BA 252 Introduction to Management Accounting

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BA 252 Introduction to Management Accounting ...

    BA 252 Introduction to Management Accounting

    Chapter 5

    Activity-Based Cost Management Systems


? Jonathan Kellogg is the owner and CEO of Booth Motors.

    ? Booth Motors is an automobile dealership with four other lines of business.

    1 Used cars

    2 Parts

    3 Service

    4 Finance and insurance

    ? Kellogg felt that as one of the largest auto dealerships in the Midwest, Booth should

    be earning much more than one percent pre-tax margin on sales.

    ? The existing accounting system allocates operating expenses to each department

    based on sales.

    Learning Objective 1

     Understand how traditional cost systems, using only unit-level drivers, distort

    product and customer costs.

Traditional Manufacturing Costing Systems

    ? Traditionally, job-order and process costing systems have assigned direct labor and

    direct materials costs to products.

    ? Indirect costs were accumulated as support department expenses.

    ? These expenses were allocated to production departments in a simple proportion.

    ? Historically, Cooper Pen had been a low cost producer of BLUE and BLACK pens.

    ? Recently, these product lines have expanded into two new products.

    ? The plant’s indirect expenses, about $180,000 per quarter, were aggregated at the

    plant level and allocated to products based on direct labor.

    ? The overhead burden rate was 300% of direct labor costs.

    ? The controller of Cooper Pen Company wondered whether they should continue to

    de-emphasize their commodity products, and to keep introducing the new specialty

    colored pens.

     Page 160 Exhibit 6-1

    ? Traditional costing systems distort product costs.

    ? They use unit level drivers, such as direct labor dollars, for allocating production

    center expenses to products.

    Learning Objective 2

    Describe why factories producing a more varied and complex mix of products have

    higher costs than factories producing only a narrow range of products.

Simple and Complex Factories

BA 242 Chapter 5 Notes Page 2 of 7

    ? A simple factory has little need for a cost system to calculate the cost of its product. ? A complex factory requires many resources to support a highly varied product mix. ? Complex factories require a cost accounting system to trace expenses to its various products.

    ? Traditional cost systems will under-estimate the cost of resources required for specialty, low-volume products.

    ? These systems will over-estimate the resource cost of high volume, standard products.

    ? Activity-based cost systems have been developed to eliminate this source of cost distortion.

    Question Time

    ? Page 191

    ? Question 1 5

    Learning Objective 3

     Design an activity-based cost system by linking resource costs to the activities

    performed and then to cost objects, such as products and customers.

Activity-Based Cost Management Systems

    ? Activity-based cost-management systems trace indirect and support expenses accurately to individual products, services, and customers.

    ? ABC systems use a simple two-stage approach similar to traditional cost systems. ? However, instead of using cost centers for accumulating costs, it uses activities. ? What do managers do in an activity-based management?

    ? Managers use information collected by the ABC system at the activity level to identify promising opportunities for reducing costs in indirect and support activities. ? The controller of Cooper Pen Company developed an activity-based cost system. ? How are overhead rates determined under activity-based costing?

    1 Identify the activities performed.

    2 Determine the cost of performing each activity.

    3 Identify a cost driver for each activity.

    4 Determine the number of units of the cost driver made available by the resources

    committed to each activity.

    5 Divide the activity cost by the number of cost driver units made available to

    determine the activity overhead rate.

    ? An activity dictionary is the list of the major activities performed by an organization’s resources.

    Tracing Costs to Activities

    ? ABC allocation procedures trace all overhead costs to activity cost pools.

    Run Machines

    Setup Machines

    Handle Production Runs

    Support Products

BA 242 Chapter 5 Notes Page 3 of 7

    ? What are examples of production activities?


    Product Sustaining


    Facility Sustaining

    ? Exhibits 5-2 & 5-3, page 166

    Learning Objective 4

    Appreciate the role for choosing appropriate activity cost drivers when tracing

    activity costs to products and customers.

    Tracing Costs From Activities to Products

    ? Activity cost drivers identify the linkage between activities and cost objects.

    ? What are some examples of cost objects?




    ? What is an activity cost driver?

    ? It is a unit of measurement for the level (or quantity) of the activity performed.

    ? What is a cost driver rate?

    ? It is a rate obtained by dividing the activity expense by the total quantity of the

    activity cost driver.

    ? What are some examples of cost drivers?

