ACTIVITY-BASED COSTING Chapter 7

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ACTIVITY-BASED COSTINGChapter 7

• Accounting Principles II
• AC 2102 - Fall Semester, 1999

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Limitations of Traditional Cost Accounting
Systems

• For companies operating in an advanced
  manufacturing environment traditional cost
  systems often are inadequate and cause the
  company to operate with severe competitive
  disadvantages
• Activity-Based Costing is a contemporary approach
  that has been developed to deal with this new and
  challenging environment

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Characteristics of An Advanced Manufacturing
Environment

• Intense Competition
• usually on a world wide level
• Continuous Improvement
• Total Quality Management
• Total Customer Satisfaction
• Sophisticated Technology

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Signs That A Companys Cost Accounting System May
Be Outdated

• The outcome of bids is difficult to explain
• Competitors prices appear to be unrealistically
  low
• Products that are difficult to produce show high
  profits
• Operational managers want to drop products that
  appear profitable
• Profit margins are difficult to explain

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Signs That A Companys Cost Accounting System May
Be Outdated

• The company has a highly profitable niche to
  itself
• Customers do not complain about price increases
• The accounting department spends a lot of time
  supplying cost data for special projects
• Some departments are using their own accounting
  systems
• Product costs change because of changes in
  financial reporting regulations

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Two Key Characteristics of Companies Who Need
More Accurate Costing Systems

• The proportion of nonunit-related overhead costs
  to total overhead costs is large
• The degree of product diversity is great

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Nonunit-Related Overhead Costs

• Using plantwide rates or departmental rates
• assumes that a products consumption of overhead
  resources is related strictly to the units
  produced (or to a single cost driver)
• But there are overhead activities that are
  unrelated to the number of units produced
• Examples Setup costs (number of batches)
  Engineering design changes (number
  of products or alterations
  requested)
• Using only unit-based activity drivers to assign
  nonunit-related costs can cause distorted product
  costs

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Product Diversity

• If products consume the nonunit overhead
  activities in the same proportion as the unit
  overhead activities,
• then no product-costing distortion will occur
  with the use of traditional costing methods
• However if the product line contains products
  that are quite diverse then such distortions will
  probably be significant

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Product Diversity

• When products consume overhead in different
  proportions
• Products consume overhead differently because
  they may be different in the following ways
• Product size
• Product complexity
• Setup Time
• Size of batches
• Special Request of Customers

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Regardless of the nature ofProduct Diversity

• Product cost will be distorted whenever the
  following situation prevails
• quantity of unit-based overhead that a product
  consumes does not vary in direct proportion to
  the quantity consumed of nonunit-based overhead

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The Basic Logic Of Activity-Based Costing

• Organization are really involved in performing a
  variety of activities
• To carry out these activities requires the
  consumption of resources
• Thus resource costs should first be assigned to
  activities and then activity costs to the
  products, services, customers, etc. for which
  these activities were performed

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The Two Stage Process OF Activity-Based Costing

• 1st Stage
• Trace costs to activities
• Rather than to an organizational unit such as a
  plant or department
• 2nd Stage
• Assign activity costs to products (or the cost
  object of interest)

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Some Key Features Of Activity-Based Costing
Systems

• Emphasizes direct tracing and driver tracing
• Exploiting cause-and-effect relationships
• In contrast, traditional costing systems tend to
  be allocation intensive
• Largely ignoring cause-and-effect relationships
• Note
• The principal computational difference between
  the two methods concerns the nature and number of
  cost drivers used

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Drivers Used In Activity-Based Costing Systems

• Uses both unit-based and nonunit-based activity
  drivers
• These drivers must reflect a cause-and-effect
  relationship
• In practical terms, drivers must explain a large
  percentage of activity cost variablity

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Number of Cost Drivers Used In Activity-Based
Costing

• The number of drivers used is generally greater
  than the number of unit-based drivers commonly
  used in a traditional system
• The ABC method produces increased product-costing
  accuracy

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First-Stage ProcedureRelating Resource Costs To
Activities

• Resources
• economic elements that are consumed in performing
  activities
• examples labor, material, electricity
• Activity
• a basic unit of work performed within an
  organization
• examples typing a letter, setting up a machine,
  assembling a product, packaging

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Determining The Cost To PerformOne Unit of An
Activity

