Chapter 5: Activity-Based Costing and Management

Summary

Many companies have replaced their volume-based costing systems with activity-based accounting systems to gain better product costing and pricing. ABC facilitates activity-based management that improves competitiveness, reduces costs, increases productivity, and augments flexibility in meeting customer needs.

Volume-based costing systems use a volume-based overhead rate, either a single rate for the entire plant or departmental rates. These volume-based overhead rates typically use measures such as direct labor-hours, machine-hours, or direct labor costs for all products or services, even if the firm has diverse products, manufacturing processes, and volumes. For firms with more than one product or process, these overhead rates often generate inaccurate and significantly distorted product costs.

Activity-based costing (ABC) assigns costs to products or services based on consumption of resources and activities. ABC systems recognize the fact that products or services are results of activities and that activities consume resources and incur costs; it recognizes the causal relationships of cost drivers to activities. ABC systems use a two-stage procedure to assign costs to products or services. The first-stage allocation is a resource cost assignment process by which factory overhead costs are assigned to activity cost pools or groups of activities called activity centers using appropriate resource consumption cost drivers. The second-stage allocation is an activity cost assignment process by which the costs of activities are assigned to products or services using appropriate activity consumption cost drivers.

Activity-based costing helps to reduce cost distortions often found in volume-based costing systems and provides more accurate product costs. It also yields a clear view of how a firm's diverse products, services, and activities contribute to the firm's bottom line. Even though developing and implementing an ABC system is expensive and time consuming, many firms found the benefit exceeds the cost of installing an ABC system.

Activity-based management (ABM) improves efficiency and effectiveness of an organization. Uses of ABM increase not only the value received by customers but also the firm's profits.

Customer profitability analysis traces costs to customers to allow management to determine customer profitability and to provide more attentive service to high-profit customers, acquire new high-profit customers, and improve the profitability of current customers.

Numerous factors play important roles in implementing ABC/ABM. To be successful, management accountants need to cooperate with engineers and manufacturing and operating managers to form a design team.