BackgroundRecall that Factory Overhead is applied to production in a rational systematic manner, using some type of averaging. There are a variety of methods to accomplish this goal. These methods often involve tradeoffs between simplicity and realism

Simple Methods Complex Methods Unrealistic Realistic

Broad AveragingHistorically, firms produced a limited variety of goods while their indirect costs were relatively small. Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of how they are actually incurredPeanut-butter CostingThe end-result: overcosting & undercosting

BackgroundThe use of broad averages in allocating indirect costs can have a number of adverse consequences.Traditional product-costing methods use a single indirect cost rate to allocate costs to all products.When a company has a variety of products, this method may not give the best results.Different products consume activities at different rates, traditional costing does not recognize these differences.Peanut-butter costing uses broad averages to assign (or spread) costs uniformly to cost objects.

Over & UndercostingOvercosting a product consumes a low level of resources but is allocated high costs per unit (Emmas dinner)Undercosting a product consumes a high level of resources but is allocated low costs per unit (James dinner)

Cross-subsidizationThe results of overcosting one product and undercosting another.The overcosted product absorbs too much cost, making it seem less profitable than it really isThe undercosted product is left with too little cost, making it seem more profitable than it really is

An Example: Plastim

Rationale for selecting a more refined costing systemIncrease in product diversityIncrease in Indirect CostsAdvances in information technologyCompetition in foreign markets

Refining a Costing SystemA refined cost system reduces the use of broad averages for assigning costs to resources. There are three principal reasons that have accelerated the demand for such refinements.Increase in product diversity. The growing demand for customized products has led to product diversity with the result that products demand differing levels of resources.

Refining a Costing SystemIncrease in indirect costs. With modern technology, companies have experienced a decrease in direct costs with a resulting increase in indirect costs.Competition in product markets. Markets have become more competitive, forcing managers to obtain more accurate cost information to help them make strategic decisions.

GuidelinesDirect-cost tracing. Identify as many direct costs as is economically feasible.Indirect-cost pools. Expand the number of cost pools so that each pool is somewhat homogeneous. Each cost in the pool has a similar cause-and-effect relationship with a single cost driver.Cost-allocation bases. The cost driver serves as the cost allocation base for each homogeneous indirect-cost pool.

Simple Costing SystemA simple costing system has few indirect (often one) cost rates and allocates costs broadly.

Plastim & Simple Costing

Activity-Based System (ABC)An activity-based system (ABC) identifies activities as fundamental cost objects.Costs are then assigned to the activities and allocated to the individual products.

ABC vs. Simple Costing SchemesABC is generally perceived to produce superior costing figures due to the use of multiple drivers across multiple levelsABC is only as good as the drivers selected, and their actual relationship to costs. Poorly chosen drivers will produce inaccurate costs, even with ABC

Plastim and ABC Illustrated

Cost HierarchiesABC uses a four-level cost structure to determine how far down the production cycle costs should be pushed:Unit-level (output-level)Batch-levelProduct-sustaining-levelFacility-sustaining-level

Cost HierarchiesOutput unit-level costs are the costs of activities performed on each individual unit of a product or service. These costs increase as the number of units produced increases.Batch-level costs are the costs of activities related to a group of units of products or services rather than the individual unit. Set-up costs are an example of batch level costs, as this cost is incurred once for each batch, regardless of the size of the batch.

Output unit-level costs are the costs of activities performed on each individual unit of a product or service. These costs increase as the number of units produced increases.Batch-level costs are the costs of activities related to a group of units of products or services rather than the individual unit. Set-up costs are an example of batch level costs, as this cost is incurred once for each batch, regardless of the size of the batch.

Cost HierarchiesProduct-sustaining costs (service-sustaining costs) are the costs of activities undertaken to support individual products or services regardless of the number of units or batches produced. Design costs are an example of this type of cost.Facility-sustaining costs are the costs of activities that cannot be traced to individual products or services but support the organization as a whole. Examples of this type of cost include general administration, rent, and building security. These costs usually lack a cause-and-effect relationship between the cost and the allocation base.

