College of San Mateo

Accounting 131

Rosemary Nurre


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Chapter 8

Activity-Based Costing–

A Tool to Aid Decision Making

Learning Objectives

1. Understand activity-based costing and how it differs from a traditional costing system.

2. Assign costs to cost pools using a first-stage allocation.

3. Compute activity rates for cost pools.

4. Assign costs to a cost object using a second-stage allocation.

5. Prepare a report showing activity-based costing margins from an activity view.

6. Compare product costs computed using traditional and activity-based costing methods.

7. (Appendix 8A) Prepare an action analysis report using activity-based costing data and interpret the report.

Chapter Overview

A. Background. A few general comments will help set the stage for the chapter.

1. ABC and GAAP. Some ABC systems are used for external as well as for internal financial reports. However, in most cases, a company’s ABC system is not integrated with the company’s regular costing system. We agree with experts who argue against integrating the two systems because of their very different purposes. We have chosen to emphasize the use of activity-based costing as a decision-making tool, although a number of exercises and problems at the end of the chapter permit an instructor to explore the use of ABC as an alternative to traditional costing systems for external reporting.

2. The ABC approach taken in the chapter. In practice activity-based costing comes in many variations. We have consciously combined the best elements from practice and have added some innovations of our own. As a consequence, the material in the chapter should be regarded as ABC as it should be rather than a description of ABC as it is commonly implemented in practice.

B. Differences Between ABC and Traditional Costing. The product costs computed in this chapter differ in major ways from the product costs in Chapters 2, 3, and 4 that describe traditional costing systems.

1. Manufacturing costs in ABC. In the ABC system described in the chapter, some manufacturing costs are excluded from product costs. This treatment follows recommendations by Cooper and Kaplan and others.

a. The chapter advocates excluding the costs of idle capacity from product costs, but without getting into the details of how this is done. It would be helpful, but not absolutely necessary, for your students to have read Appendix 3A, which goes into this subject in greater depth.

b. We also exclude organization-sustaining costs from activity-based costing product costs. These costs will be discussed in more detail below. Basically, organization-sustaining costs are excluded from product costs because they are not caused by individual products and are not relevant in decisions concerning those products.

2. Non-manufacturing costs in ABC. Strictly speaking, non-manufacturing costs are excluded from product costs under GAAP. However, to the extent that these costs are caused by specific products, excluding them results in misleading information for making decisions. It is true that these non-manufacturing costs can be deducted from product revenues in addition to unit product costs when decisions are made, but this is not always done. It is probably safer to build these costs right into product costs, which is the approach taken in this chapter. (Remember, these costs are to be used for making decisions, not valuing inventory and cost of goods sold.)

3. Multiple overhead cost pools in ABC. Traditional overhead costing systems are described in Chapters 2, 3, and 4. In these traditional systems, an entire plant may have a single overhead cost pool or each production department may have a separate overhead cost pool. In nearly all cases, overhead costs are applied to products using either direct labor-hours, direct labor cost, or machine-hours. In activity-based costing, each major activity has its own separate overhead cost pool. An activity is any event that causes the consumption of resources. The activities tracked in the ABC system may cut across many departments and the measures of activity (i.e., allocation bases) may be quite different from the traditional allocation bases.

C. Cost Hierarchy in Activity-Based Costing. Thousands of activities are carried out in most organizations. It would not be practical to track all of them in an activity-based costing system. A great deal of simplification is necessary. Activities and their costs must be combined to reduce complexity and record-keeping requirements. One way to simplify is to group activities into a hierarchy. Activities, and their costs, can be combined within each level of the hierarchy into activity cost pools—hopefully with minimal loss in accuracy. The cost hierarchy used in the text is not the only scheme that could be used, but it is reasonably comprehensive. The levels in the hierarchy are as follows:

1. Unit-level activities. These activities are performed each time a unit is produced. For example, providing power to run processing equipment is likely to be a unit-level activity.

2. Batch-level activities. These activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, tasks such as placing purchase orders, setting up equipment, and arranging for shipments to customers are batch-level activities.

3. Product-level activities. These activities relate to specific products and must be carried out regardless of how many batches or units of product are produced or sold. For example, designing a product, advertising a product, and maintaining a product manager and staff are all product-level activities.

4. Customer-level activities. These activities relate to specific customers and include sales calls, catalog mailings, and general technical support not tied to any specific product.

