53. Activity-Based Costing (ABC) and Life Cycle Costing

Question 1

Briefly describe the two potential errors of using traditional costing methods in a large, complex organization.

Answer 1

• Cross-subsidization error: This error occurs when costs being consumed by one type of customer are being allocated in error to another type of customer.
• Allocation of common fixed costs: When high-level administrative costs that are unrelated to any activities taking place at the customer or product line level are allocated among the products, the profit performance for all business units is dampened. This could push a product or customer to a “reported” loss.

Question 2

Briefly describe the focus of the activity-based costing (ABC) model and the hierarchy of types of activities that an ABC model uses.

Answer 2

• The ABC model focuses on breaking down and identifying how costs are actually consumed in an organization, and then fully costing product lines or customer lines using activities as the cost assignment base.
• The ABC model uses a hierarchy of types of activities to identify the variable nature of cost consumption. The types of activities in the ABC hierarchy include unit-level activities, batch-level activities, product line activities, and facility support activities

Question 3

What are the main benefits of activity-based costing (ABC)?

Answer 3

• ABC methods provide more accurate measures of costs of products, customers, sales agents, business units, market regions, etc.
• ABC methods can be used to identify value-added and non-value-added activities and costs.
• ABC methods support a more strategic view of cost management and product mix decisions

Question 4

What are the main limitations of activity-based costing (ABC)?

Answer 4

• ABC methods are more costly and time intensive to design, implement, and maintain.
• ABC cost consumption relationships are based on a longer time horizon than traditional systems, so substantial time and effort are needed to adjust spending on many of the activities used in the ABC solution.
• Profit-and-loss reports based on ABC methods may not conform to external reporting requirements, so organizations may need to maintain more than one version of their cost system

Question 5

What does the life-cycle costing method provide organizations?

Answer 5

• Life-cycle costing provides organizations with a more complete view of the costs of establishing and sustaining a product or customer.
• The life cycle for a product begins in the research and development stage.
• By tracking upstream costs prior to the manufacture of a product and downstream costs subsequent to the manufacture and delivery of a product, organizations can establish a more strategic view of managing all three core product stages: R&D, production, and post-sale support.