CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

LEARNING OBJECTIVES
1. Explain undercosting and overcosting of products or services 2. Present three guidelines for refining a costing system 3. Distinguish between the traditional and the activity-based costing approaches to designing a costing system . Describe a four-part cost hierarchy !. "ost products or services using activity-based costing #. $se activity-based costing systems for activity-based management %. "ompare activity-based costing systems and department-costing systems &. Evaluate the costs and benefits of implementing activity-based costing systems

CHAPTER OVERVIEW
"hapter ! emphasi'es the allocation of indirect costs within a costing system. "ompanies need to accurately measure resources used in producing different products and providing different services. (racing costs in an economically feasible way to products and services is not the difficult part of assigning costs. )llocating indirect costs provides the challenge. "ompanies produce an increasing variety of products and services and have ever-increasing amounts of indirect costs to allocate to them. ) costing system provides managers with information for many different purposes* with one important purpose* accurate costs of products or services. "osting systems may need to be refined for accurate measurement of consumption of indirect costs. )ctivity-based costing +),"- assists some companies in cost management decisions in pricing* productmix* product design* and efficiency* for example. .uidelines are presented for refining a costing system. /ituations in which erroneous impressions about product or service cost exist are described in the first part of the chapter to draw attention to the critical need for accurate information in ma0ing better decisions for an organi'ation. (he information generated by a costing system is used in decision ma0ing as is highlighted by a discussion of activity-based management near the end of the chapter. 1elpful comparisons are made between the traditional costing system described in the previous chapter and the activity-based costing approach illustrated in this chapter. (he many benefits gained from refining a costing system are noted along with steps in implementing an activity-based costing system. "osts and limitations of using an activity-based costing system approach are also described.

(he selection of appropriate or preferred cost-allocation bases is an important step for allocating indirect costs. )ctivity-based costing focuses on the cause-and-effect criterion for choosing allocation bases.

CHAPTER OUTLINE
2. 2 ). 4eflects underlying structure of operations 22 1. Different 3obs* products* or services consume indirect costs ali0e +identical or at least similara. /ingle cost pool and a single indirect-cost rate for allocation b. /imple costing system will suffice for 3ob-costing purposes 2. Different 3obs* products* or services +cost ob3ects- consume indirect costs differently a. 5ultiple cost pools and multiple indirect-cost rates for allocation b. 5easure of how different 3obs* products* or services use organi'ational resources ,. Provides information about the cost of a 3ob* product* or service 1. )ccurate information when indirect-cost allocation matches indirect-cost consumption Learning Objective 1: Explain undercosting and overcosting of products or services 2. 5isleading information when indirect-cost allocation does not match resource consumption a. Cost smoothing or peanut-butter costing6 broad averages used to uniformly assign costs though resources used nonuniformly i. Product undercosting 7 product consumes a high level of resource but is reported to have a low cost per unit6 may result in bringing in fewer revenues than costs of resources used 2ndirect-cost allocation in 3ob-costing system

ii. Product overcosting 7 product consumes a low level of resources but is reported to have a high cost per unit6 may result in losing mar0et share to competitors producing similar products or providing similar services b. Production-cost cross-subsidization6 if undercost a product will overcost at least one other product i. 4esults from cost assigned uniformly +broadly averaged- across multiple products without recogni'ing amounts of resources used by which products

ii. Effects of cost smoothing on direct and indirect costs described through text example iii. 8uestions the system of allocating overhead costs and need for improvement or refinement of such system

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Do multiple choice 1.

Assign E ercise 5-16.

Learning Objective 2: Present three guidelines for refining a costing system ". "an be changed or refined !re"ined costing s#stem$ to better measure costs of overhead resources used by different cost ob3ects even though used differently [Exhibit 5-1] 1. Direct-cost tracing6 classify as many of the total costs as direct costs as is economically feasible9reducing amount of costs classified as indirect 2. 2ndirect-cost pools6 expand number of these pools as needed until each of these pools is more homogeneous 7 costs that have same or similar cause-and-effect +or benefits-receivedrelationship with the cost-allocation base 3. "ost-allocation bases6 use cause-and-effect criterion* where possible* to identify the costallocation base for each indirect-cost pool Do multiple choice %. Assign Problems 5-%&' 5-() and 5-(1.

