Lindsay & Associates
Lindsay & Associates is a public accounting firm. Each audit
engagement is treated as an individual job. The current cost
system at Lindsay & Associates identifies only one category of
direct cost – Professional labor. The others are treated as indirect
cost – Audit support.
Current cost system at Lindsay & Associates traces direct
cost to individual jobs based on the professional hours consumed
by the job. The indirect costs – Audit support, as they incur to
support the conducting of audits – are allocated to jobs based on
the professional labor hours
One of the current clients of Lindsay & Associates (Tracy
Transport) is bidding for the next year audit at the cost of $73,000.
The audit needs 800 professional hours.
The current costing system shows that the cost of the audit
amounts to $76,000. Lindsay is uncomfortable with current cost
data and decides to review the cost system
Prof. labor cost Labor related costs
$14,400
Office staff Info. specialists Admin. Other
$2,030 $1,008 $1,252 $1,038
Nonlabor related costs
Prof. development Occupancy Phone/fax/
Prof. liability $880 $2,000 copying
insurance $1,430
$2,160 Travel & perdiem Other
$770 $392
Tracy transport
Prof. labor $50*800 = $40,000
Audit support $45*800 =$ 36,000
Total costs Prof. labor hours Cost rate
Professional labor $14,400,000 288,000 $50/H
Indirect cost $12,960,000 288,000 $45/H
Current system assign professional labor costs to audits
based on the total numbers of professional hours
But
Do the audits have the same mix of different types of
professionals?
In addition, some support costs can be traced directly to
individual audits with a little effort
And not all items in the audit support pool are consumed
by different audits in the same proportion
1
Lindsay examines the activities and concludes that
at least five separate direct-cost categories can be
identified
Professional partner labor: $100/h
Professional associate labor: $40/h
Information specialists labor: $35/h
Phone/fax/copying: traced on an as-identified basis
Travel: traced on an as-identified basis
The last three categories were previously included
in indirect costs – audit support
After interviews with professional staff, Lindsay
concludes that the indirect costs can be divided
into three subcategories with three allocation bases
that reflect reasonable usage of individual audits
Indirect cost pools Allocation base
General audit support $25 per professional labor hour
(same rate for partners and associates)
Professional liability insurance 15% of professional labor
compensation
Secretarial support $18 per professional partner labor
hour
Direct costs
Professional partner labor $100*80 $8,000
Professional associate labor $40*720 28,800
Information specialist labor $35*40 1,400
Phone/fax/copying (as identified with this audit) 800
Travel and per diem (as identified with this audit) 1,100
40,100
Indirect cost
General audit support $25*800 20,000
Professional liability insurance $36,800*15% 5,520
Secretarial support $18*80 1,440
26,960
Total cost 67,060
2
Indirect AUDIT
cost pool SUPPORT
Indirect cost Professional
allocation base labor-hours
Indirect costs
Cost object
Direct costs
Direct
costs prof.
labor
Indirect AUDIT
cost pool SUPPORT
Indirect cost Professional
allocation base labor-hours
Indirect costs
Cost object
Direct costs
prof. prof.
partner associate
Direct labor labor
costs Info. fax/
specialist Travel
phone/
labor & perdiem
copying
Indirect General Audit Prof. Insurance Secretarial
cost pool Support Liability Support
Indirect cost Professional Professional Partner
allocation base labor-hours labor-dollar labor-hours
Indirect costs
Cost object
Direct costs
prof. prof.
partner associate
Direct labor labor
costs Info. fax/
specialist Travel
phone/
labor & perdiem
copying
3
REFINING A COSTING SYSTEM
Direct-cost tracing
Classify as many of the total costs as direct
costs as is economically feasible
Indirect-cost pools
Expand the number of indirect-cost pools until
each of those pools is homogeneous
Cost-allocation bases
Identify an appropriate cost-allocation base for
each indirect-cost pool
10
FILLING CUSTOMER NEEDS COST
THE FIRM’S MONEY
served by
Activities
activities
activities
Customer consume
resources
Costs resources
cost money Resources
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COST OBJECTS ????
