Chapter 11 : Activity Based Costing and Accounting Information

Chapter 11
Activity Based Costing

TABLE OF CONTENTS
• Summary
• Understanding the concepts of activity-based costing (ABC)
• The Activity Based Costing Process Flow
• Uses Of Activity Based Costing
• Problems With Activity Based Costing

SUMMARY
Activity-based costing (ABC) is a methodology that measures the cost and
performance of activities, resources, and cost objects. Resources are
assigned to activities, then activities are assigned to cost objects based on
their use. Activity-based costing recognizes the causal relationships of cost
drivers to activities.
Activity-based costing is about:
• Measuring business process performance, activity by activity.
• Estimating the cost of business process outputs based on the cost of the
resources used in producing the product.
• Identifying opportunities to improve process efficiency and
effectiveness. Activity costs are used as the quantitative measurement.
If activities have unusually high costs or it they don't add value, they
become targets for re-engineering.
Activity-based management (ABM) is a broad discipline that focuses on
achieving customer value and company profit by managing activities. ABM
draws on activity-based costing as a major source of information.

SUMMARY
Activity-based costing is best explained by walking through its various
steps. They are:
• Identify costs
• Load secondary cost pools
• Load primary cost pools
• Measure activity drivers
• Allocate costs in secondary pools to primary pools
• Charge costs to cost objects
• Formulate reports
• Act on the information

SUMMARY
Activity-based costing (ABC) uses several cost pools, organized by
activity, to allocate overhead costs. ( Plantwide allocation uses one
cost pool for the whole plant, and department allocation uses one cost
pool for each department.) The idea is that activities are required to
produce products - activities such as purchasing materials, setting up
machinery, assembling products, and inspecting finished products.
These activities can be costly. Thus the cost of activities should be
allocated to products based on the products’ use of the activities.
ABC is too costly, spending too much time, not a priority also a barrier
mentioned by the companies. These followed by a lack of top
management support, difficulties of choosing of cost drivers, Activity-
based costing software can be expensive and high cost consultants as
the problem hindering the implementation of ABC, followed by
difficulty in identifying activities, lack of local consultants, and changes
required for company structure to fit activities selected.

UNDERSTANDING THE CONCEPTS OF ACTIVITY-BASED COSTING (ABC)
Section 1

ACTIVITY-BASED COSTING (ABC)
• Activity-based costing (ABC) is a
methodology for more precisely
allocating overhead to those
items that actually use it. The
system can be used for the
targeted reduction of overhead
costs. ABC works best in complex
environments, where there are
many machines and products,
and tangled processes that are
not easy to sort out. Conversely,
it is of less use in a streamlined
environment where production
processes are abbreviated.
ABC systems
targeted
reduction of
overhead
costs
ABC works in
complex
environment

ACTIVITY-BASED COSTING (ABC)
• Activity-based costing (ABC) is an
accounting method that identifies
and assigns costs to overhead
activities and then assigns those
costs to products. An activity-based
costing (ABC) system recognizes the
relationship between costs,
overhead activities, and
manufactured products, and through
this relationship, it assigns indirect
costs to products less arbitrarily than
traditional methods.
• Some costs are difficult to assign
through this method of cost
accounting. Indirect costs, such as
management and office staff salaries,
are sometimes difficult to assign to a
product. For this reason, this method
has found its niche in the
manufacturing sector.
ABC identifies and
assigns costs to
overhead activities
Recognizes the costs,
overhead activities,
manufactured products
relationship
Some costs are difficult
to assign such as
indirect costs

WHAT YOU NEED TO KNOW HOW DID ABC BEGIN?
• ABC came to prominence in
the 1980s, as companies
strove to improve their
products and services at the
same time as pare down
costs. They achieved
impressive results, with the
consequence that ABC is
increasingly popular
particularly in manufacturing
sectors.
ABC was
prominence
during 1980s
Popular in
manufacturing
sectors

THERE ARE FIVE BASIC STAGES INVOLVED
IN AN ABC COSTING
• Identify the product or service
• Identify every resource and
process needed to make the
product or service, and work out
the cost of each
• Remember to include "cost
drivers" for each resource and
process
• Gather information such as the
time taken up by each process or
resource, as well as cost data
• Use all the information and data
to work out the total cost of
products and services.
Identify product/service
Identify every
resource/process needed
Cost drivers to be included
Gather information i.e. time
taken for each process
Use information/data to calculate
total cost

WHAT ARE THE MAIN PLUS POINTS
OF ABC?
• ABC is very flexible. It can be
used to access most kinds of
activity—from industrial
processes to business
operations to service delivery.
It also takes into account a
much wider range of factors
than other costing methods,
so it results in a fuller picture.
Flexible
Wider
costing
method
Activity
Based
Cost

THE ACTIVITY BASED COSTING PROCESS FLOW
Section 2

1. Identify costs. The first step in
ABC is to identify those costs that
we want to allocate. This is the
most critical step in the entire
process, since we do not want to
waste time with an excessively
broad project scope. For example,
if we want to determine the full
cost of a distribution channel, we
will identify advertising and
warehousing costs related to that
channel, but will ignore research
costs, since they are related to
products, not channels.
Identity cost
Load secondary
cost pools
Load primary cost
pools
Measure activity
drivers

