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Activity-Based Costing and Activity-Based Management

by: Shannon Panagopoulos

Activity-Based Costing and Activity-Based Management ACC

Marketplace > DePaul University > ACC > Activity Based Costing and Activity Based Management
Shannon Panagopoulos
GPA 3.52

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Under and Over Costing Product-Cost Cross-Subsidization Simple Costing System Using a Single Indirect Cost Pool 5-Step Decision-Making Process Refining a Costing System (Reasons, Guidelines) ...
Managerial Accounting
Nancy Hill
Class Notes
Under and Over Costing, Product-Cost Cross-Subsidization, Simple Costing System Using a Single Indirect Cost Pool, 5-Step Decision-Making Process, Refining a Costing System (Reasons, Guidelines), Activity-Based Costing (ABC) System, Output Unit-Level Cos
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This 9 page Class Notes was uploaded by Shannon Panagopoulos on Monday January 11, 2016. The Class Notes belongs to ACC at DePaul University taught by Nancy Hill in Winter 2016. Since its upload, it has received 7 views.


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Date Created: 01/11/16
Ch. 5: Activity­Based Costing and Activity­Based Management Broad Averaging and Its Consequences ­historically, companies produced a limited variety of products ­therefore they used fewer overhead resources for operations, so  indirect/overhead costs were a small percentage of total costs ­used simple costing systems to allocate overhead costs broadly in an easy and  cheap, but reasonably accurate manner ­NOW product diversity and indirect costs have increased, and broad averaging has  become an inaccurate way of product costing ­*b/c simple peanut­butter costing broadly averages/spreads the cost of  resources uniformly to cost objects (products/services) when these products and  services do not actually use these resources uniformly  Undercosting and Overcosting ­Product overcosting: a product consumes a high level of resources per unit but is  reported to have a low cost per unit *Overcosted products will be overpriced, causing them to lose market share to  competitors with similar products  ­Product undercosting= a product consumes a low level of resources per unit but is  reported to have a high cost per unit *Undercosted products will be underpriced­ may lead to sales that result in  losses because the sale brings in less revenue than the cost of resources used ­If prices are determined by the market based on the consumer demand and  competition among many companies: product over and undercosting causes managers  to focus on the wrong products ­managers give more attention to overcosted products that show low profits,  when in fact costs and profits from these products are perfectly reasonable ­managers give less attention to undercosted items because they think they are  highly profitable, but in fact these products consume large amounts of resources and  are much less profitable than they appear Product­Cost Cross­Subsidization Product­Cost Cross­Subsidization= if a company undercosts one of its products, it will  overcost at least one of its other products  *Vice­versa ­Is very common when a cost is uniformly spread (broadly averaged) across  multiple products without managers recognizing the amount of resources each product  consumes  Simple Costing System Using a Single Indirect­Cost Pool 1) Identify the products that are chosen cost objects 2) Identify the direct costs of the products a. DM, DML 3) Select the cost­allocation bases to use for allocating indirect/overhead costs to  the products a. Supervisor salaries, engineers, manufacturing support, maintenance 4) Identify the indirect costs associated with each cost allocation base 5) Compute the rate per unit of each cost­allocation base  Budgeted indirect cost rate = (budgeted total costs in indirect­cost pool) /  (budgeted total quantity of cost­allocation base) 6) Compute the indirect costs allocated to the products 7) Compute the total cost of the products by adding all direct and indirect costs  assigned to the products 5­Step Decision­Making Process 1) Identify the problems and uncertainties 2) Obtain information 3) Make predictions about the future 4) Make decisions by choosing among alternatives 5) Implement the decision, evaluate performance, and learn  Refining a Costing System ­Refined costing system­ reduces the use of broad averages for assigning the costs of resources to cost objects; provides a better measurement of the cost  of indirect resources used by different cost objects, no matter how differently  various cost objects use indirect resources *helps managers make better decisions about how to allocate resources  and which products to produce Reasons for Refining a Costing System 1. Increase in product diversity a. Growing demand for customized products has led managers to  increase the variety of products and services offered  2. Increase in direct costs a. The use of product and process technology has led to an increase  in indirect costs and a decrease in direct costs (particularly DML  costs) b. Ie CIM= computer integrated manufacturing; FMS= flexible  management systems ­computers on the manufacturing floor instruct equipment