Overview of
Activity-Based Cost Systems
for Management Control
ACCT7320, Dr. C. Bailey
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Introduction
This presentation…
• describes how ABC systems help improve
pricing and product mix decisions.
• illustrates how ABC assists in cost
management decisions by improving
processes and product designs.
Note: ABC concerns mainly indirect
(overhead) costs!
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Undercosting and Overcosting
Product undercosting:
A product consumes a relatively high level of
resources but is reported to have a relatively
low total cost.
Product overcosting:
A product consumes a relatively low level of
resources but is reported to have a relatively
high total cost.
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Undercosting and Overcosting
Irene, Roberta, and Nancy are three bank customers.
They require different activities from the bank:
• Irene banks exclusively at the ATM.
• Roberta visits the teller daily to make deposits,
withdrawals
• Nancy deposits foreign currency as well as calling
the branch frequently to ask currency rates.
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Undercosting and Overcosting
Traditional allocation bases might apply
branch overhead to accounts based on account
balances or equal amounts per account.
Irene (who never makes any demands on the
branch) will be overcosted and appear less
profitable than she should.
Roberta and Nancy may be undercosted and
appear more profitable than they are.
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Refining a Costing System
Guidelines for refining a costing system:
Direct-cost tracing – Classify as many of the
total costs as direct costs as is economically
feasible.
Indirect-cost pools – Expand the number of
cost pools until each of these pools is
homogeneous.
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Refining a Costing System
Cost-allocation basis – Identify the preferred
cost-allocation base for each indirect-cost
pool.
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Activity-Based Costing System
ABC calculates the costs of individual
activities and assigns costs to cost objects
such as products, services, or customers based
on the activities used to produce a product or
service, serve a customer, etc.
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Two-Step Allocation
Collect costs in general ledger and subsidiary
accounts (labor, material, services, deprec., etc)
Identify activity centers
Accumulate costs into activity center cost
pools
• cost driver
Allocate costs to products and services
• activity driver
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Activity-Based Costing System
Fundamental Cost Objects: Labor,
materials, etc. (All indirect to the
Product or Service)
Cost drivers
Cost of Cost of
Other Indirect Costs of Activity A Activity B, etc.
product/svc (including
other non-ABC items) Other
Activity drivers
Cost
drivers
Cost of Product,
Direct Costs
Traced Service, Customer
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Examples of Activities
Activities at a Video Rental Store:
• Replace movies on shelves
• Ring sales:
Collect money
Sign receipt
Give copy
• Accept reservations, Hold, Call customer
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ABM
Activity Analysis
Non-value-added activity
Value-added activity Increases time spent on
Increases worth of product or service but
product or service to a does not increase worth
customer Unnecessary from
Customer is willing to customer perspective
pay for Some can be eliminated
without affecting market
value or quality
Business-value-added
activities are essential
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Activities of a
Milk Truck Delivery Person
Activity Cost Driver
Driving Time; miles; area of town
Shelving Time; number of packages;
categories of products
Paperwork Time; types of customer
Waiting Type of customer?
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Cost Hierarchies
A cost hierarchy is a categorization of costs
into different cost pools on the basis of the
different types of cost drivers (cost-allocation
bases) or different degrees of difficulty in
determining cause-and-effect relationships.
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Cost Hierarchies
ABC systems commonly use a four-part cost
hierarchy to identify cost-allocation bases:
1 Output unit-level cost
2 Batch level costs
3 Product- (or service-)sustaining costs
4 Facility-sustaining costs
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Output Unit-Level Costs...
are resources sacrificed on activities
performed on each individual unit of product
or service.
• Energy
• Machine maintenance, repairs
(depreciation?)
• Labor
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Batch-Level Costs...
are resources sacrificed on activities that are
related to a group of units of product or service
• Setup hours to run a batch
• Procurement costs of placing an order
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Product-Sustaining...
or service-sustaining, costs are resources
sacrificed on activities to support individual
products or services.
• Design costs
• Engineering costs
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Facility-Sustaining Costs...
are resources sacrificed on activities that
cannot be traced to individual products or
services but support the organization as a
whole.
• General administration
• Rent
• Building security
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Decision Usefulness of Cost Hierarchies
Different levels of cost drivers:
Level Useful for Decisions Such As…
Output-unit Shall we increase production, and at what price?
Batch How often should we produce batches?
What base amount must we charge to set up a “run”,
regardless of the number a customer wants made?
Product/Service-Sustaining Should we continue to offer this service/product?
Facility-Sustaining Shall we continue in business or dissolve it?
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Major Differences,
Traditional Costing vs. ABC
Typical System ABC
One or a few indirect Many pools
cost pools
Application base may Base more likely a
be a true cost driver true cost driver
Application base often Bases likely to be
financial (direct labor cost, non-financial (# of parts,
direct material cost, etc) number of operations,
hours of testing, etc.)
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Indicators that ABC Systems
May be Appropriate
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 (unlikely to be true!).
products make diverse demands on resources
because of differences in volume, process
steps, batch size, or complexity.
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Indicators that ABC Systems May be Appropriate,
continued...
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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Indicators that ABC Systems May be Appropriate,
continued…
operations staff have significant disagreements
with the accounting staff about the costs of
manufacturing and marketing products and
services.
automation makes it difficult to assign
overhead to products using direct labor or
machine hours
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Criticisms of ABC
Significant amount of time and cost to
implement
Must overcome barriers to change
Does not conform to GAAP
Does not promote total quality management
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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
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