2. Load secondary cost pools. Create
cost pools for those costs incurred to
provide services to other parts of the
company, rather than directly
supporting a company’s products or
services. The contents of secondary cost
pools typically include computer
services and administrative salaries, and
similar costs. These costs are later
allocated to other cost pools that more
directly relate to products and services.
There may be several of these
secondary cost pools, depending upon
the nature of the costs and how they
will be allocated.
Identity cost
Load secondary
cost pools
Load primary cost
pools
Measure activity
drivers

3. Load primary cost pools. Create a set
of cost pools for those costs more
closely aligned with the production of
goods or services. It is very common to
have separate cost pools for each
product line, since costs tend to occur at
this level. Such costs can include
research and development, advertising,
procurement, and distribution. Similarly,
you might consider creating cost pools
for each distribution channel, or for
each facility. If production batches are of
greatly varying lengths, then consider
creating cost pools at the batch level, so
that you can adequately assign costs
based on batch size.
Identity cost
Load secondary
cost pools
Load primary cost
pools
Measure activity
drivers

4. Measure activity drivers. Use a data
collection system to collect information
about the activity drivers that are used
to allocate the costs in secondary cost
pools to primary cost pools, as well as to
allocate the costs in primary cost pools
to cost objects. It can be expensive to
accumulate activity driver information,
so use activity drivers for which
information is already being collected,
where possible.
Identity cost
Load secondary
cost pools
Load primary cost
pools
Measure activity
drivers

5. Allocate costs in secondary pools to
primary pools. Use activity drivers to
apportion the costs in the secondary
cost pools to the primary cost pools.
Allocate costs in secondary
pools to primary pools.
Charge costs to cost
objects
Formulate reports
Act on the information

6. Charge costs to cost objects. Use an
activity driver to allocate the contents of
each primary cost pool to cost objects.
There will be a separate activity driver
for each cost pool. To allocate the costs,
divide the total cost in each cost pool by
the total amount of activity in the
activity driver, to establish the cost per
unit of activity. Then allocate the cost
per unit to the cost objects, based on
their use of the activity driver.
objects
Formulate reports

7. Formulate reports. Convert the
results of the ABC system into reports
for management consumption. For
example, if the system was originally
designed to accumulate overhead
information by geographical sales
region, then report on revenues earned
in each region, all direct costs, and the
overhead derived from the ABC system.
This gives management a full cost view
of the results generated by each region.
objects
Formulate reports

8. Act on the information. The most
common management reaction to an
ABC report is to reduce the quantity of
activity drivers used by each cost object.
Doing so should reduce the amount of
overhead cost being used.
objects
Formulate reports

We have now arrived at a complete ABC
allocation of overhead costs to those
cost objects that deserve to be charged
with overhead costs. By doing so,
managers can see which activity drivers
need to be reduced in order to shrink a
corresponding amount of overhead cost.
For example, if the cost of a single
purchase order is $100, managers can
focus on letting the production system
automatically place purchase orders, or
on using procurement cards as a way to
avoid purchase orders. Either solution
results in fewer purchase orders and
therefore lower purchasing department
costs.

USES OF ACTIVITY BASED COSTING
Section 3

1. Activity costs. ABC is
designed to track the cost of
activities, so you can use it to
see if activity costs are in line
with industry standards. If not,
ABC is an excellent feedback
tool for measuring the ongoing
cost of specific services as
management focuses on cost
reduction.
Activity costs
Customer
profitability
Distribution
cost
Make or buy

2. Customer profitability. Though
most of the costs incurred for
individual customers are simply
product costs, there is also an
overhead component, such as
unusually high customer service
levels, product return handling, and
cooperative marketing agreements.
An ABC system can sort through
these additional overhead costs and
help you determine which
customers are actually earning you
a reasonable profit. This analysis
may result in some unprofitable
customers being turned away, or
more emphasis being placed on
those customers who are earning
the company its largest profits.
Activity costs
Customer
profitability
Distribution
cost
Make or buy

3. Distribution cost. The typical
company uses a variety of
distribution channels to sell its
products, such as retail,
Internet, distributors, and mail
order catalogs. Most of the
structural cost of maintaining a
distribution channel is
overhead, so if you can make a
reasonable determination of
which distribution channels are
using overhead, you can make
decisions to alter how
distribution channels are used,
or even to drop unprofitable
channels.
Activity costs
Customer
profitability
Distribution
cost
Make or buy

4. Make or buy. ABC
provides a
comprehensive view of
every cost associated
with the in-house
manufacture of a
product, so that you
can see precisely which
costs will be eliminated
if an item is outsourced,
versus which costs will
remain.
Activity costs
Customer
profitability
Distribution
cost
Make or buy

5. Margins. With proper
overhead allocation from an
ABC system, you can determine
the margins of various products,
product lines, and entire
subsidiaries. This can be quite
useful for determining where to
position company resources to
earn the largest margins.
Margins
Minimum price
Production
facility cost