Learning Objective 3: Distinguish between the traditional and the activity-based costing approaches to designing a costing system 22. Activit#-based costing* a tool for refining a costing system by focusing on individual activities as fundamental cost ob3ects ). Purpose6 underlying structure of operations loo0ed at in greater detail for more understanding of how resources used and* hence* more accurate costing ,. :eatures +refer to section on ;refining cost systems<1. "osts reclassified as direct rather than indirect by subdividing existing cost pools 2. /maller cost pools created by lin0ing to different activities through cause-and-effect relationships with the cost-allocation base 3. 5easures of activities performed used as cost-allocation bases Do multiple choice (. Assign E ercise 5-1*.

Learning Objective 4: Describe a four-part cost hierarchy ". Cost hierarch#6 highlighted when identifying cause-and-effect relationships 1. "ategori'ed by different cost pool on the basis of types of cost drivers or cost-allocation bases a. +utput unit-level costs6 costs of activities performed on each individual unit of product or service =cost driver is a unit of output> Activit#-,ased Costing and Activit#-,ased -anagement 65

b. ,atch-level costs. costs of activities related to a group of units of products or services =cost driver is group of units of output> 2. "ategori'ed by different degrees of difficulty in determining cause-and-effect +or benefitsreceived- relationships a. Product-sustaining costs !or service-sustaining costs$6 costs of activities underta0en to support individual products or services regardless of the number of units or batches in which the units are produced b. /acilit#-sustaining costs. costs of activities that cannot be traced to individual products or services but support the organi'ation as a whole i. Difficult to find good cause-and-effect relationship causing some companies to deduct them as a whole from operating income rather than allocating them

ii. 2mportant to allocate when management wants to set selling prices using basis of an amount of cost that includes all costs Do multiple choice 4. Assign E ercise 5-10.

D. 2mplementation example 7 using seven-step approach to costing and the three guidelines for refining costing systems [Exhibits 5-2 and 5-3] Learning Objective 5: "ost products or services using activity-based costing 1. 2dentify the products that are the chosen cost ob3ects a. .oal to first calculate the total costs of the products b. (hen to calculate the per-unit cost of products 2. 2dentify the direct costs of the products a. "osts identified as output-unit costs b. "osts identified as batch-level costs 3. /elect the cost-allocation bases to use for allocating indirect costs to the product a. 2dentify the activities b. Define the number of activity-cost pools for grouping costs by identifying the costallocation bases c. "onsider the availability of reliable data and measures in choosing a cost-allocation base . 2dentify the indirect costs associated with each cost-allocation base a. /ome costs directly identified with a particular activity b. ?ther costs may need to be allocated to activities before the costs of the activities can be allocated to the products

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!. "ompute the rate per unit of each cost-allocation base used to allocate indirect costs to the products #. "ompute the indirect costs allocated to the products %. "ompute the total costs of the products by adding all direct and indirect costs assigned to the products Do multiple choice 510. Assign E ercise 5-%(.

E. @ey features [Exhibit 5-4] 1. :ocus of )," systems on long-run decisions a. )ll resources used by products identified regardless of how individual costs behave in the short run b. 5ore of the costs can be managed and fewer costs are regarded as fixed and given 2. 4ecognition of hierarchy of costs a. "ritical when allocating costs to products b. Easy to use to calculate total costs Learning Objective 6: $se activity-based costing systems for activity-based management :. $sage in management decisions9Activit#-based management !A,-$ 1. $sed for more than obtaining better product costs 2. $sed in management decisions for satisfying customers and improving profitability a. Pricing and product-mix decisions b. "ost reduction and process improvement decisions i. )nalysis of factors that cause costs to be incurred

ii. $se of nonfinancial and financial cost-allocation bases c. Design decisions d. Planning and managing decisions i. ,udgeted costs for activities and budgeted cost rates9normal costing used

ii. :eedbac0 from comparing budgeted to actual costs on how well activities managed Do multiple choice *. Assign E ercise 5-%4 !E ercise 6-%4 adds activit#-based budgeting$.

