F I V E
INTRODUCTION TO COST MANAGEMENT
Activity-Based Costing and Management
After studying this chapter, you should be able to . . .
1. Explain the strategic role of activity-based costing 2. Describe activity-based costing (ABC), the steps in developing an ABC system, and the beneﬁts and limitations of an ABC system 3. Determine product costs under both the volume-based method and the activity-based method and contrast the two 4. Explain activity-based management (ABM) 5. Describe how ABC/M is used in manufacturing companies, service companies, and governmental organizations 6. Use an activity-based approach to analyze customer proﬁtability 7. Identify key factors for successful ABC/M implementation
Beware of little expenses. A small leak will sink a great ship. Benjamin Franklin This chapter has a lot to do with implementing the spirit of Benjamin Franklin’s observation—in cost management terms—that it really does matter how accurately you calculate a cost. Why? Having accurate costs is important for a variety of reasons: a company might ﬁnd that it has a difﬁcult time determining which of its products is most proﬁtable. Alternatively, it ﬁnds its sales increasing but proﬁts declining and cannot understand why. Perhaps the company keeps losing competitive bids for products and services and does not understand why. In many cases, accurate cost information is the answer to these questions. Accurate cost information provides a competitive advantage. It helps a company or organization to develop and to execute its strategy by providing accurate information about the cost of its products and services, the cost of serving its customers, the cost of dealing with its suppliers, and the cost of supporting business processes within the company.
The Strategic Role of Activity-Based Costing
LEARNING OBJECTIVE 1
Explain the strategic role of activity-based costing
Activity-based costing (ABC) is a method for determining accurate costs. While ABC is a relatively recent innovation in cost accounting, it is rapidly being adopted by companies across many industries and within government and not-for-proﬁt organizations. Here is a quick example of how it works, and why it is important Suppose you and two friends (Joe and Al) have gone out for dinner to have pizza. You each order an individual size pizza, and Al suggests that you all order a plate of appetizers for the table. You and Joe ﬁgure you will have a bite or two of the appetizers, so you say OK. Dinner is great, but at the end Al is still hungry, so he orders another plate of appetizers and as before, eats all of it. When it is time for the check, Al suggests the three of you split the cost of the meal equally. Is this fair? Perhaps Al should offer to pay for the two appetizer plates. The individual pizzas are direct costs for each of you so that an equal share is fair, but while the appetizer plate was intended to be shared equally, it turns out that Al consumed most of it.
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There are similar examples in manufacturing. Suppose you and Joe and Al are also product managers at a plant that manufactures furniture. Al is in charge of sofa manufacturing, Joe of dining room tables and chairs, and you are in charge of bedroom furniture. Each of your product lines has direct materials and labor costs that are traced directly to each of you. It is your responsibility to manage these direct costs. Also, there are indirect manufacturing costs (overhead) that cannot be traced to each product, including, the following activities: materials acquisition, materials storage and handling, product inspection, manufacturing supervision, job scheduling, equipment maintenance, and fabric cutting. What if the company decides to charge each of the three product managers a “fair share” of the total indirect cost using the ratio of units produced...