ABC vs Traditional Costing The difference between ABC or Activity Based Costing and TCA or Traditional Cost Accounting

is that ABC is complex whereas TCA is simple. The ABC system began in 1981 whereas TCA methods were designed and developed between 1870 to 1920. In the TCA system, the cost objects and used up resources are required to evaluate the cost whereas in the ABC system the cost is dependent upon the activities used up by the cost objects. Activity Based Costing is accurate and preferred over the TCA cost management system. The ABC method of cost management system is adopted when the overheads of the company are high and there are large numbers of miscellaneous products. Inaccuracy or errors are most unwanted and undesirable because of the competitive rates set by the competitors in the market. Due to this heavy and stiff competition, a highly reliable and accurate method is required for the cost management. TCA or Traditional Cost Accounting uses a single overhead pool and is not able to calculate the true cost. The costs of the objects are allocated randomly based upon the labor or machine hours etc. ABC costing includes identifiable products parts or labor whereas TCA arbitrarily accumulates expenses, salaries, depreciations etc. Smaller targeted costs that are built upon activities are calculated with the help of the ABC system. The ABC system is advantageous since it helps in simplifying the decision making process and it makes management concepts become clear and target -oriented. It also helps in evaluating performances and sets standards which can help the manager to use this information for comparison purposes. In the Traditional Cost Accounting System, the company determines the cost of production after the products have been produced whereas in the target or Activity Based Accounting System, the value or cost of the product is determined on the basis of customer feedback and pocket range. The ABC system helps the company to determine whether to lower or raise the activities cost to grab the consumers. The ABC system also helps in keeping up with the competitors without sacrificing the quality and the quantity of the products. Summary: 1. Traditional cost accounting is obsolete whereas Activity Based Accounting is used more by various target-oriented companies. 2. ABC methods help the company to identify the needs of keeping or eliminating certain activities to add value to the products. 3. TCA methods focus on the structure rather than on processes whereas ABC methods focus on the activities or processes rather than on the structure.

4. ABC provides accurate costs whereas TCA accumulates values arbitrarily. 5. TCA is almost obsolete whereas ABC methods are largely in use since 1981.

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Management Accounting: Concepts, Techniques & Controversial Issues

James R. Martin Chapter 7 Activity Based Product Costing1 MAAW's Book Main Page CONTENTS
Learning Objectives Introduction ABC Concepts The ABC Technique What is ABC? Four Steps in Designing an Problems with Traditional Systems ABC System or Sub-System The Causes of Product Cost Distortions Three Steps to Obtain ABC Costs Exhibit 7-1 The Logic of ABC - Figure 7-1 Comparing Traditional Production Volume Activity Volume - Exhibit 7-2 Based Systems and ABC Systems How are Activity Measures Chosen? ABC Cost Hierarchy Distinction Between Activity Drivers and Activity Measures - Exhibit 7-3 CAM-I ABC and the Dichotomy of Capitalism What is CAM-I? Technology and Automation Controversial Issue: How Should ABC be Focused Factories and JIT Used? Quality and Customer Responsiveness Footnotes Questions

Problems Extra MC Questions

Problem Solutions

LEARNING OBJECTIVES After you have read and studied this chapter, you should be able to: 1. Explain how activity based costing (ABC) fits into an overall cost accounting system. 2. Describe the two main problems that tend to occur when companies use traditional costing. 3. Discuss the causes and directions of product cost distortions that occur in traditional costing. 4. Explain the logic underlying ABC. 5. Discuss how the concepts of fixed and variable costs are viewed in ABC. 6. Explain the distinction between production volume and activity volume. 7. Describe how activity measures are chosen when using the ABC approach. 8. Describe the ABC cost hierarchy. 9. Explain the conceptual distinction between activities, drivers and activity measures. 10. Outline four steps involved in designing an activity based costing system or sub-system.2 11. Outline three additional steps required to obtain ABC product costs. 12. Compute product cost in relatively simple ABC problems. 13. Discuss CAM-I's involvement in developing and implementing ABC concepts and techniques. 14. Discuss a controversial issue concerning how ABC should be used. 15. Discuss the connection between ABC and the dichotomy of capitalism. INTRODUCTION The main purpose of this chapter is to introduce the concepts and terminology associated with activity based costing and to discuss how activity based concepts are used to produce more accurate product costs than those obtained in the traditional cost systems presented in Chapters 4, 5 and 6. This chapter contains two relatively long sections and three fairly short sections. The first section places emphasis on the conceptual material underlying activity based costing and addresses the first nine learning objectives listed above. The second section outlines the steps involved in using the ABC technique and provides two related examples that illustrate and compare ABC with traditional costing. This section covers learning objectives 10 through 12. Sections three and four include a discussion of the CAM-I organization's involvement in the

development and implementation of ABC concepts and a short discussion of a controversial issue concerning how ABC should be used. The last section relates the emergence of activity based costing to the dichotomy of capitalism framework discussed in Chapter 1. ABC CONCEPTS WHAT IS ABC? This sub-section places activity based costing within the five part cost accounting system structure illustrated in Exhibit 2-1 of Chapter 2. Is ABC an input measurement basis, an inventory valuation method, a cost accumulation method, a cost flow assumption, a measure relating to the timing of data availability, or none of the above? Inventory Valuation Method? From our previous discussions in Chapters 2 and 6 recall that activity based product costing may be used as an alternative to the traditional inventory valuation methods, or as a separate stand alone, microcomputer based system designed only to obtain more accurate information for management decisions. If ABC replaces traditional full absorption, or variable costing, it becomes the company's inventory valuation method. Then, activity based costs flow through the perpetual inventory accounts. However, if ABC is used as a separate management decision support system where activity based product cost are determined only once per year, then ABC is not serving as the company's inventory valuation method. Resource Consumption Decision Support Model? More importantly, whether ABC is used as a replacement for traditional inventory valuation or as a stand alone method, it provides information about how and why resources are consumed. Thus, according to ABC advocates, it is not just an inventory valuation method, or just a separate product costing method. Activity based costing is a resource consumption model that can provide a wealth of information to aid in decisions concerning product and process improvements.3 We will return to this idea in Chapter 8 under the heading of activity based management (ABM). Cost Accumulation Method?

Another clarification regarding how ABC fits into the overall cost accounting system has to do with cost accumulation. Remember that there are two basic cost accumulation methods, job order costing and process costing. Activity based costing is not a cost accumulation method, therefore it does not replace these methods, but instead ABC is used to enhance the accuracy of the product costs determined in both job cost and process cost environments. Most of the illustrations of ABC in textbooks and articles are based on two to four products which seems to imply a process orientation. However, since there are likely to be more product variations or differences in a job cost environment than in a process cost environment, it is logical to assume that the potential benefits of using ABC are greater for companies that produce a large number of products to customer specifications, than for companies that have more focused processes dedicated to a few generic products. PROBLEMS WITH TRADITIONAL SYSTEMS Two main problems tend to occur when traditional inventory valuation methods are used to provide information for management decision purposes. One has to do with product cost distortions, or cross-subsidies and the other relates to the exclusiveness of traditional product costing. Product Cost Distortions and Cross Subsidies First, in traditional costing, only production volume related measures are used to allocate overhead costs to products, even though many products do not consume indirect resources (overhead) in proportion to the volume of products produced. Since many types of indirect resource costs are caused by, or driven by, non-production volume related product characteristics such as size and complexity, traditional costing tends to distort product costs. This means that too much overhead cost is allocated to some products, while too little overhead cost is allocated to other products. These distortions are frequently referred to as cross-subsidies. Generally, ABC solves this problem by separating overhead costs into different cost categories referred to as cost pools. Costs that are caused by, or driven by, the same activity are pooled together and then allocated, or traced, to products using an appropriate measure of the activity volume. Excluding Non-Manufacturing Costs A second problem with traditional cost systems is that tracing product related administrative, marketing and distribution costs to product inventories is not a generally acceptable procedure allowable for external reporting. However,

engineering design, marketing, distribution and customer service costs are clearly part of the costs of placing a product in the hands of the customer. Since these non-manufacturing costs may differ substantially from product to product and from customer to customer, ABC traces these costs to products and customers using additional cost pools and activity measures. Thus, the ABC approach provides the potential for more accurate product costs for management decisions concerning product planning, product design and introduction, product design changes, product pricing, make versus buy, product distribution, product service and product discontinuance. ABC also provides potential benefits to many service oriented industries such as banking, insurance, health care, and transportation. To keep the illustrations in this chapter fairly simple, we will concentrate on manufacturing costs, but remember that non-manufacturing costs are also traced to products and services using the ABC approach. THE CAUSES OF PRODUCT COST DISTORTIONS There are two main causes of product cost distortions in traditional costing, i.e., where a single production volume based overhead rate is used by each product department. These include product volume differences (or product volume diversity) and product differences (or product diversity). Product Volume Diversity Cost distortions from product volume differences occur when a company produces one, or more, high volume products (i.e., a relatively large number of units) and one, or more low volume products (i.e., a relatively small number of units). Generally, the low volume products will receive too little overhead when a single production volume based departmental rate is used and high volume products will receive too much overhead. Conceptually, the idea is that each type of product requires engineering, purchasing, inspection and other support, regardless of the number of units produced, thus these support costs do not vary in proportion to the number of units, but instead vary with other factors that are unrelated to production volume. If the costs of support activities are allocated to products on the basis of a production volume related measurement such as direct labor hours, low volume products will not receive cost allocations in proportion to their demands on these activities. Product Diversity

Cost distortions from product differences occur when there are variations in product size and product complexity. Small products tend to require less production volume related input (such as direct labor time) than large products, although they do not require less support in proportion to their size. Therefore small products tend to be undercosted, while large products tend to be overcosted. Product complexity generally refers to product design complexity. Products with complex designs are likely to require more engineering work, more materials related support (e.g., purchasing and materials movement), perhaps longer machine setups and more inspections than less complex products. These additional demands on the various support activities generally cause relatively complex products to be undercosted and relatively simple products to be overcosted. In addition, products that require a relatively large number of parts, unique parts and relatively more, long or complex machine setups tend to be undercharged with overhead while products that require relatively few parts, common parts, relatively few setups, short or simple setups tend to be overcharged. The generalizations in the previous paragraphs are summarized in Exhibit 7-1. The effects of product volume differences and product sized differences are illustrated in the examples below. The effects of differences in product complexity are illustrated in some of the problems at the end of this chapter. EXHIBIT 7-1 SUMMARY OF COST DISTORTIONS THAT TEND TO OCCUR IN TRADITIONAL COST SYSTEMS

TYPE OF DIVERSITY

PRODUCT TYPE OR CHARACTERISTIC

TYPE OF COST DISTORTION THAT TENDS TO OCCUR IN TRADITIONAL COST SYSTEMS

Production volume

Low Volume specialty High Volume main line

Undercost, i.e., too little overhead is allocated to these products. Overcost, i.e., too much overhead is allocated to these products. Undercost

Product Size

Small

Large Product Complexity Complex design Simple design Requires many, or unique parts, i.e., only used on a single product. Requires few, or common parts, i.e., same part used on many products. Product Machine setup requirements Requires many, long or complex machine setups. Requires few, short or simple machine setups.

