5 - 1 Overview of Activity-Based Cost Systems for Management Control ACCT7320, Dr. C. Bailey

5 - 2 Introduction  This presentation… describes how ABC systems help improve pricing and product mix decisions. describes how ABC systems help improve pricing and product mix decisions. illustrates how ABC assists in cost management decisions by improving processes and product designs.illustrates how ABC assists in cost management decisions by improving processes and product designs.  Note: ABC concerns mainly indirect (overhead) costs!

5 - 3 Undercosting and Overcosting  Product undercosting: A product consumes a relatively high level of resources but is reported to have a relatively low total cost.  Product overcosting: A product consumes a relatively low level of resources but is reported to have a relatively high total cost.

5 - 4 Undercosting and Overcosting  Irene, Roberta, and Nancy are three bank customers.  They require different activities from the bank: Irene banks exclusively at the ATM.Irene banks exclusively at the ATM. Roberta visits the teller daily to make deposits, withdrawalsRoberta visits the teller daily to make deposits, withdrawals Nancy deposits foreign currency as well as calling the branch frequently to ask currency rates.Nancy deposits foreign currency as well as calling the branch frequently to ask currency rates.

5 - 5 Undercosting and Overcosting  Traditional allocation bases might apply branch overhead to accounts based on account balances or equal amounts per account.  Irene (who never makes any demands on the branch) will be overcosted and appear less profitable than she should.  Roberta and Nancy may be undercosted and appear more profitable than they are.

5 - 6 Refining a Costing System  Guidelines for refining a costing system: Direct-cost tracing – Classify as many of the total costs as direct costs as is economically feasible. Indirect-cost pools – Expand the number of cost pools until each of these pools is homogeneous.

5 - 7 Refining a Costing System  Cost-allocation basis – Identify the preferred cost-allocation base for each indirect-cost pool.

5 - 8 Activity-Based Costing System  ABC calculates the costs of individual activities and assigns costs to cost objects such as products, services, or customers based on the activities used to produce a product or service, serve a customer, etc.

5 - 9 Two-Step Allocation  Collect costs in general ledger and subsidiary accounts (labor, material, services, deprec., etc)  Identify activity centers  Accumulate costs into activity center cost pools cost drivercost driver  Allocate costs to products and services activity driveractivity driver

Activity-Based Costing System Cost of Activity A Other Indirect Costs of product/svc (including other non-ABC items) Cost of Product, Service, Customer Fundamental Cost Objects: Labor, materials, etc. (All indirect to the Product or Service) Cost drivers Activity drivers Other Cost drivers Direct Costs Traced Cost of Activity B, etc.

Examples of Activities  Activities at a Video Rental Store: Replace movies on shelvesReplace movies on shelves Ring sales:Ring sales: Collect money Sign receipt Give copy Accept reservations, Hold, Call customerAccept reservations, Hold, Call customer

Activity Analysis Value-added activity  Increases worth of product or service to a customer  Customer is willing to pay for Non-value-added activity  Increases time spent on product or service but does not increase worth  Unnecessary from customer perspective  Some can be eliminated without affecting market value or quality  Business-value-added activities are essential ABM

Activities of a Milk Truck Delivery Person ActivityCost Driver DrivingTime; miles; area of town ShelvingTime; number of packages; categories of products PaperworkTime; types of customer WaitingType of customer?

Cost Hierarchies  A cost hierarchy is a categorization of costs into different cost pools on the basis of the different types of cost drivers (cost-allocation bases) or different degrees of difficulty in determining cause-and-effect relationships.

Cost Hierarchies  ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: 1Output unit-level cost 2Batch level costs 3Product- (or service-)sustaining costs 4Facility-sustaining costs

Output Unit-Level Costs...  are resources sacrificed on activities performed on each individual unit of product or service. EnergyEnergy Machine maintenance, repairs (depreciation?)Machine maintenance, repairs (depreciation?) LaborLabor

Batch-Level Costs...  are resources sacrificed on activities that are related to a group of units of product or service Setup hours to run a batchSetup hours to run a batch Procurement costs of placing an orderProcurement costs of placing an order

Product-Sustaining...  or service-sustaining, costs are resources sacrificed on activities to support individual products or services. Design costsDesign costs Engineering costsEngineering costs

Facility-Sustaining Costs...  are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. General administrationGeneral administration RentRent Building securityBuilding security

Decision Usefulness of Cost Hierarchies  Different levels of cost drivers: Level Useful for Decisions Such As… Output-unit Shall we increase production, and at what price? Batch How often should we produce batches? What base amount must we charge to set up a “run”, regardless of the number a customer wants made? What base amount must we charge to set up a “run”, regardless of the number a customer wants made? Product/Service-Sustaining Should we continue to offer this service/product? Facility-Sustaining Shall we continue in business or dissolve it?

Major Differences, Traditional Costing vs. ABC Typical System ABC One or a few indirect Many pools cost pools Application base may Base more likely a Application base may Base more likely a be a true cost driver true cost driver be a true cost driver true cost driver Application base often Bases likely to be Application base often Bases likely to be financial (direct labor cost, non-financial (# of parts, direct material cost, etc) number of operations, direct material cost, etc) number of operations, hours of testing, etc.) hours of testing, etc.)

Indicators that ABC Systems May be Appropriate  significant amounts of indirect costs are allocated using only one or two cost pools.  all or most costs are identified as output unit- level costs (unlikely to be true!).  products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.

Indicators that ABC Systems May be Appropriate, continued...  products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits.  complex products appear to be very profitable and simple products appear to be losing money.

Indicators that ABC Systems May be Appropriate, continued…  operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.  automation makes it difficult to assign overhead to products using direct labor or machine hours

Criticisms of ABC  Significant amount of time and cost to implement  Must overcome barriers to change  Does not conform to GAAP  Does not promote total quality management

ABC In Service And Merchandising Companies  The general approach to ABC in the service and merchandising areas is very similar to the approach in manufacturing.  Costs are divided into homogeneous cost pools and classified as output unit-level, batch level, product, or service-sustaining and facility sustaining costs.

ABC In Service And Merchandising Companies  The cost pools correspond to key activities.  Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool.

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