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# CHAPTER 5

Activity-Based Costing
and
Activity-Based Management

Learning Objective 1
Explain undercosting
and overcosting of
products and services.

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Background
Recall that factory overhead is applied to

## production in a rational systematic manner,

using some type of averaging. There are a
variety of methods to accomplish this goal.
between simplicity and realism.
Simple Methods
Methods
Unrealistic

Complex
Realistic

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Historically, firms produced a limited variety of

## goods while their indirect costs were relatively

small.
Allocating overhead costs was simple: use
broad averages to allocate costs uniformly
regardless of how they are actually incurred

Peanut-butter Costing

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## Over- and Undercosting

Overcosting a product consumes a low

## level of resources but is allocated high costs

per unit
Undercosting a product consumes a high
level of resources but is allocated low costs
per unit

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Undercosting and
Overcosting Example
Jose, Roberta, and Nancy order
separate items for lunch.
Joses order amounts to
\$14
Roberta consumed
30
Nancys order is
16
Total
\$60
What is the average cost per lunch?

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Undercosting and
Overcosting Example
\$60 3 = \$20

## Jose and Nancy

are overcosted.

Roberta is
undercosted.

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Cross-subsidization
If a company undercosts one of its products,

## then it will overcost at least one of its other

products; and vice versa.
The overcosted product absorbs too much
cost, making it seem less profitable than it
really is.
The undercosted product is left with too little
cost, making it seem more profitable than it
really is.

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Learning Objective 2
Present three guidelines for
refining a costing system.

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## Existing Single IndirectCost Pool System Example

Kole Corporation manufactures a normal lens
(NL) and a complex lens (CL).
Kole currently uses a single indirect-cost rate
job costing system.
Cost objects: NL and CL.

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## Existing Single IndirectCost Pool System Example

Normal Lenses (NL)
Direct materials
Direct mfg. labor
Total direct costs
Units produced:

\$1,520,000
800,000
\$2,320,000
80,000

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## Existing Single IndirectCost Pool System Example

Complex Lenses (CL)
Direct materials
Direct mfg. labor
Total direct costs
Units produced

\$ 920,000
260,000
\$1,180,000
20,000

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INDIRECT-COST
POLL

INDIRECT
COST-ALLOCATION
BASE

All
AllIndirect
IndirectCosts
Costs
\$2,900,000
\$2,900,000

50,000
50,000Direct
Direct
Manufacturing
Manufacturing
Labor-Hours
Labor-Hours
\$58 per Direct
Manufacturing
Labor-Hour

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COST OBJECT:
NL AND CL
LENSES

Indirect
IndirectCosts
Costs
Direct
DirectCosts
Costs

DIRECT
COSTS
Direct
Direct
Materials
Materials

Direct
Direct
Manufacturing
Manufacturing
Labor
Labor

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## Existing Single IndirectCost Pool System Example

Kole uses 36,000 direct manufacturing
labor-hours to make NL and 14,000 direct
manufacturing labor-hours to make CL.
How much indirect costs are allocated
to each product?

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## Existing Single IndirectCost Pool System Example

NL: 36,000 \$58 = \$2,088,000
CL: 14,000 \$58 = \$812,000
What is the total cost of normal lenses?
Direct costs \$2,320,000 +
Allocated costs \$2,088,000 = \$4,408,000
What is the cost per unit?
\$4,408,000 80,000 = \$55.10

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## Existing Single IndirectCost Pool System Example

What is the total cost of complex lenses?
Direct costs \$1,180,000 + Allocated costs
\$812,000 = \$1,992,000
What is the cost per unit?
\$1,992,000 20,000 = \$99.60

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## Existing Single IndirectCost Pool System Example

Normal lenses sell for \$60 each and
complex lenses for \$142 each.
Normal Complex
Revenue
\$60.00
\$142.00
Cost
55.10
99.60
Income
\$ 4.90
\$ 42.40
Margin
8.2%
29.9%

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## Refining a Costing System

A new competitor who sells NL at a price of

\$53 occurred.
Koles managers usual choices:
1. Cut the costs of NL to a level below \$53,or
2. Give up the production of NL

## What about if the cost of NL is incorrect

due to the simple approach in costing,
and in fact its cost is below \$53?