Overcost Undercost Overcost Undercost

Product Materials requirements

Overcost

Undercost Overcost

THE LOGIC OF ABC Activity based costing is based on the following ideas. First, designing, producing and distributing products and services requires many activities to be performed. Performing these activities requires resources to be purchased and used. Purchasing and using resources causes costs to be incurred. Restated in reverse order, the ABC logic is that resources generate costs, activities consume resources and products consume activities. Thus, a company's activities are identified, then costs are traced to these activities (or activity cost pools) based on the resources that they require. Then, costs are assigned, or traced from each of these activity cost pools to the company's products (or services) in proportion to the demands that each product (or service) places on each activity. In ABC, a measure of the relevant activity volume is used to trace each type of costs, rather than exclusively using measurements (or allocation bases) related to the volume of the products or services produced. Using this logic, ABC tends to solve the problems created by traditional cost or inventory valuation methods. The ABC logic is illustrated in Figure 7-1.

There are still two stages in assigning costs to products in a manufacturing environment, i.e., 1) from service departments (activities) to producing departments, and 2) from producing department activity cost pools to products. What About Fixed and Variable Costs In ABC? The traditional concepts of fixed and variable costs are frequently deemphasized in activity based costing. This is because the ABC logic looks at costs from a long run perspective while the traditional fixed/variable cost behavior methodology is based on a short run perspective. The ABC designer explicitly recognizes that all costs tend to be variable in the long run. Therefore, one of the objectives of ABC is to determine the main causes of these long run cost variations. ABC designers attempt to answer the following question. What creates the demand for the output of each of the company's main activities? The Rule of One

To help managers understand the conceptual difference between the long run and short run perspectives, Cooper and Kaplan utilize an idea they refer to as the "Rule of One". According to this rule, if a support department, or activity, uses only one unit of a particular type of resource, such as one person or one machine, then the cost of that resource can be classified as fixed. However, if more than one unit of the resource is required, then classifying the resource cost as fixed is not beneficial for product costing purposes. Something caused the demand for the resource to be greater than one. Perhaps this driver can be identified and used to trace the costs more accurately to the products or services that ultimately consume the resource through activities. Although some activity costs tend to be fixed, i.e., not respond to short run changes in activity volume, these fixed costs represent management commitments that are made to support a past, present or expected future activity level. Generally, all costs are driven by something, even if the driver appears to be inactive. Can ABC Include Fixed and Variable Costs? Does the de-emphasis on the fixed-variable cost methodology in ABC mean that activity cost cannot be separated into short run fixed and variable cost categories? The answer is that fixed and variable activity costs can be identified and traced to products and services using separate activity based rates. One potential advantage of using separate rates for fixed and variable costs is that idle capacity (or unused resource) costs can be identified for each activity if the activity rates are based on practical capacity rather than normal or planned activity volume (See the note on denominator activity levels for more on this issue). There is another potential advantage in the area of cost control. If ABC is used as the company's inventory valuation method, it would allow variance analysis to be performed for each activity. Should ABC Include Fixed and Variable Costs? The answer to this question is controversial. Some critics argue that the fixed/variable cost methodology should be eliminated because it motivates managers to add more business volume and variety in an attempt to lower the fixed costs per unit without adequately considering the long run effects. However, the additional product variety and diversity tends to cause the so called fixed costs to increase, which defeats the original purpose. Thus, the whole process is much like a dog chasing it's tail. 4 This is an interesting issue that we will return to in Chapter 11. ACTIVITY VOLUME

Activity volume refers to an input or output measurement of the quantity of work performed to accomplish an activity. These activity volume measurements may represent the frequency, duration or physical volume of an activity.5 However, the key difference between traditional costing and activity based costing is that ABC uses both production volume and non production volume activity measures to trace costs to products. Some examples of common activities and representative activity measures are presented in Exhibit 7-2. EXHIBIT 7-2 EXAMPLES OF ACTIVITY COST POOLS AND ACTIVITY MEASURES

ACTIVITY COST POOL

POTENTIALLY USEFUL ACTIVITY MEASURES

PROBABLE COST CLASSIFICATION*

Machining parts Purchasing

Number of machine hours.

Unit level.

Number of purchase orders Product or batch or ordering hours. level. Number of purchase orders Product or batch or shipments received. level. Number of engineering work orders or hours. Number of shipments, number of cubic feet or packing hours. Product level.

Receiving and Storing

Engineering

Packing

Product or batch level.

Shipping

Number of pounds shipped. Product or batch level. Number of setups or setup Batch level.

Machine Setup

time. Materials handling Number of times handled or material handling hours. Product or batch level.

Inventory control and materials planning Inspection and quality control

Number of part numbers or Product or batch administrative hours. level. Number of inspections or inspections time. Product or batch level.

* This classification scheme is discussed below.

A key idea in ABC is to find an activity measure for each activity that is closely related (correlated) to the activity costs involved. As indicated in Exhibit 7-2, a production volume related measure might be appropriate for some types of costs, (e.g., machine hours for machining ), but non-production volume related measures are more appropriate for other types of activity costs. For example, the number of purchase orders might be an appropriate choice as the activity measure for purchasing costs, while the number of engineering work orders might be a more appropriate basis for tracing engineering costs. The cost classification scheme referred to in the right hand column of Exhibit 7-2 is discussed below. HOW ARE ACTIVITY MEASURES CHOSEN? ABC designers normally use interviews with knowledgeable managers to define activities, cost pools and cost driver relationships. Although the statistical tools discussed in Chapter 3 might also be used to aid in this process, there are some serious problems that limit their usefulness for this purpose. First, analyzing short run data may produce very misleading results. This is because performing correlation analysis with short run data is not likely to reveal the drivers of long run variable costs, i.e., the costs identified as fixed costs in traditional costing. Another key idea in ABC is that reducing the volume of a particular activity measurement will not necessarily have a short run effect on the cost of the activity. Reductions in activity requirements may simply create idle or excess capacity. Data collected for a longer period (e.g., two or three years) might be more useful for identifying drivers and activity

measures for long run variable costs, but the data would have to be adjusted to remove the influence of non stationary factors such as changes in production processes, inflation and seasonal variations. As indicated in Chapter 3, these factors can cause autocorrelation which tends to confuse rather than clarify the relationships involved. There is a second potential problem when attempting to use statistical correlation analysis to identify cost drivers and activity measures to represent them. The overall correlation between an activity measure and the overall demands placed on the activity by the company's products may be fairly high, although the correlation of the activity measure with the demands of some specific products is relatively low. For example, if ninety-eight percent of a company's products require short machine setups, (e.g., one hour) while the other two percent require long setups, (e.g., eight hours) then, the overall correlation between the number of setups required and setup costs would probably be fairly high. However, assigning setup costs to products on the basis of the number of setups would tend to undercost the products that require long setups and overcost the products that require short setups. The main point of this discussion is that accurate cost tracing requires high correlation between the activity measure and the demands of each specific product, not just high overall, or average correlation.6 ABC COST HIERARCHY A cost classification scheme, sometimes referred to as the ABC cost hierarchy, places all costs into one of the following categories: 7 1. Unit level - the cost of an activity required once each time a unit of product is produced. 2. Batch level - the cost of an activity required each time a batch of products is produced. 3. Product level - the cost of an activity required to support a specific type of product. 4. Facility level - the cost of an activity associated with maintaining the facility or plant. 5. Customer level - the cost of an activity required to support a specific customer.

Batch and Product Level Activities Although it is not clear how each activity cost would be classified by a particular company, the probable cost classifications for the activities in Exhibit 7-2 are indicated in the right-hand column of the exhibit. Most of the examples in the exhibit are either product or batch level activities. If an activity is triggered mainly by the orders, lots, or batches of products produced, then it fits into the batch level category. For example, if the activities associated with purchasing, receiving and storing materials are initiated mainly by production orders for the production of batches of products, then these are batch level activities. On the other hand, if these same activities are performed mainly to keep an average inventory of raw materials available without regard for specific batches, then they might be classified as product level activities. Facility and Customer Level Activities Examples of customer level activities include accounts receivable, special packaging, distribution or shipping requirements and certain types of nonroutine customer services. Examples of facility level costs include building maintenance, property taxes and insurance, plant security and the plant manager's salary. Most of the facility level costs are common to all products and according to one view need not be assigned to products for management decision purposes. Others disagree and consider full cost to be more appropriate. We will not dwell on this controversy except to note that it is one of the many unresolved issues in accounting. What's the Point of the Cost Hierarchy? The ABC cost classification scheme helps emphasize the difference between traditional costing and activity based costing. In assigning cost to products, traditional costing treats all manufacturing costs as unit level costs, therefore they are referred to as production volume based (PVB), or unit based allocations. On the other hand, ABC recognizes that many of the support costs in a company are either related to activities associated with producing batches of products, or to other activities that are performed to support specific products. In addition, traditional costing treats marketing, distribution and customer service costs as period costs, while ABC traces, or attempts to trace, these product level and customer level costs to products and customers. DISTINCTION BETWEEN ACTIVITIES, DRIVERS AND ACTIVITY MEASURES

Conceptually, the three terms activity, driver and activity measure have different meanings although these terms are frequently used interchangeably in accounting literature. The purpose of this section is to clarify the conceptual distinction between activities, drivers and activity measures. Activities Activities represent the types of work performed in an organization. For example, purchasing represents a main activity for a company. The activities chosen in the ABC design process usually represent main activities that are made up of many sub-activities, tasks and sub-tasks. For example, many different types of work must be performed in the purchasing department, but all of this work may be conveniently classified as purchasing so that the complexity of the ABC design is kept to a manageable level. The different types of activities, along with some examples, are summarized at the top of Exhibit 7-3. EXHIBIT 7-3 ABC CONCEPTS AND TERMINOLOGY Activities - A type of work or function. Type Main activities Definition A major type of work, function or high level activity. Examples Purchasing raw materials.

Sub activities Tasks Sub tasks

A lower level type of Preparing purchased work, or activity that orders. supports a main activity. A minor type of work that Calling vendors. supports a sub activity. Part of a task. Dialing a vendor's phone number.

Drivers - Whatever causes the need for activities to be performed. Type Definition Examples

Primary drivers

The initial cause of an activity that requires resources, i.e., whatever creates the demand for an activity.

Company's overall objectives, customer demands and product specifications.

Secondary drivers

A resource consuming activity that is caused by Purchasing raw materials, a previous activity or preparing purchase orders. event.

Activity measures - A unit of measure chosen to represent an activity volume.

Type Frequency measures

Definition The number of times an activity is performed. The time consumed performing the activity.

Examples Number of purchase orders, number of engineering work orders. Ordering hours, engineering hours, machine hours.

Duration measures Physical measures

The quantity of a resource Cubic feet packed, pounds processed by an activity. shipped.

