Activity-based costing Chapter 8 Activity-based costing

Problems with conventional product costing systems General features of conventional systems Direct material and direct labour costs are traced to products Manufacturing overhead costs are allocated to products using a predetermined overhead rate Manufacturing overhead rate is calculated using some measure of production volume Non-manufacturing costs are not assigned to products continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Problems with conventional product costing systems Failure to adapt to the changing business environment Increasing levels of non-volume-driven manufacturing overhead costs Increasing proportion of non-manufacturing costs Causes of changes in costs Changing product structures Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Indicators of problems with a product costing system Product costing systems are likely to result in inaccurate product cost when… Proportion of direct labour costs decrease Proportion of manufacturing overhead costs increase Proportion of manufacturing overhead costs, not related directly to production volume, increases Non-manufacturing costs which are product-related become substantial; and Product diversity increases Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Problems with costing in service businesses Service firms tend to use firm-wide volume-based overhead rates Overhead costs are increasing in importance and are increasingly non-volume driven Customers are demanding more diverse and higher quality services Increases in product diversity and in overhead costs Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Activity-based costing A methodology that can be used to measure both the cost of cost objects and the performance of activities Can help solve problems such as Distorted product costs Poor cost control The ABC method adopted, depends on the problems that need to be addressed Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

An activity-based costing model The costing view Measures the cost of activities Assign activity costs or products Activity management view The nature of cost drivers Resource drivers Activity drivers Root cause cost drivers Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith The costing view of ABC Measuring the cost of activities Assign costs to activity centres Identify and cost the activities performed in each activity centre Assigning activity costs to products Calculate the activity cost per unit of activity driver Prepare a bill of activities for each product Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Activity-based costing terminology Activity: a unit of work performed with the organisation Cost driver: a factor or activity that causes cost to be incurred Resource driver: cost driver used to estimate the cost of resources consumed by an activity Activity driver: a cost driver used to estimate the cost of an activity consumed by the cost object continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Activity-based costing terminology Root-cause cost driver: the underlying factors that cause activities to be performed and their costs to be incurred Bill of activities: identifies the activities, the activity cost per unit of activity driver, the quantity of activity drivers consumed, and, therefore, the cost of the activities consumed by the product Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Different forms of ABC Simple approach: allocates manufacturing overhead to products ABC system for indirect costs: allocates manufacturing overhead and non-manufacturing costs to products Comprehensive system: all product-related costs, except direct material, are included in the ABC system continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Different forms of ABC Which costs should be included in an ABC system? The decision to include activity based management an in ABC systems will influence the range of costs included in the system as well as the type or cost drivers Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Activity-based hierarchy of costs and activities Unit level activities Performed for each batch of product Batch level activities Performed for each batch of products Product level (or product-sustaining) activities Performed for specific products or product families Facility level (or facility-sustaining) activities Not usually included in product costs Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Activity-based vs. conventional product costs Conventional costing assumes product costs are driven by volume-based cost drivers Conventional costing ignores batch size. Units produced in large batches consume a relatively low consumption per unit of batch costs ABC may include non-manufacturing costs Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

The benefits of ABC are greatest when… Overhead costs are a significant proportion of total cost, and a large part of overhead is not directly related to production volume The business has a diverse product range, and individual product’s use of support resources differs from their use of volume-based cost drivers continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

The benefits of ABC are greatest when... Production activity involves diverse batch sizes and product complexity Proportion of product-related costs incurred outside manufacturing is increasing relative to manufacturing costs continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

The benefits of ABC are greatest when… There are likely to be high costs associated with making inappropriate decisions, based on inaccurate product costs The cost of designing, implementing and maintaining the ABC system is relatively low due to sophisticated IT support Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Impediments to introducing ABC Lack of awareness of ABC Uncertainty about the potential benefits from ABC Firms understand the need for change but are concerned about the extensive resource requirements to implement ABC Resistance to change among managers and employees Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Other activity-based costing issues Variations in types of ABC include whether Actual (past) or budgeted costs are analysed Implementation is a one-off project or an on-going system Cost objects, other than products, are included Budgeted costs may be used in an ABC system ABC may be implemented as a one-off project or a system continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Other activity-based costing issues Implications of excess capacity ABC estimates the cost of resources used to perform activities to produce and sell products, which may not always equal the cost of resources supplied Need to account for the costs of unused capacity when budgeted costs have been used to generate activity-based product costs continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Other activity-based costing issues Behavioural issues Change can be perceived as threatening ABC may require changes in data collected and collection and analysis procedures Bottom-up change management may give some degree of ownership of any changes caused by ABC Management must be seen as committed to the change process Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Limitations of activity-based costing Facility level costs If a high level of facility-level costs are allocated to products, an arbitrary element enters into the product cost Use of average costs Unitised batch, product and facility-level costs can lead to product costs that are of limited use for decision making continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Limitations of activity-based costing Complexity The cost of updating an ABC system can be very high, but is needed to avoid producing outdated, irrelevant information The level of complexity increases when the systems is used for activity management Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Activity-based costing in service organisations ABC can be difficult to implement in service firms, because High levels of facility costs so fewer cost can be included Individual activities are difficult to identify because they are non-repetitive A non-repetitive production environment makes it difficult to identify service outputs Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith