2. Activity-Based Costing

3. 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves identifying the activities that are responsible for the generation of costs.

4. 3 Principles of ABC The essential principles of ABC are that: Activities (not products) generate costs –Definition: An activity is a process which adds value and consumes resources. Products consume activities

5. 4 Cost drivers The important events in a business that generate costs are known in ABC terminology as cost drivers. A cost driver is any factor which causes a change in the cost of an activity.

6. 5 THE USE OF COST DRIVERS Short-term variable costs can be traced to products using volume related cost drivers such as direct labour hours, machine hours or direct materials used. The cost drivers may be different depending upon how the cost is generated or driven. For example, the cost of power will be generated by (‘driven by’) the number of machine hours. This analysis is similar to traditional cost accounting.

7. 6 THE USE OF COST DRIVERS For long-term variable costs however, volume related cost drivers will tend to be inappropriate. For example, the number and cost of salaried production engineers does not depend on direct labour hours or machine hours but (in the long-term) depends on the number of times a machine has to be set up for a production run. The activity which drives the cost is the number of set ups. Production engineer costs should thus be allocated to products based on the number of set ups. This contrasts with traditional practice which often absorbs all overheads based on direct labour hours and does not take into account that different activities have different cost drivers.

8. 7 Types of activity measures Simple count of the number of times an activity occurs. Transaction driver A measure of the amount of time needed for an activity. Duration driver Two types of activity measures:

9. 8 Differences… Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. Traditional Costing The predetermined overhead rate is based on budgeted activity. This results in applying all overhead costs including unused, or idle capacity costs to products. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses. ABC Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. Unused capacity costs are treated as period expenses.

10. 9 Examples of activity cost pools and activity measures:

11. 10 Example Syarikat ABC produces Product X. The cost data are as follows: DM per unit RM15 DL per unit RM20 OH RM100,000 OH is allocated to relevant activities as follows: Required: Calculate unit cost of Product X using (i) Conventional method, (ii) ABC method.

12. 11 Product Cost using Conventional method

13. 12 Mechanism of ABC

14. 13 Product Cost using ABC method

15. 14 Example (continued) With reference to previous example, Syarikat ABC also produced another product known as Product Y. Product Y is an advanced version of Product X and hence, the production process of Product Y is more complicated than Product X. As a result, activities required to produce Product Y are different from Product X. To produce Product Y will involves the following activities: Required: Calculate unit cost of Product Y using (i) Conventional method, (ii) ABC method.

16. 15 Product Cost using Conventional method

17. 16 Mechanism of ABC

18. 17 Product Cost using ABC method

19. 18 Conclusion of the Example: Different Costs Lead to Different Selling Price What’s the impact ?

20. 19 Conclusions Each method is mathematically correct Each method is acceptable Each method yields a different cost figure, which will lead to different Gross Margin calculations Only Overhead is involved. Total Costs for the firm remain the same – they are just allocated to different cost objects within the firm Selection of the appropriate method and drivers should be based on experience, industry practices, as well as a cost- benefit analysis of each option under consideration

21. 20 ABC vs. Simple Costing Schemes ABC is generally perceived to produce superior costing figures due to the use of multiple drivers across multiple levels ABC is only as good as the drivers selected, and their actual relationship to costs. Poorly chosen drivers will produce inaccurate costs, even with ABC

22. 21 A Cautionary Tale A number of critical decisions can be made using this information: –Should one product be “pushed” over another? –Should one product be dropped? Accounting for overhead costs is an imprecise science. Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable.

23. 22 Characteristics of Successful ABC Implementations Strong top management support Cross-functional involvement Link to evaluations and rewards

24. 23 ABC Limitations Substantial resources required to implement and maintain. Resistance to unfamiliar numbers and reports. Desire to fully allocate all costs to products. Potential misinterpretation of unfamiliar numbers. Does not conform to GAAP. Two costing systems may be needed.

25. 24 THE END ADVISE & REMINDER: Now, your reading time….it’s your responsibility to read relevant chapters in the main text and additional recommended references !