ACT503 Chap.6 Activity Based Costing and Management
Activity Based Costing and Management
What a single average hides, and in which direction
Broad averaging spreads the cost of resources uniformly across cost objects regardless of how those resources are actually consumed, and its consequence is a systematic pair of errors rather than random noise. A product is overcosted when it draws little on the firm's resources and is nevertheless charged a lot per unit, and undercosted when the opposite happens.
Because the pool being spread does not change, cross subsidisation follows by arithmetic: if one product is undercosted at least one other must be overcosted by exactly as much.
The overcosted product then looks less profitable than it is and the undercosted one looks more profitable, so cost based prices are set too high on the first and too low on the second and marketing effort is pushed towards the wrong product.
Three reasons to refine, three guidelines for doing it, four levels for sorting
Refinement becomes worth its cost when product diversity increases, when indirect costs increase and when competition in the product market increases.
The three guidelines are to trace as many costs directly as is economically feasible, to expand the number of indirect cost pools until each is homogeneous, meaning every cost in it shares a cause and effect relationship with a single driver, and to use that driver as the allocation base.
An activity based system treats each separate activity as the thing being costed in the first instance, an activity being anything that happens and uses up overhead resources when it does, and sorts them into a four level hierarchy: output unit level, batch level, product sustaining and facility sustaining.
What it buys, what it does not, and what to do with it
Three differences from a traditional system are worth stating precisely.
An activity based system assigns non manufacturing costs to products as well; it declines to assign all manufacturing costs, because a facility sustaining cost with no causal driver is better left unallocated than allocated arbitrarily; and it uses more pools, each with its own activity measure, rather than one or two volume measures.
The course is explicit that using it does not guarantee more accurate costs, because accuracy comes from the causal story behind each driver rather than from the number of pools, and that total firm cost is unchanged either way since only the allocation moves.
Activity based management is the use of the figures in pricing and product mix, cost reduction and process improvement, design decisions, and planning and managing activities.
What this chapter covers
- 01
Peanut butter costing and what it does to a mixed product line
- 02
Overcosting, undercosting and cross subsidisation
- 03
The plant wide rate, the departmental method and their trade offs
- 04
Three reasons for refining a costing system
- 05
Three guidelines: direct tracing, homogeneous pools, causal bases
- 06
Activity, activity cost pool and activity measure
- 07
The four level cost hierarchy
- 08
Three differences from a traditional system
- 09
Activity based management and its four decision uses
Cost two lines both ways and name the direction of the error
- 2The plant wide rate, using the whole pool.
- 3Overhead allocated to each line under that rate, and per unit.
- 3The five activity rates.
- 4Allocation under the refined system, per unit, with the direction quantified.
Key terms
- Peanut Butter Costing
- The name the course gives to broad averaging, in which the cost of resources is spread uniformly across cost objects regardless of how those resources were actually consumed.
- Undercosting
- The condition in which a product draws heavily on the firm's resources and is nevertheless charged little per unit. It makes the product look more profitable than it is and invites bidding that wins work at a loss.
- Homogeneous Cost Pool
- A pool in which every cost shares a cause and effect relationship with a single driver, so that the driver can serve as the allocation base. Expanding the number of pools until each is homogeneous is the second refinement guideline.
- Batch Level Cost
- A cost driven by the number of groups of units treated together rather than by the number of units, such as machine setup or order handling. A volume driver cannot see it, which is why it is the usual source of undercosting.
- Facility Sustaining Cost
- A cost that cannot be traced to individual products at all, such as general administration. A refined system may legitimately leave it unallocated rather than allocate it arbitrarily, which is why an activity based product cost is not always a full cost.
- Activity Based Management
- The use of activity based figures in decisions rather than only in reports, covering pricing and product mix, cost reduction and process improvement, design decisions, and planning and managing activities.
- Activity Measure
- The allocation base of an activity cost pool, also called a cost driver, chosen because it causes the pool to grow rather than because data for it happens to exist.
- Cross Subsidisation
- The effect by which undercosting one product forces overcosting of at least one other by the same total amount, because the overhead pool being spread does not change when the allocation method does.
Activity Based Costing and Management FAQ
Which product does a single volume driver undercost?
Whatever is complex, meaning whatever consumes resources at a level above the individual unit. A product made in short runs with frequent design changes and many small orders consumes batch level and product sustaining resources that a machine hour rate cannot see, so it is charged as though it consumed only unit level resources. The simple high volume product is overcosted by exactly the same total amount.
Does refining the system make the numbers more accurate?
Not automatically. The course says plainly that the refined approach is widely taken to give better numbers, and equally plainly that adopting it is no guarantee of a more accurate cost. Accuracy comes from the causal story behind each driver, so a system with fifteen pools whose drivers were chosen because the data happened to exist is a more expensive way of being wrong.
Does the total cost of the firm change when the system is refined?
No. Only the allocation moves, so the two product totals still add to the same overhead pool. That is the arithmetic behind cross subsidisation, and it is also why an argued requirement must quantify the movement rather than describe it: the useful figure is which product moved, by how much and in which direction.
What makes an activity based system stop working after it has been installed?
Loss of the data that feeds it. The case supplied with this course describes drivers abandoned after a restructuring because recording them was seen as extra work once nobody was measured on them, and a sales function that resisted the analysis because traceable costs threatened its autonomous status. Measurement decays wherever it is not attached to someone who answers for it.
Exam move
Take one product you know is complex and one you know is simple, list the activities each actually consumes, and mark the level of each activity in the hierarchy. You will usually find that the complex product's consumption is concentrated above the unit level, which tells you the direction of the error a volume driver would make before you compute anything at all.
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