A note on “activity-based costing” terms in advanced management accounting study

A note on “activity-based costing” terms in advanced management accounting study

Briefly describe the following “activity-based costing” terms in advanced management accounting study

(Terms used in Chapter 11)

 

1.    Cost smoothing, product undercosting and product overcosting

2.    Product-cost cross subsidization

3.    Refining a costing system

4.    Activity-based costing systems

5.    An activity

6.    Time-driven activity-based costing systems

7.    Cost hierarchies

8.    Activity-based costing implementation

9.    Activity-based management: pricing and product-mix decisions

10.                    Activity-based management: cost reduction and process improvement decisions

11.                    Activity-based management: design decisions

12.                    Activity-based management: planning and managing activities

13.                    Activity-based costing and department-costing systems

14.                    Activity-based costing and the organizational context

 

Activity-based costing (ABC) improves on broad-average costing by tracing indirect costs through the activities that cause them. It supports activity-based management (ABM): using that cost information to improve profitability, processes, capacity use, and design choices.

Core costing concepts

1.    Cost smoothing, product undercosting, and product overcosting

Cost smoothing (or “peanut-butter costing”) spreads indirect costs uniformly using broad averages, even where products consume resources very differently. It can cause undercosting (reported cost is below the product’s actual resource consumption) and overcosting (reported cost exceeds it).

2.    Product-cost cross-subsidization

This is the resulting distortion where overcosted products absorb costs that should have been assigned to undercosted products. For example, a simple high-volume product may be allocated excessive overhead, effectively subsidising a complex low-volume product that requires many setups and engineering changes.

3.    Refining a costing system

Refinement means replacing overly broad cost pools and allocation bases with more homogeneous activity cost pools and cause-and-effect cost drivers. ABC refines costing by treating activities—not departments or the whole factory—as the fundamental focus for indirect-cost assignment.

4.    Activity-based costing systems

ABC systems identify activities, accumulate resource costs in activity cost pools, identify a cost driver for each activity, and assign activity costs to products, services, customers, or channels according to their actual demand for those activities.

5.    An activity

An activity is a purposeful task, event, or unit of work that consumes resources—for example, processing a purchase order, setting up a machine, inspecting output, designing a product, or delivering to a customer. Put simply, activities are what an organisation does.

6.    Time-driven activity-based costing systems

Time-driven ABC (TDABC) assigns resource costs using two main estimates: the cost of supplying practical capacity per unit of time and the time required for a transaction or activity. It can use time equations to reflect complexity, making it useful where activities vary significantly across orders, customers, or services.

7.    Cost hierarchies

A cost hierarchy groups costs by the level at which the activity is performed and identifies an appropriate driver:

o   Output-unit-level costs: vary with each unit produced, such as machine energy or machining time.

o   Batch-level costs: vary with batches or production runs, such as setups and purchase orders.

o   Product-sustaining costs: support a particular product regardless of volume, such as product design or engineering changes.

o   Facility-sustaining costs: support the organisation overall, such as senior management and building security; these are often not meaningfully traceable to individual products.

Implementing ABC

8.    Activity-based costing implementation

Typical implementation involves identifying significant activities; creating activity cost pools; assigning resource costs to those pools; selecting cost drivers; calculating activity rates; and assigning costs to cost objects based on their driver consumption. Successful implementation also requires clear objectives, reliable data, employee training, cross-functional ownership, sufficient resources, and senior-management support.

9.    ABM: pricing and product-mix decisions

Managers use ABC to assess the full resource cost and profitability of products, services, customer segments, and orders. This may support price changes, minimum-order policies, redesign, rationalisation of loss-making complexity, or a shift toward products with stronger margins after activity costs—not merely traditional overhead allocations—are considered.

10.                    ABM: cost reduction and process improvement decisions

ABC highlights costly activities and the drivers of those costs, allowing managers to target non-value-added work, reduce setups, simplify order processing, improve quality, shorten throughput time, or reduce rework. The aim is not indiscriminate cost cutting, but reducing resources consumed while preserving or improving customer value.

11.                    ABM: design decisions

ABC information can be used early in product, service, process, and customer-channel design. Managers compare alternative designs according to the activities they will require; for instance, a product can be redesigned to need fewer components, inspections, setups, or engineering changes. Design-stage decisions matter because much of a product’s eventual cost is committed before production begins.

12.                    ABM: planning and managing activities

Managers use activity information to forecast demand for activities, plan the capacity and resources needed, set activity-cost targets, and monitor actual driver usage against plans. This connects operational planning—such as expected orders, batches, setups, and deliveries—to resource and budget requirements.

Organisational application

13.                    ABC and department-costing systems

Department-costing systems allocate overhead first to production departments and then use one or a few departmental rates, such as machine-hours or labour-hours. ABC may cut across departmental boundaries: it pools costs by activities such as purchasing, setup, quality control, and distribution. Consequently, ABC can capture resource consumption more accurately when a department performs several distinct activities with different drivers.

14.                    ABC and the organizational context

ABC is most valuable where indirect costs are substantial, product/service/customer diversity is high, and traditional systems produce material distortions. Its usefulness depends on organisational fit: strategic purpose, management commitment, cross-functional participation, staff acceptance, data quality, training, system integration, and whether managers actually use ABC insights in decisions and performance management. ABC is therefore both a technical costing innovation and an organisational change initiative.

*** Also study these videos related to the topic of this note: video 1; video 2; video 3; video 4;  video 5.

  

A collection of notes on advanced management accounting