Cost and Activity Drivers Cost drivers and activity drivers are essentially the same. A driver is an underlying cause of a cost. Normally, whatever drives an activity also drives the costs of the activity. Conceptually, there are primary drivers and secondary drivers. A primary driver represents the initial cause of an activity. A secondary driver represents an activity or event that is caused by a previous activity or event. For example, the primary drivers of purchasing costs may be factors such as customer demands, product design characteristics (e.g., number of parts required) and the number of vendors selected. Therefore, purchasing is technically a secondary driver of purchasing costs. This terminology is summarized in the middle section of Exhibit 7-3. To obtain a better grasp of these concepts consider the following idea. All of a company's functions and activities require resources that generate costs,

therefore all activities are cost drivers. However, all functions and activities are performed to support the company's objectives, e.g., to generate profits, increase market share etc., thus all functions and activities are technically subordinate to these primary drivers. Activities merely represent secondary cost drivers, although the distinction between primary and secondary is likely to be forgotten or ignored after the system is designed. It is also useful to note that although activities are cost drivers, drivers do not have to be activities. Drivers may be events or other phenomena. Activity Measures Conceptually, an activity measure is not necessarily an activity, or a cost driver or an activity driver. An activity measure is instead a unit of measurement chosen to represent the activity volume and the primary driver. The activity measure provides the basis for tracing or linking the activity costs to the products that consume the activity. To understand the difference between the activity measure and the activity driver, consider the following example. The number of purchase orders might be chosen to represent the volume of work performed by the purchasing department, but the number of purchase orders is driven by whatever drives the purchasing activity. Primary, or higher level drivers are likely to be such things as the number of products produced, the number of raw materials and parts required for each product, whether the parts are common to many products or unique requirements for a single product and the number of vendors involved. Thus, to say that the number of purchase orders is the driver for purchasing costs tends to confuse the issue. Although ordering causes costs, the number of purchase orders is secondary. The number of purchase orders is a dependent variable because it is caused by something else. 8 However, since there may not be a convenient measure of the primary driver, or drivers, the number of purchase orders often serves as a reasonably accurate substitute for tracing purchasing cost to products. Another example may help to clarify the point. The number of direct labor hours is frequently used in traditional cost systems as the basis for allocating overhead costs to products. As a result, accountants frequently say that direct labor time is the cost driver. However, the number of direct labor hours depends upon, or is caused by, the level of production activity which in turn is driven by the company's objectives and customer demands. Thus, the number of direct labor hours is simply a convenient activity measure chosen to represent production activity.

The lower section of Exhibit 7-3 summarizes the terminology that relates to activity measures. There are different types of measures including frequency, duration and physical measurements. Simple frequency measures that indicate the number of times an activity is performed are appropriate when each occurrence of an activity requires the same amount of time and resources, e.g., where each purchase order requires the same amount of time to prepare on a standard form. Duration measurements and physical measurements are more appropriate where the time or resources needed to perform an activity are not uniform. THE ABC TECHNIQUE FOUR STEPS IN DESIGNING AN ABC SYSTEM OR SUB-SYSTEM9 The concepts discussed in the previous sections of this chapter can be summarized into four steps. Designing an ABC model, system or sub-system requires: 1) identifying a company's main activities, 2) determining the primary and secondary drivers for these activities, 3) aggregating activities into homogenous cost pools and 4) selecting activity measures to represent each pool. Homogeneous activity costs are those costs that are consumed in the same proportions. Recognizing these relationships allows the designer to combine homogenous costs into a single cost pool to simplify the system. Although this concept is somewhat vague when stated in this simple way, it should become clear to you after studying the examples presented below. THREE STEPS TO OBTAIN ABC COSTS After the system has been designed, ABC costs per unit can be calculated using historical costs or budgeted costs. ABC calculations can be based on annual activity costs obtained from historical records, or budget estimates made for a subsequent period. In either case, three steps are required to determine unit ABC costs once the data is available. These steps include: 1) Calculate the activity overhead rates for each activity cost pool by dividing the total annual cost of each cost pool by the total annual quantity of the activity measure associated with each pool. More precisely in equation form: Rj = Annual costs of activity j Annual quantity of activity j where: Rj = the activity overhead rate for activity j. j = the number of the activity.

If historical information is used to develop ABC unit costs, i.e., data from a prior period, then the annual costs and quantities in the calculation are established by the prior period activity levels achieved. If the ABC system is designed with budgeted data, then the annual cost estimates and annual quantities of the activity measures would depend on the capacity level chosen. Popular alternatives include practical capacity, normal or average capacity, and planned volume. 2) Determine the total annual costs of each product by multiplying the activity overhead rates by the activity quantities associated with each product as follows, Ci = Di + G(Rj)(Aji) where: Ci = Total annual cost of product i. Di = Direct cost of product i. Aji = Quantity of activity j consumed by product i. Rj = the activity overhead rate for activity j. j = the number of the activity. i = the number of the product. G = Greek sigma or summation sign meaning "the sum of". 3) Calculate each product's unit costs by dividing the total annual costs for each product i by the number of units of product i produced. ABC unit cost for product i = Ci Units of product i. These three steps are illustrated in the examples provided below. COMPARING TRADITIONAL PVB AND ABC SYSTEMS A variety of illustrations could be provided to show how product cost distortions occur in traditional production volume based (PVB) costing and how these distortions are eliminated when activity based costing is used. Two related examples are provided to show how product volume differences and product size differences tend to affect product costs. Some other types of cost distortions appear in the problems provided at the end of this chapter. Although the examples are based on manufacturing firms, similar cost distortions frequently occur in service organizations. Example 7-1: Effects of Production Volume Differences

Assume that Company A produces two products, V1 and V2 with the annual production volumes and product characteristics presented in Exhibit 7-4. 10 To emphasize the key issues involved without unnecessary complications, assume that the firm has only one production department so that all service department costs are allocated to this single department in stage 1 cost allocations. 11 This simplifying assumption allows us to ignore the first stage allocations that would only distract from the issue that we want to examine. To further simplify the illustrations, we will also assume that the activity costs are perfectly correlated to the activity measures chosen. Of course this is an unrealistic assumption, but when there are only two products, it allows us to isolate the cost distortions caused by production volume differences and product size differences precisely. EXHIBIT 7-4 ANNUAL PRODUCT DATA FOR COMPANY A PRODUCT RELATED DATA Annual production quantity in units Material cost per unit Direct labor hours per unit Direct labor cost per hour Number of purchase orders required per year Number of engineering work orders required per year Number of machine setups required per year V1 100 $50 1 $10 1 4 2 V2 1,000 $50 1 $10 2 8 4

The company's main activities have been combined into five activity cost pools along with appropriate activity measures based on management interviews. These five cost pools and the activity measurements associated with each cost pool appear in Exhibit 7-5. EXHIBIT 7-5 ANNUAL ACTIVITY COSTS FOR COMPANY A ACTIVITY Purchasing and receiving Engineering Machine setup ANNUAL COSTS ACTIVITY MEASURE

$24,000 Number of purchase orders 18,000 Number of engineering work 24,600 orders

Machining, power & maintenance Materials planning & handling Total factory overhead costs

22,000 Number of machine setups 11,000 Number of direct labor hours $99,600 Number of materials dollars ======

The way this illustration is designed, we can further simplify the problem by aggregating, or combining these five cost pools into only two homogeneous cost pools, one for non-production volume related costs and one for production volume related costs. This is possible because the consumption proportions for the three non-production related costs pools (purchasing/receiving, engineering and setups) are the same and the consumption proportions for the two production related cost pools (machining/power/maintenance, and materials planning/ handling) are the same. Since each unit of V2 requires twice as much of each type of non-production related costs as each unit of V1, these three cost pools can be combined into a single homogeneous cost pool and traced to products using any one of the three activity measures, i.e., number of purchase orders, engineering work orders or setups. Each of these measures reflects the 2 to 1 consumption ratio. Since each unit of V2 requires the same amount of direct material and direct labor as V1, the two production volume related cost pools can be combined and traced to products using either direct labor hours or materials dollars. Both of these measures reflect the 1 to 1 consumption of production volume related resources. The activity costs and measurements after combining the homogeneous cost pools are presented in Exhibit 7-6. EXHIBIT 7-6 ANNUAL ACTIVITY COSTS FOR COMPANY A COMBINED HOMOGENEOUS COST POOLS ANNUAL COSTS

ACTIVITY POOL Non-production volume related Production volume related Total factory overhead costs

ACTIVITY MEASURE

$66,600 Number of purchase orders 33,000 Number of direct labor hours $99,600

Calculating ABC Costs for Company A Step 1: Calculating Activity Overhead Rates Rj = Annual costs of activity j Annual quantity of activity j

Activity overhead rates for the two cost categories in Example 7-1 are calculated as follows: 1. Non-production volume related = $66,600 3* = $22,200 per purchase order. * Total purchase orders = 1 for V1 and 2 for V2. 2. Production volume related = $33,000 1,100* = $30 per direct labor hour. * Total direct labor hours = 100 for V1 and 1,000 for V2. Steps 2 and 3: Determining Total Annual Cost Ci = Di + 3(Rj)(Aji) And Unit Cost For Each Product The calculations for steps 2 and 3 are presented in Exhibit 7-7. In step 2 the activity overhead rates are multiplied by the quantities of the appropriate activity measures to obtain the overhead costs traced to each product. Then in step 3, the unit ABC costs are determined by dividing the cost traced to each product by the annual production quantities from Exhibit 7-4, i.e., 100 units for V1 and 1,000 units for V2. Direct material and direct labor costs are also included in the exhibit to show the total unit cost for each product. As indicated at the bottom of Exhibit 7-7, the unit ABC costs are $312 for V1 and $134.40 for V2. Comparing ABC With Traditional PVB Costing For Products V1 and V2 Now suppose Company A uses the traditional production volume based (PVB) costing approach where all overhead costs are allocated to products using direct labor hours as a single allocation basis. Then the total overhead rate would be calculated by dividing the total activity overhead costs in Exhibit 7-5 (or Exhibit 7-6) by the total number of direct labor hours, i.e., 1,100 total units multiplied by 1 hour per unit. This calculation produces a total overhead rate of $90.55 per direct labor hour ($99,600 1,100 DLHs = 90.54545). Overhead costs for each product are $90.55 since each product requires 1 direct labor hour. This is very different from the ABC unit overhead cost of $252 for V1 and $74.40 for V2 that are calculated in Exhibit 7-7. Adding direct material and direct labor costs of $60 provides a total unit cost of $150.55 for each product. Thus, the traditional costing approach would understate the unit cost of the low volume product V1 by $161.45 and overstate the unit cost of the higher volume product V2 by $16.15.

