Chapter 5

Activity-Based
Costing and
Activity-Based
Management
GROUPS 8: SCHOLARSHIP
 Table of contents

01 Broad Averaging and Its

Consequences

05 Implementing
Activity-Based Costing
02 Refining a Costing
System
Considerations in

03 Activity-Based Costing
Systems
06 Implementing
Activity-Based Costing
Systems

04 Cost Hierarchies 07 Activity-Based

Management
01
Explain how
broad averaging
undercosts and
overcosts products or
services
 Undercosting and Overcosting
Product undercosting—the cost measurement system
reports a cost for a product that is below the cost of the
resources the product consumes

Product overcosting— the cost measurement system

reports a cost for a product that is above the cost of the
resources the product consumes
 Product-Cost Cross-Subsidization

If a company undercosts one of its products, it will

overcost at least one of its other products (and by
contrast)

It 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
Organizations use this method to allocate costs to
products or services based on direct costs, such as
materials and labor, and indirect costs, such as
overhead expenses

This system is straightforward and easy to understand,

making it suitable for small businesses or those with less
complex operations
Design, Manufacturing, and
Distribution Processes
Design products processes: Company specifies
details of the simple and complex materials
needed for its new models.

Manufacture processes: The products are

molded, finished, cleaned, and inspected.

Distribute processes: Finished goods are

packed and sent to plants..
 Simple Costing System Using Single
Indirect-Cost Pool
Identify Select Compute
Cost-Allocation Bases to Use for Allocating Rate per Unit of Each
Cost Objects Indirect (or Overhead) Costs to the Products Cost-Allocation Base

1 2 3 4 5 6 7

Identify Identify Compute Compute

Product Direct Costs Indirect Costs Indirect Costs Total Cost of the Products
Associated With Each Allocated to the by Adding All Direct and
Cost-Allocation Base. Products Indirect Costs Assigned to
the Products
Simple Costing System Using Single
Indirect-Cost Pool

EXHIBIT 5-1
Overview of Plastim’s
Simple Costing System
 Simple Costing System Using Single
Indirect-Cost Pool
EXHIBIT 5-2
Plastim’s Product Costs Using the Simple Costing System
 Simple Costing System Using Single
Indirect-Cost Pool
5 Compute Rate per Unit of Each Cost-Allocation Base

𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐭𝐨𝐭𝐚𝐥 𝐜𝐨𝐬𝐭𝐬 𝐢𝐧 𝐢𝐧𝐝𝐢𝐫𝐞𝐜𝐭 𝐜𝐨𝐬𝐭 𝐩𝐨𝐨𝐥

𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐢𝐧𝐝𝐢𝐫𝐞𝐜𝐭 𝐜𝐨𝐬𝐭 𝐫𝐚𝐭𝐞 =
𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐭𝐨𝐭𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐜𝐨𝐬𝐭 𝐚𝐥𝐥𝐨𝐜𝐚𝐭𝐢𝐨𝐧 𝐛𝐚𝐬𝐞
$ 𝟐 , 𝟑𝟖𝟓 , 𝟎𝟎𝟎
¿
𝟑𝟗 , 𝟕𝟓𝟎 𝐝𝐢𝐫𝐞𝐜𝐭 𝐦𝐚𝐧𝐮𝐟𝐚𝐜𝐭𝐮𝐫𝐢𝐧𝐠 𝐥𝐚𝐛𝐨𝐫 𝐡𝐨𝐮𝐫𝐬
¿ $ 𝟔𝟎 𝐩𝐞𝐫 𝐝𝐢𝐫𝐞𝐜𝐭 𝐦𝐚𝐧𝐮𝐟𝐚𝐜𝐭𝐮𝐫𝐢𝐧𝐠 𝐥𝐚𝐛𝐨𝐫 𝐡𝐨𝐮𝐫
Applying Five-Step Decision-Making Process

STEP 1 IDENTIFY problem and uncertainties

STEP 2 OBTAIN information

STEP 3 MAKE future predictions

decisions by choosing among

STEP 4 MAKE
alternatives

the decision, evaluate

STEP 5 IMPLEMENT
performance, and learn
02
Present three
guidelines for
refining a costing
system
 Developments increasing
the Refining Costing Systems Demand
Growing demand for customized products led
product diversity managers to increase the variety of products and
services their companies offer

Direct manufacturing labor not a cost driver of these costs,

indirect costs with allocating indirect costs on the basis of direct
different cost drivers manufacturing labor not accurately measure how
resources are being used by different products.

