Week 4 - Activity-based costing

Question 1

Cost distortions under traditional costing systems vs Activity-based costing
eg. what is the allocation base?

eg. Foxconn case: machine time, no. of orders, administration time

Answer 1

Allocation base
TCS: cost centres (departments)
ABC: activities; allows co.s to see the true RESOURCE CONSUMPTION of their products

Under TCS,
1. Products produced in LARGE VOLUMES (often standard)
will receive most of the INDIRECT COSTS
2. Products produced in SMALL volumes (often more
complex, specialty products) will be UNDER-COSTED
– Resource consumption depends on COMPLEXITY more than volume
eg. no. of products, heterogeneity, design features, technology, mfg process, etc.

Question 2

5 steps for allocating indirect costs in ABC

Answer 2

1. Identify activities
2. Measure total activity cost
3. Identify COST DRIVERS
   eg. no. of customer visits
4. Calculate cost PER COST DRIVER UNIT
5. Allocate costs

Question 3

How is excess capacity allocated for traditional full costing vs ABC?

eg. Foxconn case

Answer 3

ABC
1. Products should be allocated for the activities they DEMAND & CONSUME
2. Excess capacity is NOT demanded, so should be only allocated to the biz unit, eg. HQ
*exceptions for STRATEGIC excess capacity
eg. for last minute orders, might create competitive advantage if can provide

Profit/loss per product line
- COST OF EXCESS CAPACITY
= Profit/loss (for company)
Then, ABC cost per unit

TCS
- Excess capacity is allocated to products

Question 4

4 levels of ABC hierarchy & the purpose

Answer 4

ABC hierarchy identifies at which level costs become “variable” & guides the CHOICE of COST DRIVERS
– Costs that may appear fixed (and thus irrelevant in the short-term) under a TCS may instead appear variable (and
thus relevant) under ABC!

1. Unit level costs
2. Batch level costs
3. Product level costs
   eg. design & engineering; more product lines, need more designs & engineers
4. Facility level costs
   eg. general admin, rent, plant mgmt {usually difficult to find cause-effect relationships}

In the airline example, unit level costs would vary with the output but cannot be directly traced to the single passenger
eg. aircrew salaries, jet fuel

Question 5

From Activity-based Costing to
Activity-based Management - 2 example uses of ABC

Answer 5

1. Helps identify VALUE-ADDED vs. NON value-added activities
   - activities that don’t contribute to customer value or to the org.’s needs
   = Source of INEFFICIENCY
2. Track PERFORMANCE in how activities are carried out
   - Cost drivers as measures based on which employee performance can be evaluated

Question 6

4 main advantages of ABC

Answer 6

1. Can give BETTER INFORMATION about how costs arise and how they are related to products
2. Takes into consideration that costs does not only vary with production VOLUME but also depends on COMPLEXITY
3. Can make the cost of EXCESS CAPACITY visible
4. Particularly useful when:
   – If there are LARGE INDIRECT COSTS
   – Complex products appear very profitable & simple products appear to be loss-making
   – If the co. is operating in a very COMPETITIVE industry
   » critical to make correct PRICING & PRODUCT-MIX decisions b/c competitors quickly capitalise on a company’s mistakes

eg. product-mix decisions (blue pens in Cooper & Kaplan pen factory example, 1988), pricing decisions (Colombo Frozen Yogurt case)
- Traditional costing made impulse locations appear more profitable although ABC revealed that the yogurt shops are more profitable

Question 7

4 disadvantages of ABC

Answer 7

1. Can be DIFFICULT and EXPENSIVE to identify and measure activities & cost drivers
2. The costing system can become very COMPLICATED w/ a very large number of activities and cost drivers
3. Doubtful if all costs really are VARIABLE, also in the LONGER-RUN (that is an assumption in ABC)
4. UNCERTAIN if the result provides any positive information effects on decisions

Question 8

From Activity-based Costing to
Activity-based Management (CIMA, 2001)

Answer 8

1. ABM draws on ABC to provide management reporting and decision making
2. ABM supports business excellence by providing information to facilitate long-term strategic decisions about such things as product mix and sourcing
3. ABM also supports the quest for continuous improvement by allowing management to gain new insights into activity performance by focusing attention on the sources of demand for activities…
4. …and by permitting management to create behavioural incentives to improve one or more aspects of the business {link ABC data to employees’ P&L as in GE Inc. case}

Question 9

How to link the Colombo Frozen Yogurt case to cost drivers?

Answer 9

By using different cost drivers for organisational activities, a higher amount of costs can be TRACED DIRECTLY to the product
eg. shipping costs allocated to pallets vs individual cases, merchandising allocated to kits, SG&A costs based on sales personnel time