EXHIBIT 7-7 COMPANY A COSTS TRACED TO PRODUCTS V1 AND V2 USING AN ACTIVITY BASED COST (ABC) SYSTEM

COST POOL OR CATEGORY

ACTIVITY RATE MULTIPLIED BY QUANTITY OF ACTIVITY MEASURE (Rj) (Aji)

C1=COST TRACED TO V1

ABC UNIT COST V1*

C2=COST TRACED TO V2

ABC UNIT COST V2**

1. Non-production volume related:

($22,200)(1 PO) ($22,200)(2 PO'S)

$22,200

$222.00 $44,400 $44.40

2. Production volume related:

($30)(100 DLH) ($30)(1,000 DLH)

3,000

$30.00 30,000 30.00

Total Overhead

$25,200

$252.00

$74,400

$74.40

3. Direct Material:

($50)(100) ($50)(1,000)

5,000

50.00 50,000 50.00

4. Direct Labor:

($10)(1hr)(100) ($10)(1hr)(1,000)

1,000

10.00 10,000 10.00

Totals

$31,200 =======

$312.00 ======

$134,400 =======

$134.40 ======

* C1 = $6,000 + ($22,200)(1PO) + ($30)(100DLHs) = $31,200. ABC unit cost for V1 = $31,200 100 units. ** C2 = $60,000 + ($22,200)(2POs) + ($30)(1,000DLHs) = $134,400. ABC unit cost for V2 = $134,400 1,000 units.

Using Proportions Rather than Activity Rates

A different way to solve relatively simple ABC problems is use proportions as illustrated in Figure 7-2 below. Although the non-production volume related costs could be combined as above, each activity cost pool is kept separate in Figure 7-2 to provide a somewhat different view of the solution. The proportions used are based on the data in Exhibit 7-4. For example, V1 required 1 purchase order and V2 required 2 purchase orders, therefore purchasing and receiving costs are allocated 1/3 to V1 and 2/3 to V2.

Why Traditional Production Volume Based Allocations Distort Product Costs To understand why the traditional production volume based (PVB) approach distorts product costs per unit, consider the more detailed PVB unit costs calculated in Exhibit 7-8. This exhibit illustrates the cost allocations obtained in a traditional PVB system where direct labor hours are used as the allocation basis. The separate overhead cost pools are maintained to show where the distortions occur. Therefore separate overhead rates are needed for each pool.

Dividing the annual costs of the non-production volume related pool ($66,600 from Exhibit 7-6) by 1,100 direct labor hours generates a rate of $60.5455 per direct labor hour. Of course the rate for the production volume related pool is still $30 per hour, i.e., $33,000 1,100, because the activity measure for this pool is direct labor hours in both the ABC and PVB systems. EXHIBIT 7-8 COMPANY A COST TRACED TO PRODUCTS V1 AND V2 USING A TRADITIONAL PRODUCTION VOLUME BASED (PVB) COST SYSTEM

COST POOL OR CATEGORY

ACTIVITY RATE MULTIPLIED BY QUANTITY OF ACTIVITY MEASURE

COST ALLOCATED TO V1

PVB UNIT COST V1*

COST ALLOCATED TO V2

PVB UNIT COST V2**

1.Nonproduction volume related:

($60.5455)(100DLH) ($60.5455)(1,000)

$6,054.55

$60.55 $60,545.45 $60.55

2. Production volume related:

($30)(100 DLH) ($30)(1,000)

3,000.00

$30.00 30,000.00 30.00

Total Overhead

$9,054.55

$90.55

$90,545.45

$90.55

3. Direct Material:

($50)(100 units) ($50)(1,000)

5,000.00

50.00 50,000 50.00

4. Direct Labor:

($10)(1hr)(100 units) ($10)(1hr)(1,000)

1,000.00

10.00 10,000 10.00

Totals

$15,054.55 ========

$150.55 ======

$150,545.45 ========

$150.55 ======

* PVB unit cost for V1 = $15,054.55 100 units. ** PVB unit cost for V2 = $150,545.45 1,000 units.

Production volume based allocations based on direct labor hour proportions are illustrated in Figure 7-3 below for each activity cost pool.

We can see from Exhibit 7-8 and Figure 7-3 that each unit of V1 and V2 receive the same amount of cost in each overhead cost category. This is because each product requires the same number of direct labor hours per unit (i.e., 1 hour each). At first, this may appear to be a fair and accurate way to allocate overhead. However, since Company A produces ten times as many V2's as V1's, traditional PVB costing assigns ten times as much overhead costs to V2 as it assigns to V1. More specifically, V2 receives ten elevenths

(1,000/1,100) or 90.9% of the overhead, while V1 receives only one eleventh (100/1,100) or 9.1%. This distorts the product costs per unit because V2 consumes only two thirds of the non-production volume related activities , i.e., 2 out of 3 purchase orders, 8 out of 12 engineering work orders and 4 out of 6 setups, while V1 consumes the other one third. The resulting unit cost distortions are summarized in Exhibit 7-9 where ABC and PVB unit costs are compared. EXHIBIT 7-9 COMPANY A ABC AND PVB UNIT COST COMPARISONS Amount V1 Cost Pool ABC PVB ABC PVB Unit PVB Unit or Unit Unit Unit Cost Cost is Cost V2 Category Cost V1 Cost V1 V2 Understated 1. Non production volume related 2. Production volume related Total overhead 3. Direct material 4. Direct labor Totals Amount V2 PVB Unit Cost is Overstated

$222

$60.55

$161.45

$44.40

$60.55

$16.15

30 $252 50 10

30.00 $90.55 50.00 10.00

0 $161.45 0 0

30.00 $74.40 50.00 10.00

30.00 $90.55 50.00 10.00 $150.55 ======

0 $16.15 0 0 $16.15 =====

$312 $150.55 ==== ======

$161.45 $134.40 ====== ======

The unit cost comparisons in Exhibit 7-9 reveal that the high volume product V2 subsidizes the low volume product V1. Each high volume product is overcosted by $16.15 while each low volume product is undercosted by $161.45. Since Company A produces only 100 units of V1, the distortion per unit is more significant for V1 than for V2. The graphic illustration in Figure 7-

4 shows this in a somewhat more dramatic way. The unit cost distortion that occurs for V1 is greater than the traditional PVB unit cost estimate. Although the unit cost distortions are not equal, the total cost distortions are always equal, except for small rounding errors. The approximate equality of the distortions for Company A can be verified by multiplying the unit cost distortions by the number of units involved, i.e., (100)(161.45) is approximately equal to (1,000)(16.15). To avoid the rounding error, we can compare the total costs in Exhibits 7-7 and 7-8, i.e., the total understatement for V1 is 31,200 - 15,054.55 = $16,145.45, while the total overstatement for V2 is 150,545.45 - 134,400 = $16,145.45.

Note from Exhibit 7-9 that the production volume related costs are not distorted by the traditional PVB approach. This reinforces the point made earlier that a production volume related basis may be an appropriate activity measure for tracing certain types of overhead costs to products, although it cannot be used

as the only basis in cases where all costs are not consumed in proportion to production volume.

Example 7-2: Effects of Product Size Differences Assume that Company B produces two products V2 and V3 where Product V2 is the same small high volume product that Company A produces. However, V3 is a larger size, high volume product that requires more direct material and direct labor because of it's size, but no additional support from purchasing, engineering or setups. Also assume that Company B has the same cost structure as Company A except for the differences between the two companies related to production volume and product size. Activity costs are still perfectly correlated to the activity measures chosen for the ABC system. The data for Company B are presented in Exhibits 7-10 and 7-11. The same two aggregated cost pools used for Company A can also be used for Company B because the consumption proportions are the same for each of the three nonproduction volume related activities. The products consume all three nonproduction volume related activities in the same proportions. If V3 consumed of the purchase orders, 1/3 of the engineering work orders and 1/5 of the setups, then we would not be able to combine these costs into a single homogeneous pool. EXHIBIT 7-10 ANNUAL PRODUCT DATA FOR COMPANY B PRODUCT RELATED DATA Annual production quantity in units Material cost per unit Direct labor hours per unit Direct labor cost per hour Number of purchase orders required Number of engineering work orders required Number of machine setups required V2 1,000 $50 1 $10 2 8 4 V3 1,000 $500 10 $10 2 8 4

EXHIBIT 7-11 ANNUAL ACTIVITY COSTS FOR COMPANY B SEPARATE AND COMBINED HOMOGENEOUS COST POOLS
ANNUAL COSTS

ACTIVITY

ACTIVITY MEASURE

Purchasing and receiving Engineering Machine setup Non-production volume related Machining, power & maintenance Materials planning & handling Production volume related Total factory overhead costs

$32,000 Number of purchase orders 24,000 Number of engineering work 32,800 orders $88,800 Number of machine setups Number of purchase orders 220,000 110,000 Number of direct labor hours 330,000 Number of materials dollars $418,800 Number of direct labor hours =======

Calculating ABC Costs for Company B Step 1: Calculating Activity Overhead Rates Rj = Annual costs of activity j Annual quantity of activity j Activity overhead rates for the two cost categories in Example 7-2 are calculated as follows: 1. Non-production volume related = $88,800 4* = $22,200 per purchase order. * Total purchase orders = 2 for V2 and 2 for V3. 2. Production volume related = $330,000 11,000* = $30 per direct labor hour. * Total direct labor hours = 1,000 for V2 and 10,000 for V3.

EXHIBIT 7-12 COMPANY B COST TRACED TO PRODUCTS V2 AND V3 USING AN ACTIVITY BASED COST (ABC) SYSTEM

COST POOL OR CATEGORY

ACTIVITY RATE MULTIPLIED BY QUANTITY OF ACTIVITY MEASURE (Rj) (Aji)

C2=COST TRACED TO V2

ABC UNIT COST V2*

C3=COST TRACED TO V3

ABC UNIT COST V3**

1. Non-production volume related:

($22,200)(2 PO'S) ($22,200)(2 PO'S)

$44,400

$44.40 $44,400 $44.40

2. Production volume related:

($30)(1,000 DLH) ($30)(10,000 DLH)

30,000

$30.00 300,000 300.00

Total Overhead

$74,400

$74.40

$344,400

$344.40

3. Direct Material:

($50)(1,000 units) ($500)(1,000 units)

50,000

50.00 500,000 500.00

4. Direct Labor:

($10)(1hr)(1,000) ($10)(10hrS)(1,000)

10,000

10.00 100,000 100.00

Totals

$134,400 =======

$134.40 ======

$944,400 =======

$944.40 ======

* C2 = $60,000 + ($22,200)(2POs) + ($30)(1,000DLHs) = $134,400. ABC unit cost for V2 = $134,400 1,000 units. ** C3 = $600,000 + (*$22,200)(2POs) + ($30)((10,000DLHs) = $944,400. ABC unit cost for V3 = $944,400 1,000.

