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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?
52009 Foster School of Business Cost Accounting L.DuCharme
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!)
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