[ Music ] [ Silence ] >> Now that we've got a framework down. Let's talk about the steps that it takes to design and implement and activity-based costing system. So, first things first, let's not pretend that these steps are linear. We don't completely finish step 1 before we get to step 2. It's very iterative in the sense that some of the things you learn in later steps and form what you did in the earlier steps and so sometimes firms have to go back and redo some work. Well, start at the beginning and work towards the end. So, the first step would be to identify and estimate the resources that the firm has. The second step is then to identify activities that consume those resources. Finally, we would, or third we would group activities into pools and then identify and compute appropriate drivers. Now, these first 4 steps they comprise the design phase of the activity-bases costing system and I cannot over state all of the time and energy it takes to complete these 4 steps. Firms will often times choose a small area of the company and roll out a pilot or experimental ABC system and then allocate it out to the rest of the firm and sometimes these phases can take multiple years. But after that design and implementation phase, we get to the fifth step and that is to assign cost to cost objects according to the associated activities and drivers. This is the actual use of the system over time. Now, we've talked about the first 2 steps for quite a while but we haven't talked about grouping activities or identifying and computing appropriate drivers. So, let's turn to those. Grouping activities is useful for simplifying an inherently complex system, again, we've talked about the number of activities that firms engage in we need some way to simplify those into different pools. That simplification process is informed by 2 attributes. First is the type of activity and second is the type of driver or measurement. With respect to the type of activity or type of cost, it's useful to think about costs and activities in the form of a hierarchy. We can start at the most fundamental and think about unit level activities and costs. Those are activities and costs that correspond to production volume. In previous modules we've talked about that being variable overhead. A second type of activity or cost is at the batch level and this is regardless of production volume. There are some types of costs that correspond to the processes of setting up for production. So, regardless of whether you produce 100 units or a 1000 units or 10,000 units, we're going to incur the same cost to get the equipment in place through bringing the right materials into the room etcetera. So, there are costs that don't necessarily correspond to production volume but they do to the batch. There's other types of costs that we'll refer to as product level costs and those are activities and costs that correspond to the product lines themselves, so suppose a firm produces product A and product B and they're thinking about adding product C, well that will incur additional costs and engage additional activities like marketing and administration of those products. Those don't correspond to the volume and they don't correspond to the number of batches for that new product but the fact that a new product exists leads to additional activities and costs. And finally, there are activities and costs that just correspond to the fact that we exist as an organization. We refer to these as facility or organization level activities and costs. This is a catchall category and it hopefully ideally is a small portion of the overall activities and costs that we identify, but this is again to the standard overhead. This catchall category that captures anything else that doesn't correspond to production volume, the number of batches, or the number of products that we have. Now, second component or facet has to do with the drivers. We didn't talk about drivers in the framework thus far, but where are they located? They are the connector between the activity pool and the cost object itself. They are the measure of activity that allows for the assignment of costs to the cost objects from each pool. Examples include whatever activity we have, a measure of that activity. The number of units produced. The number of batches. The number of inspections or orders, again, whatever activity is inside that activity pool we choose a measure of that activity to serve as the driver. Now that we've talked about the framework and completed that, let's turn to some of the advantages and disadvantages of activity-based costing systems. First the advantages. As we've talked about before, one key advantage of activity-based costing systems is more accurate cost information; more accurate information ultimately leads or is intended to lead to better decisions. In fact, there's a whole field referred to as activity-based management that's facilitated by activity-based costing. It allows firms to identify where the activities are most efficient and effective and emulate those in other parts of the organization. It also identifies the least effective and least efficient activities and perhaps eliminate those or improve them. A second advantage has to do with activity-based costing systems flexibility. As we mentioned before, we can choose whatever level of specification we want. We can choose things at the unit level. We can talk about the cost object being the division or department or an entire business unit. We can talk about customers and how profitable those are and I understand what the cost of engaging with different customers of different types. So, whatever cost object we want, we can in effect turn our view via the activity-based costing system and answer the question that's in front of us. Now, these advantages don't come free. There are certain disadvantages and as I mentioned before, the development and implementation of a system involves a lot of time, energy, and money. This is nothing to shrug at in the sense that firms often time takes years to implement systems and perhaps they become obsolete. That's why maintenance is another disadvantage. If a firm does not keep up with the changing nature of the business and update their system, then the information that it provides is out-of-date, unusable and perhaps leading to poor decision making.
