Activity-Based Costing and

Activity-Based Management

Chapter 5

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 Overview

• Over/under costing
• Reasons to allocate costs
• Criteria to guide allocation
• Refining a cost system
• ABC versus traditional cost systems
• Costs/Benefits of ABC
• ABC in service & retail as well as mfg.
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 Explain undercosting
and overcosting of
products and services.

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 Undercosting and
Overcosting Example
Jose, Roberta, and Nancy order
separate items for lunch.
Jose’s order amounts to $14
Roberta’s order 30
Nancy’s 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 Roberta is

are overcosted. undercosted.

The use of broad averages to allocate costs (aka peanut-

butter costing) can lead to product-cost cross-subsidization.
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 Reasons to Allocate costs

There are many reasons

for allocating costs to
cost objects.

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 Purposes of Cost Allocation

1. To provide information for economic decisions

2. To motivate managers and other employees
3. To justify costs or compute reimbursement
4. To measure income and assets for reporting
to external parties

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 Criteria to Guide
Cost-Allocation Decisions
Cause-and-effect:
Using this criterion, managers identify the
variable or variables that cause resources
to be consumed.
Benefits-received:
Using this criterion, managers identify the
beneficiaries of the outputs of the cost object.
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 Criteria to Guide
Cost-Allocation Decisions
Fairness or equity:
This criterion is often cited on government
contracts when cost allocations are the basis
for establishing a price satisfactory to the
government and its suppliers.

Ability to bear:
This criterion advocates allocating costs in
proportion to the cost object’s ability to bear them.
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 Role of Dominant Criteria

The cause-and-effect
and the benefits- Fairness and ability-
received criteria to-bear are less
guide most frequently used.
decisions related
Why?
to cost allocations.

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 Refining a Costing System

More Direct-cost tracing

Indirect-cost pools
(More homogeneous)

Better cost-allocation bases

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 Activity-Based Costing System
Activity
Indirect Cost Design Setup Shipping
Pool

Cost Parts- No. of

Allocation Square Setup No. of
feet Hours Shipments
Base

Product
Cost Lenses Lenses Lenses
Objects NL CL Other
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 Activity-Based Management

ABM describes management decisions that use

activity-based costing information to satisfy
customers and improve profits.
Product pricing and mix decisions
Cost reduction and process improvement decisions
Design decisions
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Evaluate the costs and benefits
of implementing activity-
based costing systems.

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 Benefits of ABC Systems
(When the benefits of ABC tend to be large)

Significant amounts of indirect costs are

allocated using only one or two cost pools.
All or most costs are identified
as output unit-level costs.
Products make diverse demands on
resources because of differences in
volume, process steps, batch size,
or complexity.
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 Benefits of ABC Systems

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.
Complex products appear to be very
profitable and simple products
appear to be losing money.
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 Benefits of ABC Systems

Operations staff have significant

disagreements with the accounting
staff about the costs of manufacturing
and marketing products and services.
Operations staff may even keep their
own set of books!

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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.

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 **End of Chapter 5**
(That’s all folks!)

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