ACCT 701 Chapter 5 Atkinson

(1)

Activity-Based Cost

Systems

Chapter 5

(2)

Tr

Traditional

aditional Man!actring

Man!actring

T

raditional

Man!actring

Costing Systems



 Uses actual departments or cost centers forUses actual departments or cost centers for

accumulating 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

department



 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 department

(3)

Tr

Traditional

aditional Man!actring

Man!actring

T

raditional

Man!actring

Costing Systems



 Uses actual departments or cost centers forUses actual departments or cost centers for

accumulating 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

department



 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 department

(4)

Tr

Traditional

aditional Man!actring

Man!actring

T

raditional

Man!actring

Costing Systems



 yypical volume!based pical 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

batch si'es



 Can lead to product cost distortion in anCan lead to product cost distortion in an

environment of high product variety

(5)

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

(6)

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

&

(7)

Ca%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

(8)

T"ABC # Second Parameter

 1stimation of how much of each resource2s

capacity is used by the activities performed to produce the products and services

(9)

Time-"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

(10)

T"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

(11)

T"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}

(12)

Measring the Cost o!

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

(13)

Cost 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

(14)

Cost 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

(15)

$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

(16)

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

(17)

"ecreased "emand !or

'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

(18)

Ma3ing Committed Costs

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}

(19)

Managers 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

(20)

Managers Ma3e Costs $i)ed

 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

(21)

Managers Ma3e Costs $i)ed

 %aking decisions based solely upon resource

usage may not increase profits if managers are not prepared to reduce spending to align resource

(22)

%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}

(23)

Time (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

(24)

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

(25)

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

(26)

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}

(27)

Historical 5rigins o!

Activity-Based Costing

Based Costing

(28)

Historical 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

(29)

T6o-Stage (stimation

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

(30)

7imitations 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

(31)

7imitations o! 5riginal ABC

 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

(32)

7imitations o! 5riginal ABC

 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}

(33)

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

(34)

Advantages o! T"ABC

 1nables managers to forecast future resource

demands

 1asy to update the model as resource costs and