated using only one or two cost pools. 2. All or most indirect costs are identified as output-unit-level costs (i.e., few indirect costs are described as batch-level, product-sustaining, or facility-sustaining costs). 3. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity. 4. Products that a company is well suited to make and sell show small profits, whereas products that a company is less suited to produce and sell show large profits. 5. Operations staff has significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.

Unit-output level means there is a ____:____ relationship

1:1

Product over-costing

A product is reported to have a high cost per unit but consumes a lower level of resources per unit These products will be overpriced, causing them to lose market share to competitors producing similar products

Product under-costing

A product is reported to have a low cost per unit but consumes a higher level of resources per unit These products will be underpriced and may even lead to sales that actually result in losses

Activity Based Costing asks: What __________ cause these costs?

Activities

What are the key reasons for product cost differences between simple costing systems and ABC systems?

An ABC approach focuses on activities as the fundamental cost objects. The costs of these activities are built up to compute the costs of products, and services, and so on. Simple costing systems have one or a few indirect cost pools, irrespective of the heterogeneity in the facility while ABC systems have multiple indirect cost pools. An ABC approach attempts to use cost drivers as the allocation base for indirect costs, whereas a simple costing system generally does not. The ABC approach classifies as many indirect costs as direct costs as possible. A simple costing system has more indirect costs.

What is an activity-based approach to designing a costing system?

An activity-based approach refines a costing system by focusing on individual activities (events, tasks, or units of work with a specified purpose) as the fundamental cost objects. It uses the cost of these activities as the basis for assigning costs to other cost objects such as products or services.

What is an activity?

An event, task, or unit of work with a specified purpose Activities are verbs

What is broad averaging, and what consequences can it have on costs?

Broad averaging (or "peanut-butter costing") describes a costing approach that uses broad averages for assigning (or spreading, as in spreading peanut butter) the cost of resources uniformly to cost objects when the individual products or services, in fact, use those resources in non-uniform ways. Broad averaging, by ignoring the variation in the consumption of resources by different cost objects, can lead to inaccurate and misleading cost data, which in turn can negatively impact the marketing and operating decisions made based on that information.

How does ABC refine a costing system?

By identifying individual activities as the fundamental cost objects

What does a cost hierarchy do?

Categorizes various activity cost pools on the basis of the different types of cost drivers, allocation bases, or different degrees of difficulty in determining cause-and-effect relationships

A cost driver shows a ______/______ relationship between indirect costs and the job

Cause/effect

Batch level

Cost driven by a batch of products, not units

Unit-output level

Cost driven by each unit produced

Product-sustaining

Cost driven by life cycle of a product over several years

What is costing system refinement? Describe three guidelines for refinement.

Costing system refinement means making changes to a simple costing system that reduces the use of broad averages for assigning the cost of resources to cost objects and provides better measurement of the costs of overhead resources used by different cost objects. Three guidelines for refinement are 1. Classify as many of the total costs as direct costs as is economically feasible. 2. Expand the number of indirect cost pools until each of these pools is more homogenous. 3. Use the cause-and-effect criterion, when possible, to identify the cost-allocation base for each indirect-cost pool.

Benefits of activity-based costing must be balanced against its _____________

Costs and limitations (cost-benefit)

Batch-level costs

Costs of activities related to a group of units of a product or service rather than each individual unit of product or service The cost of this setup activity varies with the setup hours needed to produce batches regardless of the total number of units produced Material handling costs, quality inspection costs, purchase orders, receiving materials, paying invoices related to purchase orders

Organizational-sustaining

Costs to sustain the entire organization

An ABC system gives managers information about the costs of making and selling _________ products

Diverse With this information, managers can make pricing and product-mix decisions

How can something be a good cost driver but poor allocation base?

Drives the cost but difficult to tie directly to Job #1 vs. Job #2

Key to ABC

Find the right cost driver for each activity

Twofold logic of ABC systems

First, when managers structure activity cost pools more finely, using cost drivers for each activity cost pool as the allocation base, it leads to more accurate costing of activities. Second, allocating these costs to products by measuring the allocation bases of different activities used by different products leads to more accurate product costs.

Describe four decisions for which ABC information is useful.

Four decisions for which ABC information is useful are 1. pricing and product mix decisions, 2. cost reduction and process improvement decisions, 3. product design decisions, and 4. decisions for planning and managing activities.

Behavioral Issues in Implementing ABC

Gain the support of top management and create a sense of urgency. --Clearly communicate the strategic benefits of ABC, such as improvements in product and process design Create a guiding coalition of managers throughout the value chain for the ABC effort. --How the resources of an organization are used, managers have the best knowledge Educate and train employees in ABC as a basis for employee empowerment --Enable employees to make improvements Seek small short-run success as proof that the ABC implementation is yielding results. --Significant change overnight is difficult, improve a process and save costs, stay on course and build momentum, motivate employees to be innovative Recognize that ABC is not perfect. (better costs but complex system) --Open and honest communications, make critical judgments

Defining activities is easy or hard?

Hard They need to have the same cost driver

Product-cost cross-subsidization

If a company under-costs one of its products, it will over-cost at least one of its other products. Similarly, if a company over-costs one of its products, it will under-cost at least one of its other products

"Increasing the number of indirect-cost pools is guaranteed to sizably increase the accuracy of product or service costs." Do you agree? Why?

Increasing the number of indirect-cost pools does NOT guarantee increased accuracy of product or service costs. If the existing cost pool is already homogeneous, increasing the number of cost pools will not increase accuracy. If the existing cost pool is not homogeneous, accuracy will increase only if the increased cost pools themselves increase in homogeneity vis-à-vis the single cost pool.