• Once an activity is defined,
• the managerial accountant must determine the
  resources which are expended in performing the
  activity
• The resources used in performing the activity are
  identified or assigned to the activity by
• Direct tracing
• Driver Tracing (called resource drivers)
• Cost Allocation

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Reducing The Number of Activity Overhead Rates

• Most organizations generally will perform
  hundreds of activities
• To calculate the rate per unit for each of these
  activities is unmanageable
• Therefore activities are grouped and the costs
  for a similar set of activities are totaled
  together
• This collection of costs for a set of activities
  is called a homogeneous cost pool

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How Activities Are Grouped

• To reduce the number of activity charging rates
  required and to streamline the costing process,
  activities are grouped in homogeneous sets based
  on similar characteristics
• (1) They are logically related
• (2) The have the same (or reasonably close)
  consumption ratios for all products
• Since the activities within the homogeneous cost
  pool have the same consumption ratio,
• costs can be assigned to all products with a
  single activity driver

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The Five Steps In The First-Stage Procedures

• (1) Activities are identified
• (2) Costs are assigned to activities
• For resources that are consumed
• (3) Related activities are grouped to form
  homogeneous sets
• (4) The costs of grouped activities are summed to
  define homogeneous cost pools
• (5) Pool (overhead charging) rates are computed
• The appropriate activity driver is selected
• Total pool costs are divided by total units of
  the activity driver

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The Second Stage Procedure In Activity-Based
Costing

• Using activity cost drivers, the costs of each
  overhead pool are assigned to products
• Thus, the costs of a product or service would
  include the following
• Any material or labor costs that can be directly
  attached to the product or service being costed
• - these costs are called prime costs
• Any other costs which would be assigned through
  activity drivers
• - these drivers are sometimes called pool rates

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The Second Stage ProcedureSome Additional
Comments

• Products or services are produced by carrying out
  various activities
• The resources consumed by each activity was
  determined in stage one
• From this analysis, resource consumption costs
  per unit of activity was determined
• These calculated costs per unit of activity are
  called activity drivers, or pool rates
• In the 2nd stage, these rates are used to charge
  the costs of activities to products and services

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ActivitiesSome Additional Comments

• Activity implies action taken or work performed
• Activities are generally what an organization
  does to satisfy customer needs
• Activities are the building blocks for
• (1) product costing
• (2) continuous improvement
• The focus of activity-based costing is activities

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Activity Identification

• Observing and listing the work performed within
  an organization
• Interviews, observation, flowcharting of
  operations, study of processes, counting of
  document flows, etc. are all used for identifying
  the activities performed within an organization
• Each activity is usually described by an action
  verb and an object
• Once identified, activities are listed in a
  document called an activity inventory

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The Activity Inventory

• List of all identified activities
• List could easily contain 200 to 300 activities
• Activity attributes are used to further describe
  and classify the activities
• Activity attributes
• nonfinancial and financial information items that
  describe individual activities
• For product costing, then attributes which
  reflect how products consume activities would be
  focused on

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Example of An Activity Inventory

• 1. Ordering materials
• 2. Receiving materials
• 3. Testing product
• 4. Setting up batches
• 5. Collecting engineering data
• 6. Welding subassemblies

• 7. Moving materials
• 8. Providing utilities
• 9. Providing space
• 10. Packaging goods
• 11. Shipping goods
• 12. Paying for materials
• 13. Billing customers
• 14. Making collections

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Classification Of ActivitiesFor Product Costing
Purposes

• Activity attributes are used to group related
  activities into sets that form the basis for
  homogeneous cost pools
• Grouping activities has several advantages
• (1) Reduces the number of overhead rates needed
• (2) Simplifies the task of product costing
• (3) Decreases the overall complexity of the ABC
  product costing model

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Two Basic Attributes That Activities Have To Have
In Common To Be Grouped In The Same Set

• (1) Activity-level attribute
• They are performed in at the same general
  activity-level
• Activities that can be logically related
• (2) Driver Attribute
• They can use the same activity driver to assign
  costs to a cost object
• They must have the same consumption ration

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Activity-level ClassificationBuilding A Set of
Related Activities

• Activities are classified into one the the
  following four general activity categories
• (1) Unit Level
• (2) Batch Level
• (3) Product Level
• (4) Facility Level
• Grouping activities into these categories
  facilitates more accurate product costing
• because each level responds to different types of
  cost drivers

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Unit-level Activities

• Are activities that are performed every time a
  unit is produced
• Examples
• quantity of direct material and direct labor
  activities varies with the numbe of units
  produced
• power and machine hours are used each time a unit
  is produced
• The costs of unit-level activities vary with the
  number of units produced

