1. Prepared by Diane Tanner University of North Florida Chapter 5 1 Allocation of Indirect Costs: Simple Costing & ABC

2. Simple Costing vs. ABC Simple costing AKA ‘Traditional’ cost allocation and peanut-butter costing Often acceptable for companies with Limited variety of goods Small amounts of indirect costs Activity-based costing Multiple cost pools Allocation of indirect costs is based on what ‘drives’ the costs Relatively expensive to implement More refined

3. Why Select a More Refined Costing System?  Recent trends  Increase in product diversity  Increase in indirect costs  Advances in information technology  Competition in foreign markets  Helps to avoid cross-subsidization  Overcosting—a product consumes a low level of resources, but is allocated a high cost per unit  Undercosting—a product consumes a high level of resources, but is allocated a low cost per unit

4. Activity-Based Costing  What is activity-based costing?  A system of allocating indirect costs to cost objects  Utilizes multiple cost pools  Is used with normal costing  Based on activities that drive costs rather than on volume-based denominators  Primarily used to allocated manufacturing overhead  Sometimes used to allocate support department costs to divisions 4 Underlying Premises Activities underlie costs. Underlying Premises Activities underlie costs.

5. Setting Up an ABC System  Step 1: Determine the cost object.  Step 2: Form cost pools.  The costs of performing a particular activity are grouped into a cost pool.  All costs in a pool should have the same cause.  Step 3: Select a cost driver that has a cause- and-effect relationship with the costs to be allocated. 5

6. How to Perform ABC Step 1: Calculate the rate for each cost pool. Estimated Cost / Estimated Activity = Rate Step 2: Multiply each cost pool rate times the respective actual activity to determine allocated costs. Step 3: Total up the allocated costs from step 2. This results in the applied overhead cost. Step 4: Add the allocated costs to the direct costs of each cost object to obtain the total cost of each cost object. 6 6

7. Considerations of ABC  Complete analysis requires allocation beyond manufacturing costs to include period costs  Activity can be measured on practical capacity, actual capacity, or other estimate  Practical capacity preferred over actual capacity because  Does not hide the cost of idle capacity within product costs  Gives a truer cost of activities used to produce the product

8. Cost Driver Selection  Selection of the appropriate cost driver is crucial  Considerations in selecting a cost driver  Experience  Industry practices  Cost-benefit analysis of each option under consideration

9. ABC Implementation Issues  After switching to ABC, companies may find that only 10 to 15% of their products are profitable  Causes management to alter the product mix by minimizing unprofitable products  Causes profits to increase  Implementation mirrors the complexity of the organization  Complete conversion to ABC requires auditors to accept the system when used for financial reporting

10. Cost Hierarchies  ABC uses a 4-level cost structure to determine how far down the production cycle costs should be pushed Factory costs that impact all the products produced in a factory, such as depreciation on the factory building, factory insurance, factory janitors, factory supplies Facility-level activities Costs specific to particular products such as training employees how to produce it, quality control on a product, etc. Product-level activities Costs specific to particular batches of products such as machine setup for a particular product, machine maintenance between each batch, etc. Batch-level activities Costs performed every time a product is produced. They are usually variable and correlate to the number of products produced, such as packaging, sanding a product edge, printing labels, etc. Unit-level activities

11. Signals that Suggest that ABC Implementation Could Help a Firm  Significant indirect costs allocated using one or two cost pools  Most or all overhead is considered unit-level  Has products that consume different amounts of resources  Has products that consistently show small profits (though the products should be profit makers)  Operations staff disagree with accounting over manufacturing and marketing costs

12. 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  Design decisions  Planning and managing activities

13. Activity-Based Management  A tool in which managers analyze activities that cause indirect costs of products or services  Goal is to improve efficiency and effectiveness of the activities in order to reduce costs  Serves as the basis for numerous process improvement programs of companies  Helps focus managerial attention on what is most important among the activities performed to create value for customers

14. Comparing ABC and Traditional Costing  Advantages of ABC over traditional costing  ABC results in more accurate costing.  ABC helps managers control costs better.  ABC considers the fact that only products that use particular resources are assigned costs.  ABC mitigates overcosting and undercosting of cost objects.  Disadvantages of ABC  Very expensive to implement  No separation of fixed and variable costs which makes incremental analysis difficult 14

15. Overcosting and Undercosting  Occurs due to broad, equal costs allocated to all products 15 Undercosting Overhead allocated under ABC is greater than if traditional is used A product consumes a relatively high level of resources but is reported to have a relatively low total cost Overcosting Overhead allocated under ABC is less than if traditional is used A product consumes a relatively low level of resources but is reported to have a relatively high total cost

16. 16 The End