Activity-Based Costing and Activity-Based Management Chapter 5

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.

Explain undercosting and overcosting of products and services.

Undercosting and Overcosting Example Jose, Roberta, and Nancy order separate items for lunch. Jose’s order amounts to $14 Roberta’s order 30 Nancy’s order is 16 Total $60 What is the average cost per lunch?

Undercosting and Overcosting Example $60 ÷ 3 = $20 Jose and Nancy are overcosted. Roberta is undercosted. The use of broad averages to allocate costs (aka peanut-butter costing) can lead to product-cost cross-subsidization.

Reasons to Allocate costs There are many reasons for allocating costs to cost objects.

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 reporting to external parties

Criteria to Guide Cost-Allocation Decisions Cause-and-effect: Using this criterion, managers identify the variable or variables that cause resources to be consumed. Benefits-received: Using this criterion, managers identify the beneficiaries of the outputs of the cost object.

Criteria to Guide Cost-Allocation Decisions Fairness or equity: This criterion is often cited on government contracts when cost allocations are the basis for 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.

Role of Dominant Criteria The cause-and-effect and the benefits- received criteria guide most decisions related to cost allocations. Fairness and ability- to-bear are less frequently used. Why?

Refining a Costing System More Direct-cost tracing Indirect-cost pools (More homogeneous) Better cost-allocation bases

Activity-Based Costing System Indirect Cost Pool Design Setup Shipping Parts- Square feet No. of Setup Hours No. of Shipments Cost Allocation Base Lenses NL Lenses CL Lenses Other Product Cost Objects

Activity-Based Management ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits. Product pricing and mix decisions Cost reduction and process improvement decisions Design decisions

Evaluate the costs and benefits of implementing activity-based costing systems.

Benefits of ABC Systems (When the benefits of ABC tend to be large) 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. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.

Benefits of ABC Systems 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.

Benefits of ABC Systems Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services. Operations staff may even keep their own set of books!

Limitations of ABC Systems The main limitations of ABC are the measurements necessary to implement the system. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.

Limitations of ABC Systems Activity-cost rates also need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand.

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.

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.

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