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ACTIVITY-BASED COSTING

Chapter 7

Accounting Principles IIAC 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Signs That A Company’s Cost Accounting System May Be Outdated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Signs That A Company’s Cost Accounting System May Be Outdated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 product’s 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 factory’s 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 all

four 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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