© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 1 Cost Management Measuring, Monitoring, and Motivating Performance Prepared by Gail Kaciuba Midwestern State University Chapter 7 Activity-Based Costing and Management

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 2 Chapter 7: Activity-Based Costing and Management Learning objectives Q1: How is activity-based costing (ABC) different from traditional costing? Q2: What are activities and how are they identified? Q3: What process is used to assign costs in an ABC system? Q4: How are cost drivers selected for activities? Q5: What is activity-based management? Q6: What are the benefits, costs, and limitations of ABC and ABM?

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 3 Q1: Product Cost Cross Subsidization Sharing the bill at a restaurant is a good example! Inappropriate pooling of indirect costs and poor choices for cost drivers can lead to the incorrect costs of products or services. If one product is under-costed, then other products may be over-costed resulting in product cost cross subsidization.

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 4 Q1: Product Cost Cross Subsidization The dieters are subsidizing the other two diners. Suppose four people go out to dinner. two people are on diets and eat lightly two people order appetizers, large meals, & dessert If they share the bill equally, then all costs were considered indirect and the cost allocation base was number of diners.

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 5 Q1: Cost System Refinement An existing cost system can be improved by increasing the number of costs tracked as direct increasing the number of indirect cost pools using a better cause-and-effect cost allocation base for each indirect cost pool

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 6 A company makes 2 products, Premium and Regular, with direct costs of $120 and $80, respectively. Each product requires 5 DL hours, and the overhead rate is $10/DL hour. However, the Premium product line is more difficult to produce and manage. It takes twice the number of engineering hours, four times the number of machine setups, and twice the hours in the machining department to get a full run of Premium out the door. Determine the traditional cost of each product and discuss. Q1: Product Cost Cross Subsidization Example PremiumRegular Direct costs (DM+DL)$120$80 Overhead (5 $10)5050 $170$130 The use of a single indirect cost pool with direct labor hours as an allocation base does not appropriately reflect the consumption of resources during production.

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 7 Q1: Activity-Based Costing (ABC) ABC is a method of cost system refinement. Indirect costs are divided into “sub-pools” of costs of activities. Activity costs are then allocated to the final cost objects using a cost allocation base (more commonly called cost drivers in ABC). Activities are measurable, making it more likely that cost drivers can be found so that a final cost object will absorb indirect costs in proportion to its use of the activity.

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 8 Q1: Traditional Costing vs. ABC Product A Product B Product C Traditional costing systems: Indirect Costs Direct Costs Direct costs are traced to the individual products. The individual products are the final cost objects. Indirect costs are grouped into one (or a small number) of cost pools; a cost allocation base assigns costs to the individual products

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 9 Q1: Traditional Costing vs. ABC Activity-based costing systems: Indirect Costs Product A Product B Product C Direct Costs The individual products are the final cost objects & direct costs are traced to the individual products. Indirect costs are assigned (traced & allocated) to various pools of activity costs. Activity 1 Activity 2 Activity 3 Activity costs are allocated to products

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 10 Q1: ABC in Manufacturing Example Alphabet Co. makes products A & B. Product A is a low-volume specialty item and B is a high-volume item. Estimated factory- wide overhead is $800,000, and the number of DL hours for the year is estimated to be 50,000 hours. DL costs are $10/hour. Each product uses 2 DL hours. Compute the traditional cost of each product if Products A & B use $25 and $10 in direct materials, respectively. First, compute the estimated overhead rate: Estimated overhead rate = $800,000/50,000 hours = $16/hour. Product AProduct B Direct materials$25$10 Direct labor $10)2020 Overhead (2 $16)3232 $77$62

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 11 Q1: ABC in Manufacturing Example Alphabet Co. is implementing an ABC system. It estimated the costs and activity levels for the upcoming year shown below. First, compute the estimated overhead rate for each activity:

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 12 Q1: ABC in Manufacturing Example

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 13 Q1: ABC in Manufacturing Example Alphabet recently completed a batch of 100 As and a batch of 100 Bs. Direct material and labor costs were as budgeted. Information about each batch’s use of the cost drivers is given below. Compute the overhead allocated to each unit of A and B.

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 14 Q1: ABC in Manufacturing Example Compute the total cost of each product and compare it to the costs computed under traditional costing. Traditional costing assigned $77 to a unit of Product A and $62 to a unit of Product B. The only difference between the two costing systems is that Product A is assigned more overhead costs under ABC. The additional overhead assigned to Product A reflects Product A’s consumption of resources.

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 15 Q2: What are Activities and How are They Identified? The ABC cost hierarchy includes the following activities: organization-sustaining facility-sustaining customer-sustaining product sustaining batch-level unit-level

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 16 Q2: ABC Cost Hierarchy Example Some of the costs incurred by the Dewey Chargem law firm are listed below. This firm specializes in immigration issues and family law. For each cost, identify whether the cost most likely relates to a(n) (1) organiz-ation- sustaining, (2) facility-sustaining, (3) customer-sustaining, (4) product- sustaining, (5) batch-level, or (6) unit-level activity and explain your choice.

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 17 Q3: What Process is Used to Assign Costs in an ABC system? Identify the relevant cost object. Identify activities, and group homogeneous activities. Assign costs to the activity cost pools. Choose a cost driver for each activity cost pool. Calculate an allocation rate for each activity cost pool. Allocate activity costs to the final cost object.

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 18 Q4: How Are Cost Drivers Selected for Activities? For each activity, determine its place in the ABC cost hierarchy. Look for drivers that have a good cause-and-effect relationship with the activities’ costs. Use a reasonable driver when there is no cause-and-effect relationship.

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 19 ABM is the process of using ABC information to evaluate opportunities for improvements in an organization. Q5: Activity-Based Management (ABM) Examples include managing & monitoring customer profitability product and process design environmental costs quality constrained resources

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 20 Activities can be defined so that different costs of servicing customers are accumulated. Q5: ABM & Customer Profitability Examples include analyzing the types of bank transactions used by various categories of customers comparing the costs of servicing insurance contracts sold to married versus single individuals comparing the costs of different distribution channels

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 21 Activities can be defined so that the costs of stages of production or of a business process are accumulated. Q5: ABM & Product/Process Improvements Examples include determining the costs of non-value-added activities so the most costly can be reduced or eliminated changing the steps in the accounts payable function to reduce the number of personnel determining the most costly stages of product development so that the time to market is reduced

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 22 Activities can be defined so that types of environmental costs are accumulated. Q5: ABM & Environmental Costs Examples include capturing the costs of contingent liabilities for waste disposal site remediation comparing the cost of recycling packaging to the cost of disposal computing the costs of treating different kinds of emissions

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 23 Activities can be defined so that categories of costs of managing quality are accumulated. Q5: ABM & Quality Costs Common categories of quality costs are costs of prevention activities costs of appraisal activities costs of production activities costs of postsales activities

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 24 Benefits more accurate product cost information employees focus attention on activities measurement of the costs of activities and business processes Q6: Benefits & Costs of ABC and ABM Costs ABC systems are difficult to design and maintain more information must be captured decision makers may not use the information appropriately

© John Wiley & Sons, 2005 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 1eSlide # 25 Judgment is required when determining activities. Q6: Uncertainties in ABC and ABM Implementation Judgment is required when selecting cost drivers. Denominator levels for cost drivers are estimates. ABC information includes unitized fixed costs, so decision makers must use ABC information correctly.