1. Activity-Based Costing and Activity-Based Management
Chapter 5
Activity-Based Costing
and
Activity-Based Management

2. Feature Story
Plastim Corporation: a manufacturer of lenses for rear taillights in automobiles.
Plastim makes two types of lenses: a complex lens CL5, and a simple lens S3.
Plastim received a letter form a major customer, Geovanni Motors (a major automobile manufacturer) indicated that a new supplier is offering the S3 lens to Geovanni at a price of $53, well below Plastim’s $63 price. Fortunately, the same competitive pressure do not exist for the complex lens, which Plastim sells to Geovanni at $137.

4. Feature Story (contd.) Plastim’s management has various options:
Can give up the Geovanni business if it is unprofitable
Can reduce the price of the S3 lens and either accept a lower margin or aggressively seek to reduce the costs.
But to make these long-run decisions, management needs to first understand the costs to make and sell the S3 and CL5 lenses.

5. Broad Averaging
Historically, firms produced a limited variety of goods while their indirect costs were relatively small.
Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of how they are actually incurred
Peanut-butter Costing
The end-result: overcosting and undercosting

6. Broad Averaging (contd.)
Overcosting – a product consumes a low level of resources but is allocated high costs per unit
Undercosting – a product consumes a high level of resources but is allocated low costs per unit
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

7. Simple Costing System at Plastim Corporation
The sequence of steps to design, produce, and distribute lenses, whether simple or complex, is:
Design products and processes.
Manufacture lenses. The lenses are molded, finished, cleaned, and inspected.
Ship and distribute lenses.
Plastim had a simple costing system that allocates indirect costs using a single indirect-cost rate. Direct manufacture labor is used as allocation base.

9. Profit margin percentage* = 6.75% Profit margin percentage = 29.20%
*Profit margin percentage = Operating income ÷ Revenues

10. Refining a Costing System
Rationale for Selecting a More Refined Costing System:
Increase in product diversity. Costs of Different products cannot be measured by a simple costing system.
Increase in Indirect Costs. (CIM and FMS)
Advances in information technology. Make it more cost-effective to implement refinements in costing systems.
Competition in product markets. More accurate cost information is needed.

11. Refining a Costing System (contd.)
Guidelines for refining a costing system:
Direct-cost tracing:
Classify as many of the total costs as direct costs of the cost object.
Indirect-cost pools.
Expand the number of indirect-cost pools until each of these pools is more homogenous. In homogenous cost pool, all of the costs have the same or similar cause-and-effect relationship with the cost-allocation base.
Example: machining costs and distribution costs in one pool or different pools? If the allocation base is machine-hours? If the allocation base is number of shipments?

12. Refining a Costing System (contd.)
Guidelines for refining a costing system:
Cost-allocation bases:
Use the cause-and-effect criterion, when possible, to identify the cost allocation base (the cause) for each indirect-cost pool (the effect)

13. Activity-Based Costing Systems
Activity-based costing (ABC) system refines a costing system by identifying individual activities as the fundamental cost objects.
An activity is an event, task, or unit of work with a special purpose – for example, designing products, setting up machines, operating machines, and distributing products.
Activities consume resources, and products consume activities. ABC calculate the costs of individual activities and assign costs to cost objects such as products on the basis of the activities needed to produce each product
Activities
Costs of
Products
Services
Customers

14. Cost Hierarchies ABC systems use a cost hierarchy with four levels:
Unit-level (output-level) costs: the costs of activities performed on each individual unit of a product or service.
Example: Molding machine operations costs (costs of energy, machine depreciation, and repair) increases with additional units of out-put produced (or machine-hours)
Batch-level costs: the costs of activities related to a group of units of products or services.
Example: setup costs increase with setup-hours needed to produce batches of lenses.

15. Cost Hierarchies (contd.)
Product-sustaining-level costs: the costs of activities undertaken to support individual products or services regardless of the number of the units or batches.
Example: Design costs depends on the time spent on designing. Design costs are also a function of the complexity of the mold (measured by the number of parts multiplied by the area over which the molten plastic must flow).
Facility-sustaining-level costs: are the costs of activities that cannot be traced to individual product but that support the organization as a whole.
Example: General administration costs (top management compensation, rent, building security)

16. Plastim’s ABC System
Plastim organizes a team to identify various activities.
The team is compressed of managers from design, manufacturing, distribution, accounting, and administration.
Defining activities is not a simple matter. Hundred of tasks were evaluated before choosing the activities.
In choosing activities, Plastim’s team identifies activities that account for a sizable fraction of indirect costs, and combine other activities that have the same allocation base into a single activity.
For example the team decides to combine the maintenance of molding machines, process control, and product inspection into a single activity – molding machine operations – because theses activities have the same cost driver – molding machine-hours

