CHAPTER 5Activity-Based Costing

andActivity-Based Management

Job CostingOverview

Broad AveragingHistorically, 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

Over and Undercosting Example

  Emma JamesJessic

aMatthe

w TotalAverag

e

Entrée $11 $20 $15 $14 $60 $15 Dessert 0 8 4 4 16 4

Drinks 4 14 8 6 32 8

Total $15 $42 $27 $24 $108 $27

Over and UndercostingOvercosting—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.

Cross-subsidizationThe results of overcosting one product and

undercosting another.The undercosted product is left with too little

cost, making it seem more profitable than it really is.

The overcosted product absorbs too much cost, making it seem less profitable than it really is.

Quick Check Overcosting a particular product may result in: A) loss of market share B) pricing the product too lowC) operating efficiencies D) understating total product costs

An Example: PTM

PTM and Simple Costing

Simple Costing System Activity-Based Cost System

DirectMaterial

Costs

DirectLaborCosts

DirectMaterial

Costs

DirectMaterial

Costs

DirectLaborCosts

DirectLaborCosts

OverheadCosts

OverheadCosts

OverheadCosts

OverheadCosts

DirectTrace

DirectTrace

DirectLabor Hours(Cost Driver)

DirectLabor Hours(Cost Driver)

ProductsProducts

DirectTrace

DirectTrace

ProductsProducts

MachiningActivity

Costs

MachiningActivity

Costs

MachineHours

(Cost Driver)

MachineHours

(Cost Driver)

Number ofParts

(Cost Driver)

Number ofParts

(Cost Driver)

Number ofInspections

(Cost Driver)

Number ofInspections

(Cost Driver)

AssemblyActivity

Costs

QualityInspection

ActivityCosts

Cost Hierarchy

Cost HierarchyABC uses a four-level cost structure to

determine how far down the production cycle costs should be pushed:Unit-level (output-level)

e.g., machine operation Batch-level

e.g., machine setup, material handling, quality inspection

Product-sustaining-level e.g., product design

Facility-sustaining-level e.g., factory rent, building security

PTM and ABC Illustrated

PTM and ABC Rate Calculation

Plastim and ABC Product Costs

Plastim: Simple and ABC Compared

4,980,000

4,980,000

ConclusionsEach method is mathematically correct.Each method is acceptable.Each method yields a different cost figure, which

will lead to different gross margin calculations.Total costs for the entire firm remain the same—

they are just allocated to different cost objects within the firm.

Selection of the appropriate method and drivers should be based on a cost-benefit analysis of each option under consideration.

Cost Benefit TestDo the benefits of adopting ABC exceed the costs?

ABC is generally perceived to produce superior costing figures due to the use of multiple drivers across multiple levels.

Benefits are higher when:Increase in product diversityIncrease in indirect costsIncrease in competition

Cost Benefit TestCosts of Adopting ABC

Generally lower with Accounting and information system expertise

to develop the system Advance information technology

Quick Check Refining a cost system includes: A) classifying as many costs as indirect costs as

is feasible B) creating as many cost pools as possible C) identifying the activities involved in a

process D) seeking a lesser level of detail

Quick Check Design of an ABC system requires: A) that the job bid process be redesigned B) that a cause-and-effect relationship exists

between resource costs and individual activities

C) an adjustment to product mix D) Both B and C are correct.

Quick Check ABC is most likely to yield benefits for

companies with all of the following characteristics except:

A) numerous products that consume different amounts of resources

B) operations that remain fairly consistent C) a highly competitive environment, where cost

control is critical D) accessible accounting and information systems

expertise to maintain the system

Activity-Based ManagementA method of management that uses ABC as

an integral part in critical decision-making situations, including:Pricing and product-mix decisionsCost reduction and process improvement

decisionsPlanning and managing activities

Pricing and Product Mix DecisionsChange the prices for products after

identifying the different total costDecide to market the higher profitability

product Shift the product mix away from less

profitable products

ABM ExamplesPricing decisions:

The cost of making the simple lens

A special order: A price of $53 for the simple lens

Simple Costing $58.75

ABC $48.98

ABM Examples (Cont’d)Product-mix decisions:

Simple Lenses

Complex Lenses

Selling price $63.00 $137.00

Cost per unit under simple costing 58.75 97.00Profit margin under simple costing 4.25 40.00Profit margin % under simple costing 6.75% 29.20%

Cost per unit under ABC 49.98 132.07Profit margin under ABC 13.02 4.93Profit margin % under ABC 20.67% 3.60%

Quick Check Companies use ABC system information to: A) analyze costs B) prepare budgets C) evaluate performance D) All of these answers are correct.

Quick Check It is important that the product costs reflect

as much of the diversity and complexity of the manufacturing process so that:

A) product costs will reflect their relative consumption of resources

B) nonvalue-added costs can be eliminated C) there is less likelihood of cross subsidizing of

product costs D) All of these answers are correct.

ABC and Service/Merchandising FirmsABC implementation is widespread in a

variety of applications outside manufacturing, including: Health CareBankingTelecommunicationsRetailingTransportation