to  set up and run quickly and automatically  ­managing complex technology and producing such diverse  products also requires additional support function resources  for activities such as production scheduling, product and  process design,  c. Since DML isn’t a cost driver of these costs, allocating indirect costs on  the basics of DML does not accurately measure how resources are being used by  different products 3. Competition in the markets a. Managers feel the need to obtain more accurate cost information to help them make important strategic decisions b. Making correct decisions about pricing and product is critical in  competitive markets because competitors quickly capitalize on a  manager’s mistake(s) Guidelines for Refining a Costing System 1. Direct­cost tracing a. Identify as many direct costs as is economically feasible b.  aims to reduce the amount of costs classified as indirect,  therefore minimizing the extent to which costs have to be  allocated rather than traced 2. Indirect­cost pools a. Expand the number of indirect­cost pools until each pool is more homogenous  b. All costs in a homogenous cost pool have the same or a similar  cause­and­effect relationship with a single cost driver that is  used as the allocation base c. EX: 1 cost pool with both indirect machine­hours and indirect  distribution costs= not homogenous because machine hours are one cost driver but not both; making them two separate indirect  cost pools, they would become homogenous  3. Cost­allocation base  a. Whenever possible, managers should use the cost driver (cause of indirect costs) as the allocation base for each homogenous  indirect cost pool (the effect) Activity­Based Costing Systems ABC costing= refines a costing system by identifying individual activities as the  fundamental cost objects  Activity= an event, task, or unit of work with a specified purpose *verbs: things a firm DOES ABC systems identify activities in all functions of the value chain, calculate costs of  individual activities, and assign costs to costs objects such as products and services on  the basis of the mix of activities needed to produce each product or service* Logic of ABC systems is twofold: 1) When managers structure activity cost pools more finely with cost drivers for  each activity cost pool as the cost allocation base, it leads to more accurate  costing of activities 2) Allocating these costs to products by measuring the cost­allocation bases of  different activities used by different producs leads to more accurate product costs Cost Hierarchies ­cost hierarchy­ categorizes various activity cost pools on the basis of the different types of cost drivers, cost­allocation bases, or different degrees of difficulty in determining the  cause and effect relationships  *ABC systems commonly use a cost hierarchy with four levels to identify  cost­allocation bases that are cost drivers of the activity cost pools 1. Output unit­level costs a. The costs of activities performed on each individual unit of a product or service  i. Machine operations costs related to the activity of running the  automated molding machines are output­level unit because,  over time, the cost of this activity increases with additional units  of output produced (or machine­hours used) 2. Batch­level costs a. The costs of activities related to a group of units of a product/service  rather than each individual product/service  i. Ex material­handling and quality­inspection costs associated  with batches (not the quantities) of products produced and the  costs of placing purchase orders, receiving materials, and  paying invoices related to the number of purchase orders placed rather than the quantity or value of materials purchased  3. Product­Sustaining costs/ Service­sustaining costs a. Costs of activities undertaken to support individual products or services regardless of the number of units or batches in which the units are  produced i. Over time, design costs depend largely on the time designers  spend on designing and modifying the product, the mold, and  the process 1. These design costs are a function of the complexity of  the mold, measured by the number of parts in the mold  by the area over which the plastic must flow Other examples: research and development costs, costs of making  engineering changes, and marketing to launch new products 4. Facility­Sustaining costs a. The costs of activities that managers cannot trace to individual  products/services but that support the organization as a whole  i. Is usually difficult to find a good cause­and­effect relationship  between these costs and the cost­allocation base, so some  companies deduct facility­sustaining costs as a separate lump­ sum from operating income rather than allocating them to  products 1. They must set prices that are much greater than the  allocated costs to recover some of the unallocated  facility­sustaining costs i. Allocating all costs to products/services  ensures that managers have taken into  account all costs when making decisions  based on costs, such as pricing  Considerations in Implementing ABC Systems ­managers choose the level of detail to use in a costing system by evaluating the  expected costs of the system against the expected benefits that result from better  