Key Topics: Traditional versus ABC systems Activities and their identification Cost hierarchy

1. Chapter 7Activity-Based Costing and Management Key Topics: Traditional versus ABC systems Activities and their identification Cost hierarchy ABC procedures ABM Benefits and costs of ABC and ABM Uncertainties

2. Traditional Overhead CostAllocation System

3. ABC Cost Allocation System

4. What Are Activities, and How Are They Identified? • Activity Type of task or function performed in an organization • Activity Identification * Tracking the use of resources * Using the cost hierarchy * Grouping homogeneous costs

5. Cost Hierarchy • Organization-sustaining activities • Activities and costs associated with overall organization (lease of headquarters office space, salary of CEO) • Facility-sustaining activities • Activities and costs associated with single manufacturing plant or service facility (property taxes, plant manager salary) • Customer-sustaining activities • Activities and costs associated with a single customer (costs of ordering and delivery)

6. Cost Hierarchy • Product-sustaining activities • Activities or costs associated with product line or one single product (advertising, depreciation) • Batch-level activities • Activities or costs associated with each batch of product (set-up costs, electricity) • Unit-level activities • Activities or costs associated with each unit (indirect materials, indirect labor)

7. ABC Procedures 1. Identify the relevant cost object 2. Identify activities 3. Assign (trace and allocate) costs to activity based cost pools 4. For each ABC cost pool, choose a cost driver

8. ABC Procedures 5. For each ABC cost pool, calculate an allocation rate Allocation Rate = Activity Cost/Volume of Cost Driver 6. For each ABC cost pool, allocate activity costs to the cost object Allocation = Allocation Rate * Actual Volume of Activity

9. Using ABC 7.21 Palmer Company uses an activity based costing system. It has the following manufacturing activity areas and has chosen related cost drivers. ActivityCost Driver Machine setup Number of setups Material handling Number of parts Machining Machine hours Assembly Direct labor hours Inspection Number of finished units

10. Develop allocation rate(not shown in textbook problem) Activity Machine setup $200,000 Material handling $320,000 Machining $208,000 Assembly $66,000 Inspection $264,000 Cost Driver Number of setups 4,000 Number of parts 640,000 Machine hours 8,000 Direct labor hours 3,000 Number of finished units 22,000

11. Cost allocation rates

12. Product information

13. Developing ABC unit cost

14. Selection of Cost Drivers • Need cause and effect relationship between cost driver and activity costs • Requires judgment in choosing and evaluating potential cost drivers • Examples

15. What Is Activity Based Management (ABM)? The process of using ABC information to evaluate the costs and benefits of production and internal support activities and to identify and implement opportunities for improvements in profitability, efficiency, and quality within an organization

16. ABM Applied • Customer profitability • Product and process design * Focus resources on value-added activities * Reduce or eliminate non-value- added activities * Target and kaizen costing

17. ABM Applied • Environmental costs • Quality * Prevention activities * Appraisal activities * Production activities * Post-sales activities • Constrained resources

18. Benefits • Increase awareness of cause and effect relationships • Promote performance improvements • Identify non-value-added activities • Motivate cost reduction • Reduce arbitrariness in cost measurement • Optimize use of constrained resources

19. Costs • System design • Accounting system modifications • Employee training • Higher costs when: * There are more activities * Activities are complex * ABC system is complex

20. Uncertainties in ABC and ABM Implementation • Choice of activities • Choice of cost drivers • Inability to foresee all possible uses of information • Choice of denominator in allocation rate