ACCT EXAM 2 (CH 7)

Activity-based costing

ABC is 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. It is ordinarily used as a supplement to, rather than as a replacement for, the company's usual costing system.

Transaction drivers

simple counts of the number of times an activity occurs such as the number of bills sent out to customers.

Duration drivers

measure the amount of time required to perform an activity such as the time spent preparing individual bills for customers.

Customer-level activities

relate to specific customers and are not tied to any specific product. For example, sales calls and catalog mailings would be customer-level activities.

Product-level activities

relate to specific products and must be carried out regardless of how many batches are run or units are produced or sold. For example, designing or advertising a product would be product-level activities.

Traditional cost systems

rely exclusively on allocation bases that are driven by the volume of production. ABC defines five levels of activity that largely do not relate to the volume of units produced.

The five steps for implementing ABC

Step 1: define activities, activity cost pools, and activity measures Step 2: assign overhead costs to activity cost pools (this is also called first-stage allocation) Step 3: calculate activity rates Step 4: assign overhead costs to cost objects (this is also called second stage allocation) Step 5: prepare management reports

activity

any event that causes the consumption of overhead resources

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. For example, heating a factory and cleaning executive offices are organization-sustaining activities.

Batch-level activities

are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities.

Unit-level activities

are performed each time a unit is produced. For example, providing power to run processing equipment would be a unit-level activity.

Benchmarking

can be used to compare an organization's activity rates with standards of performance that are external to the organization.

ABC differs from traditional cost accounting in three ways

1. Nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis. 2. Some manufacturing costs may be excluded from product costs. a. This is because ABC only assigns a cost to a product if decisions concerning that product will cause changes in the cost. b. ABC excludes two types of costs from product costs: (Organization-sustaining costs + The costs of unused or idle capacity.) 3. Numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measure of activity.

Targeting process improvements

Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvement. It involves focusing on activities to eliminate waste, decrease processing time, and reduce defects. The activity rates computed in ABC can also provide valuable clues concerning where there is waste and the opportunity for improvement.

There are four reasons why most companies do not use ABC for external reporting purposes.

External reports are less detailed than internal reports in the sense that individual product costs are not reported. External reports only disclose cost of goods sold and ending inventory. Therefore, if some products are under-costed and others are over-costed, the errors tend to cancel each other out when the product costs are added together. It is often very difficult to change a company's accounting system because it is deeply embedded within complex computer programs that have evolved over many years. An ABC system, such as the one described in the chapter, does not conform to generally accepted accounting principles (GAAP). Auditors are likely to be uncomfortable with cost allocations that are based on interviews with the company's personnel. This type of subjective data can be easily manipulated by management.

The limitations of activity-based costing

I. Implementing an ABC system requires substantial resources. The benefits of increased cost accuracy may not outweigh the implementation costs. II. ABC systems produce numbers, such as product margins, that are at odds with the numbers produced by traditional cost systems. Managers are not accustomed to managing their operations using these numbers. ABC inevitably faces resistance. This underscores the importance of having top management support for and cross-functional involvement with the ABC implementation. III. In practice, most managers insist on fully allocating all costs to products. The ABC system described in the main portion of this chapter does not conform to this preference. IV. ABC systems do not automatically identify the relevant costs for particular decisions; therefore, ABC data can be easily misinterpreted and must be used with care when making decisions. Costs assigned to products, customers, and other cost objects are only potentially relevant. V. Most organizations use ABC as a supplement to rather than a replacement for their existing cost system. Maintaining two cost systems is costlier than maintaining just one system and it may cause confusion about which set of numbers is to be relied on.

Characteristics of a successful ABC implementation

I. There should be strong top management support. (1). Without leadership from top management, some managers may not be motivated to embrace the need to change. II. Top managers should ensure that ABC data are linked to how people are evaluated and rewarded. (1). If employees continue to be evaluated and rewarded using traditional (non-ABC) cost data, they will quickly get the message that ABC is not important and they will abandon it. III. A cross-functional team should be created to design and implement the ABC system. (1). Cross-functional employees possess intimate knowledge of operations that is necessary for designing an effective ABC system. (2). Tapping the knowledge of cross-functional managers lessens their resistance to ABC because they feel included in the implementation process.

Comparison of traditional and ABC product costs

There are three reasons why the reported product margins for the two costing systems differ from one another. (1). The traditional cost system allocates all manufacturing overhead to products. The ABC system only assigns manufacturing overhead costs consumed by products to those products. (2). The traditional cost system allocates all manufacturing overhead costs using a volume-related allocation base (machine-hours). The ABC system uses volume-related and non-volume related allocation bases to assign manufacturing overhead to products. (3). The traditional cost system disregards selling and administrative expenses because they are assumed to be period expenses. The ABC system directly traces shipping costs to products and includes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned to products.

activity cost pool

a "bucket" in which costs are accumulated that relate to a single activity measure in an ABC system.

cost driver

is also used to refer to an activity measure.

activity measure

is an allocation base in an activity-based costing system