Activity-Based Costing and
Activity-Based Management
Chapter 5
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Overview
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Over/under costing
Reasons to allocate costs
Criteria to guide allocation
Refining a cost system
ABC versus traditional cost systems
Costs/Benefits of ABC
ABC in service & retail as well as mfg.
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Explain undercosting
and overcosting of
products and services.
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Undercosting and
Overcosting Example
Jose, Roberta, and Nancy order
separate items for lunch.
Jose’s order amounts to
$14
Roberta’s order
30
Nancy’s order is
16
Total
$60
What is the average cost per lunch?
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Undercosting and
Overcosting Example
$60 ÷ 3 = $20
Jose and Nancy
are overcosted.
Roberta is
undercosted.
The use of broad averages to allocate costs (aka peanutbutter costing) can lead to product-cost cross-subsidization.
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Reasons to Allocate costs
There are many reasons
for allocating costs to
cost objects.
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Purposes of Cost Allocation
1. To provide information for economic decisions
2. To motivate managers and other employees
3. To justify costs or compute reimbursement
4. To measure income and assets for reporting
to external parties
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Criteria to Guide
Cost-Allocation Decisions
Cause-and-effect:
Using this criterion, managers identify the
variable or variables that cause resources
to be consumed.
Benefits-received:
Using this criterion, managers identify the
beneficiaries of the outputs of the cost object.
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Criteria to Guide
Cost-Allocation Decisions
Fairness or equity:
This criterion is often cited on government
contracts when cost allocations are the basis
for establishing a price satisfactory to the
government and its suppliers.
Ability to bear:
This criterion advocates allocating costs in
proportion to the cost object’s ability to bear them.
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Role of Dominant Criteria
The cause-and-effect
and the benefitsreceived criteria
guide most
decisions related
to cost allocations.
Fairness and abilityto-bear are less
frequently used.
Why?
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Refining a Costing System
More Direct-cost tracing
Indirect-cost pools
(More homogeneous)
Better cost-allocation bases
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2009 Foster School of Business
Cost Accounting
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Activity-Based Costing System
Activity
Indirect Cost
Pool
Design
Setup
Shipping
Cost
Allocation
Base
PartsSquare
feet
No. of
Setup
Hours
No. of
Shipments
Product
Cost
Objects
Lenses
NL
Lenses
CL
Lenses
Other
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2009 Foster School of Business
Cost Accounting
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Activity-Based Management
ABM describes management decisions that use
activity-based costing information to satisfy
customers and improve profits.
Product pricing and mix decisions
Cost reduction and process improvement decisions
Design decisions
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Evaluate the costs and benefits
of implementing activitybased costing systems.
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2009 Foster School of Business
Cost Accounting
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Benefits of ABC Systems
(When the benefits of ABC tend to be large)
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.
Products make diverse demands on
resources because of differences in
volume, process steps, batch size,
or complexity.
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2009 Foster School of Business
Cost Accounting
L.DuCharme
Benefits of ABC Systems
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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2009 Foster School of Business
Cost Accounting
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Benefits of ABC Systems
Operations staff have significant
disagreements with the accounting
staff about the costs of manufacturing
and marketing products and services.
Operations staff may even keep their
own set of books!
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Cost Accounting
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Limitations of ABC Systems
The main limitations of ABC are the
measurements necessary to
implement the system.
ABC systems require management
to estimate costs of activity pools
and to identify and measure cost
drivers for these pools.
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2009 Foster School of Business
Cost Accounting
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Limitations of ABC Systems
Activity-cost rates also need to be
updated regularly.
Very detailed ABC systems are costly
to operate and difficult to understand.
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Cost Accounting
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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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2009 Foster School of Business
Cost Accounting
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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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2009 Foster School of Business
Cost Accounting
L.DuCharme
**End of Chapter 5**
(That’s all folks!)
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2009 Foster School of Business
Cost Accounting
L.DuCharme