# 3.8: Variations of Activity-Based Costing (ABC)

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##### 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?

Cost data can be organized in a number of ways to help managers make decisions. Four common approaches are addressed in this section:

1. Expanding ABC to include nonmanufacturing costs
2. Allocating service department costs to production departments
3. Using the hierarchy of costs to organize cost information
4. Measuring the costs of controlling and failing to control quality

## 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?

Commissions paid to sales people for the sale of specific products (often called selling, general, and administrative) are included as an operating expense in financial reports prepared for external users as required by U.S. GAAP. However, many organizations may assign commission costs to specific products for internal decision-making purposes. This treatment is not in compliance with U.S. GAAP, but it is perfectly acceptable for internal reporting purposes and may be done using activity-based costing. It is important to understand that managers have ultimate control over which costs should be allocated to products for internal reporting purposes, and this allocation often involves going beyond overhead costs.

Table 3.1 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.

Table 3.1 - Examples of Costs Allocated to Products
Cost Cost Category* OK to Allocate to Products for External Reporting (U.S. GAAP)? OK to Allocate to Products for Internal Reporting?
Direct materials Product Yes Yes
Direct labor Product Yes Yes
Sales commissions Selling No Yes
Shipping products to customers 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 2 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 2 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 production departments for internal reporting purposes even though U.S. GAAP generally does not allow it for external reporting?

Companies allocate service department costs to production departments for several reasons:

• The services provided by departments within a company are not free, and they should be used as efficiently as possible. Managers of production departments that use these services thus have an incentive to minimize their use.
• To minimize costs, Hewlett Packard and other large companies often “outsource” services like building maintenance and legal support (i.e., they have other companies provide the services for them). This creates an incentive for the company’s service departments to provide services at a reasonable cost.
• Organizations often include service department costs when determining product costs for internal decision-making purposes, as described earlier (refer to Table 3.1 for examples).

Question: How do companies allocate service department costs to production departments and how might this be done at SailRite?

Several methods of allocating service department costs to production departments are available. We introduce the simplest approach—the direct method—here (complex approaches are presented in more advanced cost accounting texts). The direct method12 allocates service department costs directly to production departments but not to other service departments.

For example, assume that SailRite Company has two service departments—Human Resources and Computer Support. Costs associated with Human Resources and Computer Support total $90,000 and$150,000, respectively. Recall that SailRite has two production departments—Hull Fabrication and Assembly. The goal is to allocate service department costs to the two production departments, as shown in Figure 3.10.

SailRite would like to allocate service department costs using an allocation base that drives these costs. Assume management decides to use the number of employees as the allocation base to allocate Human Resources costs, and the number of computers as the allocation base to allocate Computer Support costs. Allocation base activity for each production department is as follows:

Hull Fabrication Assembly Total
Number of employees 35 85 120
Number of computers 42 33 75

The allocation rate for human resource services is $750 per employee (=$90,000 department costs ÷ 120 employees). The allocation rate for computer support services is $2,000 per computer (=$150,000 ÷ 75 computers). Thus the Hull Fabrication department receives an allocation of $26,250 in human resource costs (= 35 employees ×$750 rate) and $84,000 in computer support costs (= 42 computers ×$2,000 rate). The Assembly department receives an allocation of $63,750 in human resource costs (= 85 employees ×$750 rate) and $66,000 in computer support costs (= 33 computers ×$2,000 rate).

The allocations to production departments are shown in Figure 3.11. If management chooses to allocate service department costs to production departments as described here, there must be some benefit to going through the process. Should these costs be assigned to activity cost pools for the purpose of costing products (activity-based costing)? Should production department managers be evaluated based on the use of these services? Should actual service department usage be compared to budgeted usage for each production department? The answers to these questions vary from one organization to the next. However, one point is certain—the benefits of implementing this allocation system must outweigh the costs!

