F5
Advanced Costing - ABC
Activity Based Costing
ABC
• Activity Based Costing
– Harvard professors Kaplan and Cooper
– Allocates overheads based on benefits
received from a particular indirect activity
– How to ensure that each cost unit receives a
fair share when allocating and absorbing
overheads
Activity based costing
• A method of allocating overhead costs to
products and services.
• Asks the question: ‘What drives cost?’
• Example: social work department of local
authority
• Department A uses taxis for travel to client work;
Department B takes bus or walks. Overhead
cost of travel (taxi plus bus) is shared across A
and B by number of people in each department.
• What drives cost of taxis?
• Number and length of journeys (all in A).
Activity-Based Costing System
• ABC calculates the costs of individual
activities and assigns costs to cost objects
such as products and services on the
basis of the activities undertaken to
produce each product or service.
ABC Definitions
• Activities “ value adding process that consumes
resources”
• Cost Driver “ activity or factor which generates
costs”
• Cost Pool “pooling or collection of overhead cost
which relates to a specific activity”
• Cost driver rate = Cost Pool/Cost Driver volume
Activity Based Costing (ABC)
Steps
1.Identify major activities.
2.Identify appropriate cost drivers (note: you
may have to justify your choice here in the
exam) for each activity.
3.Collect costs into pools based upon the
activities.
4.Calculate a cost driver rate e.g. €10 per
order to cover overheads in purchasing
Activity Based Costing (ABC)
Cost driver rate =
total driver pool cost
cost driver volume
Assumptions underlying ABC
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All overheads are variable
Activities consume resources
This consumption of resources drives costs
Indirect costs are high relative to direct costs
Products or services are complex
Products or services are tailored to
customers specifications
• Some products are sold in large qty and
others in smaller numbers
Traditional approach to flow of
overhead costs
• Identify overhead costs and identify cost centres
that accumulate costs.
• Step 1:Allocate indirect costs to cost centres.
• Step 2:Apportion service cost centre to
production cost centres.
• Step 3: Absorb overhead costs into product.
• PROBLEM : Too Simplistic, not reflecting
modern business complexity
Traditional and activity-based
costing for overheads
Traditional
Activity-based
Cost centres
Cost pools
Overhead cost rate
Cost driver rate
Allocate cost using cost
rate to measure
consumption of cost
Allocation cost using
cost driver rate and
estimated demand for
cost
Problems With Traditional Methods
• Production systems were historically labour
intensive or machine intensive
• Mass production of standard items
• In complex manufacturing production is
based on smaller customised batches
• Indirect costs are a high % of total costs
• These activities of scheduling, order handling
and quality control not related to production
volume
ABC – Cost Drivers
• Set up costs – number of manufacturing
set ups
• Order Processing costs- number of orders
• Packing dept – number of orders packed
• Engineering dept – number of production
runs/orders
• Air conditioning Maintenance – number of
air con units
Advantages of ABC
• More realistic costs.
• Better insight into cost drivers, resulting in
better cost control.
• Particularly useful where overhead costs are
a significant proportion of total costs.
• ABC recognises that overhead costs are not
all related to production and sales volume.
• ABC can be applied to all overhead costs, not
just production overheads.
• ABC can be used just as easily in service
costing as in product costing.
Traditional V ABC
• Merits of ABC
– ABC recognises activities cause costs and
products consume activities
– Easier to manage activities than costs
– Focus is then on activities that are not
adding value and on cost reduction
– Used to analyse the profitability of customers
and products or services
– Assists the decision making process
– Used as a basis for budgeting and planning of
overheads
Criticisms of ABC
• It is impossible to allocate all overhead
costs to specific activities.
– Some arbitrary apportionment will remain
• The choice of both activities and cost
drivers might be inappropriate.
• ABC can be more complex to explain to
the stakeholders of the costing exercise.
• The benefits obtained from ABC might not
justify the costs.
Traditional V ABC
• Criticisms of ABC
– Allows accurate product pricing but some
industries are market led in terms of price
– Needs to be applied properly in decision
making to be of benefit
– Will management make use of it?
– Lack of bespoke computer systems
Benefits from first steps in an ABC
System
The ABC model shifts the focus from what
the money was being spent on (labor,
equipment, supplies) to what the resources
acquired by spending are actually doing
Completing the ABC Model
• Once the activity cost drivers had been
determined, the following quantitative
information is needed:
– The total quantity of each activity cost driver
– The quantity of cost driver used by each
product
Completing the ABC Model
– Calculate the activity cost driver rate
(ACDR) by dividing the activity expense
by the total quantity of the activity cost
driver
– Multiply the activity cost driver rate by
the quantity of each activity cost driver
used by each of the four products
Implications of ABC
• Pricing - more realistic costs improve costplus pricing.
• Survey found that most pricing decisions
are based on
– “face to face research”
– Competitive analysis
– ABC
– Breakeven analysis
Implications of ABC
• Decision making –
– for example, research and development can be
directed at products with better margins.
– Promoting or discontinuing products
• Planning and Control
– Insight into how costs are structured and incurred
• Sales Strategy
- more realistic margins can help focus sales strategy.
– Increased sales effort on different products
Problems Implementing ABC
Problems may arise in practice from the approach
to activity-based costing that assigns many
resource expenses to activities based on
interviews, surveys, and direct observation of
production and support processes because these
activities are time-consuming and expensive
Problems Implementing ABC
– Inaccuracies and bias may affect the accuracy
of cost driver rates derived from individuals’
subjective estimates of their past or future
behaviour
– Companies must periodically repeat the
interviewing and surveying processes if they
want to keep their activity-based cost systems
updated
– Adding new activities to the system is also
difficult, requiring re-estimates of the relative
amount of resource time and effort required by
the new activity
Problems Implementing ABC
A more subtle and serious problem arises
from the interview or survey process
• People estimating how much time they
spend on a list of activities handed to them
invariably report percentages that add up to
100%
• Few individuals report that a significant
percentage of their time is idle or unused
Problems Implementing ABC
Recent journals have highlighted the following
– Incorrect belief that ABC can solve all
problems
– Lack of correct type of data
– Difficulty in determining the correct cost
drivers
– Recent surveys put ABC usage in the
UK at about 25%