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## Refining a Costing System

Direct-cost tracing: Identify as many direct costs as is
economically feasible.
Indirect-cost pools:
pools: Expand
Expand the
the number
number of
of indirect
indirect cost
cost
Indirect-cost
pool
until
each
ofof
these
pools
pool
until
each
these
poolisismore
morehomogeneous.
homogeneous
Cost-allocation base: whenever possible, use the cost
driver as the cost allocation base for each homogeneous
indirect cost pool.

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## Rationale for Selecting a More

Refined Costing System
Increase in product diversity
Increase in Indirect Costs
Competition in markets

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Learning Objective 3
Distinguish between
simple and activity-based
costing systems.

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## Activity-Based Costing System

Activity-based costing (ABC): Identify

## individual activities as the fundamental cost

objects.
An activity: an event, task, or unit of work with
a specified purpose.
ABC identify activities in all functions of the
value chain.

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## Activity-Based Costing System

1.
Fundamental
Cost Objects
Activities
Costs of Activities

2.
Assignment to Other
Cost Objects
Cost of:
Product
Service
Customer

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## Activity-Based Costing System

A cross-functional team at Kole
Corporation identified 7 key activities:
a. Design products and processes.
b. Set up molding machine.
c. Operate machines to manufacture lenses.
d. Maintain and clean the molds.

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## Activity-Based Costing System

e. Set up batches of finished lenses for shipment.
f. Distribute lenses to customers.
g. Administer and manage all processes.

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Activity
Indirect Cost
Pool

Design

Setup

Shipping

Cost
Allocation
Base

PartsSquare
feet

No. of
Setup
Hours

No. of
Shipments

Product
Cost
Objects

Lenses
NL

Lenses
CL

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## Activity-Based Costing System

Total setup costs are \$300,000.
Quantity produced
No. produced/batch
Number of batches
Setup time per batch
Total setup-hours
Direct labor-hours

NL
60,000
240
250
2 hours
500
30,000

CL
15,000
50
300
5 hours
1,500
9,750

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## Activity-Based Costing System

What is the setup cost per setup-hour?
\$300,000 2,000 hours = \$150
What is the setup cost per
direct manufacturing labor-hour?
\$300,000 39,700 = \$7.54717

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## Activity-Based Costing System

Allocation setup costs using direct labor-hours:
NL: \$7.54717 30,000 = \$226,415
CL: \$ 7.54717 9,750 = \$73,585
Total
\$300,000
Allocation setup costs using setup-hours:
NL: \$150 500
= \$ 75,000
CL: \$150 1,500
= \$225,000
Total
\$300,000

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A Cautionary Tale
A number of critical decisions can be made

Should

## one product be pushed over another?

Should one product be dropped?
Accounting for overhead costs is an imprecise

## science. Accordingly, best efforts should be

put forward to arrive at a cost that is fair and
reasonable.

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Conclusions
Each method is mathematically correct.
Each method is acceptable.
Each method yields a different cost figure, which

## will lead to different gross margin calculations.

Only overhead is involved. Total costs for the
entire firm remain the samethey are just
allocated to different cost objects within the firm.
Selection of the appropriate method and drivers
should be based on experience, industry
practices, as well as a cost-benefit analysis of
each option under consideration.

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Learning Objective 4
Describe a four-part
cost hierarchy.

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Cost Hierarchies
A cost hierarchy is a categorization of costs
into different cost pools based on cost
drivers, or cost-allocation bases, or degrees
of difficulty in determining cause-and-effect
relationships.

