L01: Recognize difference between traditional costing and ABC, and understand the nature of ABC:

Traditional Costing Systems:

- Probably impossible to determine exact cost of a product or service
- Product’s cost can be estimated most accurately when this cost can be traced directly to
the product produced or the service provided
- DM and DL costs are the easiest to determine because they can be traced directly to the
product by examining materials requi sition forms and payroll time sheets
- OH costs are indirect or joint costs that generally cannot be easily or directly traced to
individual products or services → we use estimates to assign OH costs to products and
services
- Most difficult part of calculating accurate unit costs is determining the proper amount of OH cost
to assign to each product, service, or job
- Previously used a predetermined OH rate for OH costs

Need for a New Approach:

- Historically, the use of DL as the activity base made sense because DL made up a large
portion of total manufacturing cost
- There was a high correlation between DL and the incurrence of OH cost
- DL thus became the most popular basis for allocating OH
However:
- With technological innovation, global competition, and automation, the manufacturing
environment changed dramatically
- Amount of DL used in many industries has significantly decreased
- Total OH cost from depreciation on expensive equipment and machinery from
utilities, repars, and maintenance have significantly increased
- When there is little to no correlation between DL and OH, it is inappropriate to
use plant-wide predetermined OH rates that are based on DL
 - Comapnies that use OH rates based on DL when this correlation does not exist
experience significant product cost distortions
- To avoid distortions many companies now use machine hours as the basis for allocating
OH in an automated manufacturing environment → but this can be inadequate as the only
plant-wide basis for allocating all OH
- Companies with complex processes need to use multiple allocation bases to
calculate accurate product costs
- An OH cost allocation method that uses multiple bases is activity-based costing

Activity Based Costing:

- Activity-based costing:
- Approach for allocating OH costs
- Specifically, ABC allocates OH to multiple activity cost pools, and then assigns the
activity cost pools to products and services by using cost drivers
- Activity: Any event, action, transaction, or work sequence that incurs costs when
producing a product or performing a service
- Activity cost pool: The OH costs attributed to a distinct activity (ex: ordering materials)
- Cost driver: Any factor or activity that has a direct cause-effect relationship with the
resoufces consumed
- The reasoning behind ABC cost allocation is simple:
- Products consume activities, and activities consume resources

Steps of ABC:
Activities and related cost drivers:

L02: Apply ABC to a manufacturer:

Step 1: Identify and Classify Activities and Allocate OH to Cost Pools:
- A well designed ABC system begins with an analysis of the activities performed to manufacture a
product or provide a service
- Analysis should identify all resource-consuming activities
- It requires documenting every activity undertaken to accomplish a task
Step 2: Identify Cost Drivers:
- After costs are allocated to the activity cost pools, the company must identify the cost drivers for
each cost pool
- The cost driver must accurately measure the actual consumption of the activity by the various
products
- To achieve accurate costing, a high degree of correlation must exist between the cost
driver and the actual consumption of the OH cost in the cost pool
- This is an area that has benefitted greatly from company data collection efforts at nearly
every stage of the value chain
- By applying analytics to these data, the company can increase the likelihood that cost
drivers are closely related to resource consumption
- The availability and ease of obtaining data relatin to the cost driver are important factors
that must be considered in its selection

Step 3: Calculate OH Rates:

- Company must calculate an activity based OH rate per cost driver

Step 4: Assign OH Costs to products:

- Necessary to know the use of cost drivers for each product
Unit Cost Comparison:

- Shows that costs under traditional costing are often misleading and different from ABC
- ABC allows more accurate assignment of MOH costs

L03: Benefits and Limitations of ABC:

Benefits of ABC:
- ABC employs more cost pools and therefore results in more accurate product costing
- ABC leads to enhanced control over OH costs
- ABC supports better management decisions
Advantage of multiple cost pools:
- Main mechanism by which ABC increases product cost accuracy
- Costs are assigned more accurately on the basis of the cost drivers used to produce each product
- In many companies, the number of activities can be substantial

Assigning non-manufacturing overhead costs:

- Non-manufacturing OH costs included in selling and admin expenses represent a significant
portion of company costs:
- GAAP require that these costs be expensed during the current period as period costs,
rather than assigning these costs to products
- To gain better understanding of product and/or customer profitability, many companies
use ABC to assign some non-manufacturing costs to products or customers
- If shipping costs are included in the selling expense category, these costs can usually be
directly traced to specific products
- Incurrence of other costs included in selling expenses can vary considerably
across products or customers

Classification of Activity levels:

- Unit-level activities:
- Performed for each unit of production
- Batch-level activities:
- Performed every time a company produces another batch of product
- The amount of time spent setting up machines increases with the number of batches
produced, not with the number of units produced
- Product-level activities:
- Performed every time a company produces a new type of product
- The amount of time spent on testing activities increases with the number of products a
company produces
- Facility-level activities:
- Required to support or sustain an entire production process
- These costs do not vary as a function of the number of units, batches, or products
Advantage of enforced cost control;
- Decision tool: The activity analysis flowchart is extended to identify each activity as value-added
or non value-added
- Companies use activity flowcharts to help identify the ABC activities

- Value Added Activities:

- Essential activities of a company’s operations that increase the perceived value of a
product or service to customers
- Supervision of value-added activities is in itself a value-added activity
- Non Value Added Activities:
- Non-essential activities, that if eliminated would not reduce the perceived value of a
company’s product or service
- Simply add cost to, or increase the time spent on a product or service without increasing
its perceived value

Advantage of Better Management Decisions:

- ABC information helps establish performance standards within the company and benchmark its
performance against other companies
- Can help increase profitability, improve marketing strategy, and increase employee efficiency
Some limitations of ABC and knowing when to use ABC:
- ABC can be expensive to use:
- The increased cost of identifying multiple activities and applying numerous cost drivers
discourages many companies from using ABC
- ABC systems are also more complex than traditional systems
- Some arbitrary allocations remain:
- Even though more OH costs can be assigned directly to products trough ABC, some OH
costs still need to be allocated by arbitrary cost drivers
How to know when to use ABC:
- Product lines differ greatly in volume and manufacturing complexity
- Product lines are numerous and diverse, requiring various degrees of support services
- OH costs constitute a significant portion of total costs
- The manufacturing process or the number of products has changed significantly
- Production or marketing managers are ignoring data when pricing or making other product
decisions → use “bootleg” costing data

Activity Based Management:

- An extension of ABC from a product costing system to a management function that focuses on
reducing costs and improving processes and decision making
- Also referred to as Cost Engineering, or Strategic Cost Management

L04: ABC in Service industries:

- Although initially developed and implemented by manufacturers, ABC is also widely used in
service industries
- Overall objective of ABC in a service firm is no different than it is in a manufacturing
company
- The objective is to identify the key activities that generate costs and to keep track of how
many of those activities are completed for each service performed
- A larger proportion of OH costs are company-wide costs → compared to manufacturing
companies
Traditional costing:
ABC:

Assigning OH in a service company:

Traditional costing VS ABC costing