As markets have become more competitive,

indirect costs with
different cost drivers
managers have to obtain more accurate cost
information to help them make important
strategic such as how to price products and which
products to sell.
 Guidelines for Refining a Costing System

Identify as many direct costs as is economically feasible,

Trace more costs as aiming to reduce costs classified as indirect amount by
direct costs minimizing the extent to which costs must be allocated
rather than traced.

Expand the number of indirect-cost pools until each pool is

Increase indirect-cost homogeneous. All costs in a homogeneous cost pool have the
pools number same or similar cause-and-effect with a single cost driver

managers should use the cost driver (the cause of indirect

Identify cost drivers costs) as the cost-allocation base for each homogeneous
indirect-cost pool (the effect).
03
Distinguish between
simple and activity-
based costing systems
 1. Basic Principle:

Simple Costing System Activity-Based Costing (ABC) System

- A more sophisticated method allocating costs based

- Allocate costs to products or
services based on a single cost
driver, typically a volume-
based metric like direct labor
hours or machine hours.
on drive costs activities.
- It identifies the activities involved in the production process
and assigns costs to products or services based on the
consumption of these activities.

=> Assuming that the cost

- ABC recognizes that various activities consume resources,
driver is the primary cause
not just volume-based metrics like direct labor hours.
of cost incurrence.
2. Cost Allocation:

Simple Costing System Activity-Based Costing (ABC) System

- Costs are allocated using a

- Costs are allocated based on the
predetermined overhead rate
specific activities that contribute to the
that is applied uniformly
incurrence of those costs
across all products or services.

- ABC identifies various cost pools corresponding to

=> This rate is usually
different activities and allocates costs to products or
calculated based on a single
services based on their consumption of these
cost driver..
activities.
3. Complexity:

Simple Costing System Activity-Based Costing (ABC) System

- This system is - More complex and requires a detailed

straightforward and analysis of activities, their cost drivers,
easy to implement. and their relationship to products or
services.

=> Requires minimal data => Implementing ABC may involve significant time
collection and analysis. and resources.
4. Accuracy:

Simple Costing System Activity-Based Costing (ABC) System

- easy to implement. - Provides more accurate

representation of product cost.
- may oversimplify cost
allocation and lead to inaccurate - considering multiple cost drivers and
product costing. their relationship to activities.

- especially in environments => It helps identifying the true cost drivers and the factors
where products or services have influencing the costs of products or services
diverse cost drivers
5. Cost Control and Decision Making:
Simple Costing System:

Simple costing systems may be sufficient for basic

cost control and decision-making purposes,
especially in environments with relatively
homogeneous products or services.
04
Describe
four-part
cost hierarchy
 Cost hierarchy definition
A cost hierarchy categorizes various activity-cost pools
on the basis of the different types of cost drivers or cost-
allocation bases, or different degrees of difficulty in
determining cause-effect (or benefits-received)
relationships.

In an ABC system, costs are categorized on the basis of the

different types of cost drivers utilized. ABC systems
commonly use a four-levels cost hierarchy. These cost
drivers differ in their relationship between the indirect cost
and the product or service.
 Four-levels cost hierarchy
1) Output unit-level costs
Output unit-level costs are the costs of
activities performed on each individual unit
of a product or service.

- These costs increase as the number of

units produced increases.
 Four-levels cost hierarchy
2) Batch-level costs
Batch-level costs are the costs of activities related
to a group of units of products or services rather
than the individual unit.

- Set-up costs are an example of batch level costs, as

this cost is incurred once for each batch, regardless
of the size of the batch.
 Four-levels cost hierarchy
3) Product-sustaining costs
Product-sustaining costs (service sustaining costs) are the
costs of activities undertaken to support individual
products or services regardless of the number of units or
batches produced.

- Design costs are an example of this type of cost.

 Four-levels cost hierarchy
4) Facility-sustaining costs
Facility-sustaining costs are the costs of
activities that cannot be traced to
individual products or services but support
the organization as a whole.

- Examples of this type of cost include general

administration, rent, and building security.

- These costs usually lack a cause-and-effect relationship

between the cost and the allocation base.
05
Cost products or
services using
activity-based
costing (ABC)
Definition:
Activity-based costing (ABC) is a method of assigning overhead
and indirect costs (such as salaries and utilities) to products and
services.