Costs Assigned
to resources Resources
Assigned to
activity cost
pools
Reassigned to
Activities
cost objects
Cost objects
12
4
ACTIVITY-BASED COSTING
As a specific approach to refining a costing
system
Focuses on activities as the fundamental
cost objects
ABC uses cost of activities as the basis for
assigning costs to other cost objects like
products, services, or customers
13
TRADITIONAL COSTING SYSTEM
Functional based costing system
Major assumption: Cost consumed by cost
objects through functional departments
Single cost driver
Allocation basis is usually proportional to
volume
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TRADITIONAL COSTING SYSTEM
DIRECT DIRECT
OVERHEAD
MATERIALS LABOR
DEPARTMENTS
COST OBJECTS
15
5
TRADITIONAL COST ACCOUNTING
Arbitrarily allocates overhead to the cost
objects
Total company’s overhead is allocated to
the products based on volume-based
measures e.g. labor hours, machine hours
Allocation assumption: relation between
overhead and the volume based measure
16
ABC BASIC PREMISE
RESOURCES
Activities consume
resources ACTIVITIES
Cost objects consume
activities COST OBJECTS
17
TRANSITION FROM TCA TO ABC
Traditional costing is based on the
assumption that cost incurred in
proportional to volume
But today management found that there are
two other major influences on cost:
complexity and diversity of operations
18
6
ABC DIFFERENT FROM TCA
ABC systems focus on the actual activities
performed by organizational resources rather than
focus only on the location or organization of
responsibility centers
ABC is NOT to allocate common costs to
products. The goal is to measure and then price
out all the resources used for activities that support
the production and delivery of products and
services to customers
19
TWO-STAGE ABC METHOD
Cost of Cost of
resource #1 resource #2
Activity #1 Activity #2 Activity #3
Cost object Cost object Cost object
#1 #2 #3
20
ACTIVITY BASED COSTING
More accurate cost management
methodology
Focuses on indirect costs
Traces rather than allocates each expense
category to the particular cost object
Makes “indirect” expenses “direct”
21
7
ACTIVITY BASED COSTING
steps
Identifying activities
Assigning costs of resources to activities
Determining the basis for assigning the cost
of activities to cost objectives [activity cost
drivers]
Determining the cost per unit of activity
[activity cost rate]
Reassigning costs from the activity to the
cost objective in the basis of the cost
objective’s consumption of activities
22
ACTIVITY – THE FOCAL POINT OF
ABC
Cost of resources firstly are assigned to
activities before reassigning to cost objects
Activities can be identified by decomposing
functional areas into their constituent
activities
Identification of activities
Materiality and
Objectives of ABC system
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Activity: Any event, action, transaction, or work
sequence that causes a cost to be incurred in
producing a product or providing a service.
Activity Cost Pool: The overhead cost attributed to
a distinct type of activity.
Examples:
Purchasing materials.
Setting up machines.
24
8
ACTIVITY COST
Activitycost – resources consumed to
perform an activity
Elements of cost
Labor; machinery; buildings materials;
supplies; equipment; and utilities
Usually not broken down by activities
Relationship between activities and
elements of cost
Charging in directly measurable manner or
Estimation
25
TRACING ORGANIZATIONAL
EXPESENSE TO ACTIVITIES
Account billing $117,889
Labor
$109,750
Account inquiry $102,666
Telecom.
$112,500
Occupancy Bill verification $44,423
$31,160
Printing
Correspondence $17,692
$23,500
Total: $282,670 Total: $282,670
26
ASSIGN ACTIVITY COST TO
PRODUCT
The first stage of the ABC system ends up
with the total cost of performing each of the
organization’s support activities
The second stage is to assign activity costs
to products by selecting activity cost drivers
that link the performance of activities to
demands made by individual products
27
9
ACTIVITY COST DRIVER
Quantitative measure of the output of an
activity
Types of activity cost drivers
Transaction drivers
Duration drivers
Intensity drivers
28
ACTIVITY COST DRIVER
transaction driver
Can be used when all outputs make
essentially the same demands on the activity
Least expensive but could be the least
accurate
Examples are
number of setups, number of receipts
Number of products supported
29
ACTIVITY COST DRIVER
Duration drivers
Represent the amount of time required to
perform an activity
Overcome the disadvantage of transaction
driver
More accurate but more expensive
Examples are
Setup hours
inspection hours
labor hours
30
10
ACTIVITY COST DRIVER
Intensity driver
Directly charge for the resources used each
time an activity is performed
The most accurate activity cost driver but
the most expensive
31
COST PER UNIT OF ACTIVITY
Activity cost Cost of activity
=
driver rate Units of cost driver
32
Cost of resources used during the period by the
whole organization
does not mean
The cost of resources used during the period by
all the organization’s OUTPUTS
33
11
ABC
Contribution to Management
Cost of Resources Cost of Resources
Supplied Used
Unused
Financial ABC model
statements
34
Cost of Unused Capacity
The cost of unused capacity should not be
assigned to products produced or customers
served during a period
The cost of unused capacity remains someone’s,
or some department’s, responsibility
Usually you can assign the cost of unused
capacity after analyzing the decision that
authorized the level of capacity supplied
Such an assignment is done on a lump-sum basis;
it will not be assigned to individual units of
products
35
Cost of Unused Capacity
If the unused capacity relates to a particular
product line then the cost of unused capacity is
assigned to that product line, where the demand
failed to materialize
In making assignment of unused capacity costs,
trace the costs at the level in the organization
where decisions are made that affect the supply of
capacity resources and the demand for those
resources
The lump-sum assignment of unused capacity
costs provides feedback to managers on their
supply and demand decisions
36
12
ABC only provides more accurate product
cost information than TCA
Based on this cost information, managers
are able to take corrective actions and to
make better business decisions. if managers
are not able or not willing to change a
company’s policy, there is no improvement
37
APPLICATION OF ABC
Overhead is high
Products are diverse: complexity, volume,
amount of direct labor
Cost of errors are high
Competition is stiff
38
Limitations of Activity-Based Costing
Can be expensive to use (Cost/Benefit).
Some arbitrary allocations continue.
39
13
ABC is not guided by financial
accounting requirements, there is
wide variation in the components
of ABC systems
40
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