Activity-Based Costing Systems

1. Activity-Based Costing Systems Chapter 4

2. Traditional overhead allocation system • Single predetermined rate is used to allocate overhead to products • Easy to use • Assumes all overhead is correlated with the activity base • Assumes all overhead costs are related to all products • Does not consider the product’s consumption of resources other than the base

3. An ideal system • Treat indirect costs like direct costs • Accurate assignment of the resources consumed by the individual cost objects • Different types and amounts of overhead charged to different cost objects • No allocation based on estimates • Not possible • Cost element shared by many cost objects • Cost element not related to cost objects • Not cost effective to trace accurately

4. Activity-based costing • Recognizes • Not all costs are related to the same cost driver • Not all costs are incurred at the unit level • Unit level • Batch level • Product level • Customer level • Facility level

5. Activity-based costing • Recognizes • That activities are performed to produce or support the cost object • Those activities consume resources • Can identify resources with the activities • Can identify the activities with the cost objects • Can be used for any cost object • Not GAAP for financial reporting

6. Activity-based costing • Traditional allocation method • Activity-based allocation method Costs Products Costs Activities Products First stage Second stage

7. Implementation of an ABC system • Step 1 – Develop activity dictionary • List of activities related to the cost object • How precise? • Only major activities if purpose is better cost information • More detailed if purpose is process improvement • Will probably have an “other” activity

8. Implementation of an ABC system • Identify activities (cost pools) • Interview employees • Process flowcharts • Etc. • At which level do they occur? • Unit, batch, etc. • May not want to allocate facility level costs to products

9. Implementation of an ABC system • How are the activities performed? • Inputs and outputs • What causes the activity to commence? • Production order, material requisition, etc. • How can the activity be measured? • Transactions, time, etc. • For use as possible cost drivers

10. Implementation of an ABC system • Step 2 – Determine the significant costs related to each activity • Resources used • Employee time • Wages and benefits • Assets • Depreciation, taxes, insurance, etc. • Consumables • Supplies, utilities, maintenance, etc. • “Other”

11. Implementation of an ABC system

12. Implementation of an ABC system

13. Implementation of an ABC system • Step 3 – Determine cost drivers and rates • What activity measures correlate with each cost? • Measurable • Statistically or logically have a cause-and-effect relationship with the cost • Predict or explain the consumption of resources with reasonable accuracy • Based on practical capacity for the activity • Unused capacity is its own “activity”

14. Implementation of an ABC system

15. Implementation of an ABC system

16. Implementation of an ABC system • Step 4 – Assign costs to cost objects • Determine the amount of each activity consumed by the cost object • Multiply by the rate for that activity • Total the activity costs for each cost object • Divide total by quantity of the cost object to determine unit cost

17. Implementation of an ABC system

18. Advantages of ABC • Better allocation of costs • Not perfect • Useful for estimating costs of future projects • Can be extended to activity-based management • “Now that we know what it costs, how can we do it more efficiently?”

19. Advantages of ABC • Cost object can be anything • Product • Service • Process • Customer • Employee • Location • Etc.

20. Advantages of ABC • Aids in recognizing, measuring and controlling complexity • Promotes understanding of why costs are incurred • Shifts focus from managing costs to managing activities

21. When to use ABC • High proportion of indirect costs • Complex products or processes • High volume vs. low volume products • Diverse indirect costs • Cost accounting system hasn’t evolved • Distrust of current system • Different products place different demands on resources

22. Disadvantages of ABC • Costly to implement • Costly to maintain • Likely to meet substantial resistance • Not the “real” system • “Why do you want to know what I do?”