Activity-based
Costing
1
Outcomes
• Provide advice on the allocation of non-manufacturing
overheads in manufacturing & service organisations for
decision-making purposes
• Allocate inter-service department overheads
• Determine cost hierarchies in an ABC system
• Apply product profitability analysis using ABC
hierarchies
• Discuss the application of ABC in service organisations
& other management applications
2
Generating relevant cost information
• There are 3 main reasons why a cost accumulation system
is required to generate relevant cost information:
1. Many indirect costs are relevant for decision-making
• The cost of many joint resources (e.g. support
function costs) fluctuate according to the demand
for them.
• Product introduction, discontinuation, redesign
decisions determine the demand for support
function resources and thus future costs.
• Costs of support functions are difficult to trace
directly to cost objects.
3
Generating relevant cost information
2. An attention directing system is required to identify
potentially unprofitable products that require more
detailed special studies:
• It is not feasible to periodically undertake special
studies for all products or combination of product
mixes.
3. Many product-related decisions are not independent:
• Focusing only on individual products ignores
impact that the culmination of many decisions will
have on those joint resources that fluctuate
according to the demand for them.
4
A comparison of traditional and ABC
systems
• Both systems use the two-stage allocation process.
• In the first stage traditional systems tend to allocate costs to
departments whereas ABC systems allocate costs to activities:
(ABC systems tend to have more cost centres/cost pools)
• In the second stage traditional systems rely on a small number
of volume-based cost drivers (typically direct labour or
machine hours) whereas ABC systems use many second stage
cost drivers.
• ABC systems seek to use only cause-and-effect cost drivers
whereas traditional systems often rely on arbitrary allocation
bases.
• ABC systems tend to establish separate cost driver rates for
support departments whereas traditional systems merge
support and production centre costs.
5
The emergence of ABC systems
• Traditional systems were appropriate when:
1. Direct costs were the dominant costs
2. Indirect costs were relatively small
3. Information costs were high
4. There was a lack of intense global competition
5. A limited range of products was produced.
6
Errors from relying on misleading product
costs
Traditional costing systems use volume-based (e.g. direct labour
and machine hours) second stage drivers but if volume bases are
not the cause of indirect costs reported costs will be misleading.
Example
• Products HV (a high volume product)and LV (a low volume
product)are two of several products produced by a company.
HV is made in large batches and LV is made in small batches.
HV consumes 30%of DLHs and LV consumes 5% but each
product consumes 15% of the batch-related indirect costs. The
traditional system uses DLHs as the cost driver and the ABC
system uses the number of batches processed. All overheads
(total =£1m)are batch-related .
7
Non-manufacturing overheads
• Reported product costs:
• Traditional system reports misleading information — In the longer
term overheads will not decline by £300 000 if HV is discontinued.
• ABC allocates on a cause-and-effect basis and shows high level of
resources consumed by LV —The 2 costing systems report different
messages (Traditional = Drop HV ABC = Drop LV).
• Traditional system motivates the wrong strategy.
8
Designing ABC systems
1. Identify the major activities that take place in an
organization:
• The activities chosen should be at a reasonable level of
aggregation based on cost/benefit criteria.
• Choice of activities influenced by the total cost of the activity
centre and the ability of a single cost driver to provide a
satisfactory determinant of the cost of the activity.
9
Designing ABC systems
2. Assign costs to cost pools /cost centre for each
activity:
• Costs assigned to activity cost pools will include direct
and indirect costs.
• Resource cost drivers used to assign indirect costs.
• Reliability of cost information will be reduced if arbitrary
allocations are used to assign a significant proportion of
costs to activities.
10
Designing ABC systems
3. Determine the cost driver for each major activity:
• Drivers at this stage are called activity drivers. They should:
a.
b.
c.
d.
e.
provide a good explanation of costs of each
activity pool.
be easily measurable
the data should be easy to obtain and identifiable with
the product.
• Activity cost drivers consist of transaction and duration drivers.
4. Assign the cost of activities to products:
• The cost driver must be measurable so that it can be identified with
individual products.
11
Activity Hierarchies
Manufacturing activities can be classified along a
cost hierarchy dimension consisting of:
1. Unit-level activities
• Performed each time a unit of the product or service is
produced.
• Resources are consumed in proportion to the number of
units produced or sold.
• Examples — Direct materials and labour, energy costs
and expenses consumed in proportion to machine
processing time.
12
Activity Hierarchies
2. Batch related activities
• Performed each time a batch of goods is produced.
• Costs vary with the number of batches made.
• Examples include set-ups, purchase ordering and firstitem inspection activities.
13
Activity Hierarchies
3. Product/service sustaining activities
• Performed to enable the production of individual
products or services.
• Examples include activities related to maintaining an
accurate bill of materials, preparing engineering change
notices.
14
Activity Hierarchies
4. Facility-sustaining (or business-sustaining)
activities
• Performed to support the organization as a whole.
