Chapter 7 Activity-Based Costing and Management Key Topics: Traditional versus ABC systems Activities and their identification Cost hierarchy ABC procedures ABM Benefits and costs of ABC and ABM Uncertainties Chapter 7

Traditional Overhead Cost Allocation System Chapter 7

ABC Cost Allocation System Chapter 7

What Are Activities, and How Are They Identified? Activity Type of task or function performed in an organization Activity Identification * Tracking the use of resources * Using the cost hierarchy * Grouping homogeneous costs Chapter 7

Cost Hierarchy Organization-sustaining activities Activities and costs associated with overall organization (lease of headquarters office space, salary of CEO) Facility-sustaining activities Activities and costs associated with single manufacturing plant or service facility (property taxes, plant manager salary) Customer-sustaining activities Activities and costs associated with a single customer (costs of ordering and delivery) Chapter 7

Cost Hierarchy Product-sustaining activities Batch-level activities Activities or costs associated with product line or one single product (advertising, depreciation) Batch-level activities Activities or costs associated with each batch of product (set-up costs, electricity) Unit-level activities Activities or costs associated with each unit (indirect materials, indirect labor) Chapter 7

ABC Procedures 1. Identify the relevant cost object 2. Identify activities 3. Assign (trace and allocate) costs to activity based cost pools 4. For each ABC cost pool, choose a cost driver Chapter 7

ABC Procedures 5. For each ABC cost pool, calculate an allocation rate Allocation Rate = Activity Cost/Volume of Cost Driver 6. For each ABC cost pool, allocate activity costs to the cost object Allocation = Allocation Rate * Actual Volume of Activity Chapter 7

Using ABC 7.21 Palmer Company uses an activity based costing system. It has the following manufacturing activity areas and has chosen related cost drivers. Activity Cost Driver Machine setup Number of setups Material handling Number of parts Machining Machine hours Assembly Direct labor hours Inspection Number of finished units Chapter 7

Develop allocation rate (not shown in textbook problem) Activity Machine setup $200,000 Material handling $320,000 Machining $208,000 Assembly $66,000 Inspection $264,000 Cost Driver Number of setups 4,000 Number of parts 640,000 Machine hours 8,000 Direct labor hours 3,000 Number of finished units 22,000 Chapter 7

Cost allocation rates Chapter 7

Product information Chapter 7

Developing ABC unit cost Chapter 7

Selection of Cost Drivers Need cause and effect relationship between cost driver and activity costs Requires judgment in choosing and evaluating potential cost drivers Examples Chapter 7

What Is Activity Based Management (ABM)? The process of using ABC information to evaluate the costs and benefits of production and internal support activities and to identify and implement opportunities for improvements in profitability, efficiency, and quality within an organization Chapter 7

ABM Applied Customer profitability Product and process design * Focus resources on value-added activities * Reduce or eliminate non-value- added activities * Target and kaizen costing Chapter 7

ABM Applied Environmental costs Quality * Prevention activities * Appraisal activities * Production activities * Post-sales activities Constrained resources Chapter 7

Benefits Increase awareness of cause and effect relationships Promote performance improvements Identify non-value-added activities Motivate cost reduction Reduce arbitrariness in cost measurement Optimize use of constrained resources Chapter 7

Costs System design Accounting system modifications Employee training Higher costs when: * There are more activities * Activities are complex * ABC system is complex Chapter 7

Uncertainties in ABC and ABM Implementation Choice of activities Choice of cost drivers Inability to foresee all possible uses of information Choice of denominator in allocation rate Chapter 7