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2009 Pearson Prentice Hall.All rights reserved.Activity-Based Costing andActivity-Based Management 2009 Pearson Prentice Hall.All rights reserved.BackgroundRecall:MC=DM+DL+MOH How to allocate MOH to different cost objects?Two allocation methods:Broad Averaging:simple but unrealisticActivity Based Costing:complex but realistic(FYI:ABC as a defined subject matter was first introduced in 1987 by 2 business professors.)Indirect Cost:to be allocatedDirect Costs:to be traced5-2 2009 Pearson Prentice Hall.All rights reserved.1)Broad AveragingWhen:Historically,firms produced a limited variety of goods,while their indirect costs were relatively small.How:Use broad averages to allocate MOH costs uniformly regardless of how they are actually incurredAllocation base:unit-related measures,e.g.DLH,DL$,MH,which may not be the real cost drivers.Also called:Peanut-butter Costing,Simple CostingConsequences:Overcosting&Undercosting and Cross-subsidization5-3 2009 Pearson Prentice Hall.All rights reserved.5-4OvercostingUndercostingWhat is?allocated cost actual costallocated cost actual costConsequence:Cross-subsidization:if one product is undercosted,at least one of other products will be overcosted.Over&Undercosting&Cross-SubsidizationProfitability will be misleading:Overcosted productabsorbs too much costseems less profitable than it really isUndercosted productabsorbs too little costseems more profitable than it really isMgr decision will be wrong:Mgrs tend to over-reject the product(reject a product with a seemingly low but actually high profitability).Mgrs tend to under-reject the product(not reject a product with a seemingly high but actually low profitability).2009 Pearson Prentice Hall.All rights reserved.Plastim and Simple Costing Illustrated5-5 2009 Pearson Prentice Hall.All rights reserved.Plastim&Simple Costing Calculation5-6$60/DLH*30,000 DLH=$1,800,000$60/DLH*9,750 DLH=$585,000 2009 Pearson Prentice Hall.All rights reserved.2)Activity-Based Costing(ABC)When is a refined costing system needed?Increase in product diversity;Increase in Indirect Costs;Advances in information technology;Competition in product markets.How:ABC refines a costing system by identifying individual activities as the fundamental cost objects.5-7Products makes diverse demands on resources because of differences in volume,process steps,batch size,or complexity.2009 Pearson Prentice Hall.All rights reserved.Three Guidelines for Refining a Costing SystemDirect-Cost Tracing:if economically feasibleIndirect-Cost Pools:identify activitiesCost-Allocation Bases:choose cost drivers with causal relationship5-8 2009 Pearson Prentice Hall.All rights reserved.ABC-Cost HierarchiesABC uses a four-level cost structure to determine how far down the production cycle costs should be pushed:Unit-level(output-level):material operation costsBatch-level:machine setup costsProduct-sustaining-level:product design costsFacility-sustaining-level:general administration costsQuestion:How would the cost hierachies look like if only one product is manufactured in a company?5-9 2009 Pearson Prentice Hall.All rights reserved.Plastim and ABC Illustrated5-106 activitiesi.e.cost drivers 2009 Pearson Prentice Hall.All rights reserved.Indirect Allocation RateQuestion:If all the 6 activities in Plastim have the same cost driver,what will be the Indirect Cost Allocation Rate like?5-11 2009 Pearson Prentice Hall.All rights reserved.Plastim and ABC Rate Calculation5-12 2009 Pearson Prentice Hall.All rights reserved.Plastim and ABC Product Costs5-13 2009 Pearson Prentice Hall.All rights reserved.Plastim:Simple&ABC Compared5-14Can be economically traced to the cost objects 2009 Pearson Prentice Hall.All rights reserved.Conclusions:ABC vs.Simple costingEach method is mathematically correctEach method is acceptableEach method yields a different cost figure,which will lead to different Gross Margin calculations and decision making.Only Overhead is involved.Total Costs for the entire firm remain the same they are just allocated to different cost objects within the firm5-15 2009 Pearson Prentice Hall.All rights reserved.Conclusions:ABC vs.Simple costing(contd)Why is ABC generally perceived to produce superior costing figures and eliminate cost distortions?Due to the use of multiple drivers across multiple levels that have causal relationship to costs.Are cost drivers the more the better?No.Recall Cost-benefit Principle.Does ABC always produce accurate costs?No.ABC is only as good as the cost drivers selected,and their actual relationship to costs(Cause-and-effect Relationship).Experience,industry practices are also useful in choosing cost drivers.5-16 2009 Pearson Prentice Hall.All rights reserved.Signals that suggest that ABC implementation could help a firm:Significant OH costs allocated using one or two cost poolsMost or all OH is considered unit-levelProducts that consume different amounts of resourcesProducts that a firm should successfully make and sell consistently show small profitsOperations staff disagreeing with accounting over manufacturing and marketing costs5-17 2009 Pearson Prentice Hall.All rights reserved.Activity-Based ManagementA method of management that uses ABC as an integral part in critical decision-making situations,including:Pricing&product-mix decisionsCost reduction&process improvement decisionsDesign decisionsPlanning&managing activities5-18 2009 Pearson Prentice Hall.All rights reserved.ABC and Service/Merchandising FirmsABC implementation is widespread in a variety of applications outside manufacturing,including:Health CareBankingTelecommunicationsRetailingTransportation5-19
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