Cost HierarchiesFacility-sustaining costs are the costs of activities that cannot be traced to individual products or services but support the organization as a whole. Examples of this type of cost include general administration, rent, and building security. These costs usually lack a cause-and-effect relationship between the cost and the allocation base.

Plastim and ABC Rate Calculation

Plastim and ABC Product Costs

Plastim: Simple & ABC Compared

ConclusionsEach method is mathematically correctEach method is acceptableEach method yields a different cost figure, which will lead to different Gross Margin calculationsOnly Overhead is involved. Total Costs for the entire firm remain the same they are just allocated to different cost objects within the firmSelection of the appropriate method and drivers should be based on experience, industry practices, as well as a cost-benefit analysis of each option under consideration

A Cautionary TaleA number of critical decisions can be made using this information;Should one product be pushed over another?Should one product be dropped?Accounting for overhead costs is an imprecise science. Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable.

Activity-Based ManagementA method of management that used ABC as an integral part in critical decision-making situations, including:Pricing & product-mix decisionsCost reduction & process improvement decisionsDesign decisionsPlanning & managing activities

Signals that suggest that ABC implementation could help a firm:Significant overhead costs allocated using one or two cost poolsMost or all overhead 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 costs

ABC and Service / Merchandising FirmsABC implementation is widespread in a variety of applications outside manufacturing, including: Health CareBankingTelecommunicationsRetailingTransportation

Traditional, Volume-Based Product-Costing SystemAerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.The following information is obtained from company records:

Sheet1

Mode IMode IIMode III

Production:

Units10,00020,0004,000

Runs1 run of 10,000 units4 runs of 5,000 units10 runs of 400 units

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Traditional, Volume-Based Product-Costing SystemAdditional information includes:Manufacturing overhead is determined as follows

Sheet1

Mode IMode IIMode III

Direct materials$50.00$90.00$20.00

Direct labor (hr/board)342

Setup time (hr/run)101010

Machine time (hr/board)11.252

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode IMode IIMode III

Direct materials$50.00$90.00$20.00

Direct labor60.0080.0040.00

Manufacturing overhead99.00132.0066.00

Total$209.00$302.00$126.00

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Traditional, Volume-Based Product-Costing System

Sheet1

Mode IMode IIMode III

Units produced10,00020,0004,000

Direct labor (hr/unit)342

Total hours30,00080,0008,000

Total hours required118,000

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode IMode IIMode III

Direct labor (hr/unit)342

Overhead rate per hour$33$33$33

Overhead per unit$99$132$66

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Traditional, Volume-Based Product-Costing SystemWith these product costs, Aerotech established target selling prices (Cost 125%).209.00 x 1.25

Sheet1

Mode IMode IIMode III

Direct materials$50.00$90.00$20.00

Direct labor60.0080.0040.00

Manufacturing overhead99.00132.0066.00

Total$209.00$302.00$126.00

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode IMode IIMode III

Cost per unit$209.00$302.00$126.00

Target selling price261.25377.50157.50

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective2

Activity Based Costing System (ABC)ABC systems follow a two-stage procedure to assign overhead costs to products.Assigningoverhead to products is adifficult process.I agree!

Activity Based Costing System (ABC)ABC systems follow a two-stage procedure to assign overhead costs to products.Lets beginby identifyingour major activities.Stage One Identify significantactivities and assign overheadcosts to each activity inproportion to resources used.

Activity Based Costing System (ABC)Overhead assigned to activities are called activity cost pools.Stage Two Identify cost driversappropriate to each activityand allocate overhead tothe products.

ABC systems follow a two-stage procedure to assign overhead costs to products.