Why is it important to classify costs into a cost hierarchy?

It is important to classify costs into a cost hierarchy because costs in different cost pools relate to different cost-allocation bases and not all cost-allocation bases are unit level. For example, an allocation base like setup hours is a batch-level allocation base, and design hours is a product-sustaining base, both insensitive to the number of units in a batch or the number of units of product produced. If costs were not classified into a cost hierarchy, the alternative would be to consider all costs as unit-level costs, leading to misallocation of those costs that are not unit-level costs.

An allocation base ______ indirect costs to jobs

Links

Refining a costing system helps managers ________

Make better decisions about how to allocate resources and which products to produce

Activity-based management

Method of management decision-making that uses activity-based costing information to improve customer satisfaction and profitability Include decisions about pricing and product mix, cost reduction, process improvement, and product and process design Used in management decisions for satisfying customers and improving profitability a. Pricing and product-mix decisions b. Cost reduction and process improvement decisions -------Analysis of factors that cause costs to be incurred -------Use of nonfinancial and financial cost-allocation bases c. Design decisions d. Planning and managing decisions -------Budgeted costs for activities and budgeted cost rates—normal costing used -------Feedback from comparing budgeted to actual costs on how well activities managed

ABC leads to more or less accurate product costs?

More accurate product costs

Whereas the traditional approach uses one allocation base for all FOH, Activity-Based Costing uses _________ allocation bases because there are several activities

Multiple

"ABC systems only apply to manufacturing companies." Do you agree? Explain.

No, ABC systems apply equally well to service companies such as banks, railroads, hospitals, and accounting firms, as well merchandising companies such as retailers and distributors when products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.

"Activity-based costing is the wave of the present and the future. All companies should adopt it." Do you agree? Explain.

No. An activity-based approach should be adopted only if its expected benefits exceed its expected costs. It is not always a wise investment. If the jobs, products, or services are alike in the way they consume indirect costs of a company, then a simple costing system will suffice.

"Department indirect-cost rates are never activity-cost rates." Do you agree? Explain.

No. Department indirect-cost rates are similar to activity-cost rates if (1) a single activity accounts for a sizable fraction of the department's costs, or (2) significant costs are incurred on different activities within a department but each activity has the same cost-allocation base, or (3) significant costs are incurred on different activities with different cost-allocation bases within a department but different products use resources from the different activity areas in the same proportions.

Managers attempt to take out value-added or non-value added costs?

Non-value added costs

R&D fits into which cost hierarchy?

Organizational-sustaining

Which cost hierarchy is Marketing in?

Organizational-sustaining

Four-level cost hierarchy

Organizational-sustaining costs Product-sustaining costs Batch-level costs Output unit-level costs

Why should managers worry about product overcosting or undercosting?

Overcosting may result in overpricing and competitors entering a market and taking market share for products that a company erroneously believes are low-margin or even unprofitable. Undercosting may result in companies selling products on which they are in fact losing money, when they erroneously believe them to be profitable.

Refined cost system

Reduces the use of broad averages for assigning costs of resources to cost objects (jobs, products, services) and provides better measurement of the costs of indirect resources used by different cost objects, no matter how differently various cost objects use indirect resources

The controller of a retail company has just had a $50,000 request to implement an ABC system quickly turned down. A senior vice president, in rejecting the request, noted, "Given a choice, I will always prefer a $50,000 investment in improving things a customer sees or experiences, such as our shelves or our store layout. How does a customer benefit by our spending $50,000 on a supposedly better accounting system?" How should the controller respond?

The controller faces a difficult challenge. The benefits of a better accounting system show up in improved decisions by managers. It is important that the controller have the support of these managers when seeking increased investments in accounting systems. Statements by these managers showing how their decisions will be improved by a better accounting system are the controller's best arguments when seeking increased funding. For example, the new system will result in more accurate product costs, which will influence pricing and product mix decisions. The new system can also be used to reduce product costs, which will lower selling prices. As a result, the customer will benefit from the new system.

Output unit-level costs

The costs of activities performed on each individual unit of a product or service The cost of this activity increases with additional units of output produced Machine operations costs

Facility-sustaining costs

The costs of activities that cannot be traced to individual products or services but support the organization as a whole General and administrative costs Difficult to find a good cause-and-effect relationship between these costs and the allocation base Can allocate these costs to products to make sure all costs are taken into account when making decisions

Product-sustaining costs

The costs of activities undertaken to support individual products regardless of the number of units or batches in which the units are produced Product R&D costs, costs of making engineering changes, marketing costs to launch new products

What are the main costs and limitations of implementing ABC systems?

The main costs and limitations of ABC are the measurements necessary to implement the systems. Even basic ABC systems require many calculations to determine costs of products and services. Activity-cost rates often need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand. Sometimes the allocations necessary to calculate activity costs often result in activity-cost pools and quantities of cost-allocation bases being measured with error. When measurement errors are large, activity-cost information can be misleading.

True or False: Averaging approach (traditional) usually leads to products being over-costed or under-costed

True

Indirect-cost allocation in job-costing system reflects _______

Underlying structure of operations

We want our allocation bases to be what level on the cost hierarchy?

Unit-output level Cause/effect relationship

Which cost hierarchy does distribution fit in?

Unit-output level Batch level

Which cost hierarchy is Customer Service in?

Unit-output level Batch level

Which cost hierarchy is production in?

Unit-output level Batch level

In the long-run, do managers have the ability to influence ALL costs?

Yes