Learning Objective 7: "ompare activity-based costing systems and department-costing systems. 222. )ctivity-based costing compared to department-costing systems Activit#-,ased Costing and Activit#-,ased -anagement 60

). )ctivity-based costing9a further refinement of department-costing systems 1. )ctivities within a department may incur significant costs but have different cost drivers 2. )ctivities within a department may not use resources in the same proportion ,. Departmental indirect-cost rates for allocating costs to products could result in same product costs as activity-based costing if6 1. ) single activity accounts for a si'able fraction of the departmentAs cost 2. /ignificant costs incurred on different activities but each activity has same cost-allocation base 3. /ignificant costs 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 ". ,enefits of activity-based costing must be balanced against its costs and limitations Do multiple choice &. Assign Problem 5-(%.

Learning Objective 8: Evaluate the costs and benefits of implementing activity-based costing systems. 2B. 2mplementing )," systems [Surveys of Company Pra ti e] [Con epts in ! tion] ). "hoice of level of detail and when )," li0ely to provide the most benefit 1. /ignificant amounts of indirect costs allocated using only one or two cost pools 2. )ll or most indirect costs identified as output-unit level costs 3. Products ma0e diverse demands on resources because of differences in volume* process steps* batch si'e* or complexity . Products a company is well suited to made and sell show small profits but products a company is less well suited to produce and sell show large profits !. ?perations staff significantly disagree with the accounting staff about the costs of manufacturing and mar0eting products and services ,. Cecessary measurements are main costs and limitations of an )," system 1. 5any calculations reDuired to determine costs of products and services a. )ctivity-cost rates need to be updated regularly b. Detailed system increases opportunity for error 2. )llocation bases used for which data readily available rather than preferred allocation bases Do multiple choice 1). Assign E ercise 5-%6' Problem 5-(5 !E ercise 14-%1 adds customer pro"itabilit#$.

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WRITING/DISCUSSION EXERCISES
1. Expl !" #"$%&'()*!"+ "$ (,%&'()*!"+ (- p&($#'*) (& )%&,!'%) Why should the management cost accountants be the first to recognize cost smoothing or over/undercosting? Decision ma0ers loo0 to management cost accountants for useful information

when ma0ing decisions about pricing* product mix* process improvements* and design* for example. )ccountants have an ethical obligation to provide information that is ob3ective* reliable* and relevant. (hey also have an ethical obligation for competence. 2n gathering data to prepare reports for pricing or mix decisions* accountants should note effects of product costs on profitability over a period of time and a range of products. ,ecause the costing system design is based on the operational structure of the organi'ation* the costs should reflect those operations. "onsistent losses or high profits should alert the competent accountant to either investigate further or bring the issue to the attention of management for their consideration .
.. P&%)%"* */&%% +#!$%l!"%) -(& &%-!"!"+ '()*!"+ )0)*%1

Whose work is it to refine a costing system? (hough the costing system is the responsibility of the accountants* the underlying basis for it is the structure of operations. 2f the costing system is not following operational structure because of changes to that structure and therefore needs to be refined* those people involved with operations should be involved in the refinement process. )ctivity-based costing* as a refinement to an existing costing system* reDuires that ma3or or 0ey activities be defined for their role in incurring indirect costs. ) team of people who represent 0ey activities should be brought together to identify the activities and should definitely include a representative from accounting. :rom the information put together by the team* the accounting group can build an appropriate system for accumulating and assigning costs. (he system will be more expensive to operate and maintain* and that should be a consideration in the decision to refine an existing costing system.
2. D!)*!"+#!)/ 3%*4%%" */% *& $!*!(" l "$ */% '*!,!*0-3 )%$ '()*!"+ pp&( '/%) *( $%)!+"!"+ '()*!"+ )0)*%1

If activity-based costing is so good why has it not been used before? 2n many ways* activity-based costing was the ;traditional< method before it became 0nown as ),". ?perating managers must be familiar with the activities reDuired to manufacture the companyAs products or provide their services* and in the early stages of a company* this 0nowledge would be the basis for the organi'ationAs structure and accounting. "hanges occur. (echnological and mar0etplace changes usually impact the operational portion of companies in a more costEbeneficial manner before corresponding changes occur for the staff areas of companies. )lso* many changes are small and specific to one area* with the broader understanding of possible conseDuences not readily or accurately envisioned for ma0ing corresponding changes in other areas. "onsider a wor0place using automation and sophisticated computers rather than people* as some managers did. Fithout people +direct manufacturing labor-* would direct manufacturing labor be a useful cost driver for developing a product costG (he costing system would have to change to accurately reflect such a wor0place.