Steps 2 and 3: Determining Total Annual Cost Ci = Di + 3(Rj)(Aji) And Unit Cost For Each Product The calculations for steps 2 and 3 are presented in Exhibit 7-12. Comparing ABC With Traditional PVB Costing For Products V1 and V2

Exhibit 7-13 illustrates the cost allocations obtained for Company B in traditional PVB costing where direct labor hours are used as the allocation basis. The separate overhead cost pools are maintained, as in the previous example, to show where the distortions occur. Thus, separate overhead rates are needed for each pool. Dividing the annual cost of the non-production volume related pool ($88,800 from Exhibit 7-11) by 11,000 direct labor hours generates a rate of $8.0727 per direct labor hour. Of course the rate for the production volume related pool is still $30 per hour, i.e., $330,000 11,000, because direct labor hours are used as the activity measure for this pool in both the ABC and PVB calculations. EXHIBIT 7-13 COMPANY B COST TRACED TO PRODUCTS V2 AND V3 USING A TRADITIONAL PRODUCTION VOLUME BASED (PVB) COST SYSTEM

COST POOL OR CATEGORY

ACTIVITY RATE MULTIPLIED BY QUANTITY OF ACTIVITY MEASURE

COST ALLOCATED TO V2

PVB UNIT COST V2*

COST ALLOCATED TO V3

PVB UNIT COST V3**

1.Nonproduction volume related:

($8.0727)(1,000) ($8.0727)(10,000)

$8,072.70

$8.07 $80,727.00 $80.73

2. Production volume related:

($30)(1,000 DLH) ($30)(10,000)

30,000.00

$30.00 300,000.00 300.00

Total Overhead

$38,072.70

$38.07

$380,727.00

$380.73

3. Direct Material:

($50)(1,000 units) ($500)(1,000 units)

50,000.00

50.00 500,000 500.00

4. Direct Labor:

($10)(1hr)(1,000) ($10)(10hrs)(1,000)

10,000.00

10.00 100,000 100.00

Totals

$98,072.70 ========

$98.07 ======

$980,727 ========

$980.73 ======

* PVB unit cost for V2 = $98,072.70 1,000 units. ** PVB unit cost for V3 = $980,727 1,000 units.

Exhibit 7-13 shows that in PVB costing each unit of V3 receives ten times as much overhead costs as V2 in each overhead cost category, i.e., ten elevenths or 90.9% for V3 as opposed to one eleventh or 9.1% for V2. This is because each unit of V3 requires ten direct labor hours while each unit of V2 requires only one hour. The PVB approach distorts product costs because V3 consumes only fifty percent of the non-production related support, i.e., 2 out of 4 purchase orders, 8 out of 16 engineering work orders and 4 out of 8 setups. The resulting unit cost distortions are summarized in Exhibit 7-14 where ABC and PVB unit costs are compared. The PVB approach understates the unit cost of the relatively small product V2 by $36.33 and overstates the unit cost of the relatively large product V3 by $36.33. The unit cost distortions are equal because the production volumes for V2 and V3 are equal. EXHIBIT 7-14 COMPANY B ABC AND PVB UNIT COST COMPARISONS
Amount V2 Cost Pool or ABC Unit PVB Unit PVB Unit ABC Unit PVB Unit Category Cost V2 Cost V2 Cost Cost V3 Cost V3 Understated 1. Non Production volume related 2. Production volume related Total overhead Amount V3 PVB Unit Cost Overstated $36.33

$44.40

$8.07

$36.33

$44.40

$80.73

30.00 $74.40

30.00 $38.07

0 $36.33

300.00 $344.40

300.00 $380.73

0 $36.33

3. Direct material 4. Direct labor Totals

50.00 10.00 $134.40 ======

50.00 10.00 $98.07 =====

0 0 $36.33 =====

500.00 100.00 $944.40 ======

500.00 100.00 $980.73 ======

0 0 $36.33 =====

Comparing the Unit Cost of Product V2 in Companies A and B The different cost assignments to product V2 in Companies A and B are compared in Exhibit 7-15. The comparative data shows that ABC costing produces the same unit cost of $134.40 in both companies. This precise equality occurs because of the way the examples are designed. Remember that we assumed that the activity costs are perfectly correlated with the activity measures chosen and that the two companies have the same cost structure. Of course these are not realistic assumptions, but they enable us to clearly see that the nature of the PVB cost distortion for a particular product depends on the product's characteristics relative to the other products the company produces. In the examples above, PVB costing overstates the unit cost of V2 in Company A because it is a high volume product relative to V1. However, in Company B, the PVB approach understates the unit cost of V2 because V2 is a small product relative to V3. Continuation Of The V-Product Sequence Two additional illustrations related to products V1, V2 and V3 are included in the practice problems that appear at the end of this chapter. Problem 7-1 continues this sequence of examples with a Company C that produces products V1 and V3. Since V1 is a small, low volume product and V3 is a large, high volume product, the direction of the resulting cost distortions is easy to predict. Problem 7-2 provides a fourth company in this sequence. This problem extends the V-product sequence to a Company D that produces all three products. In this company, Product V2 has conflicting characteristics in terms of the bias towards over or undercosting. V2 is a small, high volume product in Company D. In Company A, V2 is the low volume product, but size is not an issue. In Company B, it is the small product, but production volume is not an issue. Problem 7-2 reveals that the nature of the product cost distortions become impossible to predict as the number of products and product characteristics increase.

EXHIBIT 7-15 COMPARING THE DISTORTIONS FOR PRODUCT V2 IN COMPANIES A AND B

COMPANY A Cost Pool or Category 1. Non production volume related 2. Production volume related Total Overhead 3. Direct material 4. Direct labor Totals COMPANY B Amount V2 PVB Unit Cost is Understated $36.33 0 $36.33 0 0 $36.33 =====

Amount V2 PVB ABC Unit PVB Unit ABC Unit PVB Unit Unit Cost Cost V2 Cost is Cost V2 Cost V2 V2 Overstated $44.40 30.00 $74.40 50.00 10.00 $60.55 30.00 $90.55 50.00 10.00 $16.15 0 $16.15 0 0 $16.15 ===== $44.40 30.00 $74.40 50.00 10.00 $134.40 ====== $8.07 30.00 $38.07 50.00 10.00 $98.07 =====

$134.40 $150.55 ====== ======

CAM-I CONSORTIUM FOR ADVANCED MANUFACTURING INTERNATIONAL12 WHAT IS CAM-I? CAM-I is an acronym that stands for Consortium for Advanced Manufacturing - International. The consortium (pronounced, kan-sor-she-am) is made up of industrial organizations, government agencies, universities and professional accounting firms that formed in 1972 to work together in a variety of research programs. Although most of CAM-I's research programs are related to engineering and production, one program referred to as cost management systems (CMS) is related to accounting and more specifically to the material presented in this chapter. The Cost Management Systems Program (CMS)

The CMS program was organized in 1986 to improve management planning and control systems. To aid in the development and implementation of CMS, CAM-I published a conceptual design document in 1988 that focuses on managing costs through emphasis on the activities performed within a company.13 Thus, activity based accounting provides the foundation for the CMS conceptual design. The main goals of the CMS program are to help companies develop systems that are more proactive in the areas of planning, managing and reducing costs before the costs are incurred, as well as to develop systems that more accurately trace costs to products. To accomplish these goals, CAM-I's activity accounting system is developed around a data base concept where data is captured only once to satisfy multiple requirements. In addition to helping companies develop pilot ABC projects, CAM-I helps companies change from traditional management systems (purchasing, production and distribution) to just-in-time systems (JIT), then flexible manufacturing systems (FMS) and finally computer integrated manufacturing (CIM). These concepts and systems are discussed in the next chapter. CONTROVERSIAL ISSUE: HOW SHOULD ABC BE USED? Whether a company should use a single cost system, or multiple cost systems is one of the many controversial questions discussed in recent accounting literature.14 For example, some accountants have argued that traditional cost systems are satisfactory for external reporting, therefore there is no compelling reason to replace traditional general ledger cost systems with more complex and more expensive ABC systems. When a separate ABC system is used for management purposes, ABC product costs are calculated only once per year, or more often if changes are made in the production process, but it is not necessary for detailed activity based costs to flow through perpetual inventory accounts. External users of financial statements do not need to know which products are profitable, thus using ABC in the ledger simply overloads the accounting system with unnecessary detail. On the other side of the issue, advocates of single systems have argued that using two separate systems will provide two answers to every product cost related question and tend to confuse management. A practical solution, according to this group, is to use CAM-I's data base concept where activity data are captured once and then used to produce the necessary reports for both external and internal purposes. Although no definitive answer can be given for this question, most of the ABC systems in use today are separate from the firms' general ledger cost systems. Therefore, the current consensus appears to support separate systems. 15

ABC AND THE DICHOTOMY OF CAPITALISM The development of activity based costing over the last ten years has been motivated by a number of factors and trends that are related to the competitive framework outlined in Chapter 1.16 Some of these factors include: 1) rapid advancements in technology and increasing automation, 2) a strategy of some global competitors to be more focused, combined with an emphasis on just-intime practices, and 3) increasing demands for higher quality and customer responsiveness. TECHNOLOGY AND AUTOMATION Obtaining the potential advantages of rapidly increasing technology requires automating manufacturing processes. However, automation generally increases the fixed, committed or long run variable costs, relative to the direct labor and other short run variable costs. As a result, increasing automation tends to increase the cost distortions produced by traditional cost systems. This trend promotes the use of ABC to obtain more accurate product costs. FOCUSED FACTORIES AND JIT Many communitarian companies, (particularly Japanese) are more focused in that they produce fewer products in a just-in-time environment. These organizational characteristics allow Japanese companies to obtain lower and more accurate product costs than companies that have a considerable amount of product diversity. As we shall see in Chapter 8, support costs (i.e., traditional indirect costs) are not only lower in just-in-time systems relative to traditional manufacturing systems, but also tend to become direct cost. Therefore, companies that produce hundreds of products and account for them in the traditional manner cannot obtain product costs that are as accurate as the costs obtained by companies that are more focused and also apply the concepts of JIT. One result of these company differences is that the focused manufacturers sometimes appear to be underpricing and dumping products when they are merely pricing products competitively based on lower and more accurate product costs combined with a long run emphasis on building market share. There have been cases where diversified manufacturers discontinued producing high volume, main line products because they appeared to be unprofitable. 17 ABC serves as a partial solution to this problem. At least companies with diverse product lines can eliminate the cross subsidies introduced by traditional cost systems. In this way ABC can help less focused companies obtain a better

grasp of which products are profitable so that they are not tempted to drop profitable main line, high volume products and expand the production of less profitable low volume specialty products. QUALITY AND CUSTOMER RESPONSIVENESS Companies that have embraced the communitarian concepts have not only been more focused than individualistic companies, they have also been able to obtain higher quality and greater responsiveness to customer demands. These competitive advantages were obtained by following the communitarian concepts, attitudes and practices outlined in Chapter 1. As we will see in the next chapter, teamwork and cooperation are the building blocks of a just-intime continuous improvement system. One aspect of the activity based approach that we have only alluded to thus far is the potential link between activity based concepts and the just-in-time philosophy. This potential connection provides another motivation for developing the ABC methodology. Conceptually this takes us beyond activity based costing into the domain of activity based management (ABM). ABM is a broader concept than ABC and continues to evolve from the CMS conceptual design developed by CAM-I. We will examine the similarities and differences between JIT and ABM in the next chapter. FOOTNOTES
1

The source of the term activity based costing is attributed to John Deere Company and appeared in a Harvard Business School Case (187-107) published in 1987. Robin Cooper and Robert Kaplan quickly adopted the ABC terminology and the rest of the world followed their lead. An older term used for the ABC approach is transaction costing. Although the terminology is relatively new, the ideas can be traced back to around 1910 in articles written by Alexander Hamilton Church. See Relevance Lost, Chapter 3 for a discussion of Church's ideas and references. (Relevance Lost Main). (See MAAW's ABC topic).
2

Technically, ABC is a sub-system if it is combined with the other components of a cost system. See Exhibit 2-1 to see where ABC fits into a cost system.
3

This idea is discussed in more depth by Cooper, R. and R. S. Kaplan. 1991. The Design of Cost Management Systems: Text, Readings and Cases . Prentice Hall: 275-276.

