Chapter 7: Activity-Based Costing: A Tool to Aid Decision Making

Activity-Based Costing:A Tool to Aid Decision MakingChapter 7Activity–Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity, and therefore, affect “fixed”as well as variable costs.ABC is agood supplement to our traditional cost systemI agree!How Costs are Treated UnderActivity–Based CostingABC differs from traditional cost accounting in three ways.ManufacturingcostsNonmanufacturingcosts ABC assigns both types of costs to products.Traditionalproduct costingABCproduct costingHow Costs are Treated UnderActivity–Based Costing ABC does not assign all manufacturing costs to products.ManufacturingcostsNonmanufacturingcostsTraditionalproduct costingABCproduct costingAllMost, butnot allSomeABC differs from traditional cost accounting in three ways.How Costs are Treated UnderActivity–Based Costing Plantwide OverheadRateDepartmentalOverheadRatesActivity–BasedCostingNumber of cost poolsLevel of complexity ABC uses more cost pools.ABC differs from traditional cost accounting in three ways.How Costs are Treated UnderActivity–Based CostingEach ABC cost pool has itsown unique measure of activity.Traditional cost systems usually relyon volume measures such as direct laborhours and/or machine hours to allocateall overhead costs to products.ABC differs from traditional cost accounting in three ways. ABC uses more cost pools.ActivityAn event that causes the consumption of overhead resources.Activity Cost PoolA “cost bucket” in which costs related to a single activity measure are accumulated.$$$$$$How Costs are Treated UnderActivity–Based CostingActivity MeasureAn allocation basein an activity-basedcosting system.How Costs are Treated UnderActivity–Based CostingThe term cost driver is also used to refer to an activity measure.Simple countof the number oftimes an activityoccurs.TransactiondriverA measureof the amountof time neededfor an activity.DurationdriverHow Costs are Treated UnderActivity–Based CostingTwo common types of activity measures:How Costs are Treated UnderActivity–Based CostingTraditional cost systems usually rely on volumemeasures such as direct labor hours and/or machinehours to allocate all overhead costs to products.ABC definesfive levels of activitythat largely do not relateto the volume of unitsproduced.Manufacturingcompanies typically combinetheir activities into fiveclassifications.Unit-LevelActivityBatch-Level ActivityProduct-LevelActivityCustomer-LevelActivityOrganization-sustainingActivityHow Costs are Treated UnderActivity–Based CostingCharacteristics of Successful ABC ImplementationsStrong topmanagement supportLink to evaluationsand rewardsCross-functionalinvolvementDifferences Between ABC and Traditional Product CostsTraditional costing allocates all manufacturing overhead to products. ABC costing only assigns manufacturing overhead costs consumed by products to those products. There are three reasons why thereported product margins for the twocosting systems differ from one another.Differences Between ABC and Traditional Product Costs Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. ABC costing also uses non-volume related allocation bases. There are three reasons why thereported product margins for the twocosting systems differ from one another.Differences Between ABC and Traditional Product Costs Traditional costing disregards selling and administrative expenses because they are assumed to be period expenses. ABC costing directly traces shipping costs to products and includes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned to products.There are three reasons why thereported product margins for the twocosting systems differ from one another.Targeting Process ImprovementActivity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements by focusing on activities to eliminate waste, decrease processing time, and reduce defects.Benchmarking can be used to compare activity cost information with standards of performance achieved by other organizations.ABC activity rates can also provide valuable clues concerning where there is waste and the opportunity for improvement.Activity-Based Costing and External ReportingMost companies do not use ABCfor external reporting because . . .External reports are less detailed than internal reports.It may be difficult to make changes to the company’s accounting system.ABC does not conform to GAAP.Auditors may be suspect of the subjective allocation process based on interviews with employees.ABC LimitationsSubstantial resourcesrequired to implementand maintain.Resistance tounfamiliar numbersand reports.Desire to fullyallocate all coststo products.Potentialmisinterpretation ofunfamiliar numbers.Does not conform toGAAP. Two costingsystems may be needed.End of Chapter 7