Chapter 11 - Activity-based costing Flashcards
11.1 Define cost smoothing and explain how managers can determine whether it occurs with their costing system.
We might use the term cost smoothing to describe a costing approach that uses broad averages to uniformly assign the cost of resources to cost objects when the individual products, services or customers in fact use those resources in a non-uniform way.
Cost smoothing can lead to undercosting or overcosting of products or services
(1) Explain undercosting and overcosting of products
Cost smoothing can lead to undercosting or overcosting of products or services
Product undercosting - a product consumes a relatively high level of resources but is reported to have a relatively low cost
Product overcosting - a product consumes a relatively low level of resources but is reported to have a relatively high total cost
Companies that undercost products may actually make sales that result in losses under the erroneous impression that these sales are profitable. That is, these sales bring in less revenue than the cost of the resources they use.
Companies that overcost products run the risk of losing market share to existing or new competitors.
What does product-cost cross-subsidisation mean?
Product-cost cross-subsidisation means that at least one miscosted product is resulting in the miscosting of other products in the organisation
Define a “refined costing system”
Refined costing system - reduces the use of broad averages for assigning the cost of resources to cost objects and provides better measurement of the costs of indirect resources used by different cost objects - not matter how differently the different cost objects use indirect sources
(2) Present three guidelines for refining a costing system
Direct-cost tracing: Classify as many of the total costs as direct costs of the cost object as economically feasible. This guideline aims to reduce the amount of costs classified as indirect
Indirect-cost pools: expand the number of indirect-cost pools until each of these pools is more homogeneous. In a homogenous cost pool, all of the costs have the same or similar cause-and-effect (or benefits-received) relationship with the cost-allocation base.
Cost-allocation bases: use the cause-and-effect criterion, when possible, to identify the cost-allocation base (the cause) for each indirect cost pool (the effect)
(3) Distinguish between the traditional and the activity-based costing approaches to designing a costing system
Activity-based costing systems (ABC) refine costing systems by focusing on individual activities as the fundamental cost objects
An activity is an event, task or unit of work with a specified purpose, for example designing products, setting up machines, operating machines and distributing products
ABC systems focus on indirect costs because direct costs can be traced to products and jobs relatively easy
By defining activities and identifying the costs of performing each activity, ABC systems seek a greater level of detail in understanding how an organisation uses its resources (keep in mind the three features for refining a costing system)
The logic of ABC systems is that more finely structured activity-cost pools with activity-specific cost-allocation bases, which are cost drivers for the cost pool, are considered to lead to more accurate costing of activities
(4) Describe a four-part cost hierarchy
A cost hierarchy categorises costs into different cost pools on the basis of the different types of cost driver (or cost-allocation base) or different degrees of difficulty in determining cause-and effect (or benefits-received) relationships.
(1) Output-unit-level costs are resources sacrificed on activities performed on each individual unit of a product or service. Manufacturing operations costs (such as energy, machine depreciation, and repair) that are related to the activity (the cost of this activity increases with each additional unit of output produced)
(2) Batch-level costs are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. In companies that purchase many different types of direct materials, procurement costs can be significant. Procurement costs include the costs of placing purchase orders, receiving materials, and paying suppliers. These costs are batch-level costs because they are related to the number of purchase orders placed rather than to the quantity or value of materials purchased.
(3) Product-sustaining (or service-sustaining) costs are resources sacrificed on activities undertaken to support individual products or services.
(4) Facility-sustaining costs are resources sacrificed on activities that cannot be traced to individual products or services, but which support the organisation as a whole. It is usually difficult to find good cause-and-effect relationships between these costs and a cost- allocation base. This lack of a cause-and-effect relationship causes some companies not to allocate these costs to products and instead to deduct them from operating income. Other companies, allocate facility-sustaining costs to products on some basis – for example, direct manufacturing labour-hours – because management believes all costs should be allocated to products. Allocating all costs to products or services becomes particularly important when management wants to set selling prices on the basis of a cost number that seeks to include all costs.