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective3

Overhead CostsTotal budgeted cost = $3,894,000

ActivityCostPoolsMachinerycost pool$1,212,600Setupcost pool$3,000Engineeringcost pool$700,000Facilitycost pool$507,400UnitLevelBatchLevelProduct-SustainingLevelFacilityLevelIdentificationof ActivityCost Pools

Receiving/Inspectioncost pool $200,000Material-Handlingcost pool $600,000Quality-Assurancecost pool $421,000Packaging/Shippingcost pool $250,000Machinerycost pool$1,212,600Setupcost pool$3,000Engineeringcost pool$700,000Facilitycost pool$507,400UnitLevelBatchLevelProduct-SustainingLevelFacilityLevel

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective4

Machinery Cost PoolTotal budgeted cost = $1,212,600ActivitycostpoolSTAGE ONEVarious overheadcosts relatedto machinery

Calculatethe poolrateBudgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hourCostAssignmentSTAGE TWO==

Sheet1

Mode I:

$28.20per hr.

1hr. per unit

$28.20per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode II:

$28.20per hr.

1.25hr. per unit

$35.25per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode III:

$28.20per hr.

2hr. per unit

$56.40per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Calculation oftotal setup costSetup Cost PoolTotal budgeted cost = $3,000ActivitycostpoolSTAGE ONE

Sheet1

Total budgeted setup cost

$20per hour

10hr. per setup

$200cost per setup

15production runs

$3,000Total

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Calculatethe poolrate Budgeted Setup Costs $3,000Planned Production Runs 15 runs $200 per runCostAssignmentSTAGE TWO==

Sheet1

Mode I: (1 Run)

$200 per run

10,000 units per run

=$.02 per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode II: (4 Runs)

$200 per run

5,000 units per run

=$.04 per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode III: (10 Runs)

$200 per run

400 units per run

=$.50 per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Various overheadcosts relatedto engineeringEngineering salariesEngineering suppliesEngineering softwareDepreciationEngineering Cost PoolTotal budgeted cost = $700,000ActivitycostpoolSTAGE ONE

Allocate basedon engineeringtransactionsCostAssignmentSTAGE TWOEngineering Cost PoolTotal budgeted cost = $700,000

Sheet1

Mode I:

25% $700,000

10,000 units

=$17.50 per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode II:

45% $700,000

20,000 units

=$15.75 per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode III:

30% $700,000

4,000 units

=$52.50 per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Exh.5-9Various overheadcosts relatedto generaloperationsPlant depr.Plant mgmt.Plant maint.Property taxesInsuranceSecurityFacility Cost PoolTotal budgeted cost = $507,400ActivitycostpoolSTAGE ONE

Exh.5-9 Budgeted Facilities Cost $507,400Budgeted Direct-Labor Hours 118,000 $4.30/hourCostAssignmentSTAGE TWO==Calculatethe poolrate

Sheet1

Mode I:

$4.30per hr.

3hr. per unit

$12.90per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode II:

$4.30per hr.

4hr. per unit

$17.20per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Mode III:

$4.30per hr.

2hr. per unit

$8.60per unit

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Other Overhead Costs

Sheet1

Receiving and Inspection Cost Pool

BoardOverhead%Units=Cost/Unit

Mode I$200,0006%10,000=$1.20

Mode II200,00024%20,000=2.40

Mode III200,00070%4,000=35.00

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Material-Handling Cost Pool

BoardOverhead%Units=Cost/Unit

Mode I$600,0007%10,000=$4.20

Mode II600,00030%20,000=9.00

Mode III600,00063%4,000=94.50

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Quality-Assurance Cost Pool

BoardOverhead%Units=Cost/Unit

Mode I$421,00020%10,000=$8.42

Mode II421,00040%20,000=8.42

Mode III421,00040%4,000=42.10

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Packaging and Shipping Cost Pool

BoardOverhead%Units=Cost/Unit

Mode I$250,0004%10,000=$1.00

Mode II250,00030%20,000=3.75

Mode III250,00066%4,000=41.25

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Other Overhead Costs$14.82

Sheet1

Packaging and Shipping Cost Pool

BoardOverhead%Units=Cost/Unit

Mode I$250,0004%10,000=$1.00

Mode II250,00030%20,000=3.75

Mode III250,00066%4,000=41.25

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Quality-Assurance Cost Pool

BoardOverhead%Units=Cost/Unit

Mode I$421,00020%10,000=$8.42

Mode II421,00040%20,000=8.42

Mode III421,00040%4,000=42.10

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Receiving and Inspection Cost Pool

BoardOverhead%Units=Cost/Unit

Mode I$200,0006%10,000=$1.20

Mode II200,00024%20,000=2.40

Mode III200,00070%4,000=35.00

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Sheet1

Material-Handling Cost Pool

BoardOverhead%Units=Cost/Unit

Mode I$600,0007%10,000=$4.20

Mode II600,00030%20,000=9.00

Mode III600,00063%4,000=94.50

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Product Cost from ABCThese are the new product costs when Aerotech uses ABC.