See Johnson, H. T. 1989. Professors customers and value: Bringing a global perspective to management accounting. Proceedings of the Third Annual Management Accounting Symposium, (American Accounting Association): 16. (Summary).
5

These alternative types of measurements appear in Exhibit 7-3 and are discussed later in this chapter.
6

This point is discussed by Cooper, R. 1989. The rise of activity costing - Part three: How many cost drivers do you need, and how do you select them? Journal of Cost Management (Winter): 34-46; and Kaplan, R. S. 1993. Research opportunities in management accounting. Journal of Management Accounting Research (5): 1-14. (Summary).
7

For a more elaborate discussion of this cost classification scheme, see Cooper, R. 1990. Cost classification in unit-based and activity-based manufacturing cost systems. Journal of Cost Management (Fall): 4-14.
8

For the source of this distinction, see Brimson, J. A. 1991. Activity Accounting: An Activity-Based Approach (John Wiley & Sons): 121.
9

See footnote 2.

10

For the purpose of this example, i.e., to show the typical cost distortions that can occur in traditional cost systems, it does not matter if this is historical data or budgeted data.
11

Even though there is only one production department, stage 1 allocations are still needed to accurately determine the costs of providing support services if self services and reciprocal services are involved.
12

Although the organization has always been referred to as CAM-I, the original name of the consortium was Computer Aided Manufacturing - International.
13

See Callie Berliner and James A. Brimson, editors. 1988. Cost Management for Today's Advanced Manufacturing: The CAM-I Conceptual Design . Harvard Business School Press. (See the CAM-I Main page).
14

For example, see Martin, J. R. 1994. A controversial-issues approach to enhance management accounting education. Journal of Accounting Education (Winter): 59-75. (Summary).

15

See Hughes, S. B. and K. A. Paulson Gjerde. 2003. Do different cost systems make a difference? Management Accounting Quarterly (Fall): 22-30. (Summary). For an exception, see Mangan, T. N. 1995. Integrating an activitybased cost system. Journal of Cost Management (Winter): 5-13. (Summary).
16

These factors and trends are discussed in the CAM-I conceptual design. Also see Howell, R. A. and Stephen R. Soucy, 1987. The new manufacturing environment: Major trends for management accounting. Management Accounting (July): 21-27.
17

According to Johnson, this happened in the semiconductor industry. See Johnson, H. T. 1989. Managing costs: An outmoded philosophy. Manufacturing Engineering (May). QUESTIONS

(See the ABC Questions for a longer, but similar set of questions with links to find answers.)
1. Is activity based costing an inventory valuation method or a cost accumulation method? 2. Do traditional cost systems tend to apply too much, or too little overhead cost to high volume products in multiproduct companies assuming other product characteristics are equal? Why? 3. Do traditional cost systems tend to apply too much, or too little overhead costs to small products in multiproduct companies assuming other product characteristics are equal? Why? 4. Which of the following products will be overcosted in a traditional cost system? A company produces two products. Product X is a small, high volume product while product Y a large, low volume product. 5. How does the treatment of engineering, marketing and distribution costs differ between traditional cost systems and ABC systems? 6. How does the treatment of customer service costs differ in ABC systems as opposed to traditional cost systems? 7. Describe the logic underlying ABC systems.

8. How is the concept of fixed and variable costs viewed in an ABC system? 9. What is the "rule of one"? 10. Do the terms production volume and activity volume mean the same thing? Explain. 11. How are activity measures chosen in an ABC system? 12. When would high correlation between an activity measure and overhead costs be misleading in choosing an allocation basis? 13. List and define the cost categories in the ABC cost hierarchy. 14. How are batch and product level activity costs treated differently in ABC systems as opposed to traditional production volume based systems? 15. Are activity measures, activities or drivers, both or neither? Explain. 16. Why are ABC systems designed around main activities as opposed to all activities? 17. What are three types of activity measures and when would each be appropriately used in an ABC system? 18. What are the four steps involved in designing an ABC system? 19. What is a homogeneous cost pool? 20. What are the three steps needed to calculate ABC product cost per unit? 21. Assume that two multiproduct companies have the same cost structure and both companies produce product P1. However, the first company calculates the unit cost of P1 to be $100 and the second company calculates the unit cost of P1 to be $200. Explain how this could have occurred when both companies use direct labor hours as the cost allocation basis. 22. What is CAM-I? 23. What provides the foundation for the CAM-I CMS conceptual design? 24. Should ABC systems be used as replacements for traditional cost systems or as separate systems for management decision purposes?

25. What factors have motivated companies to develop ABC systems? 26. What is a focused factory? PROBLEMS PROBLEM 7-1 This problem extends the V product sequence illustrated in the chapter to a Company C that produces products V1 and V3. The relevant information appears in the tables below. The assumptions made in Examples 7-1 and 7-2 are still applicable. Company C is assumed to have the same cost structure as Companies A and B. Overhead costs are perfectly correlated with the appropriate activity measures. ANNUAL PRODUCT DATA FOR COMPANY C PRODUCT RELATED DATA Annual production quantity in units Material cost per unit Direct labor hours per unit Direct labor cost per hour Number of purchase orders required Number of engineering work orders required Number of machine setups required V1 100 $50 1 $10 1 4 2 V3 1,000 $500 10 $10 2 8 4

ANNUAL ACTIVITY COSTS FOR COMPANY C SEPARATE AND COMBINED HOMOGENEOUS COST POOLS
ANNUAL COSTS $24,000 18,000 24,600

ACTIVITY Purchasing and receiving Engineering Machine setup Non-production volume related

ACTIVITY MEASURE

Number of purchase orders Number of engineering work orders Number of machine setups $66,600 Number of purchase orders Number of direct labor hours

Machining, power & maintenance 202,000

Materials planning & handling Production volume related Total factory overhead costs

101,000

Number of materials dollars 303,000 Number of direct labor hours $369,600

Required: 1. Calculate the unit costs of products V1 and V3 using activity based costing. 2. Calculate the unit costs of products V1 and V3 using a traditional cost system where overhead costs are allocated on the basis of direct labor hours. 3. Compare the unit cost obtained in the two systems and explain which product is overcosted and which product is undercosted. 4. Compare the traditional unit cost of V1 and V3 with the traditional unit cost obtained in Examples 7-1 and 7-2. Explain the differences. PROBLEM 7-2 This problem extends the V product sequence illustrated in the chapter to a Company D that produces products V1, V2 and V3. The relevant information appears in the tables below. The assumptions made in Examples 7-1 and 7-2 and Problem 7-1 are still applicable. Company D is assumed to have the same cost structure as Companies A, B and C. Overhead costs are perfectly correlated with the appropriate activity measures. ANNUAL PRODUCT DATA FOR COMPANY D
PRODUCT RELATED DATA Annual production quantity in units Material cost per unit Direct labor hours per unit Direct labor cost per hour Number of purchase orders required Number of engineering work orders required Number of machine setups required V1 V2 V3

100 1,000 1,000 $50 $50 $500 1 1 10 $10 $10 $10 1 2 2 4 8 8 2 4 4

ANNUAL ACTIVITY COSTS FOR COMPANY D SEPARATE AND COMBINED HOMOGENEOUS COST POOLS
ANNUAL COSTS

ACTIVITY

ACTIVITY MEASURE Number of purchase orders Number of engineering work orders Number of machine setups Number of purchase orders

Purchasing and receiving $40,000 Engineering 30,000 Machine setup 41,000 Non-production volume related $111,000

Machining, power & 222,000 maintenance 111,000 Number of direct labor hours Materials planning & handling 333,000 Number of materials dollars Production volume related $444,000 Number of direct labor hours Total factory overhead costs

Required: 1. Calculate the unit costs of products V1, V2 and V3 using activity based costing. 2. Calculate the unit costs of products V1, V2 and V3 using a traditional cost system where overhead costs are allocated on the basis of direct labor hours. 3. Compare the unit cost obtained in the two systems and explain which product is overcosted and which product is undercosted. 4. Compare the traditional unit costs of V1, V2 and V3 with the traditional unit cost obtained in Examples 7-1, 7-2 and problem 7-1. Explain the differences. PROBLEM 7-3 The Pot Company produces two products A and B. The annual quantities produced in a recent period were 500 units of A and 2,000 units of B. Product A requires 2 direct labor hours per unit and product B requires 1 direct labor hour per unit. Activity cost pools and activity measurements for ABC calculations are presented below.
Cost of Activity Quantity used Quantity used by product A by product B

Activity

Activity measure

Purchasing Materials handling Engineering Total

$400,000 Ordering hours 600,000 Number of times handled 600,000 Engineering work orders $1,600,000

100 50 50

60 200 50

Required: 1. Calculate the unit overhead costs for products A and B using the ABC method. 2. Calculate the unit overhead costs for products A and B using the traditional method. Do not use the number of units produced as the allocation basis. 3. The traditional method: a. states the unit overhead cost of both products accurately. b. overstates the unit overhead cost of both products. c. understates the unit overhead cost of both products. d. overstates the unit overhead cost of A and understates the unit overhead cost of B. e. understates the unit overhead cost of A and overstates the unit overhead cost of B. 4. The ABC method: a. states the unit overhead cost of both products accurately. b. overstates the unit overhead cost of both products. c. understates the unit overhead cost of both products. d. overstates the unit overhead cost of A and understates the unit overhead cost of B e. understates the unit overhead cost of A and overstates the unit overhead cost of B. PROBLEM 7-4 The Yorb Company produces two products X1 and X2. The annual quantities produced in a recent period were 1,000 X1s and 10,000 X2s. X1 requires 1 direct labor hour per unit and X2 requires 4.9 direct labor hours per unit. Activity cost pools and activity measurements for ABC calculations are presented below.

