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Prepared byDiane TannerUniversity of North Florida

Chapter 5

Allocation of Indirect Costs:

Simple Costing & ABC

Simple Costing vs. ABC

• Simple costing• AKA ‘Traditional’ cost allocation and peanut-butter

costing• Often acceptable for companies with

• Limited variety of goods • Small amounts of indirect costs

• Activity-based costing• Multiple cost pools• Allocation of indirect costs is based on what

‘drives’ the costs• Relatively expensive to implement• More refined

Why Select a More Refined Costing System?

Recent trends Increase in product diversity Increase in indirect costs Advances in information technology Competition in foreign markets

Helps to avoid cross-subsidization Overcosting—a product consumes a low level of

resources, but is allocated a high cost per unit Undercosting—a product consumes a high level

of resources, but is allocated a low cost per unit

Activity-Based Costing

• What is activity-based costing?– A system of allocating indirect costs to cost objects– Utilizes multiple cost pools– Is used with normal costing– Based on activities that drive costs rather than on

volume-based denominators• Primarily used to allocated manufacturing overhead

– Sometimes used to allocate support department costs to divisions

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Underlying PremisesActivities underlie costs.

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Setting Up an ABC System

Step 1: Determine the cost object. Step 2: Form cost pools.

The costs of performing a particular activity are grouped into a cost pool.

All costs in a pool should have the same cause. Step 3: Select a cost driver that has a cause-

and-effect relationship with the costs to be allocated.

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How to Perform ABC

Step 1: Calculate the rate for each cost pool. Estimated Cost / Estimated Activity = RateStep 2: Multiply each cost pool rate times the

respective actual activity to determine allocated costs.

Step 3: Total up the allocated costs from step 2. This results in the applied overhead cost.

Step 4: Add the allocated costs to the direct costs of each cost object to obtain the total cost of each cost object.

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Considerations of ABC

Complete analysis requires allocation beyond manufacturing costs to include period costs

Activity can be measured on practical capacity, actual capacity, or other estimate Practical capacity preferred over actual capacity

because Does not hide the cost of idle capacity within

product costs Gives a truer cost of activities used to produce the

product

Cost Driver Selection

Selection of the appropriate cost driver is crucial

Considerations in selecting a cost driver Experience Industry practices Cost-benefit analysis of each option under

consideration

ABC Implementation Issues

After switching to ABC, companies may find that only 10 to 15% of their products are profitable Causes management to alter the product mix by

minimizing unprofitable products Causes profits to increase

Implementation mirrors the complexity of the organization

Complete conversion to ABC requires auditors to accept the system when used for financial reporting

Cost Hierarchies ABC uses a 4-level cost structure to determine how far

down the production cycle costs should be pushed• Factory costs that impact all the products produced in

a factory, such as depreciation on the factory building, factory insurance, factory janitors, factory supplies

Facility-level activities

• Costs specific to particular products such as training employees how to produce it, quality control on a product, etc.

Product-level activities

• Costs specific to particular batches of products such as machine setup for a particular product, machine maintenance between each batch, etc.

Batch-level activities

• Costs performed every time a product is produced. They are usually variable and correlate to the number of products produced, such as packaging, sanding a product edge, printing labels, etc.

Unit-level activities

Signals that Suggest that ABC Implementation Could Help a Firm

Significant indirect costs allocated using one or two cost pools

Most or all overhead is considered unit-level Has products that consume different amounts of

resources Has products that consistently show small profits

(though the products should be profit makers) Operations staff disagree with accounting over

manufacturing and marketing costs

Activity-Based Management

A method of management that uses ABC as an integral part in critical decision-making situations, including Pricing and product-mix decisions Cost reduction and process improvement

decisions Design decisions Planning and managing activities

Activity-Based Management A tool in which managers analyze activities that cause

indirect costs of products or services Goal is to improve efficiency and effectiveness of the

activities in order to reduce costs Serves as the basis for numerous process

improvement programs of companies Helps focus managerial attention on what is most

important among the activities performed to create value for customers

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Comparing ABC and Traditional Costing

Advantages of ABC over traditional costing ABC results in more accurate costing. ABC helps managers control costs better. ABC considers the fact that only products that use

particular resources are assigned costs. ABC mitigates overcosting and undercosting of cost

objects.  Disadvantages of ABC

Very expensive to implement No separation of fixed and variable costs which makes

incremental analysis difficult

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Overcosting and Undercosting Occurs due to broad, equal costs allocated to all

products

Undercosting

Overhead allocated under ABC is greater than if traditional is

used

A product consumes a relatively high level of resources but is reported to have a relatively

low total cost

Overcosting

Overhead allocated under ABC is less than if traditional is used

A product consumes a relatively low level of resources but is reported to have a relatively

high total cost

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The End