Sheet1

Mode IMode IIMode III

Direct materials$50.00$90.00$20.00

Direct labor60.0080.0040.00

Machinery28.2035.2556.40

Setup0.020.040.50

Engineering17.5015.7552.50

Facilities12.9017.208.60

Other14.8223.57212.85

Total$183.44$261.81$390.85

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective5

Distorted Product CostsBoth original and ABC target selling prices are based on (Cost 125%).[$209.00 1.25][$183.44 1.25]The selling price of Mode I and II are reducedand the selling price for Mode III is increased.

Sheet1

Mode IMode IIMode III

Traditional costing$209.00$302.00$126.00

ABC costing183.44261.81390.85

Original target selling price261.25377.50157.50

ABC target selling price229.30327.26488.56

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Can you identify any problems Aerotech is likely to face as a result of this distortion?Traditional costing understates the costof complex, low volume products.Distorted Product Costs

Sheet1

Mode IMode IIMode III

Traditional costing$209.00$302.00$126.00

ABC costing183.44261.81390.85

Cost distortion per unit25.5640.19(264.85)

Units produced10,00020,0004,000

Total cost distortion255,600803,800(1,059,400)

Sheet2

Sheet3

Sheet4

Sheet5

Sheet6

Two Key Points

A large proportion of non-unit-level activities A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately.

Product diversity When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs.

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective6

Cost DriversA characteristic of an event or activity that results in the incurrence of costs.

Cost DriversA characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .Degree ofCorrelation

Cost DriversA characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .Degree ofCorrelationCost ofMeasurement

Cost DriversA characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .Degree ofCorrelationCost ofMeasurementBehavioralEffects

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective7

Interviewing and Paper Trails

StoryboardingA procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities.Step1Step2Step3Step4These are the steps wefollow to build amemory board.

Direct versus Indirect CostsVolume-Based CostingAll production costs except direct materials and direct labor are lumped together in one overhead cost pool.Activity-Based CostingAn effort is made to account for as many costs as possible as direct costs of production.IndirectCosts

Indicators of Need for ABCLine managers do notbelieve the productcosts reportsMarketing does notuse costs reports forpricing decisionsProduct-line profitmargins are hardto explainSales are increasing,but profits are declining.Some products thathave reported highprofit margins are notsold by competitorsDirect labor is asmall percentageof total costs

Optimal Product-Costing SystemHighHighLowLowCostInformationSystemAccuracyOptimalsystemTotal CostDesign, implementationand maintenance costsCost ofinferiordecisionsresultingfrominaccurateinformation.Exh.5-13

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objective8

ABC in the Service IndustryObjectives

End of Chapter 5This ismy kind of cost pool!

******************Aerotech produces three circuit boards referred to as Mode I, Mode II and Mode III. 10,000 units of Mode I are produced in 1 run. 20,000 units of Mode II are produced in 4 runs of 5,000 units. And 4,000 units of Mode III are produced in 10 runs o f400 units. (LO1)In a traditional, job-order product-costing system, the cost of each product is the sum of its actual direct-material cost, actual direct-labor cost, and applied manufacturing overhead. The unit cost for Mode I is $209 which is $50 direct materials cost, $60 direct labor cost and $99 overhead cost. Mode II unit cost is $302 which is $90 for direct materials, $80 for direct labor and $132 for overhead. Mode III has a unit cost of $126 which is $20 direct materials cost, $40 direct labor cost and $66 overhead cost. (LO1)Aerotech applies manufacturing overhead using a predetermined overhead rate based on direct-labor hours. The total direct labor hours was estimated to be 118,000. The budgeted manufacturing overhead cost was estimated at $3,894,000. The estimated cost is divided by the estimated hours resulting in a predetermined overhead rate of $33 per hour. The overhead per unit is calculated by multiplying the direct labor hours per unit times the predetermined overhead rate per hour. (LO1)Now that Aerotech is estimated the production cost per unit, the target selling price can be set. The companys pricing policy has been to set a target price for each grill equal to 125 percent of the full product cost. The estimated unit cost is multiplied by 1.25 to arrive at the target selling price. (LO1)