decisions  Benefits & Costs of ABC Systems  Signs of benefits: ­significant amounts of indirect costs are allocated using only one or two cost pools ­all or most indirect costs are identified as output­level costs (few indirect costs are  described any other way) ­products make diverse demands on resources because of differences in volume,  process steps, batch size, or complexity ­operations staff has substantial disagreement with the reported costs of manufacturing  and marketing products and services  *When managers decide to implement ABC, they must make important choices about  the level of detail to use ­main costs and limitations of an ABC system are the measurements necessary to  implement it ­requires managers to estimate costs of activity pools and to identify and  measure cost drivers for these pools to serve as cost­allocation bases ­even basic ABC systems require many calculations to determine costs of  products and services; these measures are often costly;  ­activity cost rates also need to be updated regularly  *more detail and more cost pools created= more allocations necessary to calculate  activity costs for each period, which increases the chances of misidentifying the costs  for each cost pool  ­sometimes mangers are forced to use allocation bases for which data are readily  available, instead of the allocation bases they would have liked to use  ­when incorrect allocation cost­allocation bases are used, activity­cost  information can be misleading Behavioral Issues in Implementing ABC Systems ­to successfully implement ABC systems requires more than an understanding of the  technical details; ABC implementation often represents a significant change in the  costing system ­requires a manager to choose how to define activities and the level of detail ?? Behavioral issues a manager and management accountant must be sensitive to?? 1. Gaining support of top management and creating a sense of urgency for the ABC effort 2. Creating a guiding coalition of managers throughout the value chain for the ABC  effort 3. Educating and training employees in ABC as a basis for employee empowerment 4. Seeking small short­run success as proof that ABC implementation is yielding  results 5. Recognizing that ABC information is not perfect because it balances the need for better information against the costs of creating a complex system that few managers and employees can understand  Activity­Based Management ­ABM= a method of management decision making that uses ABC information to  improve customer satisfaction and profitability  ­broadly defined to include decisions about pricing and product mid, cost  reduction, process improvement, and product and process design Pricing and Product­Mix Decisions ­an ABC system gives manages information about the costs of making and  selling diverse products ­Managers can then make pricing and product­mix decisions Cost Reduction and Process Improvement Decisions ­Managers use ABC systems to focus on how and where to reduce costs  ­set cost reduction targets for the cost per unit of the cost­allocation base  in different activity areas *goal is to reduce these costs (distribution labor, warehouse rental costs) by  improving the way work is done without compromising customer service or the  actual or perceived value (usefulness) customers obtain from the product/service *Supervisor will attempt to take out only those costs that are nonvalue added Design Decisions ­ABC systems help managers to evaluate the effect of current products and  process designs on activities and costs and to identify new designs to reduce  costs Planning and Managing Activities ­most managers implementing ABC systems for the first time start by analyzing  actual costs to identify activity­cost pools and activity­cost rates  ­managers then calculate a budgeted rate that they use for planning, making  decisions, and managing activities  ­at year end, managers compare budgeted costs and actual costs to  evaluate how well activities were managed  ­management accountants make adjustments for underallocated or  overallocated indirect costs for each activity (using method from ch 4) ­as activities and processes change, managers calculate new activity­cost  rates  ABC and Department Costing Systems  ­companies often use costing systems with features of ABC systems, such as  multiple cost pools and multiple cost allocation bases, but do not emphasize  individual activities  Many companies have evolved their costing systems from using a single  indirect cost rate system to using separate indirect cst rates for each department  or subdepartment that can represent broad tasks  *ABC systems are a further refinement of department costing systems  ABC in Service and Merchandising Companies ­originated in manufacturing, but can be used in service and merchandising  companies ­widespread use of ABC systems in service and merchandising companies  reinforces the idea that ABC systems are used by managers for strategic  decisions rather than for inventory valuation  (inventory valuation is fairly straightforward in merchandising activities) ­service companies find great value in ABC because a vast majority of their cost  structure is composed of indirect costs


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