The Islamic University of Gaza Cost Accounting Activity-Based Costing and Activity-Based Management Dr. Hisham Madi

Activity-Based Costing Systems Activity-based costing (ABC) refines a costing system by identifying individual activities as the fundamental cost objects. An activity is an event, task, or unit of work with a specified purpose—for example, designing products, setting up machines, operating machines, and distributing products. ABC systems identify activities in all functions of the value chain, calculate costs of individual activities, and assign costs to cost objects such as products and services

Activity-Based Costing Systems ABC systems identify activities in all functions of the value chain, calculate costs of individual activities, and assign costs to cost objects such as products and services

Cost Hierarchies A cost hierarchy categorizes various activity cost pools on the basis of the different types of cost drivers, or cost-allocation bases. ABC systems commonly use a cost hierarchy with four levels—output unit-level costs, batch-level costs, product-sustaining costs, and facility-sustaining costs—to identify cost-allocation bases that are cost drivers of the activity cost pools.

Cost Hierarchies Output unit-level costs are the costs of activities performed on each individual unit of a product or service. These costs increase as the number of units produced increases. Machine operations costs (such as the cost of energy, machine depreciation, and repair) related to the activity of running the automated molding machines are output unit-level costs. They are output unit-level costs because, over time, the cost of this activity increases with additional units of output produced (or machine-hours used)

Cost Hierarchies Batch-level costs are the costs of activities related to a group of units of a product or service rather than each individual unit of product or service. Setup machine, shipment setup. Indirect setup cost increase with setup hours and number of shipments Product-sustaining costs (service-sustaining costs) are the costs of activities undertaken to support individual products or services regardless of the number of units or batches produced Design costs are an example of this type of cost. Design costs depend largely on the time designers spend on designing and modifying the product,

Cost Hierarchies Product research and development costs, costs of making engineering changes, and marketing costs to launch new products.

Cost Hierarchies Facility-sustaining costs are the costs of activities that cannot be traced to individual products or services but that support the organization as a whole. Examples of this type of cost include general administration, rent, and building security. These costs usually lack a cause-and-effect relationship between the cost and the allocation base. This lack of a cause-and-effect relationship causes some companies not to allocate these costs to products and instead to deduct them as a separate lump-sum amount from operating income

Cost Hierarchies Companies may achieve greater accuracy in overhead cost allocation by recognizing these four different levels of activities and, from them, developing specific activity cost pools and their related cost drivers. Once a company has classified its activities and identified the related resources, managers may discover that some manufacturing overhead costs can be traced directly to products. An example of a traceable manufacturing overhead cost at C&C Sports is the cost of operating the chenille machine. This cost, includes depreciation and indirect materials, is directly traceable to the award jackets because the chenille machine is used only to produce award jackets, and should not be allocated to pants and jerseys

Implementing Activity-Based Costing Step 1: Identify the products that are the chosen cost objects The cost objects are the 60,000 S3 and the 15,000 CL5 lenses that Plastim will produce in 2011 Step 2: Identify the direct costs of the products Step 3: Select the Activities and Cost-Allocation Bases to Use for Allocating Indirect Costs to the Products Plastim identifies six activities—(a) design, (b) molding machine setups, (c) machine operations, (d) shipment setup, (e) distribution, and (f) administration—for allocating indirect costs to products.

Implementing Activity-Based Costing Step 3: Select the Activities and Cost-Allocation Bases to Use for Allocating Indirect Costs to the Products Analysis of the activities performed to manufacture a product or provide a service The system assigns overhead costs directly to the appropriate activity cost pool. For example, rather than define the design activities of product design, process design, and prototyping as separate activities, Plastim defines these three activities together as a combined “design” activity and forms a homogeneous design cost pool.

Implementing Activity-Based Costing Step 4: Identify the Indirect Costs Associated with Each Cost-Allocation Base Plastim assigns budgeted indirect costs for 2011 to activities, to the extent possible, on the basis of a cause-and-effect relationship between the cost-allocation base for an activity and the cost The company must identify the cost drivers for each cost pool. The cost driver must accurately measure the actual consumption of the activity by the various products.

Implementing Activity-Based Costing To achieve accurate costing, a high degree of correlation must exist between the cost driver and the actual consumption of the overhead costs in the cost pool. The strength of the cause-and-effect relationship between the cost-allocation base and the cost of an activity varies across cost pools. For example, the cause-and-effect relationship between direct manufacturing labor-hours and administration activity costs is not as strong as the relationship between setup-hours and setup activity costs.

Implementing Activity-Based Costing Step 5: Compute the Rate per Unit of Each Cost-Allocation Base Budgeted Indirect cost rate = Step 6: Compute the Indirect Costs Allocated to the Products Step 7: Compute the Total Cost of the Products by Adding All Direct and Indirect Costs Assigned to the Products Total Budgeted Indirect Cost Budgeted quantity of cost allocation base

ABC vs. Simple Costing Schemes ABC systems trace more costs as direct costs; ABC systems create homogeneous cost pools linked to different activities; For each activity-cost pool, ABC systems seek a cost-allocation base that has a cause-and-effect relationship with costs in the cost pool; ABC is generally perceived to produce superior costing figures due to the use of multiple drivers across multiple levels

Costs and limitations of an ABC system ABC can be expensive to use The increased cost of identifying multiple activities and applying numerous cost drivers discourages many companies from using ABC. Activity cost rates also need to be updated regularly As ABC systems get very detailed and more cost pools are created, more allocations are necessary to calculate activity costs for each cost pool. This increases the chances of misidentifying the costs of different activity cost pools.

When to Use ABC How does a company know when to use ABC? Indirect costs are significant in proportion to direct costs and use only one or two cost-drivers; Product lines differ greatly in volume and manufacturing complexity. Product lines are numerous and diverse, and they require differing degrees of support services; The manufacturing process or the number of products has changed significantly—for example, from labor-intensive to capital-intensive due to automation. Operations staff has substantial disagreement with the reported costs of manufacturing and marketing products and services

Activity-Based Management The process of using activity-based costing information to manage a business’s activities, and thus its costs. is a method of management decision making that uses activity-based costing information to improve customer satisfaction and profitability

Activity-Based Management A method of management that uses ABC as an integral part in critical decision-making situations, including: Pricing and product-mix decisions Cost reduction and process improvement decisions Reduce costs by improving the way work is done without compromising customer service or the actual or perceived value (usefulness) customers obtain from the product or service Eliminate activities that consume resources but do not contribute to the value of the product non value added.

Activity-Based Management Design decisions Identifying new designs to reduce costs. Planning and managing activities

ABC and Service/Merchandising Firms The overall objective of ABC in service firms is no different than it is in a manufacturing company That objective is to identify the key activities that generate costs and to keep track of how many of those activities are performed for each service provided Health Care Banking Telecommunications Retailing Transportation