Activity-based costing (ABC) systems follow a two-stage procedure to assign overhead costs to products. (LO2)The first stage identifies significant activities in the production process and assigns overhead costs to each activity in accordance with the cost of the organizations resources used by the activity. The overhead costs assigned to each activity comprise an activity cost pool. (LO2)

After assigning overhead costs to activity cost pools in stage one, cost drivers appropriate for each cost pool are identified in stage two. Then the overhead costs are allocated from each activity cost pool to each product line in proportion to the amount of the cost driver consumed by the product line.Aerotech identified eight activity cost pools, which fall into four broad categories: unit level, batch level, product-sustaining level and facility level.The activity at the unit level must be applied to each unit produced. The activity at the batch level must be performed one time for each batch that goes into production. The product-sustaining activities are required to support the entire product line, but not needed for each unit or batch. Facility-level activities are required in order for the entire production process to occur. (LO3)

For Aerotech, only the machinery cost pool is at the unit level. There are five cost pools at the batch level: setup, receiving and inspection, material-handling, quality assurance and the packaging and shipping cost pool. The engineering cost pool is at the product-sustaining level and the facility cost pool is at the facility level. (LO3)Aerotech estimated the costs of maintenance, lubrication, depreciation, electricity, computer support and calibration. These costs are added together. The sum is the machinery cost pool budgeted cost. (LO4)Aerotech selected machine hours for the cost driver, since a product that uses more machine hours should bear a larger share of machine-related costs. The budgeted machinery costs are divided by the budgeted number of machine hours to arrive at the machinery cost pool rate. Then, for each circuit board, the machinery cost pool rate is multiplied by the number of machine hours per board. (LO4)The budgeted cost for the setup cost pool is determined by multiplying the setup cost per hour by the number of hours required per setup then multiplying that by the number of production runs. (LO4)The budgeted setup costs are divided by the planned production runs to arrive at the setup cost pool rate. Then, for each circuit board, the setup cost pool rate is divided by the number of units per run to arrive at the setup cost per unit. (LO4)

Aerotech estimated the costs of engineering salaries, supplies, software and depreciation. These costs are added together. The sum is the engineering cost pool budgeted cost. (LO4)

The engineering department has estimated that 25% of its time is spent on Mode I, 45% on Mode II and 30% spent on Mode III. For each board, the percentage of engineering time is multiplied by the budgeted engineering cost then divided by the number of units to be produced. The result is the engineering cost per unit. (LO4)

Aerotech estimated the costs of plant depreciation, management salaries, maintenance, property taxes, insurance and security. These costs are added together. The sum is the facility cost pool budgeted cost. (LO4)

Aerotech has selected to use direct labor hours as the cost driver for facilities cost. The budgeted facilities cost is divided by the budgeted direct labor hours to arrive at the facilities cost per hour. The facilities cost per unit is calculated by multiplying the facilities cost per hour by the number of direct labor hours required per board. (LO4)

