Chapter 05 Activity-Based Cost Systems

© 2012 Pearson Prentice© 2012 Pearson Prentice Hall. All rights reserved.Hall. All rights reserved.
Activity-Based Cost Activity-Based Cost Activity-Based Cost Activity-Based Cost
SystemsSystemsSystemsSystems
Chapter 5Chapter 5

TrTraditionaladitional Man!actringMan!actringTTraditionalraditional Man!actringMan!actring
Costing SystemsCosting SystemsCosting SystemsCosting Systems

Uses actual departments or cost centers forUses actual departments or cost centers for
accumulating and redistributing costsaccumulating and redistributing costs

Asks how much of an allocation basis (usuallyAsks how much of an allocation basis (usually
based on volume) is used based on volume) is used by the productionby the production
departmentdepartment

Service department expenses are allocated to aService department expenses are allocated to a
production department production department based on the ratio of thbased on the ratio of thee
allocation basis used by the production departmentallocation basis used by the production department

TrTraditionaladitional Man!actringMan!actringTTraditionalraditional Man!actringMan!actring
Costing SystemsCosting SystemsCosting SystemsCosting Systems

yypical volume!basedpical volume!based cost drivers include"cost drivers include"
#  # $irect labor hours$irect labor hours
#  # %achine hours%achine hours
#  # $irect labor dollars$irect labor dollars

Ade&uate for companies with high!volumeAde&uate for companies with high!volume
products with similar production volumes and products with similar production volumes and
batch si'es batch si'es

Can lead to product cost distortion in anCan lead to product cost distortion in an
environment of high product varietyenvironment of high product variety

© 2012 Pearson Prentice Hall. All rights reserved.
Activity-Based Cost Systems Activity-Based Cost Systems

Activity!based cost systems have been developed
to eliminate distortion

ime!driven activity!based costing systems
($AC or ime!$riven AC) estimate two
parameters and then assign indirect costs similar
to the way direct costs are assigned

T"ABC # $irst Parameter T"ABC # $irst Parameter

Cost rate for each type of indirect resource
# dentify all costs incurred to supply the resource
# dentify the practical capacity supplied by the
resource
# $etermine the capacity cost rate of the resource by
dividing its cost by the practical capacity
Ca%acity
cost rate
Cost o! ca%acity s%%lied
Practical ca%acity o! resorces s%%lied
&

Ca%acity Cost 'ate ()am%leCa%acity Cost 'ate ()am%le

Assume that indirect labor employees supply
*+5,, hours of labor in total each &uarter at a cost
of -./+,,,

he practical capacity (at .,0 of theoretical) is
about *+,,, hours per &uarter+ leading to a unit
cost (per hour) of supplying indirect labor capacity
of"
*ndirect la+or cost %er hor &
,/000
2/000 hors
& ,2 %er hor

T"ABC # Second Parameter T"ABC # Second Parameter

1stimation of how much of each resource2s
capacity is used by the activities performed to
produce the products and services

Time-"riven ABCTime-"riven ABC

Use parameter estimates to assign indirect costs"
Cost o! sing resorce i +y %rodct j &
Ca%acity cost rate o! resorce i
) antity o! ca%acity o! resorce i sed
+y %rodct j

T"ABC Pro!ita+ility 'e%ortT"ABC Pro!ita+ility 'e%ort

3efer to %adison $airy2s report+ 1xhibit 5!5

he results from the time!driven activity!based
costing system were &uite different from the
results based on the traditional cost system
# he two specialty products+ which the previous
cost system had reported as the most profitable+
were in fact the most unprofitable
# he company had added large &uantities of
overhead resources to enable these products to be
designed and produced+ but their incremental
revenue did not cover those costs

T"ABC Pro!ita+ility 'e%ortT"ABC Pro!ita+ility 'e%ort

%anagers may use insights from $AC cost
analysis to improve operations

4ossible actions include"
# 3educe setup times
# 3educe time re&uired for purchasing
# 3educe time re&uired for scheduling production
orders
# ncrease prices on unprofitable products
# mpose minimum customer order si'es
# %ake decisions on desired product mix

Measring the Cost o!Measring the Cost o!
nsed 'esorce Ca%acitynsed 'esorce Ca%acity

Activity cost driver rates are fre&uently but
incorrectly calculated based on capacity actually
used this leads to"
# rates that are too high
# the cost of unused capacity being applied to
products actually produced

Analysts can obtain a better estimate for the cost
of resources re&uired to handle each production
run by dividing activity costs by the practical
capacity of work the resources could perform

Cost o! nsed Ca%acityCost o! nsed Ca%acity

he cost of unused capacity should not be assigned
to products produced or customers served during a
period

he cost of unused capacity remains someone2s+ or
some department2s+ responsibility

Usually you can assign the cost of unused capacity
after analy'ing the decision that authori'ed the
level of capacity supplied

Such an assignment is done on a lump!sum basis
it will not be assigned to individual units of
products

Cost o! nsed Ca%acityCost o! nsed Ca%acity

f the unused capacity relates to a particular
product line then the cost of unused capacity is
assigned to that product line+ where the demand
failed to materiali'e

n making assignment of unused capacity costs+
trace the costs at the level in the organi'ation
where decisions are made that affect the supply of
capacity resources and the demand for those
resources

he lump!sum assignment of unused capacity
costs provides feedback to managers on their
supply and demand decisions

