Advanced Costing - ABC Activity Based Costing F5 Advanced Costing - ABC Activity Based Costing

ABC Activity Based Costing Harvard professors Kaplan and Cooper Allocates overheads based on benefits received from a particular indirect activity How to ensure that each cost unit receives a fair share when allocating and absorbing overheads

Activity based costing A method of allocating overhead costs to products and services. Asks the question: ‘What drives cost?’ Example: social work department of local authority Department A uses taxis for travel to client work; Department B takes bus or walks. Overhead cost of travel (taxi plus bus) is shared across A and B by number of people in each department. What drives cost of taxis? Number and length of journeys (all in A).

Activity-Based Costing System ABC calculates the costs of individual activities and assigns costs to cost objects such as products and services on the basis of the activities undertaken to produce each product or service.

ABC Definitions Activities “ value adding process that consumes resources” Cost Driver “ activity or factor which generates costs” Cost Pool “pooling or collection of overhead cost which relates to a specific activity” Cost driver rate = Cost Pool/Cost Driver volume

Activity Based Costing (ABC) Steps Identify major activities. Identify appropriate cost drivers (note: you may have to justify your choice here in the exam) for each activity. Collect costs into pools based upon the activities. Calculate a cost driver rate e.g. €10 per order to cover overheads in purchasing Charge support overheads to products on the basis of their usage of the activity

Activity Based Costing (ABC) Cost driver rate = total driver pool cost cost driver volume

Assumptions underlying ABC All overheads are variable Activities consume resources This consumption of resources drives costs Indirect costs are high relative to direct costs Products or services are complex Products or services are tailored to customers specifications Some products are sold in large qty and others in smaller numbers

Traditional approach to flow of overhead costs Identify overhead costs and identify cost centres that accumulate costs. Step 1:Allocate indirect costs to cost centres. Step 2:Apportion service cost centre to production cost centres. Step 3: Absorb overhead costs into product. PROBLEM : Too Simplistic, not reflecting modern business complexity

Traditional and activity-based costing for overheads Cost centres Cost pools Overhead cost rate Cost driver rate Allocate cost using cost rate to measure consumption of cost Allocation cost using cost driver rate and estimated demand for cost

Problems With Traditional Methods Production systems were historically labour intensive or machine intensive Mass production of standard items In complex manufacturing production is based on smaller customised batches Indirect costs are a high % of total costs These activities of scheduling, order handling and quality control not related to production volume

ABC – Cost Drivers Set up costs – number of manufacturing set ups Order Processing costs- number of orders Packing dept – number of orders packed Engineering dept – number of production runs/orders Air conditioning Maintenance – number of air con units

Advantages of ABC More realistic costs. Better insight into cost drivers, resulting in better cost control. Particularly useful where overhead costs are a significant proportion of total costs. ABC recognises that overhead costs are not all related to production and sales volume. ABC can be applied to all overhead costs, not just production overheads. ABC can be used just as easily in service costing as in product costing.

Traditional V ABC Merits of ABC ABC recognises activities cause costs and products consume activities Easier to manage activities than costs Focus is then on activities that are not adding value and on cost reduction Used to analyse the profitability of customers and products or services Assists the decision making process Used as a basis for budgeting and planning of overheads

Criticisms of ABC It is impossible to allocate all overhead costs to specific activities. Some arbitrary apportionment will remain The choice of both activities and cost drivers might be inappropriate. ABC can be more complex to explain to the stakeholders of the costing exercise. The benefits obtained from ABC might not justify the costs.

Traditional V ABC Criticisms of ABC Allows accurate product pricing but some industries are market led in terms of price Needs to be applied properly in decision making to be of benefit Will management make use of it? Lack of bespoke computer systems

Benefits from first steps in an ABC System The ABC model shifts the focus from what the money was being spent on (labor, equipment, supplies) to what the resources acquired by spending are actually doing

Completing the ABC Model Once the activity cost drivers had been determined, the following quantitative information is needed: The total quantity of each activity cost driver The quantity of cost driver used by each product

Completing the ABC Model Calculate the activity cost driver rate (ACDR) by dividing the activity expense by the total quantity of the activity cost driver Multiply the activity cost driver rate by the quantity of each activity cost driver used by each of the four products

Implications of ABC Pricing - more realistic costs improve cost-plus pricing. Survey found that most pricing decisions are based on “face to face research” Competitive analysis ABC Breakeven analysis

Implications of ABC Decision making – Planning and Control for example, research and development can be directed at products with better margins. Promoting or discontinuing products Planning and Control Insight into how costs are structured and incurred Sales Strategy - more realistic margins can help focus sales strategy. Increased sales effort on different products

Problems Implementing ABC Problems may arise in practice from the approach to activity-based costing that assigns many resource expenses to activities based on interviews, surveys, and direct observation of production and support processes because these activities are time-consuming and expensive

Problems Implementing ABC Inaccuracies and bias may affect the accuracy of cost driver rates derived from individuals’ subjective estimates of their past or future behaviour Companies must periodically repeat the interviewing and surveying processes if they want to keep their activity-based cost systems updated Adding new activities to the system is also difficult, requiring re-estimates of the relative amount of resource time and effort required by the new activity

Problems Implementing ABC A more subtle and serious problem arises from the interview or survey process People estimating how much time they spend on a list of activities handed to them invariably report percentages that add up to 100% Few individuals report that a significant percentage of their time is idle or unused

Problems Implementing ABC Recent journals have highlighted the following Incorrect belief that ABC can solve all problems Lack of correct type of data Difficulty in determining the correct cost drivers Recent surveys put ABC usage in the UK at about 25%