Chapter 5 Activity Based Costing & Activity Based Management
CROSS SUBSIDIZATION
* results of overcosting one product and undercosting another *the overcosted product absorbs too much cost, making it seem less profitable than it really is *the undercosted product is left with too little cost, making it seem more profitable than it really is
What is an activity-based approach to designing a costing system?
*ACTIVITY-BASED APPROACH-- refines a costing system by focusing on an individual activities as 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
Activity Rates
*Activity rates are very similar to the predetermined overhead rate computed in traditional costing methods [ACTIVITY RATE] = [total activity cost] / [total activity driver]
What is costing system refinement? Describe 3 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 overhead resources used by different cost objects Three guidelines for refinement-- 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 homogeneous. 3. Use the cause-and-effect criterion, when possible, to identify the cost-allocation base for each indirect-cost pool
Define undercosting and overcosting and why these problems occur.
*UNDERCOSTING-- can result in companies selling products on which they are in fact losing money, even though they incorrectly believe them to be profitable (uses a lot of our resources, but we're not allocating a lot to it) *OVERCOSTING-- may result in competitors entering a market and taking market share for products that a company incorrectly believes are low-margin or even profitable (we've allocated too many resources to it) both are actual costs
Why is it 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 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 mis-allocation of those costs that are not unit-level costs
Cost Assignment--ABC vs. Volume
*cost assignment approach for indirect (support) costs: resource costs such as factory OH are assigned to cost pools and then to cost objects (jobs, clients, products, patients, etc) --volume-based: assign factory OH to a single plant or departmental cost pool first and then to products or services using volume-based rate --ABC systems assign factory OH costs to activities or activity cost pools first and then assign these costs to cost objects using activity cost drivers
Comparison of Traditional and ABC
*high volume products usually over-costed *volume-based costing tends to under-cost low volume products and over-cost high volume products, a situation often referred to as PRODUCT COST CROSS-SUBSIDIZATION
Volume-Based or ABC
-Each method is mathematically correct -Each method is acceptable -Each method yields a different cost figure, which will lead to different gross margin calculations -Only overhead is involved. >total costs for entire firm remain same (DM and DL)-- they are just allocated to diff. cost objects within the firm -Selection of the appropriate method and drivers should be based one experience, industry practices, and cost-benefit analysis of each option under consideration -A number of critical decisions can be made using this information >should one product be "pushed" over another? >Should one product be dropped? -Accounting for OH costs is an imprecise (always average) science >accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable
Rationale for selecting a more refined costing system
-increase in product diversity -increase in indirect costs -competition in product markets > advances in informational technology (increase competitions and need for accuracy) >Competition in foreign markets/ increased competition
Behavioral Issues in Implementing ABC
1. Gain the support of top management and create a sense of urgency 2. Create a guiding coalition of managers throughout the value chain for the ABC effort 3. Educate and train employees in ABC as a basis for employee empowerment 4. Seek small short-run success as proof that the ABC implementation is yielding results 5. Recognize that ABC is not perfect (better costs but complex system) (all of them are approximations)
Describe four levels of a cost hierarchy
1. OUTPUT UNIT-LEVEL COSTS-- --costs of activities performed on each individual unit of product or service 2. 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 3. PRODUCT/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 4. FACILITY-SUSTAINING COSTS-- --costs of activities that cannot be traced to individual products or services but support the organization as a whole *to identify costs for various activities, a firm classifies all activities according to one of four ways in which the activities consume resources
Describe four decisions for which ABC information is useful
1. Pricing and Product Mix 2. Cost reduction and process improvement 3. Product design 4. Decisions for planning and managing activities *integrating all of these throughout all parts of firm for improvement *Activity based management--method of management that uses ABC as an integral part in critical decision making situations Outside of manufacturing ABC is used in: Healthcare, banking, telecommunications, retailing, transportation.
