One of the best tools for refining a costing system is activity-based costing. Activity-based
costing (ABC) refines a costing system by identifying individual activities as the fundamental cost objects. An activity is an event, task, or unit of work with a specified purpose—for example, designing products, setting up machines, operating machines, and distributing products. More informally, activities are verbs; they are things that a firm does. To help make strategic decisions, ABC systems identify activities in all functions of the value chain, calculate costs of individual activities, and assign costs to cost objects such as products and services on the basis of the mix of activities needed to produce each product or service.
After reviewing its simple costing system and the potential miscosting of product costs, Plastim decides to implement an ABC system. Direct material costs and direct manufacturing labor costs can be traced to products easily, so the ABC system focuses on refining theassignment of indirect costs to departments, processes, products, or other cost objects.Plastim’s ABC system identifies various activities that help explain why Plastim incurs the costs it currently classifies as indirect in its simple costing system. In other words, it breaks up the current indirect cost pool into finer pools of costs related to various activities. To identify these activities, Plastim organizes a team comprised of managers from design, manufacturing, distribution, accounting, and administration.
Defining activities is not a simple matter. The team evaluates hundreds of tasks performed at Plastim before choosing the activities that form the basis of its ABC system. For example, it decides if maintenance of molding machines, operations of molding machines, and process control should each be regarded as a separate activity or should be combined into a single activity. An activity-based costing system with many activities becomes overly detailed and unwieldy to operate. An activity-based costing system with too few activities may not be refined enough to measure cause-and-effect relationships between cost drivers and various indirect costs. Plastim’s team focuses on activities that account for a sizable fraction of indirect costs and combines activities that have the same cost driver into a single activity. For example, the team decides to combine maintenance of molding machines, operations of molding machines, and process control into a single activity molding machine operations because all these activities have the same cost driver: molding machine-hours. The team identifies the following seven activities by developing a flowchart of all thesteps and processes needed to design, manufacture, and distribute S3 and CL5 lenses.
a. Design products and processes
b. Set up molding machines to ensure that the molds are properly held in place and parts
are properly aligned before manufacturing starts
c. Operate molding machines to manufacture lenses
d. Clean and maintain the molds after lenses are manufactured
e. Prepare batches of finished lenses for shipment
f. Distribute lenses to customers
g. Administer and manage all processes at Plastim
These activity descriptions form the basis of the activity-based costing system sometimes called an activity list or activity dictionary. Compiling the list of tasks, however, is only the first step in implementing activity-based costing systems. Plastim must also identify the cost of each activity and the related cost driver.
1. Direct-cost tracing. Plastim’s ABC system subdivides the single indirect cost pool into seven smaller cost pools related to the different activities. The costs in the cleaning and maintenance activity cost pool (item d) consist of salaries and wages paid to workers who clean the mold. These costs are direct costs, because they can be economically traced to a specific mold and lens.
2. Indirect-cost pools. The remaining six activity cost pools are indirect cost pools. Unlike the single indirect cost pool of Plastim’s simple costing system, each of the activity-related cost pools is homogeneous. That is, each activity cost pool includes only those narrow and focused set of costs that have the same cost driver. For example, the distribution cost pool includes only those costs (such as wages of truck drivers) that, over time, increase as the cost driver of distribution costs, cubic feet of packages delivered, increases. In the simple costing system, all indirect costs were lumped together and the cost-allocation base, direct manufacturing labor-hours, was not a cost driver of the indirect costs.
Determining costs of activity pools requires assigning and reassigning costs accumulated in support departments, such as human resources and information systems, to each of the activity cost pools on the basis of how various activities use support department resources.
3. Cost-allocation bases. For each activity cost pool, the cost driver is used (whenever possible) as the cost-allocation base. To identify cost drivers, Plastim’s managers consider various alternatives and use their knowledge of operations to choose among them. For example, Plastim’s managers choose setup-hours rather than the number of setups as the cost driver of setup costs, because Plastim’s managers believe that more complex setups take more time and are more costly.
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