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Activity-based Costing

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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

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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.

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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.

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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.

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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.

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Errors from relying on misleading product costsTraditional 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 .

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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.

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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.

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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.

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Designing ABC systems

3. Determine the cost driver for each major activity:• Drivers at this stage are called activity drivers. They should:

a. provide a good explanation of costs of each

b. activity pool.

c. be easily measurable

d. the data should be easy to obtain and identifiable with

e. 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.

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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.

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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 first-item inspection activities.

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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.

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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.

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Resource consumption models• ABC systems measure the cost of using resources and not the

cost of supplying resources:

Cost of resources = Cost of resources + Cost of unused supplied used 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)

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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

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Activity 2.2 – Q 11.2 (Drury)

• 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:

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

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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 620The 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.

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 Total overheads

overhead rate Total Machine hours

10430 + 5250 + 3600 + 2100 + 4620

1 300 hours

26 000/1300hrs £20 per machine hr

20

=

=

= =

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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

Overheads @ £20 per machine hr

(4x20)80

(3x20)60

(2x20)40

(3x20)60

Total Cost per unit 148 131 84 141

Units of output 120 100 80 120

Total cost £17 760 £ 13 100 £6 720 £16 920

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Activity 2.2 – Q 11.2 (Drury) (b)Machine dept costs 10 430 Machine Hours 1300 £8.02

Set-up costs 5 250 Production runs 21 250

Stores receiving 3 600 Requisitions raised 20 x 4 45

Inspection / quality control

2 100 Production runs 21 100

Materials handling and dispatch

4 620 Number of orders executed

42 110

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 executedThe

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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

Direct Costs x output

8 160 7 100 3 520 9 720

Set-up costs per product

(6x250) 1 500

(5x250) 1 250

(4x250) 1 000

(6x250) 1 500

Stores /receiving (20 each)

900 900 900 900

Inspection/quality control

(6x100) 600

(5x100) 500

(4x100) 400

(6x100) 600

Materials handling and dispatch

(12x110) 1 320

(10x110) 1 100

(8x110) 880

(12x110) 1 320

Machine dept costs 8.02/hr

(120x4x£8.02) 3 851

(100x3x£8.02) 2 407

(80x2x£8.02) 1 284

(120x3x£8.02) 2 888

Total cost £16 331 £ 13 257 £7 984 £16 928