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Activity-Based Costing and Activity-Based Management. Chapter 5. Overview. Over/under costing Reasons to allocate costs Criteria to guide allocation Refining a cost system ABC versus traditional cost systems Costs/Benefits of ABC ABC in service & retail as well as mfg.

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Presentation Transcript
  • Over/under costing
  • Reasons to allocate costs
  • Criteria to guide allocation
  • Refining a cost system
  • ABC versus traditional cost systems
  • Costs/Benefits of ABC
  • ABC in service & retail as well as mfg.
Explain undercosting

and overcosting of

products and services.

undercosting and overcosting example
Undercosting andOvercosting Example

Jose, Roberta, and Nancy order

separate items for lunch.

Jose’s order amounts to $14

Roberta’s order 30

Nancy’s order is 16

Total $60

What is the average cost per lunch?

undercosting and overcosting example5
Undercosting andOvercosting Example

$60 ÷ 3 = $20

Jose and Nancy

are overcosted.

Roberta is


The use of broad averages to allocate costs (aka peanut-butter costing) can lead to product-cost cross-subsidization.

reasons to allocate costs
Reasons to Allocate costs

There are many reasons

for allocating costs to

cost objects.

purposes of cost allocation
Purposes of Cost Allocation

1. To provide information for economic decisions

2. To motivate managers and other employees

3. To justify costs or compute reimbursement

4. To measure income and assets for reporting

to external parties

criteria to guide cost allocation decisions
Criteria to GuideCost-Allocation Decisions


Using this criterion, managers identify the

variable or variables that cause resources

to be consumed.


Using this criterion, managers identify the

beneficiaries of the outputs of the cost object.

criteria to guide cost allocation decisions9
Criteria to GuideCost-Allocation Decisions

Fairness or equity:

This criterion is often cited on government

contracts when cost allocations are the basis

for establishing a price satisfactory to the

government and its suppliers.

Ability to bear:

This criterion advocates allocating costs in proportion to the cost object’s ability to bear them.

role of dominant criteria
Role of Dominant Criteria

Fairness and ability-

to-bear are less

frequently used.

The cause-and-effect

and the benefits-

received criteria

guide most

decisions related

to cost allocations.


refining a costing system
Refining a Costing System

More Direct-cost tracing

Indirect-cost pools

(More homogeneous)

Better cost-allocation bases

activity based costing system
Activity-Based Costing System


Indirect Cost








No. of



No. of














activity based management
Activity-Based Management

ABM describes management decisions that use

activity-based costing information to satisfy

customers and improve profits.

Product pricing and mix decisions

Cost reduction and process improvement decisions

Design decisions

Evaluate the costs and benefits of implementing activity-based costing systems.
benefits of abc systems when the benefits of abc tend to be large
Benefits of ABC Systems(When the benefits of ABC tend to be large)

Significant amounts of indirect costs are

allocated using only one or two cost pools.

All or most costs are identified

as output unit-level costs.

Products make diverse demands on

resources because of differences in

volume, process steps, batch size,

or complexity.

benefits of abc systems
Benefits of ABC Systems

Products that a company is well-suited to

make and sell show small profits while

products for which a company is less

suited show large profits.

Complex products appear to be very

profitable and simple products

appear to be losing money.

benefits of abc systems17
Benefits of ABC Systems

Operations staff have significant

disagreements with the accounting

staff about the costs of manufacturing

and marketing products and services.

Operations staff may even keep their

own set of books!

limitations of abc systems
Limitations of ABC Systems

The main limitations of ABC are the

measurements necessary to

implement the system.

ABC systems require management

to estimate costs of activity pools

and to identify and measure cost

drivers for these pools.

limitations of abc systems19
Limitations of ABC Systems

Activity-cost rates also need to be

updated regularly.

Very detailed ABC systems are costly

to operate and difficult to understand.

abc in service and merchandising companies
ABC In Service andMerchandising Companies

The general approach to ABC in the

service and merchandising areas is very

similar to the approach in manufacturing.

Costs are divided into homogeneous cost

pools and classified as output unit-level,

batch-level, product- or service-sustaining,

and facility-sustaining costs.

abc in service and merchandising companies21
ABC In Service andMerchandising Companies

The cost pools correspond to key activities.

Costs are allocated to products or customers

using activity drivers or cost-allocation

bases that have a cause-and-effect

relationship with the cost in the cost pool.