## 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?

Each category within the cost hierarchy is described as follows:

• Facility-level activities14 (or costs) are required to sustain facility operations and include items such as building rent and management of the factory. These costs are generally changed over long time horizons and are incurred regardless of how many product-, batch-, or unitlevel activities take place.
• Product-level activities15 (or customer-level activities) are required to develop, produce, and sell specific types of products. This category includes items such as product development and product advertising. These costs can be changed over a shorter time horizon than facilitylevel activities and are incurred regardless of the number of batches run or units produced.
• Batch-level activities16 are required to produce batches (or groups) of products and include items such as machine setups and quality inspections. These costs can be changed over a shorter time horizon than product- and facility-level activities and are driven by the number of batches run rather than the number of units produced. For example, a batch can consist of producing 5 units or 10,000 units. The costs in this category are driven by the number of batches, not the number of units in each batch.
• Unit-level activities17 are required to produce individual units of product and include items such as energy to run machines, direct labor, and direct materials. These costs can be changed over a short time horizon based on how many units management chooses to produce.

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 activitybased costing, and how these activities fit in the cost hierarchy, appear in Table 3.2.

Table 3.2 - Cost Hierarchy Examples
Cost Hierarchy Category Activity/Cost
Facility-level Plant depreciation
Building rent
Management of facility
Product/customer-level New product development
Product engineering
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. Qualityrelated 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?

• Prevention costs18 are costs incurred to prevent defects in products and services. Examples include designing production processes that minimize defects, providing quality training to employees, and inspecting raw materials before they are placed in production.
• Appraisal costs19 (often called detection costs) are costs incurred to detect defective products before they are delivered to customers. The cost of finished goods inspections falls in this category.
• Internal failure costs20 are the costs incurred as a result of detecting defective products before they are delivered to customers. Examples include the reworking of defective products, the scrapping of defective products, and the machine downtime resulting from process problems that cause defects.
• External failure costs21 are the costs incurred as a result of delivering defective products to customers. Examples include warranty repairs, warranty replacements, and product liability resulting from unsafe defective products.

Companies that measure these costs of quality typically calculate the costs in each category as a percent of total revenue. The goal is to steadily shift costs toward the prevention and appraisal categories and away from the internal and external failure categories. As organizations concentrate more on preventing defects, total quality costs as a percent of revenue tends to decline and product quality improves. Table 3.3 provides a summary of the four classifications of quality-related costs.

Table 3.3 - Summary of Quality Costs
Quality Cost Category Description
Prevention cost Cost of activities that prevent defects in products, such as quality training and raw materials inspections
Appraisal cost Cost of activities that detect defective products before they are delivered to customers, such as finished goods inspections and field inspections
Internal failure cost Cost of activities that result from detecting defective products before they are delivered to customers, such as rework and scrap
External failure cost Cost of activities that result from delivering defective products to customers, such as warranty repairs and warranty replacements
##### 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 3.6

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?
Direct materials Yes Yes
Salaries of sales people
Indirect materials used in production
Product promotions
Direct labor
Legal costs for patent applications
Processing payroll for human resource personnel
Depreciation of factory equipment
Marketing vice president’s salary
Cost OK to Allocate to Products for External Reporting (U.S. GAAP)? OK to Allocate to Products for Internal Reporting?
Direct materials Yes Yes
Salaries of sales people No Yes
Indirect materials used in production Yes Yes
Rent for headquarters building No Yes
Product promotions No Yes
Direct labor Yes Yes
Legal costs for patent applications No Yes
Processing payroll for human resource personnel No Yes
Depreciation of factory equipment Yes Yes
Marketing vice president’s salary No Yes
Depreciation of administrative department equipment No Yes

## Definitions

1. Departments that provide services to other departments within a company.
2. Departments directly involved with producing goods or providing services for customers.
3. A method of allocating costs that allocates service department costs directly to production departments but not to other service departments.
4. 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.
5. Activities required to sustain facility operations and include items such as building rent and management of the factory.
6. Activities required to develop, produce, and sell specific types of products.
7. Activities required to produce batches (or groups) of products.
8. Activities required to produce individual units of product, such as direct materials and direct labor.
9. Costs for activities that prevent defects in products and services.
10. Costs for activities that detect defective products before they are delivered to customers.
11. Costs incurred as a result of detecting defective products before they are delivered to customers.
12. Costs for activities that result from delivering defective products to customers.

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