6. Minimum price. Product pricing is
really based on the price that the
market will bear, but the marketing
manager should know what the cost of
the product is, in order to avoid selling a
product that will lose a company money
on every sale. ABC is very good for
determining which overhead costs
should be included in this minimum
cost, depending upon the circumstances
under which products are being sold.
Margins
Minimum price
Production
facility cost

7. Production facility cost. It is usually
quite easy to segregate overhead costs
at the plant-wide level, so you can
compare the costs of production
between different facilities.
Margins
Minimum price
Production
facility cost

Clearly, there are many valuable uses for
the information provided by an ABC
system. However, this information will
only be available if you design the
system to provide the specific set of
data needed for each decision. If you
install a generic ABC system and then
use it for the above decisions, you may
find that it does not provide the
information that you need. Ultimately,
the design of the system is determined
by a cost-benefit analysis of which
decisions you want it to assist with, and
whether the cost of the system is worth
the benefit of the resulting information.
Design
specific set
of data for
each
decision
Determine
by using
cost-benefit
analysis

PROBLEMS WITH ACTIVITY BASED COSTING
Section 4

1. Cost pool volume. The advantage
of an ABC system is the high quality
of information that it produces, but
this comes at the cost of using a
large number of cost pools – and
the more cost pools there are, the
greater the cost of managing the
system. To reduce this cost, run an
ongoing analysis of the cost to
maintain each cost pool, in
comparison to the utility of the
resulting information. Doing so
should keep the number of cost
pools down to manageable
proportions.
• Cost pool volume
• Installation time
• Multi-department
data sources
• Project basis

2. Installation time. ABC systems
are notoriously difficult to install,
with multi-year installations being
the norm when a company
attempts to install it across all
product lines and facilities. For such
comprehensive installations, it is
difficult to maintain a high level of
management and budgetary
support as the months roll by
without installation being
completed. Success rates are much
higher for smaller, more targeted
ABC installations.
data sources
• Project basis

3. Multi-department data sources.
An ABC system may require data
input from multiple departments,
and each of those departments may
have greater priorities than the ABC
system. Thus, the larger the number
of departments involved in the
system, the greater the risk that
data inputs will fail over time. This
problem can be avoided by
designing the system to only need
information from the most
supportive managers.
data sources
• Project basis

4. Project basis. Many ABC projects
are authorized on a project basis, so
that information is only collected
once; the information is useful for a
company’s current operational
situation, and it gradually declines in
usefulness as the operational
structure changes over time.
Management may not authorize
funding for additional ABC projects
later on, so ABC tends to be “done”
once and then discarded. To mitigate
this issue, build as much of the ABC
data collection structure into the
existing accounting system, so that
the cost of these projects is reduced;
at a lower cost, it is more likely that
additional ABC projects will be
authorized in the future.
data sources
• Project basis

5. Reporting of unused time. When
a company asks its employees to
report on the time spent on various
activities, they have a strong
tendency to make sure that the
reported amounts equal 100% of
their time. However, there is a large
amount of slack time in anyone’s
work day that may involve breaks,
administrative meetings, playing
games on the Internet, and so forth.
Employees usually mask these
activities by apportioning more
time to other activities. These
inflated numbers represent
misallocations of costs in the ABC
system, sometimes by quite
substantial amounts.
• Reporting of
unused time
• Separate
data set
• Targeted
usage

6. Separate data set. An ABC
system rarely can be constructed to
pull all of the information it needs
directly from the general ledger.
Instead, it requires a separate
database that pulls in information
from several sources, only one of
which is existing general ledger
accounts. It can be quite difficult to
maintain this extra database, since
it calls for significant extra staff time
for which there may not be an
adequate budget. The best work-
around is to design the system to
require the minimum amount of
additional information other than
that which is already available in
the general ledger.
• Reporting of
unused time
• Separate
data set
• Targeted
usage

7. Targeted usage. The benefits of
ABC are most apparent when cost
accounting information is difficult
to discern, due to the presence of
multiple product lines, machines
being used for the production of
many products, numerous machine
setups, and so forth – in other
words, in complex production
environments. If a company does
not operate in such an
environment, then it may spend a
great deal of money on an ABC
installation, only to find that the
resulting information is not overly
valuable.
• Reporting of
unused time
• Separate
data set
• Targeted
usage

The broad range of issues noted here
should make it clear that ABC tends
to follow a bumpy path in many
organizations, with a tendency for its
usefulness to decline over time. Of
the problem mitigation suggestions
noted here, the key point is to
construct a highly targeted ABC
system that produces the most critical
information at a reasonable cost. If
that system takes root in your
company, then consider a gradual
expansion, during which you only
expand further if there is a clear and
demonstrable benefit in doing so. The
worst thing you can do is to install a
large and comprehensive ABC
system, since it is expensive, meets
with the most resistance, and is the
most likely to fail over the long term.
Problem
of ABC
system
Expensive
ABC follows
bumpy path
Need to install
comprehensive
ABC system

Chapter 11 : Activity Based Costing and Accounting Information

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Chapter 11 : Activity Based Costing and Accounting Information