Chapter 8
Activity-based costing
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
Problems with conventional
product costing systems
 General features of conventional systems
Direct material and direct labour costs are
traced to products
Manufacturing overhead costs are allocated to
products using a predetermined overhead rate
Manufacturing overhead rate is calculated using
some measure of production volume
Non-manufacturing costs are not assigned to
products
continued
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Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
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Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
3
Problems with conventional
product costing systems
 Failure to adapt to the changing business
environment
Increasing levels of non-volume-driven
manufacturing overhead costs
Increasing proportion of non-manufacturing
costs
Causes of changes in costs
Changing product structures
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
4
Indicators of problems with a
product costing system
 Product costing systems are likely to result
in inaccurate product cost when…
Proportion of direct labour costs decrease
Proportion of manufacturing overhead costs
increase
Proportion of manufacturing overhead costs, not
related directly to production volume, increases
Non-manufacturing costs which are productrelated become substantial; and
Product diversity increases
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
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Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
6
Problems with costing in
service businesses
 Service firms tend to use firm-wide volumebased overhead rates
Overhead costs are increasing in importance
and are increasingly non-volume driven
 Customers are demanding more diverse
and higher quality services
Increases in product diversity and in overhead
costs
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
7
Activity-based costing
 A methodology that can be used to
measure both the cost of cost objects and
the performance of activities
 Can help solve problems such as
Distorted product costs
Poor cost control
 The ABC method adopted, depends on the
problems that need to be addressed
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
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Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
9
An activity-based costing
model

The costing view
1. Measures the cost of activities
2. Assign activity costs or products


Activity management view
The nature of cost drivers
 Resource drivers
 Activity drivers
 Root cause cost drivers
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
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Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
11
The costing view of ABC
 Measuring the cost of activities
Assign costs to activity centres
Identify and cost the activities performed in
each activity centre
 Assigning activity costs to products
Calculate the activity cost per unit of activity
driver
Prepare a bill of activities for each product
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
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Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
13
Activity-based costing
terminology
 Activity: a unit of work performed with the
organisation
 Cost driver: a factor or activity that causes
cost to be incurred
 Resource driver: cost driver used to
estimate the cost of resources consumed by
an activity
 Activity driver: a cost driver used to
estimate the cost of an activity consumed
by the cost object
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
14
Activity-based costing
terminology
 Root-cause cost driver: the underlying
factors that cause activities to be performed
and their costs to be incurred
 Bill of activities: identifies the activities, the
activity cost per unit of activity driver, the
quantity of activity drivers consumed, and,
therefore, the cost of the activities
consumed by the product
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
15
Different forms of ABC
 Simple approach: allocates manufacturing
overhead to products
 ABC system for indirect costs: allocates
manufacturing overhead and nonmanufacturing costs to products
 Comprehensive system: all product-related
costs, except direct material, are included in
the ABC system
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
16
Different forms of ABC
 Which costs should be included in an ABC
system?
The decision to include activity based
management an in ABC systems will influence
the range of costs included in the system as
well as the type or cost drivers
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
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Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
18
Activity-based hierarchy of
costs and activities
 Unit level activities
Performed for each batch of product
 Batch level activities
Performed for each batch of products
 Product level (or product-sustaining)
activities
Performed for specific products or product
families
 Facility level (or facility-sustaining) activities
Not usually included in product costs
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
19
Activity-based vs.
conventional product costs
 Conventional costing assumes product costs
are driven by volume-based cost drivers
 Conventional costing ignores batch size.
Units produced in large batches consume a
relatively low consumption per unit of batch
costs
 ABC may include non-manufacturing costs
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
20
The benefits of ABC are
greatest when…
 Overhead costs are a significant proportion
of total cost, and a large part of overhead is
not directly related to production volume
 The business has a diverse product range,
and individual product’s use of support
resources differs from their use of volumebased cost drivers
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
21
The benefits of ABC are
greatest when...
 Production activity involves diverse batch
sizes and product complexity
 Proportion of product-related costs incurred
outside manufacturing is increasing relative
to manufacturing costs
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
22
The benefits of ABC are
greatest when…
 There are likely to be high costs associated
with making inappropriate decisions, based
on inaccurate product costs
 The cost of designing, implementing and
maintaining the ABC system is relatively low
due to sophisticated IT support
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
23
Impediments to introducing
ABC
 Lack of awareness of ABC
 Uncertainty about the potential benefits
from ABC
 Firms understand the need for change but
are concerned about the extensive resource
requirements to implement ABC
 Resistance to change among managers and
employees
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
24
Other activity-based costing
issues
 Variations in types of ABC include whether
Actual (past) or budgeted costs are analysed
Implementation is a one-off project or an ongoing system
Cost objects, other than products, are included
 Budgeted costs may be used in an ABC
system
 ABC may be implemented as a one-off
project or a system
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
25
Other activity-based costing
issues
 Implications of excess capacity
ABC estimates the cost of resources used to
perform activities to produce and sell products,
which may not always equal the cost of
resources supplied
Need to account for the costs of unused
capacity when budgeted costs have been used
to generate activity-based product costs
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
26
Other activity-based costing
issues
 Behavioural issues
Change can be perceived as threatening
ABC may require changes in data collected and
collection and analysis procedures
 Bottom-up change management may give some
degree of ownership of any changes caused by
ABC
Management must be seen as committed to the
change process
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
27
Limitations of activity-based
costing
 Facility level costs
If a high level of facility-level costs are allocated
to products, an arbitrary element enters into the
product cost
 Use of average costs
Unitised batch, product and facility-level costs
can lead to product costs that are of limited use
for decision making
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
28
Limitations of activity-based
costing
 Complexity
The cost of updating an ABC system can be very
high, but is needed to avoid producing
outdated, irrelevant information
The level of complexity increases when the
systems is used for activity management
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
29
Activity-based costing in
service organisations
 ABC can be difficult to implement in service
firms, because
High levels of facility costs so fewer cost can be
included
Individual activities are difficult to identify
because they are non-repetitive
A non-repetitive production environment makes
it difficult to identify service outputs
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
30