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Batch-level Activities

• Are activities that are performed every time a
  batch is produced
• Examples
• Setups, production scheduling, and material
  handling
• The costs of batch-level activities vary with the
  number of batches produced
• but these costs are fixed or unaffected with
  respect to the number of units in each batch

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Product-level (Sustaining) Activities

• Are activities peformed as needed to support the
  various products produced by the company
• Examples
• Engineering changes, development of product-
  testing procedures, marketing a product, process
  engineering, and expediting
• These activities and their costs tend to increase
  as the number of different products increases

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Facility-level Activities

• Are those activities that sustain a factorys
  general manufacturing processes
• Examples
• plant management, landscaping, support of
  community programs, security, property taxes, and
  plant depreciation
• These activities benefit the organization at some
  level, but do not provide a benefit for any
  specific product

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Product-Related CategoriesActivity Driver
Classification

• Unit Level
• Batch Level
• Product Level
• Activities within these three categories contain
  product-related activities
• It is possible to measure the demands placed on
  these activities by individual products

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Activity Drivers

• Factors which measure the demands placed on
  activities by cost objects
• These drivers are used to assign the cost of
  activities to cost objects
• Activities with the same consumption ratios can
  use the same activity driver to assign costs

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Grouping Activities

• All activities, within each of the first three
  levels (unit, batch or product),
• can use the same activity driver to assign costs
• this creates a homogeneous set of activities
• results in a collection of activities that are at
  the same level and use the same activity drivers

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Facility-level ActivitiesThe Challenge of Cost
Assignment

• Pose a problem for the ABC philosophy of tracing
  costs to products
• Tracing costs to products depends on the ability
  to identify the amount of each activity consumed
  by a product
• But these activities are common to a variety of
  products
• It is not possible to identify how individual
  products consume these activities

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Facility-level ActivitiesThe Challenge of Cost
Assignment

• ABC systems usually implement a full costing
  approach and allocate these facility-level costs
  to products
• Unit level, batch-level, or product-level cost
  drivers are often used for the allocation
• Or the total overhead charged by the first three
  drivers is used as a basis for assigning
  facility-level costs

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Facility-level ActivitiesThe Challenge of Cost
Assignment

• The arbitrary or somewhat crude assignment of
  facility-related costs is not a serious problem
  in many instances
• The distortion in total product cost caused by
  questionable allocation bases may not be
  significant because these costs often make up a
  relatively small portion of the total costs

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ABC Customer-Driven Costs

• Customer diversity just as possible as product
  diversity
• Customers can consume customer-driven activities
  in different proportions
• Sources of customer diversity
• order frequency, geographic distance, sales and
  promotional support, engineering support
  requirements, service support
• Knowing costs of different customers can be vital
  for pricing, product mix decisions and improving
  profitability

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Customer Costing vs. Product CostingABC Costing
Systems

• Assigning the costs of customer service to
  customers is done in the same way that
  manufacturing costs are assigned to products
• Include in activities inventory
• order entry, order picking, shipping, making
  sales calls, evaluating a clients credit, etc.
• Assign the costs of the resources consumed to
  these activities and then to the customers
  requiring or demanding these activities

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Traditional Costing vs. ABC Costing

• Traditional Systems
• Use only unit-based drivers
• Ignore batch, product, facility level distinc.
• Assign all fixed OH in an arbitrary way
• Do not easily permit analysis of value
  non-value activities
• Frequently distort product costs

• ABC Systems
• Use all four levels of drivers
• Eplicitly consider allfour levels of activities
• Arbitrary allocations of fixed costs reduced
• Allow managers to identify which activities add
  value
• Improve accuracy of product costs

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Managerial Perspective OnActivity-Based Costing
(1)

• Offers more than just more accurate product cost
  information
• Also provides information about the costs and
  performance of activities and resources
• Can be used to trace costs accurately to cost
  objects other than products
• To activities,customers, channels of
  distribution, etc.

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Managerial Perspective OnActivity-Based Costing
(2)

• Provides means to identify areas where efficiency
  can be improved
• Basic Steps
• Better understand and know the costs of
  activities
• Evaluate the importance of each activity to the
  organization and its customers
• Better understand how efficiently each activity
  is performed
• Determine opportunities to simplify, modify, make
  more efficient, or eliminate activities

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