Chapter 8 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 l distorted product costs l poor cost control §The ABC method adopted, depends on the problems that need to be addressed

Activity-based costing terminology §Activity - a unit of work performed §Cost driver - a factor that causes cost §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 Cont.

Activity-based costing terminology §Root-cause cost driver - the basic 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

Different forms of ABC §Simple approach - includes manufacturing overhead §ABC system for indirect costs - includes manufacturing and non-manufacturing costs §Comprehensive system - includes all product-related costs, except direct material

An activity-based costing model §The costing view l measuring the cost of activities l assigning activity costs to products §Activity management view l used to determine the causes of costs

The costing view of ABC §Measuring the cost of activities l assigning costs to activity centres l identify and cost the activities performed in each activity centre §Assigning activity costs to products l calculating the activity cost per unit of activity driver l preparing a bill of activities for each product

Activity-based hierarchy of costs and activities §Unit-level activities §Batch-level activities §Product-level (or product-sustaining) activities §Facility-level (or facility-sustaining) activities l not usually included in product costs

Activity-based versus 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 includes non-manufacturing costs

ABC benefits will be greatest where... §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 Cont.

ABC benefits will be greatest where... §Production activity involves diverse batch sizes and product complexity §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

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

Other activity-based costing issues §Sources of variations in types of ABC include whether l actual (past) or budgeted costs are analysed l the implementation is a one-off project or an on-going system l cost objects, other than products, are included Cont.

Other activity-based costing issues §Implications of excess capacity l 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 l need to account for the costs of unused capacity when budgeted costs have been used to generate activity-based product costs Cont.

Other activity-based costing issues §Behavioural issues l change can be perceived as threatening ABC may require changes in data collected and collection and analysis procedures l ‘bottom-up’ change management may give some degree of ownership of any changes caused by ABC l management must be seen as committed to the change process

Limitations of activity-based costing §If a high level of facility-level costs are allocated to products, this can lead to an arbitrary element of product cost §Unitised batch, product and facility-level costs can lead to product costs that are of limited use for decision making §The cost of updating an ABC system can be very high, but is needed to avoid producing outdated, irrelevant information

Activity-based costing in service organisations §ABC can be difficult to implement in service firms, because l high levels of facility costs cause problems with costing services l individual activities are difficult to identify because they are non-repetitive l a non-repetitive production environment makes it difficult to identify service outputs

Exhibit 8.2

Exhibit 8.3

Exhibit 8.4