Activity Based Costing

1
Activity Based Costing
2
Terminal Learning Objective

• Action Conduct Activity Based Costing (ABC) by
  understanding the ABC process and then allocating
  costs to activities for managerial decision
  making.
• Condition Given a. DFAS-IN Manual
  37-100. b. DFAS-IN Regulation 37-1
• Standard Conduct an Activity Based Costing
  (ABC) analysis. Conduct Cost Allocation.

3
Introduction

• Inability to Manage Cost Well Will Result In
  Excessive Loss of Combat Capability

4
Consider the Alternatives to Meet a 10 Budget Cut

• Dumb Cut 10 of the Budget Spent on Oil and
  Lubricants
• Eliminate Combat Effectiveness
• Mindless Salami Slice All 10
• Reduce Combat Effectiveness 10?????
• Rational Manage Cost Smarter
• Maintain or Increase Combat Effectiveness

5
Chief Financial Officers Act

• Billions Of Dollars Lost Each Year Through ...
  Mismanagement
• Losses Could Be Significantly Decreased By
  Improved Management
• Great Need Of Fundamental Reform In Financial
  Management
• Current Practices Do Not Provide Timely
  Information Required For Efficient Management

6
Cost Management Requires Cost Measurement

• Management Must Have Cost Measurement to Fight
  Cost War
• Cost Measurement
• Informs Management of Financial Implications of
  Management Decisions
• Is Prerequisite to Cost Reduction
• Eliminates Free Goods
• Facilitates Best Use of Limited Resources

7
Cost Information Enables Efficient Use of
Resources

• Which Metal is Best for Transmission?

Metal A
Metal B
Metal C
Conductivity

8
ABC a Self Made Tool for Managerial Cost
Accounting

• Seek To Understand True Economic Cost
• Based on Cause-Effect Relationships
• Reflecting Drivers of Resource Consumption
• With Reasonable, But Not Precise Accuracy
• Promote Better Resource Management
• Eliminate Free Goods
• Stimulate Behavioral Change
• Enable Accountability for Cost Management

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A Broad Definition of Managerial Costing
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Why Is This Translation Needed?

• Accounting Systems Usually Measure Input or
  Source Costs
• Labor, Overhead, Materials
• Salaries, Benefits, Supplies, Contracts
• Managers Want Measurements Based on Output or
  Consumption
• Product, Service, Project
• Consuming Organization, Customer

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Managerial Costing Terms
cost pool
raw accounting data
managerial costing translation
method of distribution

managerially useful information
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Terminology

• Cost Pool
• An Aggregation of Incurred or
• Source Costs to be Distributed
• Examples
• Salary and Benefits, Supplies, Travel, etc. in
  Airfield Operations Center
• Utility Bills for Garrison

cost pool
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Terminology (Condt)

• Method of Distribution
• The Mechanics of Deriving
  Management Information
  from the Cost Pool
• Example
• Determine Unit Cost By
  Adding All Input Costs and
  Dividing by Number of Units

method of distribution
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Terminology (Condt)

• Cost Driver
• Good cost drivers distribute cost
• based on cause and effect, reflecting
• true cost consumption by a cost object
• Examples
• Activity Cost Driver
• Heating Square Footage
• Personnel Training Hours
• Accounting Reports requested

Activity Cost Pool
allocation based on cost driver
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Terminology (Condt)

• Cost Object
• The product, service, or object that created the
  costs
• Examples
• 120mm Tube Product Cost
• Morale, Welfare, Recreation Cost
• Finance School Cost

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Alternative Methods of Distribution

• Managers Can Obtain the Needed View of Cost in
  Several Ways
• Guessing Gut Feel of Cost Distribution
• Direct Costing Detailed Record Keeping of all
  Incurred Cost Transactions by Every Cost Object
• Allocation Distribution of Cost Pool in the Same
  Proportion as a Cost Driver

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Most Systems Combine Methods
cost pool
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Choosing a Method of Distribution

• Use Guessing for Simple Decision Making
• Keep Detailed Records When Accounting Cost is Low
  and High Accuracy Useful
• Allocate Overhead, Support, and Indirect Costs
  When Appropriate
• Consider Managements Needs for Precision and
  Timeliness

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Discussion Telephone Charges

• Should These be Allocated or Charged Via
  Detailed, Call-by-Call Records
• Issues to Consider
• What Does Management Need?
• Is Telephoning a Core Mission or Support
  Function?
• Are Detailed Records Available?

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Two Allocation Methods

• Rate Method
• Uses a Computed Rate per Driver Unit
• Proportion Method
• Computes a Proportional Share of the Total Cost
  Based on Driver Usage
• Both Methods
• Yield Same Results
• Represent the Same Underlying Algebra

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Reconciling the Two Methods
Total Cost Pool Total Number of Driver Units
Rate Method
Equals
Proportion Method
Number of Driver Units Used Total Number of
Driver Units
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Split the Dinner Check
Chez Buntingham
Fillet and Lobster
35.00 Chicken Kiev
15.00 Top Sirloin
20.00 Caesar Salad
9.00 Coffee 2 _at_1.00
2.00 House Wine 4 _at_5.00
20.00 Champagne
24.00 Ice Cream
4.00 Chocolate Cheesecake
6.00 Sampler
10.00 Soup/Salad
8.00 Aperitif
7 .00 Total 160.00
Carol
Alice
Thank You
Bob
Ted
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Allocation Mechanics .xls
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Allocation by Proportion
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Allocation by Rate Method
1. Determine Overhead Rate

Total Cost
Total
diners

Rate per
diner

160


4

40


2. Compute Allocation
Usage by Cost Object
x
Rate

Allocation
Bob
1
x
40



40


Ted
1
x
40



40


Carol
1
x
40



40


Alice
1
x
40



40


Total
160


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The Results
Cost Allocation for dinner check based on diners
40
Bob
30
Ted
20
Carol
Alice
10
Print
-
Reset
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Cross Subsidization
Is This Fair?
Consumption Cost allocation
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This Can Be a Significant Problem
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Incremental EffectsWhat Happens if Bob Spends
10 More?
90
80
70
60
Original
50
40
Incremental
Change
30
20
10
0
Bob Consumes
Bob Pays
30
Incremental EffectsWhat Happens if Bob Spends
10 Less?
80
70
60
Incremental Savings
50
40
Decreased Amount
30
20
10
0
Bob Consumes
Bob Pays
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Measurement Effects Motivation

• Managerial Costing Inevitably Impacts Behavior
• Design of Managerial Costing Systems Must
  Recognize and Anticipate This Effect
• Consider in this Example
• What Incentives Exist to Spend More?
• What Incentives Exist to Spend Less?
• What Would You Do if You Went to Dinner with Them
  Tonight?

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Conclusion

• Allocation Based on Number of Diners Failed to
  Reflect Resource Consumption
• Results
• Unfair Cross-Subsidizations
• The Creation of Almost Free Incremental Goods
• Dysfunctional Behavioral Motivation
• Detailed Record Keeping May be Best in This
  Problem -- i.e. Separate Checks

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Terminal Learning Objective

• Action Conduct Activity Based Costing (ABC)
  by understanding the ABC process and
  then allocating costs to activities for
  managerial decision making.
• Condition Without references.
• Standard Conduct Activity Based Costing with
  100 accuracy.