1
Chapter 5
Allocation of Indirect
Costs:
Simple Costing & ABC
Prepared by
Diane Tanner
University of North Florida
Simple Costing vs. ABC
•
Simple costing
• AKA ‘Traditional’ cost allocation and peanut-butter
costing
• Often acceptable for companies with
• Limited variety of goods
• Small amounts of indirect costs
• Activity-based costing
• Multiple cost pools
• Allocation of indirect costs is based on what
‘drives’ the costs
• Relatively expensive to implement
• More refined
Why Select a More Refined Costing System?
 Recent trends




Increase in product diversity
Increase in indirect costs
Advances in information technology
Competition in foreign markets
 Helps to avoid cross-subsidization
 Overcosting—a product consumes a low level of
resources, but is allocated a high cost per unit
 Undercosting—a product consumes a high level
of resources, but is allocated a low cost per unit
4
Activity-Based Costing
 What is activity-based costing?




A system of allocating indirect costs to cost objects
Utilizes multiple cost pools
Is used with normal costing
Based on activities that drive costs rather than on
volume-based denominators
 Primarily used to allocated manufacturing overhead
 Sometimes used to allocate support department costs to
divisions
Underlying Premises
Activities underlie costs.
5
Setting Up an ABC System
 Step 1: Determine the cost object.
 Step 2: Form cost pools.
 The costs of performing a particular activity are
grouped into a cost pool.
 All costs in a pool should have the same cause.
 Step 3: Select a cost driver that has a causeand-effect relationship with the costs to be
allocated.
How to Perform ABC
Step 1: Calculate the rate for each cost pool.
Estimated Cost / Estimated Activity = Rate
Step 2: Multiply each cost pool rate times the
respective actual activity to determine
allocated costs.
Step 3: Total up the allocated costs from step 2.
This results in the applied overhead cost.
Step 4: Add the allocated costs to the direct costs
of each cost object to obtain the total cost of
each cost object.
66
Considerations of ABC
 Complete analysis requires allocation beyond
manufacturing costs to include period costs
 Activity can be measured on practical capacity,
actual capacity, or other estimate
 Practical capacity preferred over actual capacity
because
 Does not hide the cost of idle capacity within
product costs
 Gives a truer cost of activities used to produce the
product
Cost Driver Selection
 Selection of the appropriate cost driver is
crucial
 Considerations in selecting a cost driver
 Experience
 Industry practices
 Cost-benefit analysis of each option under
consideration
ABC Implementation Issues
 After switching to ABC, companies may find
that only 10 to 15% of their products are
profitable
 Causes management to alter the product mix by
minimizing unprofitable products
 Causes profits to increase
 Implementation mirrors the complexity of the
organization
 Complete conversion to ABC requires auditors
to accept the system when used for financial
reporting
Cost Hierarchies
 ABC uses a 4-level cost structure to determine how far
down the production cycle costs should be pushed
Facility-level
activities
• Factory costs that impact all the products produced in
a factory, such as depreciation on the factory building,
factory insurance, factory janitors, factory supplies
Product-level
activities
• Costs specific to particular products such as training
employees how to produce it, quality control on a
product, etc.
Batch-level
activities
• Costs specific to particular batches of products such
as machine setup for a particular product, machine
maintenance between each batch, etc.
Unit-level
activities
• Costs performed every time a product is produced.
They are usually variable and correlate to the number
of products produced, such as packaging, sanding a
product edge, printing labels, etc.
Signals that Suggest that ABC
Implementation Could Help a Firm
 Significant indirect costs allocated using one or
two cost pools
 Most or all overhead is considered unit-level
 Has products that consume different amounts of
resources
 Has products that consistently show small profits
(though the products should be profit makers)
 Operations staff disagree with accounting over
manufacturing and marketing costs
Activity-Based Management
 A method of management that uses ABC as an
integral part in critical decision-making situations,
including
 Pricing and product-mix decisions
 Cost reduction and process improvement
decisions
 Design decisions
 Planning and managing activities
Activity-Based Management
 A tool in which managers analyze activities that cause
indirect costs of products or services
 Goal is to improve efficiency and effectiveness of the
activities in order to reduce costs
 Serves as the basis for numerous process
improvement programs of companies
 Helps focus managerial attention on what is most
important among the activities performed to create
value for customers
14
Comparing ABC and Traditional Costing
 Advantages of ABC over traditional costing
 ABC results in more accurate costing.
 ABC helps managers control costs better.
 ABC considers the fact that only products that use
particular resources are assigned costs.
 ABC mitigates overcosting and undercosting of cost
objects.
 Disadvantages of ABC
 Very expensive to implement
 No separation of fixed and variable costs which makes
incremental analysis difficult
15
Overcosting and Undercosting
 Occurs due to broad, equal costs allocated to all
products
Undercosting
Overcosting
Overhead allocated under ABC
is greater than if traditional is
used
Overhead allocated under ABC
is less than if traditional is used
A product consumes a relatively
high level of resources but is
reported to have a relatively
low total cost
A product consumes a relatively
low level of resources but is
reported to have a relatively
high total cost
The End
16