Activity-Based Costing Systems

Activity-Based Costing Part of “Activity-Based Analysis” Activity-based costing (ABC) involves determining the cost of activities and tracing their costs to cost objectives on the basis of the cost objectives utilization of units of activity. Part of “Activity-Based Analysis”

FAULTY COST SYSTEM Symptoms Competitive analysis is confusing Conflicting signals from functional areas and the accounting system Accounting system problems Irrational (or unethical) behavior by competitors may be a signal our “numbers” are wrong Competitors’ prices appear unrealistically low No competition for a highly profitable “niche” product Often those “on the line” understand relationships better than upper mgt. Operational managers want to drop “profitable” products “Difficult” products show high profits Step back and look at the “big picture” Functional areas have their own information system Accounting spends lots of time on “special projects” Major operational changes without changes in costing system

WHY ABC NOW? Competitive demands for diverse products/services Increased significance of overhead costs Growth of nonunit-based overhead Consumption ratios of unit-based and nonunit-based overhead items differ Improved information technology Significance of strategic decisions

Activity-Based Costing Activities performed to fill customer needs consume resources that cost money. Resources Activities consume resources Customer Activities Served by activities Costs Resources cost money

Activity-Based Costing The cost of resources consumed by activities should be assigned to cost objectives. Activities Assigned to activity cost pools Costs Resources Assigned to resources Cost objectives Reassigned to cost objectives

Activity-Based Costing Operationalizing the two-stage model requires: Identifying activities. Assigning costs to activities. Determining the basis for assigning the cost of activities to cost objectives. Determining the cost per unit of activity. Reassigning costs from the activity to the cost objective on the basis of the cost objective’s consumption of activities. Emphasize that in some ways this is just a refinement of traditional “cost accounting.” It is still a method of assigning indirect (overhead) costs. Ask = What is the most difficult part of this process??

Two-Stage Activity Based Costing Method First stage: Costs assigned to resources are reassigned to activities. Cost of Resource 1 Cost of Resource 2 Cost of Resource n Activity 1 Activity 2 Activity 3 Activity 4 Activity n Continued on next slide

Two-Stage Activity Based Costing Method Second stage: Costs assigned to activities are reassigned to cost objectives using an activity cost driver. Activity 1 Activity 2 Activity 3 Activity 4 Activity n Objective 1 Objective 2 Objective 3 Objective n

Manufacturing Cost Hierarchy Unit level activities Batch level activities Product level activities Facility level activities What is the importance of dividing costs into these categories?? Really more of a cost management issue Will become more important when we discuss “activity-based management” Notice that most allocation of facility level activities often reverts to a unit-level (or other arbitrary) basis

Manufacturing Cost Hierarchy This activity is performed for each unit of product produced and sold. Unit Level Examples Cost of raw materials Cost of inserting a component Utilities cost of operating equipment Some costs of packaging Sales commissions

Manufacturing Cost Hierarchy Batch Level Examples This activity is performed for each batch of product produced or sold. Cost of processing sales order Cost of issuing and tracking work order Cost of equipment setup Cost of moving batch between workstations Cost of inspection

Manufacturing Cost Hierarchy Product Level Examples This activity is performed to support each different product that can be produced. Cost of product development Cost of product marketing, such as advertising Cost of specialized equipment Cost of maintaining specialized equipment

Manufacturing Cost Hierarchy Facility Level Examples This activity is performed to maintain general manufacturing capabilities. Cost of maintaining general facilities Cost of nonspecialized equipment Cost of maintaining nonspecialized equipment Cost of real property taxes Cost of general advertising Cost of general administration

Changing Composition of Total Manufacturing Costs Activity-Based Multiple-Level Analysis Volume-Based Unit Level Analysis Variable: Only one type of variable cost is considered: Variable: Many types of variable cost drivers are considered, including: Unit level Unit level Batch level Product level

Changing Composition of Total Manufacturing Costs Activity-Based Multiple-Level Analysis Volume-Based Unit Level Analysis Fixed: Costs that do not vary with the number of units Fixed: Costs that do not respond to change in variable cost drivers are considered: Facility level

Customer Cost Hierarchy A merchandising organization or the sales division of a manufacturing organization might use the following hierarchy: This extension of cost/activity analysis into the traditional “PERIOD COSTS” is a critically important benefit of ABC. While these costs may still be reported as period costs on the external financial statement (expensed as incurred), they will more closely identified with specific products/customers/segments, etc. for internal analysis. Unit level activities Order level activities Customer level activities Facilities level activities

Customer Cost Hierarchy An organization that sells to distinct market segments might have the following cost hierarchy: Unit level activities Order level activities Customer level activities Market segment level activities Facility level activities

Benefits Of Activity Based Costing Greater understanding of the nature of operations More accurate product costing Improvement in cost control Integration with strategic management accounting While improved product/service costing seems most important, it is really a clearer understanding of operations that yields the greatest long-term benefits. Again, this is an overlap into ABM

Limitations Of Activity Based Costing Costly implementation process ABC is NOT a guarantee of becoming a “world-class” company

Practical Advice for Implementing ABC 1. Capture the attention of top management. 2. Don’t shoot the customer. 3. Decide the form ABC will take. 4. Supplement the ABC measures creativity where appropriate. 5. Be careful in costing bottlenecks that create excess capacity. 6. Challenge managers who believe their costs are fixed. 7. Calculate costs top-down and bottom-up. 8. Account for cost of capital. 9. Use multi-functional teams. 10. Don’t underestimate the need for managing change.