ACCT 701 Chapter 5 Atkinson

 Activity-Based Cost Systems Chapter 5

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T Traditional Trraditional aditional Man!actring Costing Systems 

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Uses actual departments or cost centers for accumulating and redistributing costs Asks how much of an allocation basis (usually  based on volume) is used by the production department Service department expenses are allocated to a  production department based on the ratio of the the allocation basis used by the production department © 2012 Pearson Prentice Hall. All rights reserved.

T Traditional Trraditional aditional Man!actring Costing Systems 



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Uses actual departments or cost centers for accumulating and redistributing costs Asks how much of an allocation basis (usually  based on volume) is used by the production department Service department expenses are allocated to a  production department based on the ratio of the the allocation basis used by the production department © 2012 Pearson Prentice Hall. All rights reserved.

T Traditional Trraditional aditional Man!actring Costing Systems 

ypical y pical volume!based cost drivers include"  #  $irect labor hours  #  %achine hours  #  $irect labor dollars

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Ade&uate for companies with high!volume  products with similar production volumes and  batch si'es Can lead to product cost distortion in an environment of high product variety © 2012 Pearson Prentice Hall. All rights reserved.

 Activity-Based Cost Systems 

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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

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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 o! ca%acity s%%lied & cost rate Practical ca%acity o! resorces s%%lied

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Ca%acity Cost 'ate ()am%le 

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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  © 2012 Pearson Prentice Hall. All rights reserved.

T"ABC # Second Parameter  

1stimation of how much of each resource2s capacity is used by the activities performed to  produce the products and services

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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 +y %rodct j 

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T"ABC Pro!ita+ility 'e%ort 

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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 © 2012 Pearson Prentice Hall. All rights reserved.

T"ABC Pro!ita+ility 'e%ort 

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%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 © 2012 Pearson Prentice Hall. All rights reserved.

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 © 2012 Pearson Prentice Hall. All rights reserved.

Cost o! nsed Ca%acity 

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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 © 2012 Pearson Prentice Hall. All rights reserved.

Cost o! nsed Ca%acity 

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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 © 2012 Pearson Prentice Hall. All rights reserved.

$i)ed and aria+le Costs 

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%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 © 2012 Pearson Prentice Hall. All rights reserved.

 Activity in ()cess o! Ca%acity 

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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

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"ecreased "emand !or 'esorces 

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$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 © 2012 Pearson Prentice Hall. All rights reserved.

Ma3ing Committed Costs aria+le 

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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

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Managers Ma3e Costs $i)ed 

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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

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Managers Ma3e Costs $i)ed 

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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

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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 supply with future lower levels of demand

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%dating the ABC Model 

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%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

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Time (4ations 

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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

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 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

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 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

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*m%lementation *sses 

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