Learning Objective 4 Describe a four-part cost hierarchy
A cost hierarchy categorizes various activity-cost pools on the basis of the different types of cost drivers or cost-allocation bases, or different degrees of difficulty in determining cause-and-effect (or benefits-received) relationships. ABC systems commonly use a cost hierarchy with four levels that reflect the cost drivers of the activity-cost pools: (1) output unit–level costs, (2) batch-level costs, (3) product-sustaining costs, and (4) facility-sustaining costs.
Output unit–level costs are the costs of activities performed that vary with each individual unit of the cost object, such as a product or service. Machine operations costs (such as the cost of energy, machine depreciation, and repair) related to the activity of running the automated molding machines are output unit–level costs because, over time, the cost of this activity increases with additional units of output produced (or machine-hours used). Plastim’s ABC system uses molding machine-hours, an output unit–level cost-allocation base, to allocate machine operations costs to products.
Batch-level costs are the costs of activities that vary with a group of units of the cost object, such as a product or service, rather than with each individual unit of the cost object. In the Plastim example, setup costs are batch-level costs because, over time, the cost of this setup activity varies with the setup-hours needed to produce batches (groups) of lenses regardless of the number of lenses included in each batch. For example, if Plastim produces 20% fewer lenses using the same number of setup hours, would setup costs change? No, because setup-hours, not the number of lenses produced, drive setup costs.
As described in the table in the previous section, the S3 lens requires 500 setup-hours The C5 lens requires 1,500 setup-hours The total setup costs allocated to S3 and C5 depend on the total setup-hours required by each type of lens, not on the number of lenses of S3 and C5 produced. Plastim’s ABC system uses setup-hours, a batch-level cost-allocation base, to allocate setup costs to products. Other examples of batch-level costs are material-handling and quality-inspection costs associated with batches (not the quantities) of products produced and costs of placing purchase orders, receiving materials, and paying invoices related to the number of purchase orders placed rather than the quantity or value of materials purchased.
Product-sustaining costs (service-sustaining costs) are the costs of activities undertaken to support individual products or services regardless of the number of units or batches of the product produced or services provided. In the Plastim example, design costs are product-sustaining costs. Design costs depend largely on the time designers spend on designing and modifying the product, mold, and process, not on the number of lenses subsequently produced or the number of batches in which the lenses are produced using the mold. These design costs are a function of the complexity of the mold, measured by the number of parts in the mold multiplied by the area (in square feet) over which the molten plastic must flow ( or 30 parts-square feet for the S3 lens; and or 70 parts-square feet for the C5 lens). Plastim’s ABC system uses parts-square feet, a product-sustaining cost-allocation base, to allocate design costs to products. Other examples of product-sustaining costs are product research and development costs, costs of making engineering changes, and marketing costs to launch new products.
Facility-sustaining costs are the costs of activities that managers cannot trace to individual cost objects, such as products or services, but that support the organization as a whole. In the Plastim example and at companies such as Volvo, Samsung, and General Electric, the general administration costs (including top management compensation, rent, and building security) are facility-sustaining costs. It is usually difficult to find a good cost-allocation base that reflects a cause-and-effect relationship between these costs and the cost objects, so some companies deduct facility-sustaining costs as a separate lump-sum amount from operating income rather than allocate these costs to products. Managers who follow this approach need to keep in mind that when making decisions based on costs (such as pricing), some lump-sum costs have not been allocated. They must set prices that are higher than the allocated costs to recover some of the unallocated facility-sustaining costs. Other companies, such as Plastim, allocate facility-sustaining costs to products on some basis—for example, direct manufacturing labor-hours—because management believes that all costs should be allocated to products even if it’s done in a somewhat arbitrary way. Allocating all costs to products or services ensures that managers take into account all costs when making decisions based on costs. As long as managers are aware of the nature of facility-sustaining costs and the pros and cons of allocating them, which method a manager chooses is a matter of personal preference or company custom.