Session 6 and 7: Cost Allocation and Activity-Based Costing

Question 1

Why do firms allocate costs?

Answer 1

(1) to provide information for decision-making;
(2) to calculate the ‘full cost’ of products for GAAP reporting (i.e. P&L)
(3) to reduce frivolous use of common resources (Planning + Control / Drive the right behaviours)
(4) to encourage evaluation of internally provided services (Planning + Control / Drive the right behaviours)

Question 2

What are some of the reasons cost allocation is considered ineffective?

Answer 2

• It may fail to drive correct behaviour re. use of central services
• It may not be useful for external reporting (e.g. tax / GAAP)
• It may not facilitate meaningful dialogue on cost controls
• It may fail to provide transparency on true cost of service

Question 3

What is the formula for traditional O/H cost allocation (across departments)?

Answer 3

Department O/H absorption rates = Overhead Costs / Allocation Base Volume

i.e. Stage 1, O/H traced to departments, Stage 2 O/H assigned to cost objects

Question 4

What are some of the issues with traditional cost allocation?

Answer 4

1. Allocations of costs that are not controllable (and
   then using for evaluation purposes within a
   Responsibility Accounting System)
2. Inherently arbitrary allocations (leading to
   unproductive internal debates re alternatives etc.)
3. Allocations that ‘unitize’ fixed costs (ie make them
   appear variable), instead of lump-sum FC allocations
4. Using too few overhead cost pools (thereby reducing
   allocation bases & allowance for variation in pools used)
5. Using only volume-related allocation bases (which
   don’t drive all costs e.g. batch set-ups, inspection etc.)

Question 5

What is activity based costing (ABC)?

Answer 5

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

Question 6

How does activity based costing work?

Answer 6

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.

KEY TAKEAWAYS
- Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services.
- The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task with a specific goal.
- An activity is a cost driver, such as purchase orders or machine setups.
- The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate the amount of overhead and indirect costs related to a particular activity.
ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy.

Question 7

How is ABC a broader perspective than traditional cost allocation?

Answer 7

Costs are not only allocated to products. Resources (e.g. salaries, materials, etc.) are assigned to activity cost pools. Activity drivers then assign these to cost objects.

“Activities consume resources, cost objects consume activities…”

ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for more costly products.

Question 8

What is the primary challenge with ABC?

Answer 8

It is data intensive and can require more time and resource to implement than the benefits gained.

Another problem is that because ABC is used to develop the full cost of products, it does not measure incremental costs needed to produce an item, and incremental costs are needed for decision analysis.

Question 9

What are the two stages and four steps in ABC?

Answer 9

Step 1: Identify major activities.
Step 2: Group costs of activities into cost pools.
Step 3: Identify measures of activities - the cost drivers.
Step 4: Relate costs to products using cost drivers.

(1) Trace OH to activity cost pools, associated with distinct activity cost drivers.
(2) Assign costs to jobs based on activity OH cost rates, i.e. : the ratio of OH accumulated in each activity cost pool to the corresponding level of the activity cost driver.

Question 10

How do the two stages in ABC differ from the two steps in traditional cost allocation?

Answer 10

In the first step, trace O/H to over activity cost pools, rather than departments (cost pools).
In the second step, assign costs to jobs based on activity O/H rates, rather than production department O/H rate

Question 11

What are the reasons to implement ABC instead of traditional O/H allocation?

Answer 11

• More accurate costing of products/services for decision
making e.g. less likely to under-cost complex, low volume
products and over- cost simple, high volume products;
• Improvements in cost control given
(a) managers motivated to reduce consumption of ‘cost drivers’ (which should have a valid cause-effect relationship with costs)
(b) insight on cost/efficiency of individual value-added/non-value added activities e.g. benchmarking activity cost between plants
(c) facilitates process improvements via across- organization analysis/costing of connected activities e.g. ABC links to quality and lean manufacturing initiatives

Question 12

What are the five steps in ABC?

Answer 12

(1) identify O/H cost activities
(2) analyse individual O/H costs
(3) Identify measurable cost drivers
(4) Assign O/H
(5) Make decisions

Question 13

In ABC, what does one do with costs that cannot be specifically allocated?

