1. Activity-Based Costing Systems

2. 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”

3. 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

4. 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

5. 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

6. 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

7. 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??

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

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

21. 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.