5. Organization-sustaining activities. These activities are carried out regardless of which products are produced, how many batches are run, or how many units are made. This category of activities includes cleaning executive offices, providing a computer network, arranging for loans, preparing annual reports to shareholders, and so on.

D. Mechanics of Activity-Based Costing. Exhibit 8-6 is a useful Exhibit for summarizing the mechanics of activity-based costing. You may want to refer to it frequently as you walk students through the steps of assigning costs using ABC.

1. Overview. Once the activity cost pools and their activity measures have been defined, costs are allocated to the activity cost pools. The costs in the activity cost pools are then divided by their activity measures to determine activity rates. (Activity rates are like the overhead rates of Chapter 3.) The activity rates are then used to assign costs to cost objects such as products and customers. For example, if a customer generates five orders and the activity rate for orders is $15 per order, then the customer would be assigned $75 in order costs. The mechanics are fundamentally no different from the mechanics covered in Chapter 3 for applying overhead to products. The main difference is that instead of one predetermined overhead rate, many activity rates are used.

2. First-stage allocations. (Exhibits 8-13, 8-15, and 8-9.)The first stage in the allocation process is based on a table showing the distribution of resource consumption across activities for each category of cost in the company’s bookkeeping system. For example, if indirect factory wages is one of the accounts in the company’s bookkeeping system, the table would show what percentage of indirect wages is attributable to each of the activities in the company’s ABC system. The text describes how interviews can be used to elicit these percentage distributions, but these percentage distributions are always given in all examples and problems.

The first-stage allocation is accomplished by multiplying the total cost of each account by the percentages in its row in the table showing the distribution of resource consumption across activities. For example, if the table shows that 20% of indirect factory wages are attributable to processing batches, then 20% of the cost of indirect factory wages would be allocated to that activity cost pool.

The end product of the first stage of the allocation process is a table showing how each cost such as indirect factory wages is divided up among activity cost pools.

3. The “Other” activity cost pool. In the text one activity cost pool is usually labeled “Other.” Costs are allocated to this activity cost pool in the first stage of the allocation process but they are not subsequently allocated to products, customers, or other cost objects. This activity cost pool is supposed to capture costs of idle capacity and organization-sustaining costs that should not be allocated to cost objects because they are not caused by the cost objects. In practice, these costs are almost always allocated to cost objects—the costs of idle capacity and organization-sustaining costs are seldom segregated from other costs.

4. Computation of activity rates. (Exhibit 8-5.) The total cost assigned to an activity cost pool in the first-stage allocation is divided by the total amount of activity for the cost pool to determine the activity rate for that cost pool. Each activity cost pool has its own activity rate.

5. Second-stage allocations of costs to cost objects. (Exhibit 8-8.) The activity rates can be used to assign costs to any cost object. The activity rate is simply multiplied by the amount of activity for the cost object.

6. Product and customer margins—activity view. (Exhibit 8-9) Margins for products, customers, and other cost objects can be easily constructed using the costs in Exhibit 8-8. These costs are combined with whatever costs are directly traced to the cost object (for example, direct materials), and deducted from the sales attributable to the cost object. This is the conventional approach in activity-based costing.

E. Activity Rates and Activity-Based Management. Activity rates (i.e., the cost per unit of activity) can be useful to managers in targeting business process improvements. If activity rates are available from other organizations, an unusually high cost for carrying out a particular activity can signal room for improvement. Also, if similar activities are carried out at different locations within the same organization, activity rates can help identify which locations are most efficient. The methods used at the most efficient locations can then be applied to other locations.

F. The Impact on Product Costs of Adopting an ABC System. Unit product costs are different under activity-based costing and traditional cost systems for a number of reasons. First, some manufacturing costs (i.e., the costs of idle capacity and organization-sustaining costs) are excluded from product costs under the activity-based costing approach described in the text. Second, some non-manufacturing costs are included in product costs under activity-based costing. These two differences affect the total amount of cost allocated to products. However, even if these differences are ignored or suppressed, the unit product costs will still differ between activity-based costing and traditional costing systems. For example, if a company switches to activity-based costing for external financial reports, the total costs allocated to products will remain the same, but the pattern of allocation will differ.

