Chapter 4: Activity-based costing

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Chapter 4: Activity-based costing

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This chapter discusses the principles and implementation of activity-based costing (ABC), a refined costing methodology that enhances cost measurement accuracy by identifying individual activities as fundamental cost objects. It outlines the process of distinguishing between direct and indirect costs, establishing cost-allocation bases, and categorizing indirect costs into hierarchies. The chapter highlights the evolution from simple costing systems to more sophisticated methods necessitated by increased product diversity, technological advancements, and competitive markets.

Chapter 4: Activity-based costing Broad averaging and its consequences    Undercosting: a product consumes a high level of resources but is reported to have a low cost per unit Overcosting: a product consumes a low level of resources but is reported to have a high cost per unit Product-cost cross-subsidisation: if a company undercosts one product then it overcosts at least one other product. A cost is uniformly spread across products without a recognition of which products require what resources in what amounts. Simple costing system (single indirect-cost pool)        Identify the products that are the chosen cost objects Identify the direct costs of the products Select the cost-allocation bases to use for allocating indirect costs to the products Identify the indirect costs associated with each costallocation base Compute the rate per unit of each cost-allocation base used to allocate indirect costs to the products Compute the indirect costs allocated to the products Compute the total costs of the products Refining a costing system  A 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 Causes of a refined costing system     Increase in product diversity Increase in indirect costs Advances in information technology Competition in product markets   Activity based costing (ABC) refines a costing system by identifying individual activities as the fundamental cost objects. An activity is an event, task, or unit of work with a specific purpose – e.g. designing products, setting up machines, operating machines, distributing products. Fundamental cost objects activities Assignment of other cost objects -- Costs of activities --- Cost of products, services, customers    Direct-cost tracing: ABC system reclassifies some indirect costs as direct costs by evaluating if some currently indirect costs can be traced to cost objects Indirect-cost pools: ABC system create smaller indirect cost pools linked to the different activities Cost allocation bases: for each activity cost pool, a measure of the activity performed served as the cost-allocation base. Cost hierarchies      A cost hierarchies categories indirect cost into different cost pools on the basis of the different types of cost drivers, or cost allocation bases or different degrees of difficulty in determining cause and effect relationship. ABC commonly uses a cost hierarchies with 4 levels: Output unit-level cost Batch level costs Product sustaining costs Facility sustaining costs     Output unit-level cost: the costs of activities performed on each individual unit of a product or service Batch level costs: the costs of activities related to a group of units or products or services rather than to each individual unit of product or service Product sustaining costs: the costs of activities to support individual products regardless of the No. of units or batches Facility sustaining costs: the costs of activities that cannot be traced to individual products but that support the organisation as a whole Implementing ABC        Identify the products that are the chosen cost objects Identify the direct costs of the products Select the cost allocation bases to use for allocating indirect costs to the products Identify the indirect costs associated with each cost allocation base Compute the rate per unit of each cost allocation base used to allocate indirect costs to the products Compute the indirect costs allocated to the products Compute the total cost of the products by adding all direct and indirect costs assigned to the products Using ABC for improving cost management and profitability   Activity based management is a method of management decision making that uses activity based costing information to improve customer satisfaction and profitability ABM includes decisions about pricing and product mix, reduction of costs, improvement of processes, and product design.   Pricing and product mix decisions: ABC system gives managers cost information that helps on making and selling diverse products Cost reduction and process improvement decisions: ABC systems helps identify where and how to reduce costs   Design decisions: management can evaluate how its current product and process designs affect activities and costs as a way of identifying new designs to reduce costs Planning and managing activities: companies 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 to see how well activities were managed ABC and department costing systems  Many companies use separate indirect cost rates for each department or each subdepartment Implementing ABC systems      Significant amount of indirect costs are allocated using one or two cost pools All or most indirect costs are identified as output unitlevel costs (few indirect costs as batch-level costs, product/facility-sustaining costs) Products make diverse demands on resources because of differences in volume, process steps Products that a company is well suited to make show a small profits, products that a company is less suited to produce show large profits Operations and accounting staff have significant disagreement about the costs of manufacturing and marketing products or services ABC in service and merchandising companies     ABC has many applications in service and merchandising companies Costs are divided into homogenous cost pools and classified as output unit level costs, batch level costs, product sustaining costs, or facility sustaining costs The cost pools correspond to activities Costs are allocated to products/customers using cost allocation bases that have a cause-and effect relationship with the costs in the cost pool   In a bank, ABC applications: calculate cost of performing ATM transactions, opening and closing accounts, administering mortgage, processing Visa transactions. Help identify profitable products and customer segments ABC in service: postal service: calculate cost of delivering mails. Delivering to remote locations is far greater than delivering within urban areas. ABC helps manage and reduce costs.

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