Activity-Based Costing

Learning Objectives Explain under-costing and over-costing of products or services Distinguish between the traditional and the activity-based costing approaches to designing a costing system Present three guidelines for refining a costing system Describe a four-part cost hierarchy Cost products or services using activity-based costing Compare activity-based costing systems and simple costing system Activity-Based Management

Cost Smoothing (Peanut butter costing) The term cost smoothing describes a particular costing approach that uses broad averages for assigning the cost of resources uniformly to cost objects when the products/services use those resources in a non-uniform way Cost smoothing can lead to ---------------------or --------------------------of product and services

Over & Undercosting Overcosting – Undercosting –

Under costing and Over costing Example Jose. Rob, and Naney order separate items for lunch Jose’s order amounts to $14 Rob Consumed 30 Naney’s order is 16 Total $ 60 What is the average cost per lunch?

Cross – Subsidization Means that if a company undercosts one of its products, then it will overcost at least one of its other products. Similarly, if a company overcosts one of its products, it will undercost at least one of its other products. It occurs when a cost is-------------------------------------------------------------------------------------------------------------------------------------------------------

Product costing with single indirect cost pool system Use seven step process Identify the product that are the chosen cost objects Identify the direct costs of the products Select the cost allocation bases to use for allocating indirect costs to the products Identify the indirect costs associated with each allocation base Compute the rate per unit of each allocation base used to allocate indirect costs to the products Compute the indirect costs allocated to the products Compute the total cost of the products by adding all direct and indirect costs assigned to the products

Refining a costing system A refined costing system reduces the use of broad averages for assigning the cost of resources to cost objects and Provides the better measurement of the costs of indirect resources used by different cost objects

Rationale for selecting a more refined costing system The Past The Present

Background to ABC………. The promoters of ABC; Robert Kaplan and his colleagues from HBS

ABC as a powerful programme of cost management In 1980s’; American Goods were Struggling in the Global Market But Japanese were successful in Cost reduction Quality improvement their products became very competitive in the global market

several waves of developing ABC In the first wave, In the second, In the third wave,

Deficiencies and misconceptions of traditional costing Cost centre managers’ mistaken belief on profitability improvement. The traditional cost allocation system could prompt managers to make unwise decisions. Not flexible Problem of timeliness

The above deficiencies led to the new programme of cost management initiated by Harvard business School academics and allied professional journals. The 1987 historical analysis of the ‘ relevance lost’ thesis became a turning point in the history of management accounting, and the birth of subsequent cost management techniques.

Cost Hierarchies A cost hierarchy categorizes various activity cost pools on the basis of Different types of cost drivers/cost-allocation bases or Different degrees of difficulty in determining cause and effect relationship

Cost Hierarchies Unit-level (output-level) Batch-level Product-sustaining-level Facility-sustaining-level

Output Unit-Level Costs These are resources sacrificed on activities performed on each individual unit of product or service. Examples: Energy. Machine deprecation, Repairs Batch - Level Costs These are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. Examples: Setup hours, Procurement costs

Product-Sustaining Costs These are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services. Example: Design costs Engineering costs, overtime Facility – Sustaining Costs There are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. Example: General Administration. rent. building security

QUIZ unit-level costs. batch-level costs. product-sustaining costs. Advertising of a specific product is an example of unit-level costs. batch-level costs. product-sustaining costs. facility-sustaining costs.

QUIZ The allocation of indirect costs in an activity-based costing system may require other costs to be allocated to activities before the costs of the activities can be allocated to the products. is simplified because more costs are identified as direct costs. requires the use of heterogeneous cost pools. is simplified because a limited number of activities are identified as cost objects.

Comparison between Simple Costing System vs ABC System

Simple Costing System

Activity Based Costing System

QUESTION

Conclusions Each method is mathematically correct Each method is acceptable Each method yields a different cost figure, which will lead to different Gross Margin calculations Only Overhead is involved. 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 experience, industry practices, as well as a cost-benefit analysis of each option under consideration

A Cautionary Tale A number of critical decisions can be made using this information; Should one product be “pushed” over another? Should one product be dropped? Accounting for overhead costs is an imprecise science. Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable.

ABC vs. Simple Costing Schemes ABC is generally perceived to produce superior costing figures due to the use of multiple drivers across multiple levels ABC is only as good as the drivers selected, and their actual relationship to costs. Poorly chosen drivers will produce inaccurate costs, even with ABC

Limitations of ABC Systems Numerous measurements are required to implement the system Required to estimate the costs of activity pools and to identify and measure cost drivers for those pools Activity-cost rates need to be updated regularly. Costly to operate and difficult to understand

Activity Based Management (ABM)