(5) Cost products or services using activity-based costing
Step 1 - identify the chosen cost objects
Step 2 - identify the direct costs of the products
Step 3 - select the cost-allocation bases to use for allocating indirect costs to the products
Step 4 - identify the indirect costs associated with each cost-allocation base
Step 5 - compute the rate per unit of each cost-allocation base used to allocate indirect costs to the products
Step 6 - compute the indirect costs allocated to the products
Step 7 - compute the total costs of the products by adding all direct and indirect costs assigned to them
We emphasise two key features of ABC systems. First, these systems identify all costs used by products, whether the costs are variable or fixed in the short run. Why? Because the focus of ABC systems is on longer-run decisions when more of the costs can be managed and fewer costs are regarded as fixed and given. Hence, ABC systems identify all resources used by products regardless of how individual costs behave in the short run. Second, as we have already described, recognising the hierarchy of costs is critical when allocating costs to products. It is easiest to use the cost hierarchy to calculate total costs. For this reason, we recommend calculating total costs first. The per-unit costs can then be easily calculated by dividing total costs by the number of units produced.
Define activity-based management
Activity-based management (ABM) describes management decisions that use activity-based costing information to satisfy customers and manage profitability
(6) How can managers use activity-based costing systems for activity-based management ?
Pricing and product-mix decisions - An ABC system gives management particular insights into the cost structures for making and selling diverse products. As a result, management can make pricing and product-mix decisions.
Cost reduction and process improvement decisions - Manufacturing and distribution personnel use ABC systems to focus cost reduction efforts. Managers set cost reduction targets in terms of reducing the cost per unit of the cost-allocation base in different activity areas
Design decisions - Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can then work with their customers to evaluate the costs and prices of alternative design choices.
Planning and managing activities - Most companies implementing ABC systems for the first time analyse actual costs to identify activity-cost pools and activity-cost rates. Many companies then use ABC systems for planning and managing activities. They specify budgeted costs for activities and use budgeted cost rates to cost products using normal costing. At year-end, budgeted and actual costs are compared in order to provide feedback on how well activities were managed. Adjustments are also made for under- or overallocated indirect costs for each activity area using the methods described in Chapter 3 (adjusted allocation-rate approach, proration or write-off to cost of goods sold)
(7) Compare activity-based costing and department-costing systems
Using department indirect-cost rates to allocate costs to products results in the same product costs as activity-cost rates if (1) a single activity accounts for a sizable fraction of the department’s costs, or (2) significant costs are incurred on different activities within a department but each activity has the same cost-allocation base, or (3) significant costs are incurred on different activities with different cost-allocation bases within a department but different products use resources from the different activity areas in the same proportions. Where any one of these three conditions holds, using department indirect-cost rates rather than activity rates is often adequate. In companies where none of these conditions hold, department costing systems can be refined using ABC. Emphasising activities leads to more focused and homogeneous cost pools, and aids in identifying activity-cost-allocation bases that have a better cause-and-effect relationship with the costs in activity-cost pools. But the benefits of an ABC system must be balanced against its costs and limitations.
Name 6 signals that indicate ABC systems are likely to provide benefits
1 Significant amounts of indirect costs are allocated using only one or two cost pools.
2 All or most indirect costs are identified as output-unit-level costs (i.e. few indirect costs are described as batch-level, product-sustaining or facility-sustaining costs).
3 Products make diverse demands on resources because of differences in volume, process steps, batch size or complexity.
4 Products that a company is well suited to make and sell show small profits, whereas products that a company is less suited to produce and sell show large profits.
5 Complex products appear to be very profitable, and simple products appear to be losing money.
6 Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.
(8) Appreciate the significance of organisational context issues in activity-based costing/ management system design and implementation
- Organisations are subject to a variety of social and behavioural influences.
One manager’s aspirations will differ from the pursuits of another at the personal level.
Different individuals tend to be motivated in different ways by common reward criteria. Moreover, individuals behave differently when working in teams as opposed to operating individually.
Organisations have distinct cultures and sub-cultures and, often, political influence at the corporate level is tied to ‘belonging’ to particular groups or cliques or is simply determined by functional specialism.
It is important to recognise that the implementation of a novel cost management approach can, in part, be the outcome of pressure for change as articulated by influential groups within the enterprise who show a preference for more financially oriented approaches to managerial control
Bureaucracies are more likely to adopt and implement ABC
Resistance to accounting system change is often present
Aside from organisational culture and related contextual factors, it is likely that attitudes towards and preferences for cost management practices are influenced by wider factors which can be nationally rooted
11.10 How is an activity-based approach different from a traditional approach to designing a job- costing system?
An ABC approach differs from the traditional approach by its fundamental focus on activities. An ABC approach typically results in (a) more indirect-cost pools than the traditional approach, (b) more cost drivers used as cost- allocation bases, and (c) more frequent use of non-financial variables as cost-allocation bases.