    Handle Production Runs -- Production Runs

    Support Products -- Number of Products

    Setup Machines -- Setup Hours

    Run Machines -- Machine Hours

    ? Exhibit 5-5 & 5-6, Page 169

    ? Exhibit 5-7 & 5-8; Page 170

    More Questions and a Problem

    ? Page 191 Question 6, 7, 9, & 10

    ? Page 195 Problem 29

    Learning Objective 5

     Use the information from a well-designed activity-based cost system to improve

    operations and make better decisions about products and customers.

Product Profitability

    ? A bill of activities is the set of activities and their costs associated with individual


    ? Activity-based management (ABM) involves decisions on pricing, distribution,

    product design, and minimum order sizes so that loss products can become


    Activity-Based Cost systems

    ? Activity cost drivers are the central innovation of activity-based cost systems.

BA 242 Chapter 5 Notes Page 4 of 7

    ? They are also the most costly aspects of ABC systems.

    ? The selection of an activity cost driver reflects a subjective trade-off between

    accuracy and the cost of measurement.

    ? ABC system designers can choose from three different types of activity cost drivers.

    ? Transaction drivers count how often an activity is performed. ? What are some examples?

     number of setups

     number of receipts

     number of products supported

    ? Duration drivers represent the amount of time required to perform an activity. ? What are some examples?

     setup hours

     inspection hours

     direct labor hours

    ? Intensity drivers directly charge for the resources used each time an activity is


    ? What are some examples?

     actual time

     specific resources committed

    ? Intensity drivers may be simulated with a weighted index approach.

    ? The goal of a properly constructed ABC system is to have a cost system that

    balances the cost of errors made from inaccurate estimates with the cost of


    Learning Objective 6

     Understand the importance of measuring the practical capacity of resources and

    the cost of unused capacity.

Measuring the Cost of Resource Capacity

    ? Practical capacity represents the maximum output that could be handled efficiently. ? The activity cost driver rate should reflect the underlying efficiency of the process.

    ? How should the activity cost driver rate be computed?

    ? The numerator represents the cost of supplying resource capacity to do work.

    ? The denominator should match the numerator by representing the quantity of

    work the resources can perform.

    ? The cost of unused capacity is the cost of capacity available but not utilized.

    ? There are two ways for organizations to actively manage unused capacity.

    1 Increase the volume of business.

    2 Reduce the supply of unused resources.

    Learning Objective 7

     Assign marketing, distribution, and selling expenses to customers.

Marketing, Selling, and Distribution Expenses

BA 242 Chapter 5 Notes Page 5 of 7

    ? The costs of marketing, selling, and distribution expenses have been increasing rapidly. ? Many of these expenses do not relate to individual products or product-lines. ? These expenses are associated with individual customers, market segments, and distribution channels.

    ? What are examples of marketing, selling, and distribution activities?

    Travel to Customers

    Distribute Sales Catalog

    Service Customers

    Provide Marketing and Technical Support

    Warehouse Inventory for Customers

    ? What are examples of activity cost drivers?

    Actual Expenditures

    Number of Mailings

    Time Spent on Customers

    Quantity of Inventory and space required

    Learning Objective 8

     Analyze customer profitability.

Customer Profitability Exhibit 5-10, Page 180

    Learning Objective 9

     Appreciate the role for activity-based cost systems for service companies.

Service Companies

    ? Why are service companies ideal candidates for activity-based costing? ? The majority of their costs are indirect and appear to be fixed. ? The variable cost is essentially zero.

    ? Why do service companies need to identify the differential profitability of

    individual customers?

    ? Because the variation in demand for organizational resources is much more

    customer-driven than in manufacturing organizations.

    Learning Objective 10

    Discuss the barriers for implementing activity-based cost systems and how these

    might be overcome.

Barriers to Implementing ABC

    ? What are some of the barriers to implementing ABC systems? ? Lack of clear business purpose

    ? Lack of senior management commitment

    ? Delegating the project to consultants

    ? Poor ABC model design

    ? Individual and organizational resistance to change

BA 242 Chapter 5 Notes Page 6 of 7

BA 242 Chapter 5 Notes Page 7 of 7


    ? Jonathan Kellogg and his controller developed an activity-based cost model of Booth Motors.

    ? They identified activities for three of the product lines.

     New Vehicle Department

     Finance & Insurance


    ? What did the product line analysis show?

    ? Profits from financing and insuring new and used cars accounted for nearly 50% of total dealer profitability.

    ? The profitable car line had the lowest average days on lot.

    ? Seemingly, most popular car lines were unprofitable.

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