Accounting Discussion #3 (part A)

ABC differs from traditional cost accounting in three ways. The first is that nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis. For example, ABC systems can assign sales commissions, shipping costs, and warranty repair costs to specific products.

The second major difference between ABC and traditional cost accounting is that some manufacturing costs may be excluded from product costs. This is because ABC only assigns a cost to a product if decisions concerning that product will cause changes in the cost. ABC excludes two types of costs from product costs:

• Organization-sustaining costs (which will be formally defined later); and
• The costs of unused or idle capacity.

The third major difference between ABC and traditional cost accounting is that numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measure of activity. ABC cost pools are created to correspond to the activities performed in an organization 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 approach), since more than one activity is often performed within each department.

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.

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 using the base.

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.

An activity is any event that causes the consumption of overhead resources.

An activity cost pool is a “bucket” in which costs are accumulated that relate to a single activity measure in an ABC system.

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 measure. The two most common types of activity measures are shown on the next slide.

Two types of activity measures include:

• Transaction drivers – simple counts of the number of times that an activity occurs such as the number of bills sent out to customers.
• Duration drivers — measures of the amount of time needed to perform an activity such as the time spent preparing individual bills for customers.

Traditional cost systems rely exclusively on allocation bases that are driven by the volume of production. ABC defines five levels of activity that largely do not relate to the volume of units produced.

In an activity-based cost system, companies typically combine their activities into the following five classifications:

• Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment would be a unit-level activity.
• Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities.
• Product-level activities relate to specific products and must be carried out regardless of how many batches are run or units are produced or sold. For example, designing or advertising a product would be product-level activities.
• Customer-level activities relate to specific customers and are not tied to any specific product. For example, sales calls and catalog mailings would be customer-level activities.
• 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. For example, heating a factory and cleaning executive offices are organization-sustaining activities.

There should be strong top management support. Without leadership from top management, some managers may not be motivated to embrace the need to change.

Top managers should ensure that ABC data are linked to how people are evaluated and rewarded. If employees continue to be evaluated and rewarded using traditional (non-ABC) cost data, they will quickly get the message that ABC is not important and they will abandon it.

A cross-functional team should be created to design and implement the ABC system. Cross-functional employees possess intimate knowledge of operations that is necessary for designing an effective ABC system. Tapping the knowledge of cross-functional managers lessens their resistance to ABC because they feel included in the implementation process.

Activity-based management is used in conjunction with ABC to identify areas that would benefit from process improvement. It involves focusing on activities to eliminate waste, decrease processing time, and reduce defects.

While the theory of constraints approach discussed in Chapter 1 is a powerful tool for targeting process improvement efforts, the activity rates computed in ABC can also provide valuable clues concerning where there is waste and the opportunity for improvement.

Benchmarking can be used to compare an organization’s activity rates with standards of performance that are external to the organization.

There are four reasons why most companies do not use ABC for external reporting purposes. First, external reports are less detailed than internal reports in the sense that individual product costs are not reported. External reports only disclose cost of goods sold and ending inventory. Therefore, if some products are undercosted and others are overcosted, the errors tend to cancel each other out when the product costs are added together. Next, it is often very difficult to change a company’s accounting system because it is deeply embedded within complex computer programs that have evolved over many years.

Third, an ABC system, such as the one described in the chapter, does not conform to generally accepted accounting principles (GAAP). It excluded some organization-sustaining manufacturing costs, some unused capacity costs, and it included some nonmanufacturing costs in its product cost calculations. These cost system design attributes do not comply with GAAP. Finally, auditors are likely to be uncomfortable with cost allocations that are based upon interviews with the company’s personnel. This type of subjective data can be easily manipulated by management.

There are five limitations of activity-based costing. First, implementing an ABC system requires substantial resources. The benefits of increased cost accuracy may not outweigh the implementation costs.  Next, ABC systems produce numbers, such as product margins, that are at odds with the numbers produced by traditional cost systems. Managers are not accustomed to managing their operations using these numbers; hence, ABC inevitably faces resistance. This underscores the importance of having top management support for, and cross-functional involvement with, the ABC implementation. Also, in practice, most managers insist on fully allocating all costs to products. The ABC system described in the main portion of this chapter does not conform to this preference.  The next limitation is that ABC systems do not automatically identify the relevant costs for particular decisions; therefore, ABC data can be easily misinterpreted and must be used with care when making decisions. Costs assigned to products, customers, and other cost objects are only potentially relevant. Finally, most organizations use ABC as a supplement to, rather a replacement for, their existing cost system. Maintaining two cost systems is costlier than maintaining just one system and it may cause confusion about which set of numbers is to be relied on.

End of chapter 6.

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