Chapter 8 (Garrison Text)                                                                                                              
Dr. M.S.  Bazaz

Activity-Based Costing: A Tool to Aid Decision Making

Learning Objectives:

• Explain the major differences between activity-based costing and a traditional costing system.
• Distinguish between unit level, batch-level, product-level, customer-level, and organization-sustaining activities
• Assign costs to cost pools using a first-stage allocation.
• Compute activity rates for cost pools and explain how they can be used to target process improvements.
• Assign costs to a cost object using a second-stage allocation.
• Prepare a report showing activity-based costing product margins from an activity view.
• Prepare an action analysis report using activity-based costing data and interpret the report.
• Use the simplified approach to compute activity-based costs and margins.

 
ABC is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” costs.

In the traditional cost accounting system, the objective is to properly value inventories and cost of goods sold for external financial reports.  In activity-based costing, the objective is to understand overhead and the profitability of products and customers. The major differences are:

• Nonmanufacturing as well as manufacturing costs may be assigned to products.
• Some manufacturing costs may be excluded from product costs.
• There are a number of overhead cost pools, each of which is allocated to products and other costing objects using its own unique measure of activity.
• The allocation bases often differ from those used in traditional costing systems.
• The overhead rates, or activity rates, may be based on the level of activity at capacity rather than on the budgeted level of activity.

In traditional cost accounting, only mfg. costs are assigned to products.  Selling, general, and administrative expenses are treated as period expenses and are not assigned to products.  Under ABC, however, nonmanufacturing costs such as commissions, paid to salespersons, shipping costs, and warranty repair costs, which can easily traced to individual products are included in the product costs.  On the other hand and despite the traditional cost accounting, some manufacturing costs that are not caused by the products (i.e., security guard’s wage), do not participate in product costing under ABC.  A cost is assigned to a product only if there is good reason to believe that the cost would be affected by decisions concerning the product.

In Traditional cost accounting, predetermined overhead rates are computed by dividing budgeted overhead costs by a measure of budgeted activity such as budgeted direct labor-hours.  This practice results in applying the costs of unused, or idle, capacity to products, and it results in unstable unit product costs.  In ABC, however, products are charged for the costs of capacity they use.  In other words, the costs of idle capacity are not charged to products.  This results in more stable unit costs and is consistent with the objective of assigning only those costs to products that are actually caused by the products.

Basic steps that often should be taken by the ABC team to implement activity based costing:

• Identify and define activities and activity pools*.
• Wherever possible directly traced costs to activities and cost objects.
•  Assign costs to activity cost pools.
• Calculate activity rates.
• Assign costs to cost objects using the activity rates and activity measures.
• Prepare management reports.

• * A useful way to think about activities and how to combine them is to organize them into five general levels: unit level, batch level, product level, customer level, and organization-sustaining activities.
• Unit-level activities are performed each time a unit is produced, i.e. power to run processing equipment.
• Batch-level activities are performed each time a batch is handled or processed, i.e. set up.
• Product-level activities relate to specific products regardless of how many batches are run or units are produced, designing a product.
• Customer-level activities relate to specific customers and include activities such as sales calls, catalog mailings.
• Organization-sustaining activities are carried out regardless of which customers are served, which product are produced, how many batches are run, or how many units are made.  This category includes activities such as cleaning executive office, providing a computer network, preparing annual reports to shareholders.

An activity cost pool is a “bucket” in which costs are accumulated that relate to a single activity in the ABC system.

Process of cost allocation:
The first-stage allocation in an ABC system is the process by which overhead costs are assigned to activity cost pools.
The second-stage allocation in an ABC system is to relate overhead costs to ultimate cost objects (products, customer orders, and customers).  In this stage activity rates are used to apply costs to products and customers.

Activity-based management (ABM) focuses on managing activities as a way of eliminating waste and reducing delays and defects.  In this regard, powerful tools such as TQM, process reengineering, and/or benchmarking can be used which provide a systematic approach to identifying the activities with greatest room for improvement.

Implementing activity-based costing often will typically shift costs from high-volume to low-volume products, but the effects will be much more dramatic on unit costs of the low-volume products.  The unit costs of the low-volume products will increase far more than the unit costs of the high-volume products will decrease.

A vital part of activity-based analysis of product or customer profitability is an action analysis that identifies who is ultimately responsible for each cost and the ease with which the cost can be adjusted.  In this regard, the action analysis and using colors to code how easily costs can be adjusted are suggested, see, Journal of Cost Management, fall 1993, pp. 44-52.

ABC and External Reporting:
ABC often are not used for external reporting for the following reasons:

1. External reports are less detailed than internal reports prepared for decision-making.  In the external reports, individual product costs are not reported.  Only cost of goods sold and inventory valuation are disclosed.
2. It is often very difficult to make changes in a company’s accounting system.
3. An ABC system does not conform to GAAP. 
4. Auditors are likely to be uncomfortable with allocations that are based on interviews with the company’s personnel.  Management to make earnings can easily manipulate such subjective data and other key variables look more favorable.