1. Activity-Based Costing and Activity-Based Management
Chapter 5

2. Overview Over/under costing Reasons to allocate costs
Criteria to guide allocation
Refining a cost system
ABC versus traditional cost systems
Costs/Benefits of ABC
ABC in service & retail as well as mfg.

3. Explain undercosting
and overcosting of
products and services.

4. Undercosting and Overcosting Example
Jose, Roberta, and Nancy order
separate items for lunch.
Jose’s order amounts to $14
Roberta’s order
Nancy’s order is
Total $60
What is the average cost per lunch?

5. Undercosting and Overcosting Example
$60 ÷ 3 = $20
Jose and Nancy
are overcosted.
Roberta is
undercosted.
The use of broad averages to allocate costs (aka peanut-butter costing) can lead to product-cost cross-subsidization.

6. Reasons to Allocate costs
There are many reasons
for allocating costs to
cost objects.

7. Purposes of Cost Allocation
1. To provide information for economic decisions
2. To motivate managers and other employees
3. To justify costs or compute reimbursement
4. To measure income and assets for reporting
to external parties

8. Criteria to Guide Cost-Allocation Decisions
Cause-and-effect:
Using this criterion, managers identify the
variable or variables that cause resources
to be consumed.
Benefits-received:
Using this criterion, managers identify the
beneficiaries of the outputs of the cost object.

9. Criteria to Guide Cost-Allocation Decisions
Fairness or equity:
This criterion is often cited on government
contracts when cost allocations are the basis
for establishing a price satisfactory to the
government and its suppliers.
Ability to bear:
This criterion advocates allocating costs in proportion to the cost object’s ability to bear them.

10. Role of Dominant Criteria
The cause-and-effect
and the benefits-
received criteria
guide most
decisions related
to cost allocations.
Fairness and ability-
to-bear are less
frequently used.
Why?

11. Refining a Costing System
More Direct-cost tracing
Indirect-cost pools
(More homogeneous)
Better cost-allocation bases

12. Activity-Based Costing System
Indirect Cost
Pool
Design
Setup
Shipping
Parts-
Square
feet
No. of
Setup
Hours
No. of
Shipments
Cost
Allocation
Base
Lenses NL
Lenses CL
Lenses
Other
Product
Cost
Objects

13. Activity-Based Management
ABM describes management decisions that use
activity-based costing information to satisfy
customers and improve profits.
Product pricing and mix decisions
Cost reduction and process improvement decisions
Design decisions

14. Evaluate the costs and benefits of implementing activity-based costing systems.

15. Benefits of ABC Systems (When the benefits of ABC tend to be large)
Significant amounts of indirect costs are
allocated using only one or two cost pools.
All or most costs are identified
as output unit-level costs.
Products make diverse demands on
resources because of differences in
volume, process steps, batch size,
or complexity.

16. Benefits of ABC Systems
Products that a company is well-suited to
make and sell show small profits while
products for which a company is less
suited show large profits.
Complex products appear to be very
profitable and simple products
appear to be losing money.

17. Benefits of ABC Systems
Operations staff have significant
disagreements with the accounting
staff about the costs of manufacturing
and marketing products and services.
Operations staff may even keep their
own set of books!

18. Limitations of ABC Systems
The main limitations of ABC are the
measurements necessary to
implement the system.
ABC systems require management
to estimate costs of activity pools
and to identify and measure cost
drivers for these pools.

19. Limitations of ABC Systems
Activity-cost rates also need to be
updated regularly.
Very detailed ABC systems are costly
to operate and difficult to understand.

20. ABC In Service and Merchandising Companies
The general approach to ABC in the
service and merchandising areas is very
similar to the approach in manufacturing.
Costs are divided into homogeneous cost
pools and classified as output unit-level,
batch-level, product- or service-sustaining,
and facility-sustaining costs.

21. ABC In Service and Merchandising Companies
The cost pools correspond to key activities.
Costs are allocated to products or customers
using activity drivers or cost-allocation
bases that have a cause-and-effect
relationship with the cost in the cost pool.

22. **End of Chapter 5** (That’s all folks!)