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Cost Hierarchies
ABC systems commonly use a four-level
cost hierarchy to identify cost-allocation
bases:
1.

## Output unit-level costs

2.

Batch-level costs

3.

Product-sustaining costs

4.

Facility-sustaining costs

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## Output Unit-Level Costs

These are resources sacrificed
on activities performed on each
individual unit of product or service.
Machine operations costs: Energy,
Machine depreciation, Repairs
Cost allocation base: Machine-hours

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Batch-Level Costs
These are resources sacrificed on activities
that are related to a group of units of
product(s) or service(s) rather than to each
individual unit of product or service.
Setup costs, Procurement costs
Cost allocation base: Setup-hours

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Product-Sustaining Costs
These are resources sacrificed on activities
undertaken to support individual products or
services regardless of the number of units or
batches.
Design costs, Engineering costs
Cost-allocation base: Parts-square feet

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Facility-Sustaining Costs
These are resources sacrificed on activities that
cannot be traced to individual products or
services but support the organization as a whole.
compensation, rent, building security
Cost-allocation base: no allocation
or manufacturing labor-hours

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Learning Objective 5
Cost products or services using
activity-based costing.

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Implementing
Activity-Based Costing
Step 1

Step 2

## Identify the direct costs

of the products.

NL (60,000)
CL(15,000)

Direct material
Direct labor
Mold cleaning and
maintenance

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Implementing
Activity-Based Costing
Cleaning and maintenance costs of
\$360,000 are direct batch-level costs,
because these costs consist of workers
wages for cleaning molds after each
batch of lenses is run.

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Implementing
Activity-Based Costing
Normal Lenses (NL)
Cost Hierarchy
Description
Category
Direct materials
Unit-level
\$1,520,000
Direct mfg. labor
Unit-level
800,000
Cleaning and maint. Batch-level
160,000
Total direct costs
\$2,480,000

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Implementing
Activity-Based Costing
Complex Lenses (CL)
Cost Hierarchy
Description
Category
Direct materials
Unit-level
\$ 920,000
Direct mfg. labor
Unit-level
260,000
Cleaning and maint. Batch-level
200,000
Total direct costs
\$1,380,000

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Implementing
Activity-Based Costing
Step 3
Select the activities and cost-allocation bases to
use for allocating indirect costs to the products.
a. Design: parts-square feet (100)
b. Setup molding machine: setup hours (2,000)
c. Machine operations: machine hours (12,750)

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Implementing
Activity-Based Costing
e. Shipment setup: shipments (200)
f. Distribution: cubic feet delivered (67,500)
hours (39,750)

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Implementing
Activity-Based Costing
Step 4
Select
Identify
the cost-allocation
the indirect costs
bases
associated
to use for
allocating
with each
indirect
cost-allocation
costs to the base
products.
.
(1)
(2)
(3)
Activity
Cost Hierarchy
Total Costs
Design
Product-sustaining
\$450,000
Setups
Batch-level
\$409,200
Operations Unit-level
\$637,500

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Implementing
Activity-Based Costing
Step 4
Select
Identify
the cost-allocation
the indirect costs
bases
associated
to use for
allocating
with each
indirect
cost-allocation
costs to the base
products.
.
(1)
(2)
(3)
Activity
Cost Hierarchy
Total Costs
Shipment
Batch-level
\$810,000
Distribution
Unit-level
\$391,500
\$255,000

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Implementing
Activity-Based Costing
Step 5
Compute the rate per unit of each cost
allocation base.

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Implementing
Activity-Based Costing
Step 6
Compute the indirect costs allocated
to the products.
Design costs: total 450,000, Total parts-square feet: 100
Design costs per part-square foot:
450,000 / 100 = 45,000
NL parts-square:30, CL parts-square: 70
Design costs allocated to NL: 45,000 * 30 =135,000
Design costs allocated to CL: 45,000 * 70 =315,000

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Implementing
Activity-Based Costing
Step 7
Compute the costs of the products.
NL and CL would show three
direct cost categories.
1.
Direct materials
2.

