Activity-Based Costing Systems Chapter 4

Traditional overhead allocation system  Single predetermined rate is used to allocate overhead to products  Easy to use  Assumes all overhead is correlated with the activity base  Assumes all overhead costs are related to all products  Does not consider the product’s consumption of resources other than the base

An ideal system  Treat indirect costs like direct costs  Accurate assignment of the resources consumed by the individual cost objects  Different types and amounts of overhead charged to different cost objects  No allocation based on estimates  Not possible  Cost element shared by many cost objects  Cost element not related to cost objects  Not cost effective to trace accurately

Activity-based costing  Recognizes  Not all costs are related to the same cost driver  Not all costs are incurred at the unit level  Unit level  Batch level  Product level  Customer level  Facility level

Activity-based costing  Recognizes  That activities are performed to produce or support the cost object  Those activities consume resources  Can identify resources with the activities  Can identify the activities with the cost objects  Can be used for any cost object  Not GAAP for financial reporting

Activity-based costing  Traditional allocation method  Activity-based allocation method CostsProducts CostsProductsActivities First stageSecond stage

Implementation of an ABC system  Step 1 – Develop activity dictionary  List of activities related to the cost object  How precise?  Only major activities if purpose is better cost information  More detailed if purpose is process improvement  Will probably have an “other” activity

Implementation of an ABC system  Identify activities (cost pools)  Interview employees  Process flowcharts  Etc.  At which level do they occur?  Unit, batch, etc.  May not want to allocate facility level costs to products

Implementation of an ABC system  How are the activities performed?  Inputs and outputs  What causes the activity to commence?  Production order, material requisition, etc.  What is the output of the activity?  Units produced, pieces assembled, time consumed, etc.  How can the activity be measured?  Transactions, time, etc.  For use as possible cost drivers

Implementation of an ABC system  Step 2 – Determine the significant costs related to each activity  Resources used  Employee time  Wages and benefits  Assets  Depreciation, taxes, insurance, etc.  Consumables  Supplies, utilities, maintenance, etc.  “Other”

Implementation of an ABC system

 Step 3 – Determine cost drivers and rates  What activity measures correlate with each cost?  Measurable  Statistically or logically have a cause-and-effect relationship with the cost  Predict or explain the consumption of resources with reasonable accuracy  Based on practical capacity for the activity  Unused capacity is its own “activity”

Implementation of an ABC system

 Step 4 – Assign costs to cost objects  Determine the amount of each activity consumed by the cost object  Multiply by the rate for that activity  Total the activity costs for each cost object  Divide total by quantity of the cost object to determine unit cost

Implementation of an ABC system

Advantages of ABC  Better allocation of costs  Not perfect  Useful for estimating costs of future projects  Can be extended to activity-based management  “Now that we know what it costs, how can we do it more efficiently?”

Advantages of ABC  Cost object can be anything  Product  Service  Process  Customer  Employee  Location  Etc.

Advantages of ABC  Aids in recognizing, measuring and controlling complexity  Promotes understanding of why costs are incurred  Shifts focus from managing costs to managing activities

When to use ABC  High proportion of indirect costs  Complex products or processes  High volume vs. low volume products  Diverse indirect costs  Cost accounting system hasn’t evolved  Distrust of current system  Different products place different demands on resources

Disadvantages of ABC  Costly to implement  Costly to maintain  Likely to meet substantial resistance  Not the “real” system  “Why do you want to know what I do?”