Chapter 7

							                     Chapter 7
            Activity-Based Costing and
                    Management
        Key Topics:
            –Traditional versus ABC systems
            –Activities and their identification
            –Cost hierarchy
            –ABC procedures
            –ABM
            –Benefits and costs of ABC and ABM
            –Uncertainties


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   Traditional Overhead Cost
       Allocation System




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            ABC Cost Allocation
                 System




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     What Are Activities, and
     How Are They Identified?
• Activity
     Type of task or function performed in an
     organization

• Activity Identification
  * Tracking the use of resources
  * Using the cost hierarchy
  * Grouping homogeneous costs


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               Cost Hierarchy
• Organization-sustaining activities
     – Activities and costs associated with overall
       organization (lease of headquarters office space,
       salary of CEO)
• Facility-sustaining activities
     – Activities and costs associated with single
       manufacturing plant or service facility (property
       taxes, plant manager salary)
• Customer-sustaining activities
     – Activities and costs associated with a single
       customer (costs of ordering and delivery)

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               Cost Hierarchy

• Product-sustaining activities
     – Activities or costs associated with product line or
       one single product (advertising, depreciation)
• Batch-level activities
     – Activities or costs associated with each batch of
       product (set-up costs, electricity)
• Unit-level activities
     – Activities or costs associated with each unit
       (indirect materials, indirect labor)


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            ABC Procedures

1.Identify the relevant cost object
2.Identify activities
3.Assign (trace and allocate) costs to
  activity based cost pools
4.For each ABC cost pool, choose a cost
  driver


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            ABC Procedures
5.For each ABC cost pool, calculate an
  allocation rate
Allocation Rate = Activity Cost/Volume of Cost Driver


6.For each ABC cost pool, allocate
  activity costs to the cost object
Allocation = Allocation Rate * Actual Volume of Activity




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                        Using ABC
7.21 Palmer Company uses an activity
  based costing system. It has the
  following manufacturing activity areas
  and has chosen related cost drivers.
            Activity            Cost Driver
            Machine setup       Number of setups
            Material handling   Number of parts
            Machining           Machine hours
            Assembly            Direct labor hours
            Inspection          Number of finished units



Chapter 7
            Develop allocation rate
             (not shown in textbook problem)
            Activity
            Machine setup              $200,000
            Material handling          $320,000
            Machining                  $208,000
            Assembly                    $66,000
            Inspection                 $264,000
            Cost Driver
            Number of setups             4,000
            Number of parts            640,000
            Machine hours                8,000
            Direct labor hours           3,000
            Number of finished units    22,000


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            Cost allocation rates




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            Product information




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   Developing ABC unit cost




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            Selection of Cost Drivers

• Need cause and effect relationship
  between cost driver and activity costs
• Requires judgment in choosing and
  evaluating potential cost drivers
• Examples



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            What Is Activity Based
            Management (ABM)?
    The process of using ABC information
    to evaluate the costs and benefits of
    production and internal support
    activities and to identify and implement
    opportunities for improvements in
    profitability, efficiency, and quality within
    an organization


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            ABM Applied
• Customer profitability
• Product and process design
  * Focus resources on value-added
          activities
  * Reduce or eliminate non-value-
          added activities
  * Target and kaizen costing


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            ABM Applied
• Environmental costs
• Quality
  * Prevention activities
  * Appraisal activities
  * Production activities
  * Post-sales activities
• Constrained resources
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              Benefits
• Increase awareness of cause and effect
  relationships
• Promote performance improvements
• Identify non-value-added activities
• Motivate cost reduction
• Reduce arbitrariness in cost
  measurement
• Optimize use of constrained resources
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                  Costs
•   System design
•   Accounting system modifications
•   Employee training
•   Higher costs when:
    * There are more activities
    * Activities are complex
    * ABC system is complex
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     Uncertainties in ABC and
       ABM Implementation

• Choice of activities
• Choice of cost drivers
• Inability to foresee all possible uses of
  information
• Choice of denominator in allocation rate


Chapter 7