ACT 202 SPRING 2008 (SIH) -CASE STUDY

1: Why is it important to know the true cost of a process, product or service?

Answer:

It's Important to know the true cost of a process, product or service. Because of
companies use traditional indirect-cost allocations may actually lose money on certain
products, orders and customers; even though, their accounting systems report them as
profitable. Because of pricing and quotation practices usually rely on the same flawed
cost data, the errors are perpetuated.

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.

If you know the true price of a product or service then it puts you in a better position to
make sure that it is being priced correctly so the company can maximize its profits.
However, it can be quite expensive because the more detailed the data gets, the more it
costs. It needs to be balanced against the benefits that the information provides.

When you go to Wal-Mart and buy a cheap product, you should know that the product
is cheap because Wal-Mart has either a lower cost on raw materials (lower quality
materials) and also a lower cost on labors (part time employees that don’t receive benefits
and work for minimum wage), so Wal-Mart is able to offer you a low cost.

For any given product, you have two different costs: fixed and variable. So, how is the
price setting for a given product?

P= fixed cost + variable cost + possible profit

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For retailers, like Wal-Mart:

P= Lowest possible fixed cost + lowest possible variable cost + maximum possible profit
For retailers like Ten Thousand Villages:
P= fair fixed cost + fair variable cost + fair profit
Francisco Van Der Hoff, in the Congress of Humanity and Social Science at York
University (Toronto) stated that the cost of producing any product is composed of three
elements:

True
 cost of production. This means not only the cost of the raw material, but also the
land, salary of workers, and opportunity cost of growing a product instead of another.
Social
 cost: The impact and repercussions for the worker and his or hers surroundings
like education for children and hazardous working conditions.
Environmental
 cost: The cost of soil degradation, fertilizer poured in the land and
hazard to the ecosystem, et cetera.
So, next time, think twice before buying a cheap product that may be done at the expense
on somebody else’s quality of life.

2. Do you agree with the statement, “Activity Based Costing is very costly and time
consuming"?
Answer:

Yes, Activity Based Costing is very costly and time consuming. The traditional ABC
model has been difficult for many organizations to implement because of the high costs
incurred to interview and survey people for the initial ABC model, the use of subjective
and costly-to-validate time allocations, and the difficulty of maintaining and updating the
model as (i) processes and resource spending change, (ii) new activities are added, and
(iii) increases occur in the diversity and complexity of individual orders, channels and
customers.

Time-Driven ABC approach also overcomes a serious technical problem associated

with employee surveys. The fact that, when asked to estimate time spent on activities,

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employees invariably report percentages that add up to 100. Managers should take into
account time that is idle or unused. The method also supports time equations, a feature
that enables the ABC model to reflect the complexity of real-world operations by
showing how specific order, customer, and activity characteristics cause processing times
to vary.

An aspect of ABC that should be apparent is that ABC requires information to be

gathered and maintained on a number of different activities. As a result, the use of ABC
is often quite costly to organizations. Implementing ABC systems in theory might sound
easy but in the reality, it's very difficult.

3. Does Activity Based Costing produce an accurate costing picture?

Answer:

In most cases, a company's traditional cost-accounting system adequately measures the

direct costs of products and services, such as material and labor. As a result, ABC
implementation typically focuses on indirect costs, such as manufacturing over-head and
selling, general, and administrative costs. Given this focus, the primary goal of ABC
implementation is to reclassify most, if not all, indirect costs (as specified by the
traditional cost-accounting system) as direct costs. As a result of these reclassifications,
the accuracy of the costs is greatly increased.

According to Ray H. Garrison and Eric W. Noreen, there are six basic steps required to
implement an ABC system:

1. Identify and define activities and activity pools

2. Directly trace costs to activities (to the extent feasible)
3. Assign costs to activity cost pools
4. Calculate activity rates
5. Assign costs to cost objects using the activity rates and activity measures
previously determined
6. Prepare and distribute management reports

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Coca-Cola has developed world-class ABC modeling teams, learned this lesson by
putting their ABC systems through several redesigns. They found that simpler designs
generally produced higher levels of accuracy.

ABC corrects for the limitations of traditional costing by identifying all the work
activities and their costs that go into manufacturing a product, delivering a service or
performing a process. ABC can even distinguish the cost of servicing different customers.

The traditional cost management approach--in which cost allocation is based on labor
hours, gallons, pounds or other units of output rarely reflects the true cause-and-effect
relationship between indirect and overhead costs and individual products, services,
channels or customers. ABC was developed as a practical solution for problems
associated with traditional cost management.

4. Can you identify all the ‘activities’ for ‘small company’ and generalize them in
few categories?
Answer:

A common framework for combining activities in manufacturing small company is as

follows:

Unit-level activities are performed each time a unit is produced. For example, providing
power to run processing equipment would be a unit- level activity.Example:Small
companies activities are operating a press, direct labor whose are assigned in forging be
used of manufacture different weight of automobile parts.

Small company

Activity Level of Activity Possible Activity measure

Press Operating Unit Press Hour
Direct labor(associate in Unit Direct labor
Forging operation)
Machine shop workers Unit Machine Hours

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Batch-level activities are performed each time a batch is handled or processed,
regardless of how many units are in the batch. For example, setting up equipment and
material movement are batch-level activities of small company
Activity Level of Activity Possible Activity measure
Equipment Setup Batch Hours of setup time ,Number
Of setup
Material Movement Batch Number of loads transferred

.
Product-level activities relate to specific products and must be carried out regardless of
how many batches are run or units produced and sold. For example, induction heating,
finished good storage facility would be product-level activities.
Activity Level of Activity Possible Activity measure
Induction heating Production Parts weight

Customer-level activities relate to specific customers and are not tied to any specific
product. For example, Organization-sustaining activities are carried out regardless of
which customers are served, which products are produced, how many batches are run, or
how many units are made. For example, parts go to on the shipping area to be sorted,
packed and loaded into trucks for delivery to customers are customer level activities of
small company.