The ABC system of cost accounting is based on activities, which are

considered any event, unit of work, or task with a specific goal.

ABC assigns a cost to every activity during the production process, such as
employees testing the product or prototyping.

Manufacturing companies with a high overhead cost can use ABC to

determine where their funds are going. These organizations can see which
products are profitable because ABC provides specific cost breakdowns for
their production.
 ILLUSTRATION:
For example, a small restaurant sells 100 glasses of soda and
200 plates of food for 300 items. They receive an electric bill
at the end of the month for $300. Using these details, they can
divide the $300 electric bill by the 300 items, which equals $1
in electricity for each item. But the business uses more
electricity to make food when they compare the electricity it
uses to produce soda. This is when ABC becomes necessary.
They may choose to sell their food at a higher price than soda.
ILLUSTRATION:
The ABC formula:
The ABC formula looks for calculating the
overhead costs of a product or service.

x amount of activity cost driver

The cost pool in the formula represents the group of individual costs that an
organization associates with an activity.
The activity-base costing steps:
Step 1. Identify activities
In ABC, an activity is process that consumes overhead
resources when creating a product.
=> This stage aims to identify all activities an organization
requires when making its products.

Example activities that an organization can identify:

 Setting up machinery
 Purchasing material
 Running machines
 Assembling product
 Inspect final product
The activity-base costing steps:
Step 2. Assign cost pools
During this phase, an organization groups the total cost for every
significant activity, forming a cost pool for each activity. Each pool
can contribute to the object cost.

For example, within a cost pool for the activity involving

purchasing materials, it can include the costs for items such as
rent for the purchasing department's office space. It can also
include purchasing team members' salaries and the depreciation
of buying office equipment.
The activity-base costing steps:
Step 3. Identify cost drivers
For an organization to identify its cost drivers are the production,
purchasing, accounting, and quality control. Cost drivers directly
affect an organization's overhead cost.

An organization can divide cost drivers into three categories:

 Transaction drivers
 Duration drivers
 Intensity drivers
The activity-base costing steps:
Step 4. Calculate ABC
An organization can perform this step by dividing the
overhead costs by the cost driver activity level.

The result represents the cost per unit of activity.

An organization can charge the cost of the activity to their

products with this result by multiplying it with the number of
units, hours, or parts they use for every activity.
 ILLUSTRATION:
Montreal Bakery is a Quebec-based bakery specialized in muffins. The company
allocates $1,000 in overhead to setting up five new mixers, which represent their cost
drivers. Montreal Bakery set up one of these mixers to produce 100 chocolate muffins
every day. Using the ABC formula, the company's accountant calculates the overhead
costs for these muffins:

 Cost pool in total: $1,000

 Cost drivers: 5 mixers
 Amount of activity cost driver: 1 mixer
Formula: $200 = ($1,000 / 5) x 1

The overhead costs for the chocolate muffins were $200.

 06
Evaluate the benefits
and costs of
implementing activity-
based costing systems
 Benefits and Costs of
Activity-Based Costing Systems

Significant amounts of indirect costs are allocated

using only one or two cost pools.

All or most indirect costs are identified as output unit–level costs

(few indirect costs are described as batch-level costs, product-
sustaining costs, or facility-sustaining costs).
 Benefits and Costs of
Activity-Based Costing Systems
Products make diverse demands on resources because of differences in
volume, process steps, batch size, or complexity.

Products that a company is well suited to make and sell show

small profits, whereas products that a company is less suited to
make and sell show large profits.

Operations staff has substantial disagreement with the

reported costs of manufacturing and marketing products
and services..
07
Explain how
managers use
activity-based
costing systems in
activity-based
management
A method of management that used ABC as an integral part in
critical decision-making situations, including:
Pricing and product-mix decisions

Cost reduction and process improvement decisions

Design decisions

Planning and managing activities

 Signals that suggest that ABC implementation
could help a firm:
Significant overhead costs allocated using one or two cost pools

Most or all overhead is considered unit-level

Products that consume different amounts of resources

Products that a firm should successfully make and sell

consistently show small profits
Operations staff disagreeing with accounting over
manufacturing and marketing costs
 ABC and Service / Merchandising Firms:

ABC implementation is widespread in a variety of applications outside

manufacturing, including:
 Health Care
 Transportation
 Banking
 Telecommunications
 Retailing
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