$i)ed and aria+le Costs$i)ed and aria+le Costs

%ost indirect expenses assigned by an AC
system are committed costs

Committed costs become variable via a two!step
procedure"
# $emands for resources change either because of
changes in the &uantity of activities performed or
because of changes in the efficiency of performing
activities
# %anagers make decisions to change the supply of
committed resources to meet the new level of
demand for the activities performed by these
resources

Activity in ()cess o! Ca%acity Activity in ()cess o! Ca%acity

f &uantity of demands for a resource exceeds its
capacity+ the result is bottlenecks+ pressure to work
faster+ delays+ or poor!&uality work

Shortages can occur on machines and6or human
resources

7acing such shortages+ companies typically
increase committed costs+ which is why many
indirect costs increase over time

"ecreased "emand !or"ecreased "emand !or
'esorces'esorces

$emands for indirect and support resources also
can decline

1ven for many unit!level resources+ reduced
demands for work does not immediately lead to
spending decreases

he reduced demand for organi'ational resources
lowers the cost of resources used+ but this decrease
is offset by an e&uivalent increase in the cost of
unused capacity

Ma3ing Committed CostsMa3ing Committed Costs
aria+learia+le

After unused capacity has been created+ committed
costs will vary downward only if managers
actively reduce the supply of unused resources

A resource cost varies downward if management
acts"
# o reduce the demands for the resource
# o lower the spending on it

Managers Ma3e Costs $i)edManagers Ma3e Costs $i)ed

8rgani'ations often create unused capacity
through activity!based management actions

hey keep existing resources in place+ when
demands for the activities performed by the
resources have diminished

hey also fail to find new activities that could be
done by the unused resources already in place


he organi'ation receives no benefits from
activity!based management decisions that reduce
demands on their resources if capacity is not
reduced or redeployed

7ailure to capture benefits from activity!based
management is not because their costs are 9fixed:

he cost of these resources is only 9fixed: if
managers do not exploit the opportunities from the
unused capacity they helped to create


%aking decisions based solely upon resource
usage may not increase profits if managers are not
prepared to reduce spending to align resource
supply with future lower levels of demand

%dating the ABC Model%dating the ABC Model

%anagers may easily update their time!driven
AC model to reflect changes in their operating
conditions

%anagers may also easily update the capacity cost
rates
# Changes in the costs of resources supplied or
resources re&uired affect the cost rate estimates
# Shifts in the efficiency of the activities affect the
unit time estimate

Time (4ationsTime (4ations

A feature that enables the model to reflect how
particular order and activity characteristics cause
processing time to vary

$ata for time e&uations are typically already in the
company2s enterprise resource planning system

Allow the time!driven AC model to accurately
and simply reflect the variety and complexity in
orders+ products+ and customers

ABC at Service Com%anies ABC at Service Com%anies

Although AC had its origins in manufacturing
companies+ many service organi'ations today are
obtaining great benefits from this approach
# n practice+ the actual construction of an AC
model is nearly identical for both types of
companies
# his should not be surprising since+ in
manufacturing companies+ the AC system focuses
on the 9service: component of the company

ABC at Service Com%anies ABC at Service Com%anies

Service companies in general are ideal candidates
for activity!based costing
# ;irtually all costs are indirect and appear to be
fixed
# hey often do not have direct+ traceable costs to
serve as convenient allocation bases
# hey must supply virtually all their resources in
advance to provide the capacity to perform work
for customers during each period

*m%lementation *sses*m%lementation *sses

<ot all AC systems have been sustained or
contributed to higher profitability for the company

ssues include"
# =ack of clear business purpose
# =ack of senior management commitment
# $elegating the pro>ect to consultants
# 4oor AC model design
# ndividual and organi'ational resistance to change
# 4eople feel threatened

Historical 5rigins o! Activity-Historical 5rigins o! Activity-
Based CostingBased Costing
Appendix 5!?

Historical 5riginsHistorical 5rigins

ime!driven AC is a contemporary version of the
original AC method introduced in the ?@.,s

he original version used a two!stage estimation
approach

T6o-Stage (stimationT6o-Stage (stimation
A%%roach A%%roach

7irst stage
# nterview and survey employees to identify
principle activities and estimate percentage of time
spent on activities
# Use percentages to assign costs to activities

Second stage
# Assign activity costs to products based on
estimates of the &uantity of each activity used in
the production of the product

7imitations o! 5riginal ABC7imitations o! 5riginal ABC

4roblems may arise in practice from the approach
to activity!based costing that assigns many
resource expenses to activities based on
interviews+ surveys+ and direct observation of
production and support processes because these
activities are time!consuming and expensive


naccuracies and bias may affect the accuracy of
cost driver rates derived from individuals2
sub>ective estimates of their past or future
behavior

Companies must periodically repeat the
interviewing and surveying processes if they want
to keep their activity!based cost systems updated

Adding new activities to the system is also
difficult+ re&uiring re!estimates of the relative
amount of resource time and effort re&uired by the
new activity


A more subtle and serious problem arises from the
interview or survey process
# 4eople estimating how much time they spend on a
list of activities handed to them invariably report
percentages that add up to ?,,0
# 7ew individuals report that a significant percentage
of their time is idle or unused

Advantages o! T"ABC Advantages o! T"ABC

1asy and fast to build an accurate model even for
large enterprises

1xploits the detailed transactions data that are
available from 134 systems

Uses time e&uations that use specific
characteristics of particular orders+ processes+
suppliers+ and customers

Advantages o! T"ABC Advantages o! T"ABC

1nables managers to forecast future resource
demands

1asy to update the model as resource costs and
process efficiencies change

Chapter 05 Activity-Based Cost Systems

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