Chapter 7 Activity Based Costing A Tool to Aid Decision Making Activity based costing ABC is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore fixed as well as variable costs usually used as a supplement to the company s usual costing system Activity Based Costing An Overview Activity based costing differs from traditional cost accounting in 3 ways o Nonmanufacturing as well as manufacturing costs may be assigned to products but only on a cause and effect basis Manufacturing and nonmanufacturing costs are taken into account for the cost of the product o Some manufacturing costs may be excluded from product costs Two types of manufacturing overhead costs are not applied to products Do not assign organization sustaining costs to products like factory security guard s salary Do not assign idle capacity o Numerous overhead cost pools are used each of which is allocated to products and other cost objects using its own unique measure of activity Product costs used to be majority direct labor and simple products now more overhead costs and more complex products Activity based approach uses more cost pools and unique measures of activity to better understand the costs Activity is any event that causes the consumption of overhead resources Activity cost pool is a bucket in which costs are accumulated that relate to a single activity measure in the ABC system Activity measure is an allocation base in an activity based costing system o Transaction drivers are simple counts of the number of times an activity occurs such as the number of bills sent out to customers o Duration drivers measures the amount of time required to perform an activity such as the time spent preparing individual bills for customers more accurate but harder to record Activity based costing defines five levels of activity o Unit level activities are performed each time a unit is produced cost of unit level activities should be proportional to the number of units produced o Batch level activities are performed each time a batch is handled or processed regardless of how many units are in the batch o Product level activities relate to specific products and typically must be carried out regardless of how many batches are run or units of product are produced or sold o Customer level activities relate to specific customers o Organization sustaining activities are carried out regardless of which customers are served which products are produced how many batches are run or how many units are made Designing an Activity Based Costing ABC System 3 essential characteristics of a successful ABC implementation o Top managers must strongly support ABC implementation bc their leadership is instrumental in properly motivating all employees to embrace the need to change o Top managers should ensure that ABC data is linked to how people are evaluated and rewarded o A cross functional team should be created to design and implement the ABC system Steps for implementing ABC o 1 Define activities activity cost pools and activity measures Can be difficult and time consuming to identify the activities that will form the foundation for the system o 2 Assign overhead costs to activity cost pools o 3 Calculate activity rates o 4 Assign overhead costs to cost objects using the activity rates and activity measures o 5 Prepare management reports The Mechanics of Activity Based Costing Step 2 assign overhead costs to activity cost pools o First stage allocation is an ABC system that assigns functionally organized overhead costs derived from a company s general ledger to the activity cost pools o Organization sustaining costs are assigned to the other cost pool and are not allocated to products Step 3 calculate activity rates o Total cost for each activity total activity o Activity rate not calculated for the other category of costs since they are not assigned to products Step 4 assign overhead costs to cost objects o Second stage allocation activity rates are used to apply overhead costs to products and customers Step 5 prepare management reports o Product and customer profitability reports Comparison of Traditional and ABC Product Costs Traditional system assigns only manufacturing costs and uses a plant wide overhead rate to assign manufacturing overhead costs How the pie is divided is how each method is different Traditional and activity based costing systems report different product margins bc traditional cost systems allocate all manufacturing overhead costs to products while the ABC system does not assign all manufacturing overhead costs traditional cost system allocates all of the manufacturing overhead costs using a volume related allocation base that may or may not reflect what actually causes the cost traditional cost system overcost high volume products and undercost low volume products ABC system assigns the nonmanufacturing overhead costs caused by products to those products on a cuase and effect basis while the traditional system disregards these costs Action analysis report provides more detail about costs and how they might adjust to changes in activity Targeting Process Improvements Activity based management involves focusing on activities to eliminate waste decrease processing time and reduce defects First decide what to improve Activity rates can provide valuable clues concerning where there is waste and opportunity for improvement Benchmarking is a systematic approach to identify activities with the greatest room for improvement compare the performance of an organization with the performance of another Activity Based Costing and External Reports Activity based costing is not really used for external reports bc o External reports are less detailed than internal reports prepared for decision making o It is difficult to make changes in a company s accounting system o An ABC system does not conform to GAAP o Auditors are likely to be uncomfortable with allocations that are based on interviews with company employees The Limitations of Activity Based Costing Major project requires a lot of resources More costly to maintain once implemented Can be misinterpreted Appendix 7A ABC Action Analysis Action analysis helps managers determine which costs are relevant in a decision and to place responsibility for the elimination of those costs on the appropriate managers Calculation of activity rates is more involved during action analysis
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