Activity-based Costing

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

Generating relevant cost information There are 3 main reasons why a cost accumulation system is required to generate relevant cost information: 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.

Generating relevant cost information 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. 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.

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.

The emergence of ABC systems Traditional systems were appropriate when: Direct costs were the dominant costs Indirect costs were relatively small Information costs were high There was a lack of intense global competition A limited range of products was produced.

Errors from relying on misleading product costs Traditional 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 .

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.

Designing ABC systems 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.

Designing ABC systems 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.

Designing ABC systems Determine the cost driver for each major activity: Drivers at this stage are called activity drivers. They should: provide a good explanation of costs of each activity pool. be easily measurable the data should be easy to obtain and identifiable with the product. Activity cost drivers consist of transaction and duration drivers. Assign the cost of activities to products: The cost driver must be measurable so that it can be identified with individual products.

Activity Hierarchies Manufacturing activities can be classified along a cost hierarchy dimension consisting of: 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.

Activity Hierarchies 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.

Activity Hierarchies 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.

Activity Hierarchies 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.

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)

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

Activity 2.2 – Q 11.2 (Drury) Product A B C D Output in units 120 100 80 Costs per unit R Direct material 40 50 30 60 Direct labour 28 21 14 Machine hours (per unit) 4 3 2 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:

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 4 620 The 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 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) = = = = 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 = = = =

Activity 2.2 – Q 11.2 (Drury) Product A B C D Costs per unit R Direct material 40 50 30 60 Direct labour 28 21 14 Overheads @ £20 per machine hr (4x20) 80 (3x20) (2x20) Total Cost per unit 148 131 84 141 Units of output 120 100 Total cost £17 760 £ 13 100 £6 720 £16 920

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 2 100 100 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 Materials handling & dispatch Orders executed The

Activity 2.2 – Q 11.2 (Drury) (b) Activity-based costing