Chapter 10- Activity Based Costing and Management
-gross margin is not suited for a measure of product profitability; this metric is designed for
financial reporting and not for decision making because it often excludes controllable costs and
includes noncontrollable costs
-contribution margin ignores changes in capacity costs
-profit margin- (CM-cost of capacity resources) appropriate for evaluating long-term
profitability
-Four steps in designing a product costing system:
1. determine how to form cost pools
2. identify which cost pools to allocate (to separate the costs of capacity resources into
controllable and noncontrollable costs to properly evaluate the impact of various long-term
decisions on profitability)
3. identify the cost driver to use for allocating each cost pool
4. determine the appropriate denominator volume of each cost driver to calculate allocation rates
-activity-based costing (ABC)- an approach to determine product costs (controllable costs of
capacity resources)
STEP 1: Forming Cost Pools
-ABC systems use activities as the basis for forming cost pools
-an organization is a set of coordinated business processes
-business process- converts organizational inputs into a measurable output; a collection of
activities—form cost pools by the activities that make up a business process; captures the notion
that products require activities and activities consume resources
Example- purchase order processing, inventory management, production scheduling, production
operations, quality control, sales order processing
-classify activities into one of four categories
1. unit-level activities- proportional to product volume; the more units a firm produces the
greater machining, assembly, and inspection times
Example- assembly, inspection, and machining
2. bath-level activities- pertain to a group of units; executing production orders and customer
orders that may pertain to many units
Example-receive and process customer orders, issue and process production orders
3. product-or customer-level activities- relate to a specific product or a specific customer; such
activities do not relate to a production volume or batch, rather these activities relate to
introducing a product, maintaining it, or enhancing its features
Example- product-specific advertising and the work of product managers and product engineer,
production and marketing support, warehouse products
4. facility-level activities- sustain the business; not specific to any particular unit, batch, or
product, but pertain to the business as a whole
Example-activities performed by security personnel, building and grounds maintenance, and
general administration staff
To determine the costs in each cost pool- need to analyze each account to determine the activities
facilitated by the expenditure
STEP 2: Deciding Which Costs to Allocate
-ABC focuses on controllable costs and the traditional allocation approach allocates all
manufacturing costs and expenses regardless of their controllability
-cost pool 8 includes expenses as the salaries of administrative personnel that are only
controllable at the business levelnot going to be allocated
STEP 3: Identifying Cost Drivers
-identify an appropriate cost driver/allocation basis for each pool
-an appropriate cost driver is one that has a the strongest casual relation with the costs in the cost
pool
-production support cost pool; the cost driver can be traced to each product line
-marketing support cost pool; can be a subjective estimate because marketing and sales staff do
not keep detailed time sheets
-warehousing cost pool; the cost driver is the % area occupied
STEP 4: Measuring Denominator Volume
-ABC systems frequently use practical capacity as the denominator volume when calculating
allocation rates
-traditional systems compute allocation rates by dividing the costs in the cost pool by the actual
or budgeted volume in any given period-this spreads the capacity costs over actual or budgeted
volume regardless of whether we use, or expect to use, available capacity fully; this means when
production volume is low we spread capacity costs over a smaller production volume, driving up
allocation rates which will make products seem costlier
-ABC systems use practical capacity which is an estimate of the maximum possibly activity
level, as the basis to allocate capacity costs; this means it does not change across periods. If a
product consumes the same amount of resources the costs allocated to it will stay the same
(method assigns capacity costs to products strictly in proportion to use)
Computing Product Costs
1. Compute the allocation rate
2. Multiply the rate by the number of cost driver units in a cost object
-perform these steps for each cost pool then add the costs across the pools to get the product cost
Cross subsidizing- we allocate more than a proportionate share of capacity costs to high-volume
products when we use volume-based drivers such as direct labor hours; because total overhead is
the same, volume-based allocations generally underreport costs for low-volume products
-facility level costs are not allocated because they are not controllable at the product level
-activity-based management- how to use the information from ABC systems to improve
profitability by managing products, customers, and resources
-ABC provides useful information for product planning by providing accurate estimates of
profit margin
-a firm cannot survive unless its products have a positive profit margin
-customer planning --examine the profitability of individual customers and market segments
and take appropriate actions to improve profitability
-whale curve- most business have a mix of high and low profit customers and it can be
presented in this curve