Chapter 8 Activity-based costing

Chapter 8 Activity-based costing
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

Problems with conventional product costing systems
General features of conventional product costing 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e 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 and increased product diversity Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

Indicators of problems with a product costing system
Product costing systems are likely to result in inaccurate product costs when … Proportion of direct labour costs decreases Proportion of manufacturing overhead costs increases Proportion of manufacturing overhead costs, not related directly to production volume, increases Non-manufacturing costs that are product-related become substantial Product diversity increases Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e 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 quality increase the level of non-volume-driven overhead costs Cast doubt on the accuracy of service costs derived from a conventional product costing system Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e 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 form of ABC method adopted depends on the problems that need to be addressed Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

An activity-based costing model
The costing view Measures the cost of activities Assigns activity costs or products Activity management view Provides information to manage activities, managing costs and other sources of customer value The nature of cost drivers Resource drivers Activity drivers Root cause cost drivers Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

Costing view Step one: Measuring the cost of activities
Assign costs to activity centres Identify and cost the activities performed in each activity centre Step two: Assigning activity costs to products Calculate the activity cost per unit of activity driver Prepare a bill of activities for each product Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

Activity-based costing terminology
A unit of work performed within the organisation Cost driver A factor or activity that causes cost to be incurred Resource driver A 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

Different forms of ABC Simple approach: allocates manufacturing overhead costs to products ABC system for indirect costs: allocates manufacturing overhead costs and non-manufacturing costs to products Comprehensive system: allocates all product-related costs, except direct material, to products and activity management continued Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

Different forms of ABC Which costs should be included in an ABC system? Depends on the purpose of the system, which depends on the needs of management A decision to include activity-based management in an ABC system will influence the range of costs included in the system, as well as the type of cost drivers identified Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e 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 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

Activity-based versus conventional product costs
Conventional product 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

When to use ABC 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 an individual product’s use of support resources differs from their use of volume-based cost drivers Production activity involves diverse batch sizes and product complexity continued Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

When to use ABC Proportion of product-related costs incurred outside manufacturing is increasing relative to manufacturing costs 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e 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 ongoing 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 ABC may be used to cost other cost objects, such as the costs of using suppliers or customer-related costs continued Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

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 Committed resources are supplied in advance of being used in production Need to account for the costs of unused capacity when budgeted costs have been used to generate activity-based product costs continued Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

Behavioural issues in implementing activity-based costing Change can be perceived as threatening ABC may require changes in the data that is collected and changes in 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e 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 the product cost Facility level costs bear no obvious relationship to products Use of average costs in decision making Batch, product and facility level costs that have been divided by the number of units produced can lead to product costs that are of limited use for decision making Desirable to use unit level cost in the short term or total product cost in the longer term continued Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e 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 system is used for both activity management and product costing Activity-based management requires more extensive and detailed analysis of cost and activities Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

Activity-based costing in service organisations
ABC can be difficult to implement in service firms because there are High levels of facility costs, so fewer costs 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 Despite these issues, ABC is used in many major Australian service firms Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith

Chapter 8 Activity-based costing

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