17. Plastim’s ABC System (contd.)
The team identifies the following seven activities by developing a flow chart of all the steps and processes needed to design, manufacture, and distribute S3, and CL5 lenses:
Design products and processes
Setup molding machines
Operate molding machines to manufacture lenses
Clean and maintenance the mold after molding
Prepare batches of finished lenses for shipment
Distribute lenses to customer
Administrate and manage all processes at Plastim

18. Implementing ABC at Plastim
Identify the products that are the chosen cost objects
The cost objects are: the S3, and CL5 lenses
Identify the direct costs of the products.
Direct material costs, direct manufacturing labor costs, mold cleaning and maintenance costs.
Select the cost-allocation bases to use for allocating indirect costs to the products.
Identify activities and cost driver (cost allocation base) for each activity. Six activities in Plastim to allocate indirect costs to products.

19. Implementing ABC at Plastim (contd.)
Identify the indirect costs associated with each cost allocation-base.
In this step, overhead costs incurred by plastim are assigned to activities on the basis of a cause-and-effect relationship. For example all costs have the cause-and-effect relationship to cubic feet of packages moved are assigned to the distribution costs.
Some costs are easily identified with a particular activity. For example costs of material used in design, depreciation of machines used in design, salaries paid to design engineers, are easily identified with design activity.
Other costs need to be allocated across activities. For example: manufacturing engineer estimate the time spent on design, setting up machines, and operating molding machines.

20. Implementing ABC at Plastim (contd.)
Compute the rate per unit of each cost-allocation base used to allocate indirect costs to the products.
Compute the Indirect costs allocated to the product
Compute the total costs of the products by adding all direct and indirect costs assigned to the products.

24. Comparing Alternative Costing System
Exhibit 5-6 compares the simple costing system using a single indirect-cost pool and the ABC system in Plastim Corporation:
ABC systems trace more costs as direct costs.
ABC systems create homogenous cost pools linked to different activities.
For each activity-cost pool, ABC systems seek a cost-allocation base that has a cause-and-effect relationship with costs in cost pool.
ABC is generally perceived to produce superior costing figures due to the use of multiple drivers across multiple levels
ABC is only as good as the drivers selected, and their actual relationship to costs. Poorly chosen drivers will produce inaccurate costs, even with ABC.

26. Using ABC Systems for Improving Management and Profitability
Activity-Based Management (ABM) is a method of management decision-making that uses activity-based costing information to improve customer satisfaction and profitability.
ABM includes :
Pricing and product-mix decisions:
Plastim example: ABC indicates that Plastim can match its competitor's price of $53. Without this information, plastim may decide to reduce its business in simple lenses and focus on complex lenses.
Focusing on complex lenses would be a mistake because the cost is much higher ($ versus $79 under simple costing)
As Plastim reduces prices on simple lenses, it may need to negotiate a higher price on complex lenses.

27. Using ABC Systems for Improving Management and Profitability (contd.)
Cost reduction and process improvement decisions:
Managers use ABC systems to focus on how and where to reduce costs.
Managers set cost reduction targets in terms of reducing the cost per unit of the cost-allocation base in different activity areas. For example: decreasing distribution cost per cubic foot of products delivered by improving the efficiency of the distribution activity, and by eliminate or reduce the cost of non-value added activities.
ABC systems highlight the amount of unused capacity as separate line item, which signals to managers an opportunity for reducing costs. (redeploying labor to other uses, or laying off workers)

28. Using ABC Systems for Improving Management and Profitability (contd.)
Design decisions:
Managers can evaluate how the current product and process designs affect activities and costs as a way of identifying a new design to reduce costs.
For example, decrease the complexity of the mold will reduce costs of design, materials, labor, setups, molding machine operations, mold cleaning.
Planning and managing activities:
Companies specify budgeted costs for activities and use budgeted cost rates to cost products. At year-end, budgeted costs and actual costs are compared to provide feedback on how well activities were managed.

29. Activity-Based Costing and Department Costing Systems
Department Costing Systems: using separate indirect cost rates for each department ( for example, design, manufacturing, distribution, and so on).
Department Costing systems will result in the same product cost as ABC systems if each activity within the department has the same cost driver (cost-allocation base).
Department Costing Systems can be refined using ABC.

30. Implementing ABC Systems
Warning signs that suggest that ABC could help a firm:
Significant overhead costs allocated using one or two cost pools
Most or all overhead costs are considered unit-level
Products that consume different amounts of resources
Products that a firm should successfully make and sell consistently show small profits
Operations staff disagreeing with accounting over manufacturing and marketing cost.

31. Implementing ABC Systems (contd.)
When a company decides to implement ABC, it must make important choices about the level of detail to use.
Managers should weigh the benefits against the costs and limitations of implementing a more-detailed costing system