Activit#-,ased Costing and Activit#-,ased -anagement

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5. D%)'&!3%

-(#&-p &* '()* /!%& &'/0

As a cost reduction measure for batch-level costs the number of units !rocessed !er batch were increased" What effect could this have on com!any-wide costs? )n increase in the number of units per batch processed may be an acceptable means of reducing costs* but a danger exists in increasing the units per batch to reduce the cost per unit or per batch. 2f the increase in number of units is per batch only so that fewer batches result in the same total number of units processed* thus reducing setup costs* such a measure could be helpful to company-wide costs. 2f* however* the increase in the number of units per batch or setup is done solely to reduce a per batch cost and more units of product are processed in total with no increase in sales volume* inventory will build up and result in increased costs to the company. (he company should loo0 for ways to reduce the setup costs in order to reduce batch si'es and batch costs. (he 3ust-in-time philosophy advocates no inventory of in-process or finished goods. $nder that system batch si'es would be continually reduced resulting in more setups* but the cost of the setup would receive the attention for cost reduction* not the setup cost per unit.
5. C()* p&($#'*) (& )%&,!'%) #)!"+ '*!,!*0-3 )%$ '()*!"+

Activity-based costing has so many advantages increased accuracy for !roduct costing and added value for decision making why is it a more recent develo!ment in costing systems? "osting systems do develop from the underlying structure of operations. 4ecent changes in the variety of products and the complexity in how resources are used have necessitated refinements and changes to the traditional or existing costing systems. )t the time traditional or existing costing systems developed* they were improvements or refinements to the then existing systems. (echnological advances have made it possible to design and use costing systems with the amount of detail and calculations reDuired by ),". (hose same technological advances made possible the changes in the variety of products and complexity in how resources are used for companies. )ccounting* through such a mechanism as a costing system* responds to changes in operations while at the same time providing the information that is acted upon to initiate change in those operations.
6. U)% '*!,!*0-3 )%$ '()*!"+ )0)*%1) -(& '*!,!*0-3 )%$ 1 " +%1%"*

#an a com!any $organization% use activity-based costing and not have activity-based management? Hes* a company could implement activity-based costing and gain value in determining better product costs but not use the fullness of the information to influence decision ma0ing. 2f the information from activity-based costing is used to manage the activities* then activity-based management is employed. $sing activity-based costing without using activity-based management is similar to an earlier era* late 1I#Js and the 1I%Js* when $. /. managers used numbers as numbers to manage.K Cumbers are symbols for a wealth of information* and when they are used as symbols with understanding of what they represent* numbers are helpful. 2f used without that understanding* they can be dangerous. (he same situation could occur with activity-based costing and activity-based management. )ctivity-based costing is a whole company approach and wor0s best when so employed through activity-based management and activity-based budgeting.
K+/ee ;(he Cext )merican :rontier< by 4obert ,. 4eich in the 5arch 1I&3 issue of (he )tlantic 5onthly-

0) Chapter 5

7. C(1p &% '*!,!*0-3 )%$ '()*!"+ "$ $%p &*1%"*-'()*!"+ )0)*%1)

Wouldn&t a com!any benefit from structuring their de!artments to match the defined activities used in A'# so that costs would be easier to assign to the activities when they were also the de!artment&s? )ctivity-based costing is an approach to ;costing a product*< which is an accounting responsibility. Departments are created for reasons other than to develop the cost of the product. Departments may exist along the categories of the value chain* for example. 2n some instances* a 0ey activity would be housed within a single department. 2n other instances* more than one 0ey or defined activity might operate within the same department. (hough the activities generated large amounts of indirect costs* had different cost drivers* and used resources in different proportions* they could be within the same category of the value chain* such as manufacturing* and* thus* be one department. 2n yet other instances* a defined or 0ey activity for generating indirect costs might span more than one department. (he costing system is to reflect the underlying structure of operations* not vice versa.
8. E, l# *% */% '()*) "$ 3%"%-!*) (- !1pl%1%"*!"+ '*!,!*0-3 )%$ '()*!"+ )0)*%1)