Aerotech has four other batch level cost pools: receiving and inspection, material handling, quality assurance, and packaging and shipping. Each of these departments has estimated the costs and the percentage of time spent on each of the three circuit boards. The budgeted costs are multiplied by the percentage to determine the cost per unit for each board. (LO4)The cost per unit for each of these batch level costs is added together for each board. (LO4)Now Aerotech has new product costs for each board. It is the sum of the costs for direct materials, direct labor, machinery, setup, engineering, facilities and costs accumulated as other costs. (LO4)Using the existing target pricing policy, the unit cost based on ABC costing is multiplied by 1.25 to arrive at the ABC target selling price. Under ABC costing, the selling price for Mode I and Mode II boards has decreased, but the selling price for the Mode III board has increased significantly. (LO5)The cost per unit under ABC costing is deducted from the traditional costing unit cost. This is cost distortion per unit. The problem with cost distortion is more evident when the cost distortion per unit is multiplied by the number of units produced. The essence of the problem is that the traditional, volume-based costing system was over costing the high-volume product lines (Modes I and II) and under costing the complex, relatively low volume product line (Mode III). The high-volume products basically subsidized the low volume line. The activity-based costing system revealed this problem by more accurately assigning overhead costs to the three product lines. When the costs are understated, so is the selling price. (LO5)

To summarize, each of the following characteristics will undermine the ability of a volume-based product-costing system to assign overhead costs accurately. 1. A large proportion of non-unit-level activities and 2. Product diversity. When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs. When either of these characteristics is present, a volume-based product- costing system is likely to distort product costs. (LO5)

A cost driver is a characteristic of an event or activity that results in the incurrence of costs. In activity-based costing systems, the most significant cost drivers are identified. Then a database is created, which shows how these cost drivers are distributed across products. Three factors are important in selecting appropriate cost drivers. (LO6)

The first is the degree of correlation. The concept of an activity-based costing system is to infer how each product line consumes the activity by observing how each product line consumes the cost drive, that is, how closely the two are correlated. The closer the correlation, the more accurate the cost assignments will be. (LO6)

Designing any information system entails cost-benefit trade-offs. The more activity cost pools there are in an activity-based costing system, the greater will be the accuracy of the cost assignments. However, more activity cost pools also entail more cost drivers, which results in greater costs of implementing and maintaining the system. (LO6)

Information systems have the potential not only to facilitate decisions but also to influence the behavior of decision makers. This can be good or bad, depending on the behavioral effects. In identifying cost drivers, an ABC analyst should consider the possible behavioral consequences. Dysfunctional behavioral effects are also possible. (LO6)The information used in ABC systems initially come from extensive interviews with key employees in each of the organizations support departments and a careful review of each departments records. (LO7)

Storyboarding is a procedure used to develop a detailed process flowchart, which visually represents activities and the relationships among the activities. A storyboarding session identifies the key activities involved in each department. These activities are written on small cards and placed on a large board in the order they are accomplished. After several storyboarding sessions, a completed storyboard emerges, recording key activity information vital to the ABC project. (LO7)

In traditional, volume-based costing systems, only direct material and direct labor are considered direct costs. All other production costs are lumped together in one overhead cost pool and applied to products on the basis of a volume-related measure such as direct labor. Thus, all of these costs are treated as indirect costs with respect to the firms products. In contrast, under an activity-based costing system, an effort is made to account for as many costs as possible as direct costs of production. Any cost that can possibly be traced to a particular product line is treated as a direct cost of that product. (LO7)Some indicators can signal the need for a new costing system. Direct labor is a small percentage of total costs. Sales are increasing, but profits are declining. Marketing personnel are unwilling to use reported product costs in making pricing decisions. Product-line profit margins are difficult to explain. Line managers do not believe the product costs reported by the accounting department. Some products that have reported high profit margins are not sold by competitors.(LO7)

Designing an optimal information system involves trade-offs between the costs and benefits of increased accuracy. The optimal information system minimizes the total cost of designing, implementing, and maintaining the system, along with the costs of inferior decisions caused by faulty information. (LO7)

The overall objectives of ABC in service firms are no different than they are in manufacturing companies. Managers want more accurate information about the cost of producing the services they are selling. Moreover, they want to use this information to improve operations and to better meet the needs of their customers in a more cost effective manner. The general approach of identifying activities, activity cost pools, and cost drivers is used in the service industry as well as in manufacturing. The classification of activities into unit-level, batch-level, product- sustaining-level, and facility level activities also applies in service industry settings. (LO8)