Activity Purchasing Materials handling Engineering Total

Cost of Activity

Activity measure

Quantity used Quantity used by product by product X2 X1 10 20 15 20 30 15

$200,000 Ordering hours 400,000 Number of times handled 100,000 Engineering work orders $700,000

Required: 1. The unit overhead cost for X1 using the ABC method (rounded to 2 decimal places) is a. 63.64 b. 14.00 c. 262.67 d. 276.67 e. some other amount. 2. The unit overhead cost for X2 using the ABC method (rounded to 2 decimal places) is a. 26.27 b. 42.33 c. 63.64 d. 68.60 e. some other amount. 3. The unit overhead cost for X1 using the traditional method (rounded to 2 decimal places) is a. 63.64 b. 14.00 c. 262.67 d. 276.67 e. some other amount. 4. The unit overhead cost for X2 using the traditional method (rounded to 2 decimal places) is a. 26.27 b. 42.33 c. 63.64 d. 68.60 e. some other amount. 5. In the problem above, the traditional method a. states the unit overhead cost of both products accurately. b. overstates the unit overhead cost of both products. c. understates the unit overhead cost of both products. d. overstates the unit overhead cost of X1 and understates the unit overhead cost of X2. e. understates the unit overhead cost of X1 and overstates the unit overhead cost of X2. 6. In the problem above the ABC method a. states the unit overhead cost of both products accurately. b. overstates the unit overhead cost of both products. c. understates the unit overhead cost of both products. d. overstates the unit overhead cost of X1 and understates the unit overhead cost of X2.

e. understates the unit overhead cost of X1 and overstates the unit overhead cost of X2. PROBLEM 7-5 The Russell Company produces two products, A and B. The quantities produced in a recent period were 2,000 A's and 8,000 B's. Product A is a large specialty product that is produced in small batches. Product B is a smaller product that is produced in somewhat larger batches. Activity cost pools and activity measurements for stage two calculations are presented below.
Cost of Activity Quantity used Quantity used by product A by product B 16,000 100 15 24,000 200 35

Activity

Activity measure

Machining $100,000 Number of machine hours Receiving & storing 60,000 Number of purchase orders Set-ups 40,000 Number of set-ups Total $200,000

Required: Choose the best answer for each question below and show supporting calculations on the right hand side. 1. The unit overhead cost for Product A using the ABC method is a. 16 b. 20 c. 36 d. 40 e. some other amount. 2. The unit overhead cost for Product B using the ABC method is a. 8.50 b. 15 c. 16 d. 20 e. some other amount. 3. The unit overhead cost for Product A using the traditional method is a. 20 b. 36 c. 30 d. 40 e. some other amount. 4. The unit overhead cost for Product B using the traditional method is a. 15 b. 16 c. 17.50 d. 20 e. Some other amount. 5. In the problem above, the traditional method a. states the unit overhead cost of both products accurately. b. overstates the unit overhead cost of both products. c. understates the unit overhead cost of both products. d. overstates the unit overhead cost of Product A and understates the unit

overhead cost of B. e. understates the unit overhead cost of A and overstates the unit overhead cost of B. 6. In the problem above the ABC method a. states the unit overhead cost of both products accurately. b. overstates the unit overhead cost of both products. c. understates the unit overhead cost of both products. d. overstates the unit overhead cost of A and understates the unit overhead cost of B. e. understates the unit overhead cost of A and overstates the unit overhead cost of B. 7. In the Russell Company problem above, the traditional cost allocations are distorted by product volume differences and product size differences. Which of the following statements describes what occurs when the traditional cost allocation method is used in this problem? a. Both production volume differences and product size differences cause the unit costs to be distorted in the same direction. b. Product size differences tend to cause the unit cost of Product A to be understated, while product volume differences have the opposite effect. c. Product volume differences tend to cause the unit cost of product B to be understated, while product size differences have the opposite effect. d. The effects of the size differences more than offset the effects of the production volume differences and cause the unit cost of the low volume product to be overstated and the unit cost high volume product to be understated. e. None of these. PROBLEM 7-6 The Jagar Company produces two products, J1 and J2. Some information for a recent period is provided below.
Data J1 J2

Annual production quantity Direct material costs per unit Direct labor hours per unit Machine hours per unit Purchase orders per year Machine setups per year

900 $100 1 1/10 20 6

100 $100 1 1/10 10 3

Although Jagar Company is currently using direct labor hours to allocate all overhead costs to products, a consultant has recommended activity based costing using the activity cost pools and measurements below.
Activity Cost Pool 1. Purchasing & receiving 2. Machining, power & maintenance 3. Materials planning & handling 4. Machine set-up Annual Costs Activity Measure

Number of purchase orders. $3,000 Number of machine hours. 6,000 Number of material dollars. 2,000 Number of machine set-ups. 1,000 $12,000

1. The total overhead (activity) cost allocated to J1 (rounded to dollars) using the current method is a. 6,000 b. 6,667 c. 9,867 d. 10,800 e. some other amount. 2. What is the minimum number of homogeneous cost pools that can be used to accurately allocate Jagars activity costs using the ABC concept? a. 1 b. 2 c. 3 d. 4 e. 5 3. Using the ABC method, the total overhead (activity) cost allocated to J1 (rounded to dollars) is a. 6,000 b. 6,667 c. 9,867 d. 10,800 e. some other amount. 4. Now, just consider cost pool 1, i.e., purchasing and receiving costs. The current allocation method based on direct labor hours a. accurately allocates these costs to J1. b. overstates the allocation to J1 by $700. c. understates the allocation to J1 by $700. d. overstates the allocation to J1 by $500. e. understates the allocation to J1 by $500.

5. The current allocation method based on direct labor hours a. distorts the overhead allocations for all four activity cost pools. b. only distorts the overhead allocations for cost pools 2 and 4. c. only distorts the overhead allocations for cost pools 2 and 3. d. only distorts the overhead allocations for cost pools 1 and 3. e. only distorts the overhead allocations for cost pools 1 and 4. 6. Activity based costing can be used as a (an) a. basic cost system. b. inventory valuation method. c. cost accumulation method. d. cost flow assumption. e. none of these. 7. Using the ABC cost hierarchy developed Robin Cooper, traditional cost systems tend to distort the allocations of which of the following? a. unit level costs. b. batch level costs. c. product level costs. d. a and b. e. b and c. 8. Assume that "Packing" has been defined as a main activity for ABC costing purposes. Also assume that customer orders contain different quantities of products and the products are many different sizes. Which of the following activity measurements would tend to provide a basis for the most accurate packing cost allocations? a. The number of orders packed. b. The number of units packed. c. The number of packing hours. d. a or b. e. b or c. 9. Activity based cost systems would probably provide the greatest benefits for organizations that use a. job order costing. b. process costing. c. historical costing. d. standard costing. e. absorption costing. 10. Activity based costing is based on the idea that a. products consume costs and activities consume products. b. drivers consume costs and activities consume drivers. c. activities consume resources and products consume activities. d. products consume resources and customers consume products. e. drivers consume resources and customers consume activities. PROBLEM 7-7 The Cola Company produces two products, regular cola, RC and clear cola, CC. RC is Cola Company's main product and CC is a specialty product. Some product related data are presented below.

Data Annual production quantity (cases) Direct material costs per unit (case) Machine hours per unit (case) Purchase orders per year Machine setups per year

RC 90,000 $240 1/2 160 6

CC 10,000 $300 1/2 40 4

Although Cola Company is currently using machine hours to allocate all overhead costs to products, a consultant has recommended activity based costing using the activity cost pools and measurements below.
Activity Cost Pool 1. Purchasing & receiving 2. Machining, power & maintenance 3. Materials planning & handling 4. Machine set-up Annual Costs Activity Measure

Number of purchase orders. $5,000,000 Number of machine hours. 8,000,000 Number of material dollars. 2,000,000 Number of machine set-up 1,000,000

1. The total overhead cost allocated to CC using the current method is a. 8,000,000 b. 14,400,000 c. 1,600,000 d. 4,600,000 e. 1,777,778 2. Using the ABC method suggested by the consultant, the total overhead cost allocated to CC (rounded to dollars) would be a. 5,443,902 b. 5,643,902 c. 3,311,111 d. 2,443,902 e. none of these. 3. Now, just consider machine set-up costs. The current traditional method a. accurately states the machine set-up costs of CC. b. overstates the machine set-up costs of CC by $300,000. c. understates the machine set-up cost of CC by $300,000. d. overstates the machine set-up cost of CC by $150,000. e. understates the machine set-up cost of CC by $150,000. 4. Using the current traditional method of allocating overhead to RC and CC a. accurately allocates the overhead for all four activity cost pools. b. distorts the overhead allocations for all four activity cost pools. c. only distorts the overhead allocations of the second activity cost pool. d. only accurately states the overhead allocations of the second cost pool.

e. accurately states the overhead allocations for activity cost pools 2 and 3, but not 1 and 4. 5. If the number of cases of RC and CC were used as the allocation basis for all overhead cost, this method would a. accurately allocate the overhead for all four activity cost pools. b. distort the overhead allocations for all four activity cost pools. c. only distort the overhead allocations of the second activity cost pool. d. only accurately state the overhead allocations of the second cost pool. e. accurately state the overhead allocations for activity cost pools 2 and 3, but not 1 and 4. PROBLEM 7-8 This problem extends the Company A illustration in the text. The summary Exhibit 7-9 is reproduced below for convenience. EXHIBIT 7-9 COMPANY A ABC AND PVB UNIT COST COMPARISONS
Amount V1 Cost Pool or ABC Unit PVB Unit PVB Unit ABC Unit Category Cost V1 Cost V1 Cost is Cost V2 Understated 1. Non production volume related 2. Production volume related Total overhead 3. Direct material 4. Direct labor Totals PVB Unit Cost V2 Amount V2 PVB Unit Cost is Overstated

$222

$60.55

$161.45

$44.40

$60.55

$16.15

30 $252 50 10 $312 ====

30.00 $90.55 50.00 10.00 $150.55 ======

0 $161.45 0 0 $161.45 ======

30.00 $74.40 50.00 10.00 $134.40 ======

30.00 $90.55 50.00 10.00 $150.55 ======

0 $16.15 0 0 $16.15 =====

1. Suppose Company A sets the sales price of each product at $225 to provide a markup of approximately 50% over the traditional production volume based unit cost of $150.55. What effect will the cost distortions have on net income if the company sells 100 units of V1 and 500 units of V2 at this price? 2. Relate your findings in question 1 to the controversy over whether ABC should be used as a replacement for the companys general ledger system or as a separate stand alone system for management decision purposes.

Cost Allocation

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A cost is generally understood to be that sacrifice incurred in an economic activity to achieve a specific objective, such as to consume, exchange, or produce. All types of organizationsbusinesses, not-for-profits, governmentalincur costs. To achieve missions and objectives, an organization acquires resources, transforms them in some manner, and delivers units of product or service to its customers or clients. Costs are incurred to perform these activities. For planning and control, decisions are made about areas such as pricing, program evaluation, product costing, outsourcing, and investment. Different costs are needed for different purposes. In each instance, costs are determined to help management make better decisions. When incurred, costs are initially reviewed and accumulated by some classification system. Costs with one or more characteristics in common may be accumulated into cost pools. Costs are then reassigned, differently for specified purposes, from these cost pools to one or more cost objects. A cost object is an activity, a unit of product or service, a customer, another cost pool, or a segment of an organization for which management needs a separate measurement and accumulation of costs. Costs assigned to a cost object are either direct or indirect. A direct cost can be traced and assigned to the cost object in an unbiased, cost-effective manner. The incurrence of an indirect cost cannot be so easily traced. Without such a direct relationship to the cost object, an indirect cost requires an in-between activity to help establish a formula relationship. When the indirect cost is assigned through the use of this formula, the cost is considered allocated. The activity used to establish the in-between linkage is called the basis of allocation.

