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chap008doc - Chapter 2

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    Chapter 8

    Lecture Notes

    Chapter theme: This chapter introduces students to

    activity-based costing (ABC) which is a tool that has 1 been embraced by a wide variety of service,

    manufacturing, and non-profit organizations.

    I. Activity-based costing: key definition

    A. ABC is a costing method that is designed to provide

    managers with cost information for strategic and other

    decisions that potentially affect capacity and therefore

     2 ―fixed‖ as well as variable costs. It is ordinarily used as

    a supplement to, rather than as a replacement for, the

    company’s usual costing system.

II. How costs are treated under activity-based costing

    A. ABC differs from traditional cost accounting in three

    ways:

    Learning Objective 1: Understand activity-based

    costing and how it differs from a traditional costing 3

    system.

    i. Nonmanufacturing as well as manufacturing

    costs may be assigned to products, but only on

    a cause-and-effect basis.

     4 1. For example, ABC systems can assign sales

    commissions, shipping costs, and warranty

    repair costs to specific products.

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    ii. Some manufacturing costs may be excluded

    from product costs.

    1. This is because ABC only assigns a cost to a

    product if decisions concerning that product

    will cause changes in the cost. 5 2. ABC excludes two types of costs from

    product costs:

    a. Organization-sustaining costs (which

    will be formally defined later)

    b. The costs of unused or idle capacity.

Helpful Hint: Emphasize that ABC systems that are

    used to support internal decision making do not need to

    conform to GAAP. Therefore, while GAAP requires

    treating selling and administrative expenses as period

    expenses and it requires assigning all manufacturing

    costs to products, ABC systems can assign selling and

    administrative expenses to products and they can

    exclude manufacturing costs from product costs where

    appropriate.

    iii. Numerous overhead cost pools are used, each

    of which is allocated to products and other cost

    objects using its own unique measure of

    activity.

    1. ABC cost pools are created to correspond to

    the activities performed in an organization 6

    that cause the consumption of overhead

    resources. Therefore, the total number of

    ABC cost pools will definitely exceed one

    (as in the plantwide approach) and it is

    likely to exceed the number of departments

    within a company (as in the departmental

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    approach) since more than one activity is

     6 often performed within each department.

    2. Each ABC cost pool has its own unique

    measure of activity. On the contrary,

    traditional cost systems usually rely on

    direct labor hours and/or machine hours

    to allocate all overhead costs to products.

    a. Direct labor and machine hours work

    correctly when changes in the quantity

    of the base are correlated with changes

    in the overhead costs being assigned

     7 using the base.

    b. Relying exclusively on these bases to

    assign overhead costs to products has

    come under increased scrutiny since,

    on an economy-wide basis, direct labor

    and overhead costs have been moving

    in opposite directions and the variety

    of products produced by companies

    has increased.

    B. Key definitions/concepts

i. An activity is any event that causes the

    consumption of overhead resources.

    ii. An activity cost pool is a ―bucket‖ in which 8

    costs are accumulated that relate to a single

    activity measure in an ABC system.

    iii. An activity measure is an allocation base in an

    activity-based costing system. The term cost

    driver is also used to refer to an activity 9

    measure. The two most common types of

    activity measures are:

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    1. Transaction drivers are simple counts of

    the number of times an activity occurs such

    as the number of bills sent out to customers.

    2. Duration drivers measure the amount of 10

    time required to perform an activity such as

    the time spent preparing individual bills for

    customers.

Helpful Hint: Introduce the cost-benefit concept by

    explaining that transaction drivers are more prevalent

    in practice than duration drivers because the data is

    much easier to obtain. The additional accuracy

    provided by duration drivers often times does not pass

    the cost-benefit test.

    iv. Traditional cost systems rely exclusively on

    allocation bases that are driven by the volume

    of production. ABC defines five levels of 11

    activity that largely do not relate to the

    volume of units produced.

    1. Unit-level activities are performed each

    time a unit is produced.

    a. For example, providing power to run

    processing equipment would be a unit-

    level activity.

    2. Batch-level activities are performed each

    time a batch is handled or processed, 12

    regardless of how many units are in the

    batch.

    a. For example, setting up equipment and

    shipping customer orders are batch-

    level activities.

    3. Product-level activities relate to specific

    products and must be carried out regardless

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    of how many batches are run or units are

    produced or sold.

    a. For example, designing or advertising

    a product would be product-level

    activities.

    4. Customer-level activities relate to specific

    customers and are not tied to any specific

    product.

    a. For example, sales calls and catalog

     12 mailings would be customer-level

    activities.

    5. Organization-sustaining activities are

    carried out regardless of which customers

    are served, which products are produced,

    how many batches are run, or how many

    units are made.

    a. For example, heating a factory and

    cleaning executive offices are

    organization-sustaining activities.

    III. Designing an activity-based costing (ABC) system

    A. Characteristics of a successful ABC implementation:

    i. There should be strong top management

    support. 13

    1. Without leadership from top management,

    some managers may not be motivated to

    embrace the need to change.

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ii. Top managers should ensure that ABC data are

    linked to how people are evaluated and

    rewarded.

    1.<