Activity-Based Costing: A Tool to Aid Decision Making Chapter McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc All rights reserved Activity–Based Costing (ABC) ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect “fixed” as well as variable costs ABC is a good supplement to our traditional cost system I agree! 8-2 How Costs are Treated Under Activity–Based Costing ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways ways Manufacturing costs Nonmanufacturing costs Traditional product costing ABC product costing  ABC assigns both types of costs to products 8-3 How Costs are Treated Under Activity–Based Costing ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways ways Traditional product costing Nonmanufacturing costs Mo st, b ut not all Some All Manufacturing costs ABC product costing  ABC does not assign all manufacturing costs to products 8-4 How Costs are Treated Under Activity–Based Costing Level of complexity ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways ways Activity–Based Activity–Based Costing Costing Departmental Departmental Overhead Overhead Rates Rates Plantwide Plantwide Overhead Overhead Rate Rate Number of cost pools  ABC uses more cost pools 8-5 How Costs are Treated Under Activity–Based Costing ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways ways Each Each ABC cost cost pool pool has has its its own own unique unique measure measure of activity Traditional Traditional cost cost systems systems usually usually rely rely on on volume volume measures measures such such as as direct direct labor labor hours hours and/or and/or machine machine hours hours to to allocate allocate all all overhead overhead costs costs to to products products  ABC uses more cost pools 8-6 How Costs are Treated Under Activity–Based Costing Activity An event that causes the consumption of overhead resources Activity Cost Pool A “cost bucket” in which costs related to a single activity measure are accumulated $$ $ $ $ $ 8-7 How Costs are Treated Under Activity–Based Costing Activity Measure The term cost driver is also used to refer to an activity measure An allocation base in an activity-based costing system 8-8 How Costs are Treated Under Activity–Based Costing Two common types of activity measures: Transaction driver Duration driver Simple count of the number of times an activity occurs A measure of the amount of time needed for an activity 8-9 How Costs are Treated Under Activity–Based Costing ABC defines five levels of activity that largely not relate to the volume of units produced Traditional Traditional cost cost systems systems usually usually rely rely on on volume volume measures measures such such as as direct direct labor labor hours hours and/or and/or machine machine hours hours to to allocate allocate all all overhead overhead costs costs to to products products 8-10 How Costs are Treated Under Activity–Based Costing Unit-Level Activity Batch-Level Activity Manufacturing companies typically combine their activities into five classifications Product-Level Activity Organizationsustaining Activity Customer-Level Activity 8-11 Characteristics of Successful ABC Implementations Strong top management support Link to evaluations evaluations and rewards Cross-functional involvement 8-12 Targeting Process Improvement Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvements While the theory of constraints approach discussed in Chapter is a powerful tool for targeting improvement efforts, activity rates can also provide valuable clues on where to focus improvement efforts Benchmarking Benchmarking can can be be used used to to compare compare activity activity cost cost information information with with world-class world-class standards standards of of performance performance achieved achieved by by other other organizations organizations 8-13 Activity-Based Costing and External Reporting Most companies not use ABC for external reporting because 1 External External reports reports are are less less detailed detailed than than internal internal reports reports 2 ItIt may may be be difficult difficult to to make make changes changes to to the the company’s company’s accounting accounting system system 3 ABC ABC does does not not conform conform to to GAAP GAAP 4 Auditors Auditors may may be be suspect suspect of of the the subjective subjective allocation allocation process process based based on on interviews interviews with with employees employees 8-14 ABC Limitations Substantial resources required to implement and maintain Resistance to unfamiliar numbers and reports Desire to fully allocate all costs to products Potential misinterpretation of unfamiliar numbers Does not conform to GAAP Two costing systems may be needed 8-15 Appendix 8A: ABC Action Analysis Conventional ABC analysis does not identify potentially relevant costs An action analysis report helps because it: • Shows what costs have been assigned to a cost object • Indicates how difficult it would be to adjust those costs in response to changes in the level of activity 8-16 Appendix 8B A A modified modified form form of of activity-based activity-based costing costing can can be be used used to to develop develop product product costs costs for external external financial financial reports reports ABC ABC product product costs: costs: •• Include Include organization-sustaining organization-sustaining costs costs and and unused unused capacity capacity costs costs •• Exclude Exclude nonmanufacturing nonmanufacturing costs costs even even ifif they they are are caused caused by by the the products products 8-17 End of Chapter 8-18 ... Activity–Based Costing ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways ways Manufacturing costs Nonmanufacturing costs Traditional... Activity–Based Costing ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways ways Traditional product costing Nonmanufacturing costs... Costing Level of complexity ABC ABC differs differs from from traditional traditional cost cost accounting accounting in in three three ways ways Activity–Based Activity–Based Costing Costing Departmental