Cost Allocations and Activity-Based Costing and Activity-Based Management

Preface The use of modern manufacturing practices (such as automation, computer control machines, robotics, JIT) can significantly change the structure of the cost production. Management accounting literature has seen the development of an alternative approach for allocating costs to individual products in 1980; this is commonly known as ABC or activity-based costing, or more recently as ABM or activity-based management.

How do organization allocate the cost to products and services? Traditional cost systems use volume-driven allocation bases, such as direct labor hours and machine hours, to assign common organizational expenses to individual products or services. In practice, many of the organizational resource demands by individual products and customers aren’t proportional to the volume of units product or sold (Cooper and Kaplan, 1992).

How do organization allocate the cost to products and services? Consequently, the above conventional cost allocation practice suffers from the following limitations: Ignores non-volume related support activities, such as material handling, material procurement, set-ups, production scheduling, and inspection Assumption that products consume all resources in proportion to their production volumes my result in distorted product costs. It’s inappropriate in today’s organizational environment where companies produce a wide range of products and experience intense global competition.

How do organization allocate the cost to products and services? Traditional manufacturing involves routine manufacturing with high-labor content which are relatively simple. In a highly technical manufacturing environment, the labor content is declining rapidly. Consequently, product costing based on traditional costing systems involve very high overhead allocation rates.

ABC: What is it and what does it offer? The Chartered Institute of Management Accountants (CIMA) defines ABC as: Cost attribution to cost units on the basis of benefit received from indirect activities, e.g. ordering, setting-up, assuring quality. ABC endeavours first to establish the cost of the activities going on in the various factory department, which are creating the overheads and then relating these activities to the products.

STEPS IN ABC METHODOLOGY ORGANIZATIONAL ACTIVITY Identify the organization’s major activities COST DRIVER Identify the cost driver for each major activities COST CENTER Establish cost center for each major activities COST OF ACTIVITIES Allocate the cost of activities according their demand for activities

CLASSIFICATION OF ORGANIZATIONAL ACTIVITIES FOR ABC SYSTEM Under an ABC system, the following activities can be identified (Cooper, 1990) UNIT LEVEL ACTIVITIES Relate to the number of units products. Setting up a machine or processing purchase order BATCH RELATED ACTIVITIES Supporting activities to different products in the product line PRODUCT-SUSTAINING ACTIVITIES FACILITY SUSTAINING ACTIVITIES Relate to administration, plant management, accounting services and lighting and heating of the factory that can’t be traced to individual products or services

POTENTIAL COST DRIVERS Manufacturing Activity Potential Cost Drivers Unit level Weight of direct material used Number of direct labour hours Number of machine hours Number of kilowatt-hours used Batch level Amount of material handling Number of setups Number of inspections Amount of production scheduling Product-sustaining level Hours of engineering labour Equipment maintenance hours The time spent by designers Facility-sustaining level General administration hours Building security and rent

Review Example Gamma Products manufacture product A and product B. The following information is available from this company: Product A Product B Materials ($) 120,000 125,000 Direct Labour ($) 60,000 75,000 Units Produced 10,000 15,000 Direct Labour Hours 3,000 5,000 Machine Hours 1,200 2,500 Engineering Labour House 125 250 Set-ups 60 70

Review Example The overheads have been absorbed on the direct labour cost method: $4 per direct labour hour. The following details are also available: Machine-related overhead $ 350,000 Set-ups $ 120,000 Engineering costs $ 220,000 Traditional costing system: Overhead allocation: Product A: 3,000 direct labor hours x $4.00 per hour = $12,000 Product B: 5,000 direct labor hours x $4.00 per hour = $20,000

Review Example Company’s total cost to produce the products: Product A: Direct Material $120,000 + Direct Labor $60,000 + Overhead $120,000= $300,000 Product B: Direct Material $125,000 + Direct Labor $75,000 + Overhead $200,000= $400,000 ABC System: Cost pool rates: Machine-related overhead rate: Total machine overhead $350,000/(Machine hours for A and B 1,200+2,500) = $94.60 Set-ups rate: Total set-ups costs $120,000/(Set-ups for A and B 60+70) = $923.08 Engineering rate: Total engineering costs $220,000/(Engineering hours for A and B 125 + 250) = $586.67

Review Example Cost assigned to products: Product A Product B Total Machine-related overhead (Machine hours x $94.60) $113,520 $236,500 $350,020 Set-ups costs (No. of setups x $923.08) $55,385 $64,616 $120,001 Engineering costs $73,334 $146,668 $220,002 Total costs $242,239 $447,784 $690,023

Limitations of ABC An ABC systems, suffers from practical deficiencies. In theory, it should be possible to trace all overheads, but in practice it’s quite likely that there will be some costs that can’t be traced, for example the cost of the head office administrative staff. Consequently, arbitrary allocations are likely to remain (Hoque, 2000a)

Activity-based Management: What is it and what does it offer? Activity-based management (ABM) has been defined (Hansen and Mowen, 1997) as a system-wide, integrated approach that focuses management’s attention on activities with the objective of improving customer value and the firm’s profit.

Activity-based Management: What is it and what does it offer? The ABM philosophy contends that management must focus on the performance criteria that all global competitors can use as common denominators – the productivity and efficiency of activities that support value-adding business processes, which must deliver the highest value at the lowest cost (Digman, 1999)

Activity-based Management: What is it and what does it offer? Process Value Analysis (PVA) is rooted in philosophy that management must focus on accountability for activities such as driver analysis, activity analysis, and performance evaluation.

Activity-based Management: What is it and what does it offer? Driver Analysis helps identify the root cause of activity costs. Activity Analysis is concerned with identifying, describing, and evaluating an organization’s activities Activity-based Performance Evaluation tend to measuring performance that is critical to strategic management and control.

Summary ABC is simply based on the premise that businesses must understand the factors that drive each major activity, the cost of activities and how activities relate to products in order to run the business efficiently and effectively. ABM or activity-based management, where emphasis is not only costs, but also activity analysis, activity-based budgeting, activity performance management and the like.

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