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- Activity-Based Cost Systems
Nguyen Phong Nguyen
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Traditional Cost Systems (TCS)
• TCS are systems that allow assigning
indirect/overhead costs to cost objects based on
volume-based measures.
• Plant-wide and departmental rates based on direct
labor hours, machine hours, or other volume-based
measures are used successfully by many
organizations.
– However this approach to costing is equivalent to an
averaging approach and may produce distorted, or
inaccurate costs.
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- Traditional Cost Systems
Direct Direct Overhead
Material Labor Costs
Costs Costs
Direct Direct DLH
Trace Trace Allocation
Cost objects
Example: Tan Thanh Corporation
Activity Usage Measures
Deluxe Regular Total
Units produced 10 100
Prime costs 800 8,000 8,800
Direct labor hours 20 80 100
Machine hours 10 40 50
Setup hours 3 1 4
Number of moves 6 4 10
Activity Cost Data (Overhead Activities)
Activity Activity Cost
Setting up equipment 1,000
Moving goods 1,000
Machining 1,500
Assembly 500
Total 4,000
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- Tan Thanh Corp: Traditional Cost Systems
• Plant-wide overhead rate =…………………
………………............................../DLH
• Overhead cost allocated to
o Deluxe = …………………………………………….
o Regular =…………………………………………….
• Unit cost of
o Deluxe = …………………………………………….
o Regular =…………………………………………….
Limitations of Traditional
Cost Systems
Product cost distortions
can be damaging, Continuous
Improvement Total Quality
particularly for those Management
firms whose business
environment is
characterized by:
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- Limitations of Traditional
Cost Systems (continued)
• The need for more accurate product costs has
forced many companies to take a look at their
costing procedures.
• Two major factors impair the ability of unit-
based plant-wide and departmental rates to
assign overhead costs accurately:
– The proportion of nonunit-related overhead costs
to total overhead costs is large.
– The degree of product diversity is great.
Activity-based Costing: the basic idea
Resource: Indirect labor
Activity: Inspect
Move Maintain Set up Prepare
incoming
materials machines machines tooling
materials
# maint. hrs.
# setup hrs.
# receipts
# moves
Activity
# setups
cost driver:
Cost driver
rate
Product,
Customers 8
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- ABC Cost Systems
Overhead Costs
Direct Direct
Material Labor
Costs Costs
Machining Assembly Inspection
activity activity activity
costs costs costs
Direct Direct Processing # of
# of parts
Trace Trace Hours inspections
Cost objects
ABC Cost System
ABC systems refine costing systems by focusing on individual
activities as the fundamental cost object
they measure utilization of each activity by cost objects and assign
the cost of the activity accordingly
total cost of activity
÷ total utilization of = Cost driver
per period
activity per period rate
(“cost pool”)
overhead cost
cost driver units × Cost driver = assigned
used by cost object rate
to cost object
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- General Procedure
• Determine the set of activities j performed in
each department (cost center)
• determine a Cost Driver for each activity j
measuring the causal relationship between
– resource consumption of the activity and its
– utilization by products or customers
• assign resource costs to activities j
– each activity is assigned a cost pool Cj
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General Procedure (cont’d)
• Determine the total level xj of budgeted
utilization of the activity
• Determine the cost driver rate = Cj
xj
• Determine (actual) usage xjl of cost driver j
by each user l
• Activity-based cost assignment to user l:
Sj xjl Cj
xj
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- Key step: Assigning resource costs to
activities
• Resource costs per activity is an important
piece of information to management
• This is usually done by interviews with
department managers on
– activities performed
– the proportion of working time usually spent on
each activity
– no excessive precision required
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Cost Hierarchies
• ABC systems commonly use a four-level cost
hierarchy to identify cost-allocation bases:
1) Output unit-level cost
2) Batch level costs
3) Product-sustaining costs
4) Facility-sustaining costs
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- Cost Hierarchies
Types of activity cost drivers
Accounting
cost
• Number of transactions
• Duration of transaction
– if time consumed varies among individual
instances of the activity
• Intensity or direct charging
– number of staff of different wage groups
assigned to an activity per time unit
– resources actually used for the individual
instance of an activity
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- Appropriate number of cost drivers
• Small cost pools do not alter unit costs much
• if additional information has to be acquired on a
cost driver consider the information cost and
compare it to the benefit of the better decision
• do not add a cost driver which is an approximate
linear combination of cost drivers already used
– existing cost pools should share in the cost that would
be assigned to that pool according to the weights of
the linear combination
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Optimal Product-Costing System
Cost
Total Cost
High
Cost of
inferior
decisions
resulting Design, implementation
from and maintenance costs
inaccurate
information.
Information
Low System
Low High Accuracy
Optimal
system
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- Tan Thanh Corp: ABC
• Activities: setting-up equipment, moving of
materials
• Cost drivers: set-up hour (duration), number
of moves (transaction)
• Activity rate
o Set-up = ………………………………/set-up hour
o Moving = ……………………………./move
o Machining = …………………….…/machine hour
o Assembly = …………………………/DLH
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Tan Thanh Corp: ABC
• Overhead costs allocated to
o Deluxe = …………………………………………………………..
o Regular = ………………………………………………………….
• Unit cost under ABC
o Deluxe = …………………………………………………………..
o Regular = …………………………………………………………..
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- Critique
• ABC systems are full cost systems
– they average fixed costs over products according to cost
driver utilization: every individual unit carries the same cost
per unit of driver utilized
– costs for which a cost driver is not available (e.g. leading a
department) are allocated to cost pools of measurable
activities
• For change management decisions an incremental
costing approach is more adequate, when the size of
the cost pool will not change proportionally with the
cost driver (non-linearities in the cost function) due to
– fixed costs
– economies of scale
– economies of scope
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