Lecture Cost management: Measuring, monitoring, and motivating performance (2e): Chapter 7 - Eldenburg, Wolcott’s

Chapter 7 - Activity-based costing and management. The following will be discussed in this chapter: What is activity-based costing (ABC)? What are activities and how are they identified? What process is used to assign costs in an ABC system?...

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• Q1 : What is activity-based costing (ABC)?

• Q2 : What are activities and how are they identified?

• Q3 : What process is used to assign costs in an ABC system?

• Q5 : What are GPK and RCA?

• Q4 : What is activity-based management?

• Q6 : How does information from ABC, GPK, and RCA affect

managers’ incentives and decisions?

Q1:  Activity­Based Costing (ABC)

• ABC is a method of cost system refinement.

• Indirect costs are divided into “sub-pools” of

costs of activities.

• Activity costs are then allocated to the final cost objects using a cost allocation base (more

commonly called cost drivers in ABC).

• Activities are measurable, making it more likely that cost drivers can be found so that a final cost object will absorb indirect costs in proportion to

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Traditional costing systems:

Indirect Costs

Direct Costs

Direct Costs Direct Costs

Direct costs are traced to the individual products

The individual products are the final cost objects

Indirect costs are grouped

into one (or a small

number) of cost pools; a

cost allocation base

assigns costs to the

individual products

Q1:  Traditional Costing Systems

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Direct Costs

Direct Costs Direct Costs

The individual products are the final cost objects & direct costs are traced to the individual products

Indirect costs are

assigned (traced &

allocated) to various pools

Q1:  ABC Costing Systems

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The ABC cost hierarchy includes the following activities:

organization

plant or service facility

single product

Q2:  ABC Cost Hierarchy Example

Some of the costs incurred by the Dewey Chargem law firm are listed

below This firm specializes in immigration issues and family law For each cost, identify whether the cost most likely relates to a(n) (1) organiz-ation- sustaining, (2) facility-sustaining, (3) customer-sustaining, (4) product-

sustaining, (5) batch-level, or (6) unit-level activity and explain your choice.

Bookkeeping software

Salary for partner in charge of family law

Office supplies

Subscription to family law update journal

Telephone charges for local calls

Long distance telephone charges

Window washing service

Salary of receptionist

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1. Identify the relevant cost object

2. Identify activities and group

homogeneous activities

3. Assign costs to the activity cost pools

4. Choose a cost driver for each activity cost

pool

5. Calculate an allocation rate for each

activity cost pool

6. Allocate activity costs to the final cost

object.

Q3:  How Are Cost Drivers Selected for Activities?

• For each activity, determine its place

in the ABC cost hierarchy

• Look for drivers that have a good

cause-and-effect relationship with the activities’ costs.

• Use a reasonable driver when there is

no cause-and-effect relationship.

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Alphabet Co makes products A & B Product A is a low-volume

specialty item and B is a high-volume item Estimated factory- wide

overhead is $800,000, and the number of DL hours for the year is

estimated to be 50,000 hours DL costs are $10/hour Each product

uses 2 DL hours Compute the traditional cost of each product if

Products A & B use $25 and $10 in direct materials, respectively.

First, compute the estimated overhead rate:

Estimated overhead rate = $800,000/50,000 hours = $16/hour.

Q3:  ABC in Manufacturing Example

Alphabet Co is implementing an ABC system It estimated the costs

and activity levels for the upcoming year shown below.

First, compute the estimated overhead rate for each activity:

Prod A Prod B Total Cost Driver Machine set-ups $200,000 3,000 2,000 5,000 # set-ups

Inspections 140,000 500 300 800 # inspections

Materials handling 80,000 400 400 800 # mat'l requistions Machining dep't 320,000 12,000 28,000 40,000 # machine hours Quality control dep't 60,000 600 150 750 # tests

$800,000

Estimated Activity Levels Estimated

Costs

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Machine set-ups $200,000 5,000 set-ups $40 /setup

Inspections 140,000 800 inspections $175 /inspection

Materials handling 80,000 800 mat'l requistions $100 /requisition

Machining dep't 320,000 40,000 machine hours $8 /mach hr

Quality control dep't 60,000 750 tests $80 /test

$800,000

Estimated Costs Estimated Activity Overhead Rate

Q3:  ABC in Manufacturing Example

Alphabet recently completed a batch of 100 As and a batch of 100 Bs

Direct material and labor costs were as budgeted Information about each batch’s use of the cost drivers is given below Compute the overhead

allocated to each unit of A and B.

100 Bs Machine set-ups 60 10

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Compute the total cost of each product and compare it to the costs

computed under traditional costing.

Traditional costing assigned $77 to a unit of Product A and $62 to a unit of Product B.

Prod A Prod B Direct material $25.00 $10.00

• ABM is the process of using ABC information to evaluate opportunities for improvements in an organization.

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• analyzing the types of bank transactions used

by various categories of customers

• comparing the costs of servicing insurance

contracts sold to married versus single individuals

• comparing the costs of different distribution

channels

• Activities can be defined so that the costs of stages

of production or of a business process are

accumulated.

Q4:  ABM & Product/Process Improvements

• Examples include

• determining the costs of non-value-added

activities so the most costly can be reduced or eliminated

• changing the steps in the accounts payable

function to reduce the number of personnel

• determining the most costly stages of product

development so that the time to market is

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• Activities can be defined so that types of

environmental costs are accumulated.

Q4:  ABM & Environmental Costs

• Examples include

• capturing the costs of contingent liabilities for

waste disposal site remediation

• comparing the cost of recycling packaging to the cost of disposal

• computing the costs of treating different kinds of emissions

• Activities can be defined so that categories of costs

of managing quality are accumulated.

Q4:  ABM & Quality Costs

• Common categories of quality costs are

• costs of prevention activities

• costs of appraisal activities

• costs of production activities

costs of postsales activities

– Each cost is traced to a cost center (smaller than a

department) which performs a single repetitive activity, and is the responsibility of one manager)

– Output measures tracks the volume of resource use

– Costs are segregated into proportional (change with volume in resource use) and fixed

Q5 : Capacity Definitions

continuous, uninterrupted operations 365 days/year

upcoming time period

capacity used and one of the above measures of capacity

• Resource Consumption Accounting (RCA)

• Builds on GPK and ABC principles

• Each cost is assigned to a resource cost pool

– Labor and machinery are often placed in different cost pools since they are different types of resources

– RCA involves a significantly larger number of cost pools than traditional accounting

– Like GPK, segregates proportional and fixed costs

– Utilizes theoretical rather than practical capacity for

allocating fixed costs

• More likely to focus manager attention on reducing idle and productive resource time

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• Benefits

– Generates multi-level internal income statements useful for short terms decisions because it focuses on marginal cost

– Increases cause & effect awareness among managers

– Categorizes costs (and generates profit margin) at the product, product group, division, and company level

– Avoids arbitrary allocations of fixed costs

• Drawbacks

– Can be costly to implement

– Can result in a large number of variances to analyze

allocation rate

denominator

Actual, budgeted,

or practical capacity

Budgeted or practical capacity Theoretical capacity

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• Benefits

• more accurate and relevant product cost information

• employees focus attention on activities

• measurement of the costs of activities and business processes

• identify non-value-added activities and reduce costs

Q6:  Decision Making with ABC, GPK, and RCA

• Costs

• systems can be difficult to design and maintain

• more information must be captured

• decision makers may not use the information

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