INTRODUCTION The Role, History & Direction of Accounting

Chapter 7
Accounting Principles II
AC 2102 - Fall Semester, 1999
Limitations of Traditional
Cost Accounting Systems
• For companies operating in an advanced
manufacturing environment traditional cost
systems often are inadequate and cause the
company to operate with severe competitive
• Activity-Based Costing is a contemporary
approach that has been developed to deal with
this new and challenging environment
Characteristics of An
Advanced Manufacturing Environment
• Intense Competition
– usually on a world wide level
Continuous Improvement
Total Quality Management
Total Customer Satisfaction
Sophisticated Technology
Signs That A Company’s Cost
Accounting System May Be Outdated
• The outcome of bids is difficult to explain
• Competitors’ prices appear to be
unrealistically low
• Products that are difficult to produce show
high profits
• Operational managers want to drop products
that appear profitable
• Profit margins are difficult to explain
Signs That A Company’s Cost
Accounting System May Be Outdated
• The company has a highly profitable niche
to itself
• Customers do not complain about price
• The accounting department spends a lot of
time supplying cost data for special projects
• Some departments are using their own
accounting systems
• Product costs change because of changes in
financial reporting regulations
Two Key Characteristics of Companies
Who Need More Accurate Costing Systems
• The proportion of nonunit-related
overhead costs to total overhead costs
is large
• The degree of product diversity is great
Nonunit-Related Overhead Costs
• Using plantwide rates or departmental rates
– assumes that a product’s consumption of
overhead resources is related strictly to the units
produced (or to a single cost driver)
• But there are overhead activities that are unrelated
to the number of units produced
– Examples: Setup costs (number of batches)
Engineering design changes (number
of products or alterations requested)
• Using only unit-based activity drivers to assign
nonunit-related costs can cause distorted product
Product Diversity
• If products consume the nonunit overhead
activities in the same proportion as the unit
overhead activities,
– then no product-costing distortion will
occur with the use of traditional costing
• However if the product line contains
products that are quite diverse then such
distortions will probably be significant
Product Diversity
• When products consume overhead in
different proportions
• Products consume overhead differently
because they may be different in the
following ways:
Product size
Product complexity
Setup Time
Size of batches
Special Request of Customers
Regardless of the nature of
Product Diversity
• Product cost will be distorted whenever the
following situation prevails:
– quantity of unit-based overhead that a
product consumes does not vary in direct
proportion to the quantity consumed of
nonunit-based overhead
The Basic Logic Of
Activity-Based Costing
• Organization are really involved in
performing a variety of activities
• To carry out these activities requires
the consumption of resources
– Thus resource costs should first be
assigned to activities and then activity
costs to the products, services, customers,
etc. for which these activities were
The Two Stage Process OF
Activity-Based Costing
• 1st Stage:
– Trace costs to activities
– Rather than to an organizational unit such
as a plant or department
• 2nd Stage:
– Assign activity costs to products (or the
cost object of interest)
Some Key Features Of
Activity-Based Costing Systems
• Emphasizes direct tracing and driver tracing
– Exploiting cause-and-effect relationships
• In contrast, traditional costing systems tend
to be allocation intensive
– Largely ignoring cause-and-effect relationships
• Note:
– The principal computational difference between
the two methods concerns the nature and number
of cost drivers used
Drivers Used In
Activity-Based Costing Systems
• Uses both unit-based and nonunitbased activity drivers
• These drivers must reflect a cause-andeffect relationship
• In practical terms, drivers must explain
a large percentage of activity cost
Number of Cost Drivers Used In
Activity-Based Costing
• The number of drivers used is
generally greater than the number of
unit-based drivers commonly used in a
traditional system
• The ABC method produces increased
product-costing accuracy
First-Stage Procedure
Relating Resource Costs To Activities
• Resources:
– economic elements that are consumed in
performing activities
– examples: labor, material, electricity
• Activity:
– a basic unit of work performed within an
– examples: typing a letter, setting up a machine,
assembling a product, packaging
Determining The Cost To Perform
One Unit of An Activity
• Once an activity is defined,
– the managerial accountant must
determine the resources which are
expended in performing the activity
• The resources used in performing the
activity are identified or assigned to the
activity by
– Direct tracing
