BASED COSTING AND MANAGEMENT
No. The costs of developing a product are sunk at the time the product goes into
production. These costs are not controllable. Proponents of activity based costing express
the view that these costs should not be viewed as product level costs and therefore should
not be assigned to products.
Once incurred, these costs are not relevant for short-term
decisions about pricing. Of course, prudent managers will estimate these costs prior to
incurring them. That is, they will evaluate profitability including these costs, using long-
term prices to estimate revenues and quantities. The key challenge facing managers is to
ensure that both the short- and the long-run views are given appropriate weight when they
As we have discussed in the text, there are many reasons why ABC systems are difficult
to implement and maintain in practice. First, ABC systems are information intensive.
Numerous measurements are necessary. Second, they require a stable operational
environment. As firms change over time, cost structures change and cost drivers and cost
rates have to be routinely updated. Therefore, maintaining the decision usefulness of
ABC systems in changing environments is onerous, time consuming and costly. Indeed, a
popular estimate is maintaining an ABC system for a medium sized facility requires a 0.5
FTE person or about $75,000 per year.
If the firm does not cut spending on the resources freed up, and revenues stay the same,
then the reported profits will not change because the company is not translating improved
efficiencies into cash flow savings. The key additional step required is to either cut
spending on freed up resources or gainfully utilize freed up resources by producing and
selling more goods and services.
The current system is a volume-based allocation. Let us first compute the overhead rate
per labor hour.
Total overhead cost
Total labor hours
(1,000,000 × 2.2) + (2,000,000 × 1.9)
+ (40,000 × 2.1) = 6,084,000
$12,776,400/6,084,000 = $2.10/labour hour
We can now compute product profitability as follows: