1314-IBMS-IBO-FIN-lecture 3

CHAPTER 23
Performance Measurement, Compensation, and Multinational
Considerations

CHAPTER 5
Activity-Based Costing and Activity-based Management

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Homework
23-27
23-30
Additional info (about the literature to study)

will be published on BB.

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23-27

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23-30

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CHAPTER 5
Activity-Based Costing
and
Activity-Based Management

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Background
Recall that performance of sub-units can be

measured by using ROI, RI, and EVA etc.

All of these measures include income/profit.

Income (think of an income statement) can

be calculated by subtracting costs from

revenues.
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Basic Cost Terminology

Costsacrificed resource to achieve a specific

objective
Actual costa cost that has occurred
Budgeted costa predicted cost
Cost objectanything of interest for which a
cost is desired

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Basic Cost Terminology

Cost accumulationa collection of cost data

in an organized manner
Cost assignmenta general term that
includes gathering accumulated costs to a
cost object. This includes:
Tracing accumulated costs with a direct

relationship to the cost object and

Allocating accumulated costs with an indirect
relationship to a cost object

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Direct and Indirect Costs

Direct costs can be conveniently and

economically traced (tracked) to a cost object.

Indirect costs cannot be conveniently or
economically traced (tracked) to a cost object.
Instead of being traced, these costs are
allocated to a cost object in a rational and
systematic manner.

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BMW: Assigning Costs to a

Cost Object

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Cost Examples
Direct Costs
Parts
Assembly line wages
Indirect Costs
Electricity
Rent
Property taxes

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Note: Cost Behavior is

looking at costs in a different
way!
Variable costschanges in total in proportion

to changes in the related level of activity or

volume.
Fixed costsremain unchanged in total
regardless of changes in the related level of
activity or volume.
Costs are fixed or variable only with respect to
a specific activity or a given time period.

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Cost Behavior
Variable costs are constant on a per-unit

basis. If a product takes 5 pounds of

materials each, it stays the same per unit
regardless if one, ten, or a thousand units
are produced.
Fixed costs change inversely with the level
of production. As more units are produced,
the same fixed cost is spread over more and
more units, reducing the cost per unit.
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Cost Behavior Summarized

Total Dollars
Dollars
Total

Cost
Cost per
Per Unit
Unit

Change in
in
Change
Unchanged in
proportion with
with relation to output
Variable Costs proportion
Variable Costs
output
output
More output = More cost
More output =
Change
More cost
Change inversely
inversely
with
Unchanged in
Fixed Costs
with output
Unchanged in
output
More output
= lower cost
Fixed Costs
relation
to
output
relation to output More output
per unit
=
lower cost
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Multiple Classification of
Costs
Costs may be classified as:
Direct/Indirect, and
Variable/Fixed
These multiple classifications give rise to

important cost combinations:

Direct and variable
Direct and fixed
Indirect and variable
Indirect and fixed
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Multiple Classification of
Costs, Visualized

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Back to indirect costs

How to allocate these costs to a cost object?

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Background
Recall that factory overhead is applied to

production in a rational systematic manner,

using some type of averaging. There are a
variety of methods to accomplish this goal.
These methods often involve trade-offs
between simplicity and realism.
Simple Methods
Methods
Unrealistic

Complex

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Realistic

Broad Averaging
Historically, firms produced a limited variety

of goods while their indirect costs were

relatively small.
Allocating overhead costs was simple: use
broad averages to allocate costs uniformly
regardless of how they are actually incurred.
Peanut-butter costing

The end-result: overcosting and undercosting

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Over and Undercosting

Overcostinga product consumes a low level

of resources but is allocated high costs per

unit.
Undercostinga product consumes a high
level of resources but is allocated low costs
per unit.

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Cross-subsidization
The results of overcosting one product and

undercosting another.
The overcosted product absorbs too much
cost, making it seem less profitable than it
really is.
The undercosted product is left with too little
cost, making it seem more profitable than it
really is.

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5-19
Lets have a look at 5-19 to find out how this

ABC actually works.

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Conclusions
Each method is mathematically correct.
Each method is acceptable.
Each method yields a different cost figure, which

will lead to different gross margin calculations.

Only overhead is involved. Total costs for the
entire firm remain the samethey are just
allocated to different cost objects within the firm.
Selection of the appropriate method and drivers
should be based on experience, industry
practices, as well as a cost-benefit analysis of
each option under consideration.
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Rationale for Selecting a More

Refined Costing System
Increase in product diversity
Increase in indirect costs
Advances in information technology
Competition in foreign markets

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5-21

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5-22

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Homework
5-23

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