– Driver Tracing (called resource drivers)
– Cost Allocation
Reducing The Number of
Activity Overhead Rates
• Most organizations generally will perform
hundreds of activities
• To calculate the rate per unit for each of
these activities is unmanageable
• Therefore activities are grouped and the
costs for a similar set of activities are
totaled together
– This collection of costs for a set of
activities is called a homogeneous cost
How Activities Are Grouped
• To reduce the number of activity charging rates
required and to streamline the costing process,
activities are grouped in homogeneous sets
based on similar characteristics:
(1) They are logically related
(2) The have the same (or reasonably close)
consumption ratios for all products
• Since the activities within the homogeneous
cost pool have the same consumption ratio,
– costs can be assigned to all products with a
single activity driver
The Five Steps In The
First-Stage Procedures
(1) Activities are identified
(2) Costs are assigned to activities
– For resources that are consumed
(3) Related activities are grouped to form
homogeneous sets
(4) The costs of grouped activities are summed to
define homogeneous cost pools
(5) Pool (overhead charging) rates are computed
– The appropriate activity driver is selected
– Total pool costs are divided by total units of the activity
The Second Stage Procedure In
Activity-Based Costing
• Using activity cost drivers, the costs of each
overhead pool are assigned to products
• Thus, the costs of a product or service would
include the following:
– Any material or labor costs that can be directly
attached to the product or service being costed
- these costs are called prime costs
– Any other costs which would be assigned
through activity drivers
- these drivers are sometimes called pool rates
The Second Stage Procedure
Some Additional Comments
• Products or services are produced by carrying
out various activities
• The resources consumed by each activity was
determined in stage one
– From this analysis, resource consumption
costs per “unit” of activity was determined
– These calculated costs per “unit” of activity
are called activity drivers, or “pool” rates
• In the 2nd stage, these rates are used to charge
the costs of activities to products and services 22
Some Additional Comments
• Activity implies action taken or work
• Activities are generally what an
organization does to satisfy customer needs
• Activities are the building blocks for
(1) product costing
(2) continuous improvement
• The focus of activity-based costing is
Activity Identification
• Observing and listing the work performed
within an organization
• Interviews, observation, flowcharting of
operations, study of processes, counting of
document flows, etc. are all used for
identifying the activities performed within an
• Each activity is usually described by an action
verb and an object
• Once identified, activities are listed in a
document called an activity inventory
The Activity Inventory
• List of all identified activities
• List could easily contain 200 to 300 activities
• Activity attributes are used to further describe
and classify the activities
• Activity attributes
– nonfinancial and financial information items
that describe individual activities
• For product costing, then attributes which
reflect how products consume activities would
be focused on
Example of An Activity Inventory
1. Ordering materials
2. Receiving materials
3. Testing product
4. Setting up batches
5. Collecting engineering
6. Welding
7. Moving materials
8. Providing utilities
9. Providing space
10. Packaging goods
11. Shipping goods
12. Paying for materials
13. Billing customers
14. Making collections
Classification Of Activities
For Product Costing Purposes
• Activity attributes are used to group related
activities into sets that form the basis for
homogeneous cost pools
• Grouping activities has several advantages:
(1) Reduces the number of overhead rates needed
(2) Simplifies the task of product costing
(3) Decreases the overall complexity of the ABC
product costing model
Two Basic Attributes That Activities
Have To Have In Common To Be
Grouped In The Same Set
(1) Activity-level attribute
– They are performed in at the same general
– Activities that can be logically related
(2) Driver Attribute
– They can use the same activity driver to
assign costs to a cost object
– They must have the same consumption
Activity-level Classification
Building A Set of Related Activities
• Activities are classified into one the the
following four general activity categories:
(1) Unit Level
(2) Batch Level
(3) Product Level
(4) Facility Level
• Grouping activities into these categories
facilitates more accurate product costing
– because each level responds to different
types of cost drivers
Unit-level Activities
• Are activities that are performed every time
a unit is produced
• Examples:
– quantity of direct material and direct labor
activities varies with the numbe of units
– power and machine hours are used each time a
unit is produced