Describe 4 signs that help indicate when ABC systems are likely to provide the most benefits
1. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity 2. 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 3. Operations staff have substantial disagreements with the reported costs of manufacturing and marketing products and services. 4. Significant amounts of indirect costs are allocated using only one or two cost pools
Signals the suggest that ABC implementation could help a firm
1. Significant amounts of indirect costs are allocated using only one or two cost pools -----could be plantwide, dept. wide 2. All or most indirect costs are identified as output unit-level costs -----almost impossible for all to be unit-level 3. Products make diverse demands on resources because of volume, process steps, batch size, or complexity ------(product diversity) some may use a lot of resources because large volume, or some large batches 4. Products that a company is well-suited to make show small profits whereas products that a company is less suited to make show large profits -------C-H versus Avalon and Camry
Key reason for product cost differences between simple costing systems and ABC systems?
ABC approach attempts to use cost drivers as the allocation base for indirect costs, whereas simple costing system generally does not
Plantwide Overhead Rate
BMOR = [Total Estimated OH] / [Total Estimated Cost Driver] or: AMOR= [Total OH] / [Total Cost Driver] (department overhead rate: similar concept except OH cost pools and selected base are obtained by department)
Broad Averaging
BROAD AVERAGING-- describes a costing approach that uses broad averages for assigning the cost of resources uniformly to cost object Consequences of Broad Averaging on cost= by ignoring the variation in the consumption of resources by different cost objects, broad averaging can lead to inaccurate product costing.
Review: Cost Accumulation Cost Measurement OH Assignment Method
Cost Accumulation-- job costing vs. process costing Cost Measurement--actual, normal, standard costing OH Assignment Method--Volume-based vs. ABC
Accuracy/ Simplicity Trade-off
Most Simple less accurate- Plantwide OH Rate (least refined) (traditional volume based cost systems) Middle- Departmental OH Rates (traditional volume based cost systems) More Complex More Accurate- Activity Based Costing (most refined)
What are the main costs and limitations of implementing ABC systems?
The measurements necessary to implement it require many calculations and can be costly to operate
"ABC systems only apply to manufacturing companies". Do you agree? Explain.
No--ABC is most commonly used method of overhead allocation in the management accounting. ABC method helps in the identification of the activities involved in the manufacturing process, organization and assignment of the cost to each of the individual activities according to the actual consumption of each product
"ABC is the wave of the present and the future. All companies should adopt it." Do you agree? Explain.
No--ABC is not suitable for all the companies even though it has significant advantages over traditional costing methods. According to ABC, the costs and resources are allocated to activities and the drivers are assigned to each activity. Therefor, the companies with wide overheads and diverse activities to produce goods and services to the consumers best benefit from ABC. Some companies have costs that can't be assigned to a single activity and some companies do not have multiple activities--these don't benefit much by ABC.
"Department indirect-cost rates are never activity-cost rates". Do you agree? Explain.
No--department indirect costs are similar to activity cost rates if: 1. A single activity of department accounts for a sizable fraction of the department's cost 2. If allocation base of different activities are the same and significant cost is incurred 3. Significant costs re-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
Does increasing the number of indirect-cost pools guarantee an increase in the accuracy of product or service costs?
No--if the existing cost pool is already homogeneous, increasing the number of cost pools will not increase accuracy No--if the existing cost pool is not homogeneous, accuracy will increase only if the increased cost pools themselves increase in homogeneity
"Increasing the number of indirect-cost pools is guaranteed to sizable increase the accuracy of product or service costs." Do you agree? Why?
No--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.
Classify following activities into one of cost hierarchy categories: a) Quality testing performed in each individual unit b)Creating and testing prototype models c)Supervising the entire manufacturing operation d)Machine setup cost incurred to produce a batch of units e)Creating pottery molds f)Pouring wet clay into the mold g)Firing multiple pots in a kiln h)Shipping pots to Garden World retailer i)Keeping track of inventory
a) Quality testing performed in each individual unit --Output Unit-Level b)Creating and testing prototype models --Product c)Supervising the entire manufacturing operation --Facility d)Machine setup cost incurred to produce a batch of units --Batch-level e)Creating pottery molds --Product( b/c do it once, used for all others) f)Pouring wet clay into the mold --Unit/output ( do it for each one) g)Firing multiple pots in a kiln --Batch (amount ready to be fired for each batch) h)Shipping pots to Garden World retailer --Customer level i)Keeping track of inventory --Facility
