CHAPTER 5
Activity-Based Costing
and
Activity-Based Management
Problems with One Overhead Pool
• In the last chapter, the author indicated that one
overhead pool can lead to less accurate cost
allocation if the overhead is actually incurred in a
non-uniform fashion by each product.
• This is known as Peanut-Butter costing. You are
spreading cost evenly across all products when in
fact some products create greater or lesser
amounts of overhead.
Product Cross-Subsidization
• Undercosting – product consumes a lot of resources
but has little MOH allocated to it.
 Set price too low – may actually lose money on these.
• Overcosting – consumes fewer resources than the
allocation of MOH would suggest.
 Set price too high – you may lose market share as
competitors enter the market with a lower selling price.
Refinements in Overhead Costing
• Want to tie costs incurred to cost objects more
accurately
• 3 Improvements
 Increase direct cost tracing - pull costs out of
overhead and trace to products
 Increase number of indirect cost pools - so that all
costs in a pool have the same relationship with the
cost allocation base
 Identify appropriate cost-allocation bases for each
indirect cost pool (cause and effect)
Why is this so important?
• Refinements in our cost systems are needed more now
than ever.
 Increases in diversity of product lines and mass customization
 Increase in indirect costs as a % of the total product cost
 Price competition
• Advances in computer technology allow us to create
better cost systems.
Activity-Based Costing
• A system that deals more effectively with allocation of
overhead
• Utilizes more cost pools/ allocation bases
• Cost pools reflect activities taking place
 Purchasing all raw materials, set-up costs, design costs
• Allocation bases are units of the activity
 # of parts purchases, # of different parts
 # of setups
Cost Hierarchy
• We gather costs into pools based on the
following hierarchy of costs.




Unit-level costs
Batch-level costs
Product or Service sustaining costs
Facility sustaining costs
Unit Level Costs
• Some costs vary as the # of units completed
vary.
 Direct costs are examples of unit-level costs
 Machine operating costs increase as the number of
products worked on increases
 machine hours might the
appropriate driver to use.
Batch-level Costs
• Some costs are increased not by the # of units
but by the # of batches.
 Machine set-up, recalibration, tool and dies,
reprogramming CAD/CAM computers for each
custom order, etc.
• These costs don’t vary by direct labor hour, but
they vary as the # of batches vary. We want a
cost allocation base that reflects the batches.
Product Sustaining Costs
• We incur costs to sustain a particular product
or service.
 Manufacturing: design costs of new product
 College: costs incurred to bring a new program on
line
 Accounting: costs incurred to provide a new service
(Web Trust)
• Allocation base must reflect the # or complexity
of products or services
Facility Sustaining Costs
• These represent broad-based costs of running a particular facility
 utilities, rent of space, depreciation of the building
• It doesn’t make sense to allocate these costs on the basis of a
unit-level driver, so we might use floor space per department as
the initial allocation method.
Activity-Based Costing
• What kinds of companies would benefit from
ABC?
 Those with multiple products consuming different
amounts of indirect costs
 Those with complex, varied operations
 Those in highly competitive environments where
cost control is critical
 Those with access to accounting and information
systems expertise
How to Implement ABC
• Understand the activities in your facility
• Categorize the activities into different cost
hierarchy
• Select the allocation base which explains the
cost of the various activities identified
• Compute allocation rates
• Allocate costs to products
• Used revised data in the decision process
Activity-Based Costing
• Disadvantages
 Availability of reliable data - we may need to
redesign the information system to get what we
need
 Cost to design and implement are higher
 Some costs may feed into multiple activities.
Shared costs must be allocated to activities first
then to products
ABC and ABM
• ABC improves product costing.
 ABM uses ABC data to improve customer satisfaction and
profitability.
• ABM allows us to
 make better pricing and product mix decisions
 reduce costs and improve processes now that we understand
our costs
• design changes that might lower costs without affecting
product quality and performance
 more effectively plan and manage activities
• more effective evaluation of performance
Keep on rollin’…