When combining these activities, they should be grouped together at the appropriate
level. Batch-level activities should not be combined with unit-level activities, and so on.
Furthermore, activities should only be combined within a level if they are highly
correlated with each other. Each combined group of activities forms what is called an
activity cost pool which is defined as a “bucket” that accumulates costs related to a single
allocation base.

Activities and Activity Levels at Siemens Electric Motor

Works

Activity Level of Activity Possible Activity measure

Press Operating Unit Press Hour
Direct labor(associate in Unit Direct labor
Forging operation)
Machine shop workers Unit Machine Hours
Equipment Setup Batch Hours of setup time ,Number
Of setup
Material Movement Batch Number of loads transferred
Induction heating Production Parts weight

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5. Can you identify the “activity cost pools” for “small company” and explain how
these cost pools can be measured?
Answer:
The initial step in an ABC system is identifying overhead cost pools. ABC systems are
unique in that they focus on the specific nature of the activity and the costs associated
with that activity. These costs are referred to as cost pools.
Under ABC, activity cost pools may be classified into four major categories:
1. Unit-level activities are those activities performed for individual units of product.
Direct materials and direct labor costs are examples of unit-level activities (as the number
of parts of automobile manufactured increases, direct materials(Steel bars) and direct
labor costs will also increase). With respect to overhead costs(Forging Cost), the utilities,
maintenance, and depreciation costs associated with production machinery are examples
of unit-level activities, since these costs increase with increases in the number of parts of
automobile produced.

2. Batch-level activities are performed based on individual production runs (or “batches”
of products). The costs associated with production setup are examples of batch-level
costs, since products produced in a larger number of production runs (batches) result in
greater production setup costs. Other examples of batch-level activities include
production order processing costs and inspection costs. Like production setup costs, the
costs of processing production orders and inspecting inventory also increases as the
number of production runs increases.
3. Product-level activities are those activities performed for the development of specific
products or product lines. Product-level activities are not incurred at the individual unit
level or the production run level.
Instead, these costs are related to the overall production of entire parts or parts lines. An
example of a product-level activity for small company is materials handling costs,
induction heating.
4. Facility-level activities differ from the previous types of activities in that they relate to
the overall production of all of the organization’s products and not a single individual

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product or product line. Examples of facility-level activities for Small Company include
maintenance costs and costs related to the general production facilities (such as rent,
depreciation, property taxes, insurance, utilities, and maintenance). A unique aspect of
facility-level activities is that, while they are necessary to support the overall production
process, the level of costs associated with these activities is unaffected by either the
quantity or mix of products being manufactured. For example, Small company
depreciation of production facilities would not be affected by the number of units
produced (unit-level activities), number of production runs (batch-level activities), or
shifts in production from one product to another (product-level activities).

Because facility-level activities cannot be identified with individual products or product

lines, these costs must be arbitrarily allocated among the organization’s products.
Arguments have been made that the relationship between facility-level activities and
products is so tenuous that allocating these costs to products does not provide the
organization with meaningful product cost information. Proponents of accumulating these
costs with products argue that these costs are incurred by the organization and must be
recovered through the selling price of the organization’s inventory. Failure to accumulate
facility-level costs with products may result in the organization’s failure to consider these
costs in product pricing decisions.

Activity Cost Pool Level of Activity Activity measure

Setup Cost Batch Numbers of
setup, hours of setup time

Forging Cost Unit/Product Press hours, labor

hours, parts weight
Machining Cost Unit Numbers of machine
setup, Machine hours
Material movement cost Batch Number of loads
transferred

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 In an Activity-based costing system (ABC), the term allocation base is replaced by
the term activity measure, and the term cost driver is also used.
The two types of activity measures are:
Transaction driver – a simple count of the number of times that an activity occurs.
This is the least accurate type of activity measure.
Duration driver – measures the amount of time needed to perform an
activity. This is more accurate than a transaction driver, but it takes more effort to record.
The following are the examples of activity cost pools and corresponding activity
measures:
Activity Cost PoolDefinition Activity Measures
1 Customer order Assign all costs of Number of customer
resources that are orders
consumed by taking
and processing
customer orders
2 Product Designs Assign all costs of Number of product
resources consumed design
by designing products
3 Order Size Assign all costs of Machine-hours
resources consumed
as a consequence of
the number of units
product
4 Customer Assign all costs No of active
Relations associated with customers
maintaining relations
with customers

BIBILIOGRAPHY

 http://www.aicpa.org/pubs/jofa/aug1999/cokins.htm

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 Published: July 5, 2006Paper Released: November 2003Authors: Robert S.
Kaplan and Steven R. Anderson http://hbswk.hbs.edu/item/5436.html

 Michael S. Luehlfing
Revised by Wendy H. Mason
http://www.referenceforbusiness.com/management/A-Bud/Activity-Based-
Costing.htmlhttp://www.aicpa.org/pubs/jofa/aug1999/cokins.htm

 http://fmaccounting.com/steps-in-implementing-activity-based-costing-
systemabc/

 http://fmaccounting.com/types-of-activity-measures-activity-cost-pool-and-
corresponding-activity-meas
http://acct.tamu.edu/strawser/acct210/Spring%2008/Texts/Man%20Ch%2005.pdf

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