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CHAPTER 5

Activity-Based Costing
And Activity-Based
Management

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Allocation of factory overhead

Allocated to WIP in a rational, systematic manner.


A variety of methods can be used.
Methods involve tradeoff - simplicity versus realism

Simple Methods
Unrealistic

Complex Methods
Realistic

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Allocation methods in the past


Historically
Limited product mix
Relatively few indirect costs
Simple allocation schemes using broad averages
Such methods are called peanut-butter costing
Result: Over- and under-costing

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Cost distortions
Overcosting Product consumes few resources
but is allocated high costs per unit
Undercosting Product consumes many
resources but is allocated low costs per unit

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Product cross-subsidization
Overcosting one product while undercosting
another

Overcosted
Cost allocated to product is more than actual cost
Products actual profit is higher than calculated profit
Undercosted
Cost allocated to product is less than actual cost
Products actual profit is lower than calculated profit

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Each allocation method


is

mathematically correct
is acceptable
yields different cost figures
yields different Gross Margin figures
affects overhead only
Total Costs for the entire firm are unchanged

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Selecting allocation method


Factors to consider
Experience
Industry practice
Cost-benefit tradeoff for each method

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Accurate costing information

Used for critical decisions


Which products should be pushed?
Which products should be discontinued?

Accounting for overhead costs is inherently


imprecise
Information technology has given firms the ability to
compete on cost like never before

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When is cost refinement needed?


1. Product diversity has increased
Costs to support products differ greatly
Classic direct cost allocation bases (ex., DLH) do not reflect
differences in support costs
2. Indirect costs have increased
Automation leads to high overhead costs. May be inaccurate to
allocate using classic allocation bases
3. Product markets have become more competitive
Razor-thin margins require accurate costing

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ABC cost hierarchy


Four-level cost structure

Unit-level (output-level)
Batch-level
Product-sustaining-level
Facility-sustaining-level

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ABC vs. Simple Costing Schemes


ABC
use of multiple drivers across multiple levels
superior cost accuracy
vulnerable to poorly chosen drivers, which
produce inaccurate costs

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Activity-Based Management
Use of ABC in critical decisions

Pricing & product-mix decisions


Cost reduction & process improvement decisions
Design decisions
Planning & managing activities

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Reasons to adopt ABC


Significant

overhead costs, very few cost pools


All overhead is treated as unit-level
Products consume resources in different amounts
Apparently solid products consistently show small profits
Operations staff disagrees with accounting about costs
of manufacturing and marketing

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ABC for Service/Merchandising Firms


ABC is widely used outside manufacturing

Health Care
Banking
Telecommunications
Retailing
Transportation

2009 Pearson Prentice Hall. All rights reserved.

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