Use of Broad Average

●​ In allocating indirect costs can have a number of adverse consequences

●​ Traditional product-costing methods use a single indirect cost rate to allocate costs
to all products
●​ Different products consume activities at different rates, traditional costing does not
recognize these differences

Refined Cost System

●​ Reduces the use of broad averages for assigning costs of resources to cost objects
●​ Reasons:
○​ Increase in product diversity
○​ Increase in indirect costs
○​ Competition in product markets

Three Guidelines for Refining a Costing System:

●​ Direct-Cost Tracing
○​ Identify as many direct costs as is economically feasible
●​ Indirect-Cost Pools
○​ Each cost in the pool has a similar cause-and-effect relationship with a
single cost driver
●​ Cost-Allocation Bases
○​ The cost driver serves as the cost allocation base for each homogeneous
indirect-cost pool

How Costs are Treated Under Activity-Based Costing (ABC)

●​ ABC differs from traditional cost accounting in three ways:

Traditional Product Costing (All)

Manufacturing Costs
ABC Product Costing (Most, but not
all)

Non-manufacturing Costs ABC Product Costing (Some)

●​ ABC assigns both types of costs to products
●​ ABC does not assign all manufacturing costs to products
●​ ABC differs from traditional cost accounting in three ways:
○​ Activity Based Costing (Highest Level of Complexity)
○​ Departmental Overhead Rates (Middle Level of Complexity)
○​ Plantwide Overhead (Lowest Level of Complexity)
●​ ABC uses more cost pools
●​ ABC differs from traditional cost accounting in three ways:
○​ Each ABC cost pool has its own unique measure of activity
○​ Traditional cost systems usually rely on volume measures such as direct
labor hours and/or machine hours to allocate all overhead costs to products
●​ ABC defines four levels of activity that largely do not relate to the volume of units

Activity
●​ An event that causes the consumption of overhead resources
Activity Cost Pool
●​ A “cost bucket” in which costs related to a single activity measure are accumulated

Activity Measure
●​ The term cost driver is also used to refer to an activity measure
●​ An allocation base in activity-based costing system

Four Classifications of Activities (Manufacturing)

●​ Output unit-level cost
●​ Batch-level cost
●​ Product-sustaining cost
●​ Facility-sustaining cost

Unit Output-Level
●​ Cost of activities performed on each individual unit of a product or service
●​ Example:
○​ Machine Operations Costs such as the cost of energy, machine
depreciation, and repair related to activity of running the automated
molding machines
○​ They are output level cost because, overtime, the cost of this activity
increases with additional units of output produced (or machine-hours used)

Batch-Level Costs
●​ Costs of activities related to a group of units of a product or services rather than
each individual unit of product or service
●​ Example:
○​ Set-up costs – batch level costs because over time, the cost of this set-up
activity increases with set-up-hours needed to product batches
○​ Other examples of batch level costs are material-handling and quality
inspection cost associated with batches not the quantities of product
produced

Product-sustaining Costs
●​ Are the costs of activities undertaken to support individual products or services
regardless of the number of units or batches in which the units are products
●​ Example:
○​ Design cost – product sustaining cost because over time, design costs
depend largely on the time designers spend on designing and modifying
the product, the mold and the process

Facility-sustaining costs
●​ Costs of activities that cannot be traced to individual products or services but
support the organization as a whole
●​ Example:
○​ General Administration Costs (including top management compensation,
rent and building security) – usually difficult to find a good cause and effect
relationship between these costs and the cost-allocation base
Example of Activity-Based Cost:

Manufacturing overhead is allocated to products using a single plantwide overhead rate

based on machine hours.

Activity Cost Pools at Baxter Battery:

Activity Cost Pool Activity Measure

Customer orders Number of customer orders

Design changes Number of design changes

Order size Machine-hours

Customer relations Number of active customers

Other NOT applicable

Customer orders
●​ Assigned all costs of resources that are consumed by taking and processing
customer orders

Design Changes
●​ Assigned all costs of resources consumed by customer-requested design changes

Order Size
●​ Assigned all costs of resources consumed as a consequences of the number of
units produced

Customer Relations
●​ Assigned all costs associated with maintaining relations with customers

Other
●​ Assigned all facility-sustaining costs and unused capacity costs
Example:

Direct Materials, Direct Labor, and Shipping are EXCLUDED because Baxter Battery’s
existing cost system can directly trace these costs to products or customer orders

At Baxter Battery the following distribution of resource consumption across activity cost
pools is determined.
The ABC team determines that Baxter Battery will have these total activities for each
activity cost pool:
●​ 10,000 customer orders
●​ 4,000 design changes
●​ 800,000 machine-hours
●​ 2,000 customers served

Now the team can compute the individual activity rates by dividing the total cost for each
activity by the total activity levels:

Baxter Battery Information:

Sure Start
1.​ Requires no new design resources
2.​ 800,000 batteries ordered with 4,000 separate orders
3.​ Each SureStart requires 36 minutes of machine time for a total of 480,000
machine-hours

LongLife
1.​ Requires no new design resources
2.​ 400,000 batteries ordered with 6,000 separate orders
3.​ 4,000 custom designs prepared
4.​ Each LongLife requires 48 minutes of machine time for a total of 320,000
machine-hours
Product Margin Calculations
1.​ Gather each product’s sales and direct cost data.

2.​ Incorporate the previously computed activity-based cost assignments pertaining

to each product.

3.​ Deduct each product’s direct and indirect costs from sales.

●​ The product margins can be reconciled with the company’s net operating income
as follows:

Product Margin – Traditional Cost System

1.​ Gather each product’s sales and direct cost data

2.​ Compute the plantwide overhead rate

 3.​ Allocate manufacturing overhead to each product

4.​ Compute product margins

ABC vs. Traditional Product Costs

●​ Traditional Cost System overcosts the “SureStarts” and reports a lower product
margin for this product
○​ It also undercosts the LongLifes and reports a higher product margin for
this product
●​ Example:

●​ Three reasons why the reported product margins for the two costing systems differ
from one another:
1.​ Traditional costing allocates all manufacturing overhead to products. ABC
costing only assigns manufacturing overhead costs consumed by products
to those products
2.​ Traditional costing allocates all manufacturing overhead costs using a
volume-related allocation base. ABC costing uses non-volume related
allocation bases
3.​ Traditional costing disregards selling and administrative expenses because
they are assumed to be period expenses. ABC costing directly traces
shipping costs to products and includes non-manufacturing overhead costs
caused by products in the activity cost pools that are assigned to products

Activity-Based Costing Limitations

●​ Substantial resources required to implement and maintain
●​ Resistance to unfamiliar numbers and reports
●​ Desire to fully allocate all costs to products
●​ Potential misinterpretation of unfamiliar numbers
●​ Does NOT conform to GAAP. Two costing systems may be needed