Week 5 - Activity Based Costing

Question 1

What are the 4 criteria used to guide cost-allocation decisions?

Answer 1

1. Cause-and-effect
2. Benefits received
3. Fairness or equity
4. Ability-to-bear

Question 2

What is the cause-and-effect criterion about? (Guiding cost-allocation decisions)

Answer 2

Using this, managers identify the variables that cause resources to be consumed. e.g. managers may use hours of testing as the variable when allocating the costs of a quality testing area to products.

Cost allocations based on this criterion are likely to be the most credible to operating personnel.

Question 3

What is the benefits received criterion about? (Guiding cost-allocation decisions)

Answer 3

Using this, managers identify the beneficiaries of the outputs of the cost object. The costs of the cost object are allocated among the beneficiaries in proportion to the benefits each receives.

Question 4

What is the fairness/equity criterion about? (Guiding cost-allocation decisions)

Answer 4

It allocates costs based on what is considered ‘reasonable’ or ‘fair’. This makes it a more flawed criterion, as what one party considers fair, another may not.

Question 5

What is the ability-to-bear criterion about? (Guiding cost-allocation decisions)

Answer 5

Costs are allocated in proportion to the cost object’s ability to bear them.

Question 6

What is peanut butter costing?

Answer 6

Using broad averages for assigning (or spreading) the cost of resources uniformly to cost objects although the individual outputs may not use these resources in a uniform way.

Question 7

Broad averaging can lead to undercosting or overcosting of outputs. What does product undercosting and overcosting mean?

Answer 7

Product undercosting - a product consumes a high level of resources but is reported to have a low cost per unit.

Product overcosting - the opposite.

e.g. going out to dinner and sharing the bill. One person may have ordered less but has to pay more than their share and vice versa.

Question 8

What are the strategic consequences of product undercosting?

Answer 8

Undercosts outputs will be underpriced, increasing demand for these outputs but lowering profits. It can lead to sales that result in losses - the sales brig in less revenue than the cost of the resources they use - although the company has the impression that these sales are profitable.

Question 9

What are the strategic consequences of product overcosting?

Answer 9

Leads to overpricing, causing these outputs to lose market share to competitors producing similar outputs.

Question 10

What is product-cost cross subsidisation?

Answer 10

The idea that if a company undercosts one of its outputs, then it will overcost at least one of its other outputs and vice versa. This is very common when cost is uniformly spread (broadly averaged) across multiple outputs without recognising the amount of resources consumed by each product.

Question 11

What does a refined costing system do?

Answer 11

Reduces the use of broad averages for assigning the cost of resources to cost objects (e.g. jobs, products, services) and provides better measurement of the costs of indirect resources used by different cost objects - no matter how differently various cost objects use indirect resources.

Question 12

What are three principal reasons for the demand for such refinements to costing systems?

Answer 12

1. Increase in product diversity
2. Increase in indirect costs
3. Competition in product markets

The use of broad averages in these will likely lead to distorted and inaccurate cost information

Question 13

What has enabled companies to implement refinements to costing systems?

Answer 13

Advancements in information technology - it’s easier than ever to gather data and analyse it

Question 14

What are the three guidelines for refining a costing system?

Answer 14

1. Direct cost tracing - identify them
2. Indirect cost pools - expand the number of indirect cost pools under each pool is more homogeneous, i.e. all of the costs in a cost pool have a similar cause-and-effect relationship with a single cost driver that is used as the cost-allocation
3. Cost-allocation bases -whenever possible, use the cost driver (the cause of indirect costs) as the cost-allocation base for each homogeneous indirect cost pool (the effect)

Question 15

What is activity-based costing (ABC)?

Answer 15

One of the best tools for refining a costing system.

It identifies individual activities as the fundamental cost objects.

Question 16

Why do you need to have the right amount of activities in the ABC system?

Answer 16

Too many activities and the system becomes overly detailed and unwieldy to operate.

Too few activities and the system may not be refined enough to measure cause-and-effect relationships between cost drivers and various indirect costs.

Question 17

In choosing activities, firms must identify activities which account for:

Answer 17

A sizeable fraction of indirect costs and combines activities that have the same cost driver into a single activity.

Question 18

Why are ABC systems usually more accurate?

Answer 18

1. Structuring activity pools more finely with cost drivers for each activity cost pool as the cost-allocation base leads to more accurate costing of activities.
2. Allocating these costs to outputs by measuring the cost-allocation bases of different activities used by different outputs leads to more accurate product costs.

Question 19

Activity-based cost hierarchy comprises 4 levels. What are they?

Answer 19

• Output unit-level costs
• Batch-level costs
• Product-sustaining costs
• Organisation-sustaining costs

Question 20

What are output unit-level costs?

Answer 20

Costs of activities performed on each individ. unit of product. They are output unit-level costs because, over time, the cost of this activity (e.g. running automated moulding machines) increases with additional units of output produced (or machine hours used)

e.g. Product handling

Question 21

What are batch-level costs?

Answer 21

Costs of activities related to a group of units of output rather than individ. units.

e.g. Delivery

Question 22

What are product-sustaining costs?

Answer 22

Costs of activities undertaken to support individ. outputs regardless of the number of units or batches in which the units are produced.

e.g. Design costs

Question 23

What are organisation-sustaining costs?

Answer 23

Costs of activities that cannot be traced to individ. outputs but that support the organisation as a whole. It’s usually difficult to find a good cause-and-effect relationship between these costs and the cost-allocation base.

e.g. General admin costs (including top management compensation and building security).