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Activity-Based Costing andActivity-Based Management

Chapter 5

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Overview

• Over/under costing

• Reasons to allocate costs

• Criteria to guide allocation

• Refining a cost system

• ABC versus traditional cost systems

• Costs/Benefits of ABC

• ABC in service & retail as well as mfg.

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Explain undercosting

and overcosting of

products and services.

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Undercosting andOvercosting Example

Jose, Roberta, and Nancy orderseparate items for lunch.

Jose’s order amounts to $14Roberta’s order 30Nancy’s order is 16Total $60

What is the average cost per lunch?

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Undercosting andOvercosting Example

$60 ÷ 3 = $20

Jose and Nancyare overcosted.

Roberta isundercosted.

The use of broad averages to allocate costs (aka peanut-butter costing) can lead to product-cost cross-subsidization.

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Reasons to Allocate costs

There are many reasons

for allocating costs to

cost objects.

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Purposes of Cost Allocation

1. To provide information for economic decisions

2. To motivate managers and other employees

3. To justify costs or compute reimbursement

4. To measure income and assets for reportingto external parties

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Criteria to GuideCost-Allocation Decisions

Cause-and-effect:Using this criterion, managers identify thevariable or variables that cause resources

to be consumed.

Benefits-received:Using this criterion, managers identify the

beneficiaries of the outputs of the cost object.

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Criteria to GuideCost-Allocation Decisions

Fairness or equity:This criterion is often cited on government

contracts when cost allocations are the basisfor establishing a price satisfactory to the

government and its suppliers.

Ability to bear:This criterion advocates allocating costs in

proportion to the cost object’s ability to bear them.

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Role of Dominant Criteria

The cause-and-effectand the benefits-received criteria

guide mostdecisions related

to cost allocations.

Fairness and ability-to-bear are lessfrequently used.

Why?

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Refining a Costing System

More Direct-cost tracing

Indirect-cost pools

(More homogeneous)

Better cost-allocation bases

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Activity-Based Costing System

No. ofSetupHours

LensesNL

LensesCL

LensesOther

CostAllocationBase

ProductCostObjects

No. ofShipments

Parts-Square

feet

SetupDesign ShippingActivityIndirect CostPool

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Activity-Based Management

ABM describes management decisions that useactivity-based costing information to satisfy

customers and improve profits.

Product pricing and mix decisions

Cost reduction and process improvement decisions

Design decisions

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Evaluate the costs and benefits of implementing activity-

based costing systems.

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Benefits of ABC Systems(When the benefits of ABC tend to be large)

Significant amounts of indirect costs areallocated using only one or two cost pools.

All or most costs are identifiedas output unit-level costs.

Products make diverse demands onresources because of differences involume, process steps, batch size,

or complexity.

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Benefits of ABC Systems

Products that a company is well-suited tomake and sell show small profits whileproducts for which a company is less

suited show large profits.

Complex products appear to be veryprofitable and simple products

appear to be losing money.

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Benefits of ABC Systems

Operations staff have significantdisagreements with the accounting

staff about the costs of manufacturingand marketing products and services.

Operations staff may even keep their own set of books!

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Limitations of ABC Systems

The main limitations of ABC are themeasurements necessary to

implement the system.

ABC systems require managementto estimate costs of activity poolsand to identify and measure cost

drivers for these pools.

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Limitations of ABC Systems

Activity-cost rates also need to beupdated regularly.

Very detailed ABC systems are costlyto operate and difficult to understand.

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ABC In Service andMerchandising Companies

The general approach to ABC in theservice and merchandising areas is very

similar to the approach in manufacturing.

Costs are divided into homogeneous costpools and classified as output unit-level,

batch-level, product- or service-sustaining,and facility-sustaining costs.

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ABC In Service andMerchandising Companies

The cost pools correspond to key activities.

Costs are allocated to products or customersusing activity drivers or cost-allocation

bases that have a cause-and-effectrelationship with the cost in the cost pool.

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**End of Chapter 5**(That’s all folks!)