TYPES OF ALLOCATIONS
Cost allocations can be made both within and across time periods. If two or more cost objects share a common facility or program, the cost pool of the shared unit is a common

cost to the users and must be divided or allocated to them. Bases of allocation typically are based on one of the following criteria: cause-and-effect, benefits derived, fairness, or ability to bear. The selection of a criterion can affect the selection of a basis. For example, the allocation of the costs of a common service activity across product lines or programs based on relative amounts of revenue is an ability to bear basis, whereas the same allocation based on the relative number of service units consumed by each product line or program would reflect either the benefits derived or the cause-and-effect criteria. Cost allocation then is the assignment of an indirect cost to one or more cost objects according to some formula. Because this process is not a direct assignment and results in different amounts allocated depending on either the basis of allocation or the method (formula) selected, some consider cost allocation to be of an arbitrary nature, to some extent. Costs of long-lived assets are allocated and reclassified as an expense across two or more time periods. For anything other than land, which is not allocated, the reclassification of tangible assets is called depreciation (for anything other than natural resources) or depletion (for natural resources) expense. The bases for these allocations are normally either time or volume of activity. Different methods of depreciation and depletion are available. The costs of long-lived intangible assets, such as patents, are allocated across time periods and reclassified as amortization expense. The basis for these allocations is normally time. Cost allocations within a time period are typically across either organizational segments known as responsibility centers or across units of product or service or programs for which a full cost is needed. Allocations may differ depending on whether a product or program is being costed for financial reporting, government contract reimbursement, reporting to governmental agencies, target pricing or costing, or life-cycle profitability analysis. Allocations to responsibility centers are made to motivate the centers' managers to be more goal-congruent in their decisions and to assign to each center an amount of cost reflective of all the sacrifices made by the overall organization on behalf of the center. These allocations can be part of a price or transfers of cost pools from one department to another.

ETHICAL CONSIDERATIONS
Allocations can involve ethical issues. Often the federal government issues contracts to the private sector on a cost-plus basis; that is, all the actual costs incurred to complete a contract plus a percentage of profit is reimbursed to the contractor performing the contract. A contractor completing both governmental and private-sector contracts may select a formula that tends to allocate more indirect costs to governmental contracts than to nongovernmental ones. A contractor may also try to include in reimbursement requests costs that are not allowable by the governmental agency. A contractor may even try to double-count a cost item by including it as a direct cost of the contract and as a part of an indirect cost pool allocated to the contract. Lastly, a contractor may attempt to have a reimbursement cover some of the costs of unused capacity. Audits are made of costs of government contracts to identify inappropriate costs.

SERVICE FIRMS, NOT-FOR-PROFIT ORGANIZATIONS, AND MERCHANDISERS

Service and not-for-profit organizations allocate costs, too. The cost object can be a unit of service, an individual client, or a cluster (category) of clients. The costs of a service firm are typically professional labor and indirect costs in support of the labor. The basis for allocating these indirect costs is often professional labor hours (either billable or total) or the cost of such, reflective of either cause-and-effect or benefits-received criteria. For not-for-profit organizations, the proportions to be allocated are best figured in terms of units of the resource on hand, such as the number of full-time equivalents, amount of square footage, or number of telephone lines. An important point to remember is that the principles of allocation are the same for for-profit and not-for profit organizations. The only difference is that the cost objects will be dissimilar. Merchandisers, unlike most service and not for-profit organizations, have inventory that must be costed for external and internal reporting purposes. In these cases, the cost object is a unit of inventory. Incidental costs associated with the acquisition and carrying of the inventory are mostly direct costs easily traceable clearly assignable to the entire inventory, if not to individual units.

MANUFACTURERS
Manufacturers need to cost the resources required to complete their products. In costing a unit of product for inventory valuation, costs of production are assigned. With the unit of product as the cost object, production costs are either direct costs (traceable usage of materials and labor) or indirect costs (all of the other production costs, referred to as overhead). The indirect production costs are allocated. Traditionally, manufacturers using labor-intensive technologies used a single basis of allocation based on labor, either in hours or in cost, associated with a single indirect cost pool. A manufacturer using a more capital intensive technology might use a nonlabor basis such as machine hours. Today many firms produce a varied set of products, using varied technologies with many levels of complexity. Such firms need a more refined cost assignment system that uses multiple bases of allocation with multiple indirect cost pools, such as activity based costing. While for product costing a unit of output remains the final cost object, the technology a producer uses can require a cost assignment to an intermediate cost pool (object) prior to an assignment to a unit of output. For instance, a batch technology has a cost assignment first to an individual job order (batch); the total cost assigned to the job order is then unitized over the units in the batch to determine cost of one unit of output. Alternatively, for a given period in a process technology, costs are accumulated by (assigned to) each production process; the total cost assigned is then unitized across the total number of (equivalent) units produced by that process to cost-out a unit of output. Manufacturers also incur service department costs (such as computer center costs) in support of production departments. These service department costs are indirect to a unit

of production and for full costing must be allocated, first to respective production areas and then to the units of output. Such allocations are called service department allocations, and the basis of allocation is normally an activity reflective of the nature of demands made on the service department by other departments, both service and production.

JOINT PRODUCTION ALLOCATIONS

Allocations are also required in a joint production process. When two or more separately identifiable final products initially share a common joint production process, the products are called joint products. The point at which they become separately identifiable is referred to as the split-off point. Manufacturing costs incurred prior to this split-off point are referred to as joint costs and need to be allocated across the different joint products for product costing purposes. The bases for allocating the joint costs typically include (1) relative sales value at split-off, (2) net realizable value at split-off (as an approximation of the sales value at split-off), (3) final sales value at the completion of the production process, and (4) the number of physical units of the joint products at split-off. Many would consider this list of bases to be in an order of descending preference of use. Normally there are additional production costs beyond the split-off point. These additional costs are incurred in order to complete each joint product. For a given joint product, the net realizable value at split-off is calculated by subtracting the additional costs to complete from the final sales value of the finished joint product.

SERVICE DEPARTMENT (RE)ALLOCATIONS

There are three basic methods to allocate service department costs to production departments or programs in a not-for-profit: (1) the direct method; (2) the step method; and (3) the reciprocal method. The basis for allocation of service area costs should ideally be causally related to the demands made on that area by other areas. Both cause-andeffect and benefits-received criteria are taken into account. If the service areas provide service to each other (referred to as reciprocal services), the reciprocal method is the most accurate, the step method next, and the direct method the least accurate. With different service and production departments as cost objects, costs are initially accumulated on a department-by-department basis. Departments working directly on programs or units of product or service are production departments. The other departments are service departments. The allocation problem then is to reassign service department costs to production departments or programs for both performance evaluation and product or program costing. Within a production department, these allocated service costs are then reallocated to units of service or product according to the bases of allocation that each respective production department uses for its indirect costs. The direct method ignores reciprocal services. A service department's costs are allocated to the production departments according to the extent to which each production department uses (or, for budgeting purposes, intends to use) the services of the service department. This "extent" is determined on a percentage basis by either the amount of

services actually provided by the service department to all the production departments or by the amount of services the service department is capable of providing at normal or full capacity. Variable and fixed costs may be allocated separately, resulting in a dual allocation process (for example, variable costs based on actual usage and fixed costs based on budgeted usage). The step method partially takes reciprocal services into account by allocating service department costs to production departments on a sequential basis. The service department that provides the greatest amount of service to the other service departments is allocated first; the one providing the second greatest amount of service to the other service departments is allocated second; and so forth. The absolute dollar amounts of costs incurred within service departments can be used to break a tie in usage, the larger amount allocated first. Once a service department has been allocated, it is ignored for all subsequent allocations. The reciprocal method takes into account all the reciprocal services by setting up a set of simultaneous equations, one equation per service department. For any given service department, its equation is: Total allocable cost direct costs of the service department costs allocated from each of the other service departments based on this department's use of the other service departments. Once these equations are solved, the resultant allocable cost (sometimes referred to as the reciprocal or artificial cost) is reallocated across all the other departments, service and production, according to the original percentage usages. Two additional issues, fairness and acquiring the service from the inside or from the outside, concern the allocation of a common cost. The amount of common service cost allocated to a using department may be greater that what it would cost that department to obtain the same service from the outside. A variation of the reciprocal method provides an analysis to help the manager of a using department decide whether to obtain the service from another department within the organization or to contract outside for the service from another organization. The amount of a particular service department's cost allocated to a using department may be dependent on the extent to which other departments also use this service department. This does not seem to be fair.

BIBLIOGRAPHY
Blocher, Edward J., Chen, Kung H., and Lin, Thomas W. (1999). Cost Management: A Strategic Emphasis. New York: Irwin/McGraw-Hill. Brown, Clifford D. (1999). Accounting and Reporting Practices of Nonprofit Organizationshoices and Applications. New York: American Institute of Certified Public Accountants. Horngren, Charles T., Foster, George, and Datar, Srikant M. (2000). Cost Accounting: A Managerial Emphasis. Upper Saddle River, NJ: Prentice Hall.

Ijiri, Yuji. (1975). Theory of Accounting Measurement. Sarasota, FL: American Accounting Association. Kaplan, Robert S., and Atkinson, Anthony A. (1989). Advanced Management Accounting. Englewood Cliffs, NJ: Prentice-Hall. Statements on Management Accounting (4B): Allocation of Service and Administrative Costs. (1985). Montvale, NJ: National Association of Accountants. Willson, James D., and Colford, James P.(1990). Controllership: The Work of the Managerial Accountant. New York: Wiley. Source: Encyclopedia of Business and Finance, 2001 Gale Cengage. All Rights Reserved. Full copyright.
Activity Based Costing, often called ABC, is a costing system that identifies the various activities performed in a firm and uses multiple cost drivers (volume and non volume based cost drivers) to assign overhead costs (or indirect costs) to products. ABC recognizes the causal relationship of cost drivers with activities.

Activity-based costing (ABC) is an accounting method that allows businesses to gather data about their operating costs. Costs are assigned to specific activities-such as planning, engineering, or manufacturing-and then the activities are associated with different products or services. In this way, the ABC method enables a business to decide which products, services, and resources are increasing their profitability, and which are contributing to losses. Managers are then able to generate data to create a better budget and gain a greater overall understanding of the expenses that are required to keep the company running smoothly. Generally, activity-based costing is most effective when used over a long period of time, as opposed to shorter-term solutions such as the theory of constraints (TOC).

The cornerstone of ABC is distinguishing between value-added costs and non-value-added costs. A value-added cost is the cost of an activity that cannot be eliminated without affecting a product's value to the customer. Valueadded costs are necessary (as long as the activity that drives such costs is performed efficiently). In contrast, companies try to minimize non-valueadded costs-costs that can be eliminated without affecting a product's value to the customer. Activities such as handling and storing inventories, transporting partly finished products from one part of the plant to another, and changing the set-up of production line operations to produce a different model of the product are all non-value-added activities that can be reduced, if not eliminated, by carefull redesign of the plant layout and the production process.

The following diagram explains working of Activity Based Costing and it differentiates from Traditional costing.

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