3.

## Cleaning and maintenance

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Implementing
Activity-Based Costing
NL and CL would show six indirect cost pools.
1.

Design

2.

## Molding machine setups

3.

Manufacturing operations

4.

Shipment setup

5.

Distribution

6.

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Implementing
Activity-Based Costing
The total cost of NL: \$2,998,953
The unit cost of NL: \$49.98
The total cost of CL: \$1,981,047
The unit cost of CL: \$132.07

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Learning Objective 6
Use activity-based
costing systems for
activity-based management.

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Activity-Based Management
ABM is a method of management decision making
that uses activity-based costing information
to satisfy customers and improve profits.
Product pricing and mix decisions
Cost reduction and process improvement decisions
Design decisions
Planning and managing activities

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## Product Pricing and

Mix Decisions
ABC gives management insight into the cost
structures for making and selling diverse products.
It provides more accurate product cost information
and more detailed information on costs of activities
and the drivers of those costs.

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## Cost Reduction and Process

Improvement Decisions
Manufacturing and distribution personnel use ABC
systems to focus on how and where to reduce costs.
Managers set cost-reduction targets in terms of
reducing the cost per unit of the cost-allocation
base in different activity areas and take out of those

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Design Decisions
Management can identify and evaluate new designs
to improve performance by evaluating how product
and process designs affect activities and costs.
Companies can work with their customers to
evaluate the costs and prices of alternative designs.

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## Planning and Managing Activities

Companies specify budgeted costs for activities and
use budgeted cost rates to cost products.
At year-end, budgeted costs and actual costs are
compared to provide feedback on how well
activities were managed.

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Learning Objective 7
Compare activity-based costing
systems and departmentcosting systems.

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## ABC and Department

Indirect-Cost Rates
In many situations, department costing systems
can be refined by ABC,
because the cost drivers of resources in each
department or sub-department differ from the
single, company-wide, cost-allocation base.

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## ABC and Department

Indirect-Cost Rates
ABC: two cost pools, setup cost pool and
machine operation cost pool; setup-hours and
operation-hours
ABC leads to more-focused and homogenous cost
pools, identifies cost-allocation bases with better
cause-effect relationship with cost pools, hence
provides more accurate cost information.

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Learning Objective 8
Evaluate the costs and benefits
of implementing activity-based
costing systems.

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## Warning Signs That Suggest That ABC

Could help a Firm
1. Significant amounts of indirect costs are
allocated using only one or two cost pools.
2. All or most costs are identified as output
unit-level costs.
3. Products make diverse demands on
resources because of differences in volume,
process steps, batch size, or complexity.

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## Warning Signs That Suggest That ABC

Could help a Firm
4. Products that a company is well-suited to
make and sell show small profits while
products for which a company is less suited
show large profits.
5. Operations staff have significant
disagreements with the accounting staff about
the costs of manufacturing and marketing
products and services.

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## Limitations of ABC Systems

The main limitations of ABC are the
measurements necessary to
implement the system.
ABC systems require management
to estimate costs of activity pools
and to identify and measure cost
drivers for these pools.

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## Limitations of ABC Systems

Activity-cost rates also need to be
updated regularly.
Very detailed ABC systems are costly
to operate and difficult to understand.

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## ABC In Service and

Merchandising Companies
The general approach to ABC in the
service and merchandising areas is very
similar to the approach in manufacturing.
Costs are divided into homogeneous cost
pools and classified as output unit-level,
batch-level, product- or service-sustaining,
and facility-sustaining costs.

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## ABC In Service and

Merchandising Companies
The cost pools correspond to key activities.
Costs are allocated to products or customers
using activity drivers or cost-allocation
bases that have a cause-and-effect
relationship with the cost in the cost pool.