• The costs of unit-level activities vary with
the number of units produced
Batch-level Activities
• Are activities that are performed every time
a batch is produced
• Examples:
– Setups, production scheduling, and material
• The costs of batch-level activities vary with
the number of batches produced
– but these costs are fixed or unaffected
with respect to the number of units in
each batch
Product-level (Sustaining) Activities
• Are activities peformed as needed to
support the various products produced by
the company
• Examples:
– Engineering changes, development of producttesting procedures, marketing a product,
process engineering, and expediting
• These activities and their costs tend to
increase as the number of different products
Facility-level Activities
• Are those activities that sustain a factory’s
general manufacturing processes
• Examples:
– plant management, landscaping, support of
community programs, security, property taxes,
and plant depreciation
• These activities benefit the organization at
some level, but do not provide a benefit for
any specific product
Product-Related Categories
Activity Driver Classification
Unit Level
Batch Level
Product Level
Activities within these three categories
contain product-related activities
• It is possible to measure the demands placed
on these activities by individual products
Activity Drivers
• Factors which measure the demands
placed on activities by cost objects
• These drivers are used to assign the
cost of activities to cost objects
• Activities with the same consumption
ratios can use the same activity driver
to assign costs
Grouping Activities
All activities, within each of the first
three levels (unit, batch or product),
– can use the same activity driver to assign
– this creates a homogeneous set of
– results in a collection of activities that are
at the same level and use the same
activity drivers
Facility-level Activities
The Challenge of Cost Assignment
• Pose a problem for the ABC philosophy of
tracing costs to products
• Tracing costs to products depends on the
ability to identify the amount of each
activity consumed by a product
• But these activities are common to a variety
of products
• It is not possible to identify how individual
products consume these activities
Facility-level Activities
The Challenge of Cost Assignment
• ABC systems usually implement a full
costing approach and allocate these facilitylevel costs to products
• Unit level, batch-level, or product-level cost
drivers are often used for the allocation
• Or the total overhead charged by the first
three drivers is used as a basis for assigning
facility-level costs
Facility-level Activities
The Challenge of Cost Assignment
• The arbitrary or somewhat “crude”
assignment of facility-related costs is not a
serious problem in many instances
• The distortion in total product cost caused
by questionable allocation bases may not be
significant because these costs often make
up a relatively small portion of the total
ABC & Customer-Driven Costs
• Customer diversity just as possible as product
• Customers can consume customer-driven activities
in different proportions
• Sources of customer diversity:
– order frequency, geographic distance, sales and
promotional support, engineering support
requirements, service support
• Knowing costs of different customers can be vital
for pricing, product mix decisions and improving
Customer Costing vs. Product Costing
ABC Costing Systems
• Assigning the costs of customer service to
customers is done in the same way that
manufacturing costs are assigned to
• Include in activities inventory:
– order entry, order picking, shipping, making
sales calls, evaluating a clients credit, etc.
• Assign the costs of the resources consumed
to these activities and then to the customers
requiring or demanding these activities
Traditional Costing vs. ABC Costing
Traditional Systems
Use only unit-based
Ignore batch, product,
& facility level distinc.
Assign all fixed OH in
an arbitrary way
Do not easily permit
analysis of value &
non-value activities
Frequently distort
product costs
ABC Systems
Use all four levels of
Eplicitly consider all
four levels of activities
Arbitrary allocations
of fixed costs reduced
Allow managers to
identify which
activities add value
Improve accuracy of
product costs
Managerial Perspective On
Activity-Based Costing (1)
• Offers more than just more accurate product
cost information
• Also provides information about the costs
and performance of activities and resources
• Can be used to trace costs accurately to cost
objects other than products
– To activities,customers, channels of
distribution, etc.
Managerial Perspective On
Activity-Based Costing (2)
• Provides means to identify areas where efficiency
can be improved
• Basic Steps:
– Better understand and know the costs of activities
– Evaluate the importance of each activity to the
organization and its customers
– Better understand how efficiently each activity is
– Determine opportunities to simplify, modify, make
more efficient, or eliminate activities