• Examples include plant management, property costs and
salaries of general administrative staff.
• Common to all products and services – not allocated to
products/services.
15
Resource consumption models
• ABC systems measure the cost of using resources and not the cost
of supplying resources:
Cost of resources =
supplied
Cost of resources
used
+ Cost of unused
capacity
• Periodic financial statements measure the cost of resources supplied
(i.e.15 000 orders at a cost of £300 000 in Example11.2).
• ABC systems measure the cost of resources used (i.e.13 000 orders at a
cost of £20 per order in Example 11.2 shown on sheet 11.13).
• The difference between the cost of resources supplied and the cost of
resources used represents the cost of unused capacity (i.e. 2 000 orders
at £20 per order =£40 000)
16
Resource consumption models
• Unused capacity arises with committed resources because they
must be acquired in discrete amounts in advance of usage.
• With flexible resources supply can be continually adjusted to
match exactly the usage of resources.
• Managers make decisions that will result in a change of activity
usage (e.g. discontinuation decisions reduce cost of resources
used and increase the cost of unused capacity).
• Cash flow consequences will only arise if action is taken to
remove unused capacity by reducing spending on the supply of
resources.
• The periodic reporting of unused capacity signals the need for a
change in the spending on the supply of resources
17
Activity 2.2 – Q 11.2 (Drury)
Product
A
B
C
D
Output in units
120
100
80
120
Costs per unit
R
R
R
R
Direct material
40
50
30
60
Direct labour
28
21
14
21
Machine hours (per unit)
4
3
2
3
• The four products are similar and are usually produced in
production runs of 20 units and sold in batches of 10
units.
• The production overhead is currently absorbed by using a
machine hour rate and the total of the production
overhead for the period has been analysed as follows:
18
Activity 2.2 – Q 11.2 (Drury)
Machine dept costs (rent, business rates, depreciation & supervisor
10 430
Set-up costs
5 250
Stores receiving
3 600
Inspection / quality control
2 100
Materials handling and dispatch
4 620
The cost drivers to be used are as listed below for the overhead costs shown:
Cost
Cost Driver
Set up costs
Number of production runs
Stores receiving
Requisitions raised
Inspection/quality control
Number of production runs
Materials handling & dispatch
Orders executed
The number of requisitions raised on the stores was 20 for each product & the
number of orders executed was 42, each order being for a batch of 10 of a product.
19
Activity 2.2 – Q 11.2 (Drury)
a) Total machine hours = (120 x 4) + (100 x 3) +(80 x 2) +
(120 x 3)
= 1300 hrs
Machine hour
overhead rate
Total overheads
= Total Machine hours
10430 + 5250 + 3600 + 2100 + 4620
=
1 300 hours
= 26 000/1300hrs =
£20 per machine hr
20
Activity 2.2 – Q 11.2 (Drury)
Product
A
B
C
D
Costs per unit
R
R
R
R
Direct material
40
50
30
60
Direct labour
28
21
14
21
(4x20)
80
(3x20)
60
(2x20)
40
(3x20)
60
Total Cost per unit
148
131
84
141
Units of output
120
100
80
120
£17 760
£ 13 100
£6 720
£16 920
Overheads @ £20 per
machine hr
Total cost
21
Activity 2.2 – Q 11.2 (Drury) (b)
Machine dept costs
10 430 Machine Hours
Set-up costs
5 250 Production runs
Stores receiving
3 600 Requisitions raised
Inspection / quality
control
Materials handling and
dispatch
£8.02
21
250
20 x 4
45
2 100 Production runs
21
100
4 620 Number of orders
executed
42
110
Cost
The
1300
Cost Driver
Set up costs
Number of production runs
Stores receiving
Requisitions raised
Inspection/quality control
Number of production runs
Materials handling & dispatch
Orders executed
22
Activity 2.2 – Q 11.2 (Drury) (b)
Activity-based costing
Product
A
B
C
D
120
100
80
120
Costs per unit
R
R
R
R
Direct material
40
50
30
60
Direct labour
28
21
14
21
Direct costs per
unit
68
71
44
81
8 160
7 100
3 520
9 720
(6x250)
1 500
(5x250)
1 250
(4x250)
1 000
(6x250)
1 500
900
900
900
900
Direct Costs x
output
Set-up costs per
product
Stores /receiving
(20 each)
Inspection/quality
control
Materials handling
and dispatch
Machine dept costs
8.02/hr
Total cost
(6x100)
(5x100)
600
500
(12x110)
(10x110)
1 320
1 100
(120x4x£8.02) (100x3x£8.02)
3 851
2 407
£16 331
£ 13 257
(4x100)
(6x100)
400
600
(8x110)
(12x110)
880
1 320
(80x2x£8.02) (120x3x£8.02)
1 284
2 888
£7 984
£16 928
23