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

2. Introduction This presentation…
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.
Note: ABC concerns mainly indirect (overhead) costs!

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.

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.
Roberta visits the teller daily to make deposits, withdrawals
Nancy deposits foreign currency as well as calling the branch frequently to ask currency rates.

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.

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.

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

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.

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 driver
Allocate costs to products and services
activity driver

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

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

12. Activity Analysis Non-value-added activity
ABM
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
Value-added activity
Increases worth of product or service to a customer
Customer is willing to pay for

13. Activities of a Milk Truck Delivery Person
Activity Cost Driver
Driving Time; miles; area of town
Shelving Time; number of packages;
categories of products
Paperwork Time; types of customer
Waiting Type of customer?

14. 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.

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

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

17. 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 batch
Procurement costs of placing an order

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

19. 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 administration
Rent
Building security

20. 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?
Product/Service-Sustaining Should we continue to offer this service/product?
Facility-Sustaining Shall we continue in business or dissolve it?

21. 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
be a true cost driver true cost driver
Application base often Bases likely to be
financial (direct labor cost, non-financial (# of parts,
direct material cost, etc) number of operations,
hours of testing, etc.)

22. 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.

23. 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.

24. 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

25. 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

26. 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.

27. 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.

28. End