Prepared by Diane Tanner University of North Florida ACG Allocating Indirect Costs: Simple Costing & ABC 2-2

Stage 2 Cost Allocation Stage 1. Allocate Support Costs to Cost Pools Stage 2. Allocate Production Cost Pools to Cost Objects Support Department #2 Support Department #1 Support Department #3 Direct and Indirect Costs Production Department #1 Production Department #2 Cost Object A Cost Object B

Allocation of Indirect Costs to Cost Objects  Allocation method depends on how managers ‘group’ overhead costs  Groups of overhead costs are cost pools  Methods of allocating indirect product costs to products (Variations of normal costing)  Simple (traditional) cost allocation  A single “plant-wide” overhead rate used for entire factory  Dual cost allocation  Separation of indirect costs into two pools…one for fixed and one for variable costs  Activity based costing  Multiple overhead rates—one for each activity

Simple Costing vs. ABC Simple costing Also known as ‘Traditional’ cost allocation and peanut- butter costing Often acceptable for companies with Limited variety of goods Small amounts of indirect costs Activity-based costing Multiple cost pools Allocation of indirect costs is based on what ‘drives’ the costs Relatively expensive to implement More refined

Simple Costing  All indirect costs (manufacturing overhead) are grouped into one cost pool  Allocations are based on activities that are volume- based  Direct labor hours  Direct labor cost  Machine hours  Number of units produced 5 Estimated MOH Estimated Activity Overhead rate = Allocated overhead = Overhead Rate × Actual Activity

Activity-Based Costing  Indirect costs are separated into multiple cost pools  Typically 5 to 8 pools  Based on activities that drive costs rather than on volume-based denominators  Primarily used to allocate manufacturing overhead  Sometimes used to allocate support or other common costs 6 Underlying Premise ….Activities underlie costs. Estimated MOH Estimated Activity Overhead Rate = Allocated overhead = Overhead Rate × Actual Activity Multiple Rates and Allocations

Cost Hierarchies ABC uses a 4-level cost structure to determine how far down the production cycle costs should be allocated (i.e., the cost drivers). Factory costs that impact all the products produced in a factory, such as depreciation on the factory building, factory insurance, factory janitors, factory supplies Facility-level activities Costs specific to particular products such as training employees how to produce it, quality control on a product, etc. Product-level activities Costs specific to particular batches of products such as machine setup for a particular product, machine maintenance between each batch, etc. Batch-level activities Costs performed every time a product is produced. They are usually variable and correlate to the number of products produced, such as packaging, sanding a product edge, printing labels, etc. Unit-level activities

Signals that Suggest that ABC Implementation Could Help a Firm  Significant indirect costs are allocated using one or two cost pools  Most or all overhead is considered unit-level  Has products that consume different amounts of resources  Has products that consistently show small profits (though the products should be profit makers)  Operations staff disagree with accounting over manufacturing and marketing costs

Setting Up an ABC System Step 1: Determine the cost object. Step 2: Form cost pools.  Group the costs of performing a particular activity together.  All costs in a pool should have the same cause.  The costs will differ in nature; i.e., can include indirect wages, depreciation, maintenance, supplies, etc. Step 3: Select a cost driver that has a cause-and-effect relationship with the costs to be allocated.  Considerations in selecting a cost driver  Experience  Industry practices  Cost-benefit analysis of each option under consideration 9

How to Perform ABC Step 1: Calculate the rate for each cost pool. Estimated Cost / Estimated Activity = Rate Step 2: Multiply each cost pool rate times the respective actual activity to determine allocated costs. Step 3: Total the allocated costs from step 2. This results in the allocated (applied) overhead cost. Step 4: Add the allocated costs to the direct costs of each cost object to obtain the total cost of the cost objects. 10

Capacity Considerations of ABC  Activity can be measured on practical capacity, actual capacity, or other estimate  Practical capacity preferred over actual capacity because  Does not hide the cost of idle capacity within product costs  Gives a truer cost of activities used to produce the product

Comparing ABC and Traditional Costing  Advantages of ABC over traditional costing  More accurate costing  Helps managers control costs better  ABC mitigates product cross-subsidization  Disadvantages of ABC over traditional  Very expensive to implement  No separation of fixed and variable costs which makes incremental analysis difficult 12

Product Cross-Subsidization  Occurs when costs are allocated to all units equally Undercosting Overhead allocated under ABC is greater than if traditional is used A product consumes a relatively high level of resources but is reported to have a relatively low total cost Overcosting Overhead allocated under ABC is less than if traditional is used A product consumes a relatively low level of resources but is reported to have a relatively high total cost

Recent Trends That Affect Choice of Allocation Method  Increase in product diversity  Some products use more resources than others  Increase in indirect costs  Machines (depreciation) replace workers (direct labor)  Advances in information technology  Direct labor not needed  Competition in foreign markets  Costs must be reduced to stay competitive

ABC Implementation Issues  After switching to ABC, companies may find that only 10 to 15% of their products are profitable  Causes management to alter the product mix by minimizing unprofitable products  Profits usually increase  Implementation mirrors the complexity of the organization  Complete conversion to ABC requires auditors to accept the system when used for financial reporting

Activity-Based Management  A tool in which managers analyze activities that cause indirect costs of products or services  Goal is to improve efficiency and effectiveness of the activities in order to reduce costs  Serves as the basis for numerous process improvement programs of companies  Helps focus managerial attention on what is most important among the activities performed to create value for customers

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