The biggest changes in product costs from switching to an ABC system occur when the ABC system includes batch or product-level costs. In this case, costs ordinarily shift from high-volume products to low-volume products. Consequently, the total and per unit costs of the high-volume products decrease and the total and per unit costs of the low-volume products increase. When overhead costs are shifted from one product to another, a given dollar amount is implicitly subtracted from the total cost of one product and added to the total cost of the other product. Since the total cost of all products remains the same, what is taken away from one product must be added to another product. However, the effects on unit costs are not symmetrical. The per-unit costs of the low-volume products must go up more than the per-unit costs of the high-volume products go down.

G. Appendix 8A: ABC Action Analysis. The conventional ABC analysis discussed in the chapter has some important drawbacks for decision-making. Most importantly, with a product margin analysis such as the one shown in Exhibit 8-9, it is unclear who is actually responsible for a cost. For example, if a product is dropped because of a negative margin, it is unclear who would be responsible for actually carrying out reductions in costs. An activity cost pool may contain costs from many departments. If a product is dropped, the activities associated with the product will presumably disappear, but will the costs? If it is unclear who would be responsible for reducing the costs, no one may actually take any action. This is particularly true for personnel costs. What manager will voluntarily give up personnel if there is no accountability?

Be sure to reinforce the idea that the costs assigned to a product, customer, or whatever in an activity-based costing system are relevant in a decision only if the costs would actually change if the decision were taken. For example, in a product drop decision, the costs of resources are relevant only if spending would decrease as a result of the decision or the resources would be redeployed to more profitable uses. In the latter case, this means that the resources would have to be redeployed to the constraint.

An action analysis report makes it much clearer what costs are likely to be relevant in a decision and who in the organization would be responsible for the cost if an action is taken. Unfortunately, preparing an action analysis report requires considerably more work than the more conventional analysis.

1. Activity rates. (Exhibit 8A-2) The action analysis approach differs from the conventional ABC approach beginning with the computation of the activity rates. In the conventional analysis, a single activity rate is computed for each activity cost pool. In an action analysis, a rate is computed for each cost category within an activity cost pool. Looking at Exhibit 8A-2, only the rates at the bottom of the Exhibit would be computed in a conventional analysis. In an action analysis, the entire table is filled out.

2. Second-stage allocations. (Exhibit 8A-3) In an action analysis, an entire matrix of costs is computed rather than just a total cost for each activity cost pool. Looking at Exhibit 8A-3, only the costs at the bottom of the Exhibit would be computed in a conventional analysis. In an action analysis, the entire table is filled out by multiplying activities by the activity rates in each cell.

3. The conventional activity analysis. From the action analysis cost matrix in Exhibit 8A-3, it is easy to construct the conventional activity analysis report showing product margins. Just take the totals from the bottom of the cost matrix. Note that these costs are identical to the costs computed earlier in the chapter in Exhibit 8-8.

However, using the row totals from Exhibit 8A-3, it is possible to look at the margins of products and other cost objects from a different perspective. Instead of abstract labels like “order processing costs” for the various activity cost pools, the costs are labeled using the account titles from the company’s bookkeeping system. This makes it clear what the costs actually consist of and who in the organization would be responsible for taking action if a decision is made.

4. Ease of adjustment codes. (Exhibit 8A-4) Some costs, such as direct materials, are much easier to adjust than other costs, such as the total wages of experienced supervisors. As a consequence, some costs are more likely to be relevant in a decision than others. The ease of adjustment codes provide a way of assisting managers in making these distinctions.

a. Green. These costs adjust automatically to changes in activity without any management action. Examples include direct materials and the cost of power to run machines.

b. Yellow. These costs could, in principle, be adjusted to changes in activity, but management action would be required. Direct labor is usually such a cost, as are many discretionary expenses.

c. Red. These costs would be very difficult to adjust to changes in activity and management action would be required. Examples include time-based depreciation and many salaries.

5. Action analysis report. (Exhibit 8A-5) The action analysis report combines the cost information from the row totals in Exhibit 8A-3 with the ease of adjustment codes in Exhibit 8A-4. This report makes it much clearer where costs would need to be adjusted in the organization as the result of an action, who would be responsible for the change in costs, and which costs are likely to be relevant and which costs are likely to be irrelevant in decisions. Such an action analysis report is not the final step in the decision-making process. Further analysis, such as illustrated in Chapter 13, would be necessary before making any major decision.