Answer 13

Costs that cannot be allocated, are treated in the same way as period costs in traditional cost allocation.

Question 14

What is an activity cost driver?

Answer 14

An activity cost driver is an accounting term. A cost driver affects the cost of specific business activities. In activity-based costing (ABC), an activity cost driver influences the costs of labor, maintenance, or other variable costs. Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity.

Question 15

How do activity cost drivers work?

Answer 15

An activity cost driver, also known as a causal factor, causes the cost of an activity to increase or decrease. There may be multiple cost drivers associated with an activity. An example is a change in the cost of warehousing or a change in the level of production. More technical cost drivers are machine hours, the number of engineering change orders, the number of customer contacts, the number of product returns, the machine setups required for production, or the number of inspections. If a business owner can identify the cost drivers, the business owner can more accurately estimate the true cost of production for the business.

• Activity-based costing (ABC) is an accounting method that allocates both direct and indirect costs to business activities.
• A cost driver simplifies the allocation of manufacturing overheads, such as the costs of factory space and electricity.
• Management selects cost drivers based on the associated variables of the expense incurred.

Question 16

From a decision-making standpoint, what should the allocated cost measure?

Answer 16

The opportunity cost of using a company resource.

Question 17

What are the three steps in traditional cost allocation?

Answer 17

(1) identify the cost objectives,
(2) form cost pools,
(3) select an allocation base to relate the cost pools to the cost objectives.

Question 18

What do you do in the first step of cost allocation (identifying the cost objectives)?

Answer 18

Determine the product, service or department that is to receive the allocation - this is known as the cost objective. This might be a a cost aligned to products (e.g. depreciation of a drilling press to brackets and flanges), service contracts (e.g. computer-processing costs allocated to a contracts 1, 2 and 3), or product lines (e.g. general and admin costs to estate-planning services and loan services).

Question 19

What do you do in the second step of cost allocation (forming cost pools)?

Answer 19

Group individual costs whose total is allocated using one allocation base. These are generally along departmental (e.g. maintenance department supplies, small tools, and other small costs) or major activity (e.g. equipment set-up tools and other small costs) lines. The biggest concern is to ensure that costs are homogenous or similar in the same pool – you can test this by breaking into smaller pools and if there is no substantial difference, keep to the larger pool.

Be wary of including all manufacturing O/H in a single cost pool (a popular, but questionable, approach); allocations from a large pool containing costs related to very different activities are not likely to provide useful information.

Question 20

What do you do in the third step of cost allocation (selecting an allocation base)?

Answer 20

Select an allocation base that relates the cost pool to the cost objectives. They must share commonalities.

Examples:
Cost Objective - Manufactured products
Cost Pools - could be direct labour hours, direct labour cost, or machine hours

Cost Objective - Divisions in a Firm
Cost Pools - could be sales dollars, total assets or divisional profit

Question 21

What are the different approaches to cost allocation?

Answer 21

Cause-and-effect allocation: allocation should be on this basis, i.e. cost objectives caused the costs to be incurred. When indirect costs are fixed, this is not feasible. And multiple allocation bases may appear equally valid, but have substantially different results. There are other ways to allocate instead, should cause-and-effect not be possible.

Relative benefits approach: the base should result in more costs being allocated to the cost objectives that benefit the most from incurring the cost. May cause other issues.

Ability to bear costs: allocation base should result in more costs being allocated to more profitable areas.

Equity approach: should feel fair. Can be challenging to satisfy everyone.

Question 22

How does allocation of service department costs typically work?

Answer 22

• Direct method of allocating cost: services department costs are allocation to production departments but not to other service departments. Alternatives that acknowledge service departments use one another’s services are much more complex.
• Allocating budgeted costs rather than actuals is preferable; keeps service departments from passing on inefficiencies.

Question 23

What are the five, main problems with cost allocation?

Answer 23

(1) allocations of costs that are not controllable
(2) arbitrary allocations
(3) allocations of fixed costs that make the fixed costs appear to be variable costs
(4) allocations of manufacturing O/H to products using too few O/H cost pools
(5) use of only volume-related allocation bases

Question 24

What is the problem with allocation of costs that are not controllable?

Answer 24

A responsibility accounting system usually traces revenues and costs to organisational units and individuals with responsibility. The problem is that not all costs are controllable (e.g. building costs), which can cause frustration. If these costs must be allocated, they should be clearly identified.

Question 25

What is the problem with arbitrary allocations?

Answer 25

Most costs are inherently arbitrary - there is no one, ‘true’ or ‘valid’ allocation. Managers may be frustrated by cost-plus contracts that appear inherently unfair.

Question 26

What is the problem with unitised fixed costs?

Answer 26

This may make fixed costs appear to be variable costs. When fixed costs are unitised (stated on a per unit basis), this is likely to happen. To remedy the problem, allocations of fixed costs must be made in such a way that they appear fixed to the managers whose departments receive the allocations. This can be done using lump-sum allocations of fixed costs; this lump-sum is predetermined, and cannot change based on activity level of the unit receiving the allocation. They should compel the manager to spend the money allocated correctly. They should remain the same year-to-year, and should not be altered based on activity from other divisions.

Question 27

What is the problem with too few cost pools?

Answer 27

A couple of cost pools keep things very simple, but may distort the big picture.

For example:
One Cost Pool
= Total O/H ⌹ Total Labour Hours =
1,000,000 ⌹ 50,000 = $20 per labour hour
Product A: $20 x 25,000 labour hours = $500,000
Product B: $20 x 25,000 labour hours = $500,000

Two Cost Pools
= Assembly O/H ⌹ Assembly Labour Hours =
600,000 ⌹ 40,000 = $15 per assembly labour hour
= Finished O/H ⌹ Finishing Labour Hours =
400,000 ⌹ 10,000 = $40 per finishing labour hour
Product A: $15 x 16,000 labour hours = $240,000
Product A: $40 x 9,000 labour hours = $360,000
= $600,000
Product B: $15 x 24,000 labour hours = $360,000
Product B: $40 x 1,000 labour hours = $40,000
= $400,000

Generally, the more cost pools, the more accurate the allocations.

Question 28

What is the problem with using only volume-related cost pools?

Answer 28

Not all O/H costs vary with volume. Direct labour hours, direct labour cost and machine hours are all measures that assume O/H costs are proportional to production volume. ABC is the only means by which to resolve this problem. An example: a high production machine and a low production machine require the same amount of setup time. But in a proportional cost allocation, the high production machine unfairly takes on a greater amount of that burden, and is over-costed.

Question 29

What are the four levels of activities in the Hierarchy of Activities?

Answer 29

(1) Unit Level
(2) Batch Level
(3) Product Level
(4) Facility Level

Question 30

What are some major activities and cost drivers at the Unit Level?

Answer 30

Handling materials and parts: number of material requisitions
Producing goods using manufacturing equipment: number of machine hours
Packing customer orders: Number of boxes shipped

Question 31

What are some of the major activities and cost drivers at the Batch Level?

Answer 31

Processing purchase orders for materials and parts: number of purchase orders
Setting up machines and workstations: number of setups
Inspecting products for quality control: number of inspections

Question 32

What is a major activity and cost driver at product level?

Answer 32

Product design: number of hours worked by designers

Question 33

What is a major activity and cost driver at facility level?

Answer 33

Factory administration: This is likely to be arbitrary

Question 34

What are the benefits of using ABC?

Answer 34

• Less likely to under-cost complex, low-volume products
• Less likely to over-cost simple, high-volume products
• May lead to improvements in cost control.

Question 35

What is Activity-based Management (ABM)?

Answer 35

A management tool that involves analysing and costing activities with the goal of improving efficiency and effectiveness. As you would expect, ABM is closely related to ABC, but the two schemes differ in their primary goals. Whereas ABC focuses on activities with the goal of measuring the costs of products and services produced by them, ABM focuses on activities with the goal of managing the activities themselves.