46 6.8 Variations of Activity-Based Costing (ABC)
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Last updated
- Dec 28, 2020
Learning Objectives
- Expand the use of activity-based costing.
Question: The primary focus of activity-based costing thus far has been on allocating manufacturing overhead costs to products. Although this is important for external reporting purposes, we can expand ABC to include costs beyond manufacturing overhead. Also, we can organize costs in different ways to help managers evaluate performance. What different approaches can be used to organize cost data in a way that helps managers make better decisions?
External Reporting and Internal Decision Making
Question: U.S. Generally Accepted Accounting Principles require the allocation of all manufacturing costs to products for inventory costing purposes. The choice of an allocation method is not critical to this process. Companies that use direct labor hours, machine hours, activity-based costing, or some other method to allocate overhead costs to products are likely to be in compliance with U.S. GAAP. Throughout this chapter, we have illustrated how ABC is used to allocate manufacturing overhead costs. However, organizations often use ABC for purposes that go beyond allocating costs solely for external reporting. How might ABC be used to help companies in areas other than external reporting?
Table 6.1 provides examples of costs that could be allocated to products. It also includes cost categories—product, selling, and general and administrative (G&A)—and indicates whether the cost allocation complies with U.S. GAAP for external reporting. As you can see in the far right column, all costs can be allocated to products for internal reporting purposes.
| Cost | Cost Category* | OK to Allocate to Products for External Reporting (U.S. GAAP)? | OK to Allocate to Products for Internal Reporting? |
|---|---|---|---|
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Direct materials
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Product | Yes | Yes |
|
Direct labor
|
Product | Yes | Yes |
| Manufacturing overhead** | Product | Yes | Yes |
| Sales commissions | Selling | No | Yes |
| Shipping products to customers | Selling | No | Yes |
| Product advertising | Selling | No | Yes |
| Legal costs for product lawsuit | G&A | No | Yes |
| Processing payroll for production personnel | G&A | No | Yes |
| Company president’s salary | G&A | No | Yes |
| Costs of implementing ABC | G&A | No | Yes |
*See Chapter 5 for information about category definitions.
**Includes all manufacturing costs other than direct labor and direct materials, such as factory-related costs for supervisors, building rent, machine maintenance, utilities, and indirect materials. See Chapter 5 for more detail.
Allocating Service Department Costs Using the Direct Method
Question: Most companies have departments that are classified as either service departments or production departments. Service departments10 provide services to other departments within the company and include such functions as accounting, human resources, legal, maintenance, and computer support. Production departments11 are directly involved with producing goods or providing services for customers and include such functions as ordering materials, assembling products, and performing quality inspections. Why do companies often allocate a share of service department costs to
Question: How do companies allocate service department costs to production departments and how might this be done at SailRite?
The Hierarchy of Costs
Question: Some organizations group activities into four cost categories, called the hierarchy of costs, to help managers form cost pools for activity-based costing purposes. The cost hierarchy13 Credit for developing the cost hierarchy is generally given to R. Cooper and R. S. Kaplan, “Profit Priorities from Activity-Based Costing,” Harvard Business Review, May 1991, 130–35.groups costs based on whether the activity is at the facility level, product or customer level, batch level, or unit level. What is the difference between each of these categories, and how does this information help managers?
The cost hierarchy serves as a framework for managers to establish cost pools and determine what drives the change in costs for each cost pool. It also provides a sense of how quickly (or slowly) costs change based on decisions made by management. Examples of activities often identified by companies using activity-based costing, and how these activities fit in the cost hierarchy, appear in Table 6.2.
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Cost Hierarchy Category
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Activity/Cost
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|---|---|
| Facility-level | Plant depreciation |
| Building rent | |
| Management of facility | |
| Product/customer-level | New product development |
| Product engineering | |
| Product marketing and advertising | |
| Maintaining customer records | |
| Batch-level | Machine setups |
| Processing purchase orders | |
| Batch quality inspections | |
| Unit-level | Energy to run production machines |
| Direct labor | |
| Direct materials |
Measuring the Costs of Controlling and Improving Quality
Question: The hierarchy of costs is not the only approach organizations use to group costs. Managers are also concerned about measuring the costs associated with quality. Quality-related costs can be organized into four categories. The first two categories—prevention and appraisal—are costs incurred to control and improve quality. The final two categories—internal failure and external failure—are costs incurred as a result of failing to control and improve quality. What is the difference between these cost categories, and how does this information help managers improve quality?
Key Takeaway
Activity-based costing is not simply used to allocate manufacturing overhead costs to products for external reporting purposes; it is also often used to allocate selling, general, and administrative costs to products for internal decision-making purposes. A number of methods can be used to assist in the cost allocation process. For example, the cost of service departments can be allocated to production departments using the direct method. Also the cost hierarchy can be used to help establish cost pools and identify cost drivers used to allocate costs. Organizations are also concerned with measuring and reducing the cost of quality by categorizing quality costs into four categories—prevention, appraisal, internal failure, and external failure.
Review problem 6.6
Fill in the following table to identify if the cost item can be included in the cost of products for external reporting purposes and/or internal reporting purposes. The first item is completed for you.
| Cost | OK to Allocate to Products for External Reporting (U.S. GAAP)? | OK to Allocate to Products for Internal Reporting? |
|---|---|---|
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Direct materials
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Yes | Yes |
| Salaries of sales people | ||
| Indirect materials used in production | ||
| Rent for headquarters building | ||
| Product promotions | ||
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Direct labor
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||
| Legal costs for patent applications | ||
| Processing payroll for human resource personnel | ||
| Depreciation of factory equipment | ||
| Marketing vice president’s salary | ||
| Depreciation of administrative department equipment |
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Definitions
- Departments that provide services to other departments within a company.
- Departments directly involved with producing goods or providing services for customers.
- A method of allocating costs that allocates service department costs directly to production departments but not to other service departments.
- A method of costing that groups costs based on whether the activity is at the facility level, product or customer level, batch level, or unit level.
- Activities required to sustain facility operations and include items such as building rent and management of the factory.
- Activities required to develop, produce, and sell specific types of products.
- Activities required to produce batches (or groups) of products.
- Activities required to produce individual units of product, such as direct materials and direct labor.
- Costs for activities that prevent defects in products and services.
- Costs for activities that detect defective products before they are delivered to customers.
- Costs incurred as a result of detecting defective products before they are delivered to customers.
- Costs for activities that result from delivering defective products to customers.