Is it !ossible that when all the signs !oint to the need for costing system refinement s!ecifically A'# that it is really too late to do anything? A'# is so e(!ensive and timeintensive in its im!lementation that it&s !ossible that a com!any couldn&t get it done in time to be effective" 2n some instances* the situation described above might actually exist. /ometimes a company does wait too long to ma0e changes and are bought out by another company rather than initiate and ma0e necessary changes. (his is not usually the case. 4ecogni'ing that a problem exists is usually the first step in developing a solution. 5anagers do not have to wait until a complete revamping of the system is developed to ta0e advantage of information gained from wor0ing toward a solution. Problem solving or decision ma0ing is a process* and sometimes on the way to solving one problem* other problems are solved* thereby negating the need to solve what was considered the original problem. 2n deciding to implement ),"* for example* the company could refine their department indirect-cost rates by use of multiple cost-pools and multiple cost-allocation bases and find those to be adeDuate. )," isnAt appropriate for every company. "onsideration and study of )," may provide benefit to any company.

Activit#-,ased Costing and Activit#-,ased -anagement

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SUGGESTED READINGS
)nderson* (.* ;)," Evolution*< ""E +Lune 1II!- p.2# = p>. )sada*(.* ,ailes* L. and /u'u0i* @.* ;2mplementing ),5 with 1oshin 5anagement*< #ana$ement ! ountin$ %uarter&y +Finter 2JJJ- p.# =#p>. ,amber* M. N 1ughes 22* @.* ;)ctivity-,ased "osting in the /ervice /ector6 (he ,uc0eye Cational ,an0*< "ssues in ! ountin$ Edu ation +)ugust 2JJ1- p.3&1 =2&p>. ,easley* 5.* "arello* L. and 1ermanson* D.* ;Lust /ay OCoA*< Strate$i 'inan e +5ay 1III- p.!2 =#p>. ,rewer* P.* ;)n )pproach (o ?rgani'ing a 5anagement )ccounting "urriculum*< "ssues in ! ountin$ Edu ation +5ay 2JJJ- p.211 =2!p>. ,rewer* P.* "ampbell* 4.* N 5c"lure* 4.* ;Filson Electronics +)- and +,-6 )n )," "apstone Experience*< "ssues in ! ountin$ Edu ation +)ugust 2JJJ- p. 13 = #p>. "o0ins* ..* ;Mearning (o Move ),"*< (ourna& of ! ountan y +)ugust 1III- p.3% =3p>. 999* ;2f )ctivity-,ased "osting 2s the )nswer*< ""E +)ugust 1II%- p.3& =!p>. Damitio* L.* 1ayes* .. and @int'ele* P.* ;2ntegrating )," and ),5 at Dow "hemical*< #ana$ement ! ountin$ %uarter&y +Finter 2JJJ- p.22 =!p>. Dra0e* ).* 1a0a* /. and 4avenscroft* /.* ;)n )," /imulation :ocusing on 2ncentives and 2nnovation*< "ssues in ! ountin$ Edu ation +)ugust 2JJ1- p. 3 =2Ip>. :oster* .. and /wenson* D.* ;5easuring the /uccess of )ctivity-,ased "ost 5anagement and 2ts Determinants*< (ourna& of #ana$ement ! ountin$ )esear h +:all 1II%- p.1JI =33p>. 1ic0s* D.* ;Hes* )," 2s for /mall ,usiness* (oo*< (ourna& of ! ountan y +)ugust 1III- p. 1 =3p>. @rumwiede* @.* ;(he 2mplementation /tages of )ctivity-,ased "osting and the 2mpact of "ontextual and ?rgani'ational :actors*< (ourna& of #ana$ement ! ountin$ )esear h +1II%-B1J- p.23I =3Ip>. 5c.owan* ).* ;Perceived ,enefits of ),"5 2mplementation*< ! ountin$ *ori+ons +5arch 1II&- p.31 =2Jp>. 5iller* L.* "mp&ementin$ ! tivity-,ased #ana$ement in -ai&y .perations +1II#-* Lohn Filey N /ons* 2nc.* Cew Hor0. =/elected by the (rustees of 25) :oundation for )pplied 4esearch* 2nc.* as being of interest to 25) members.> Platt* D. N (owry* @.* ;Pecos Products6 ) Pro3ect 2ntroducing "omplexity into the /tudy of )ctivity-,ased "osting*< "ssues in ! ountin$ Edu ation +:ebruary 2JJ1- p.II =2#p>.

0% Chapter 5