Activity-Based Cost Systems CHAPTER 5 Activity-Based Cost Systems

A Review: Direct and Indirect Cost Direct cost: cost that are traceable to a product, activity, or department (a cost object). DM&DL Indirect cost: cost that are not traceable to a cost object. Instead, this type of cost is normally common to more than one cost objects and needs to allocated. OH, selling costs, general & administration costs. Indirect cost needs to be allocated among the cost objects.

TERMS USED IN COST ALLOCATION Cost pools grouping of a set of homogeneous costs whose total is allocated using one allocation base. Cost pools can be organized along departmental lines, e.g. Maintenance, Personnel depts. major activities, e.g. equipment setups, inspections. Cost object something that you are trying to estimate the cost of, e.g., product, department, project, customer, etc. For example, if computer costs are allocated to contracts, the contracts are the cost object

TERMS USED IN COST ALLOCATION Cost driver something that cause cost to change, e.g., pounds of direct material, # of setups, # of inspections, etc. Allocation base the denominator used to assign cost. This can be a cost driver, or something convenient, e.g., # of units, machine/ labor hours. An allocation base relates cost pool to the cost objects

Historical Origins of Cost Allocation Methods Traditional volume-based costing (peanut butter costing) Original ABC: introduced in the 1980s Time-driven ABC (TDABC): A contemporary version of ABC introduced by Dr. Robert S. Kaplan and Dr. Steven Anderson in 2004.

Traditional Costing vs. ABC spreading common cost evenly over units, products, departments, or other volume-based allocation basis (Peanut-butter costing) under costing (estimated cost<actual cost), resulting in under pricing and losing money; over costing (estimated cost>actual cost), resulting in over pricing and losing units of sales. XYZ company example (handout)

Activity-Based Costing (ABC) Activity-based cost systems have been developed to eliminate distortion Activity-based cost (ABC) assign resource expenses to activities 7

Activity Cost Drivers Activity cost drivers represent the quantity of activities used to produce individual products: ACTIVITY ACTIVITY COST DRIVER HANDLE PRODUCTION RUNS PRODUCTION RUNS SET UP MACHINES SETUP HOURS SUPPORT PRODUCTS NUMBER OF PRODUCTS RUN MACHINES MACHINE HOURS PROVIDE FRINGE BENEFITS LABOR DOLLARS 8

Original ABC vs TDABC Kaplan and Anderson (2004) Article (handout) E5-25 Pg 200