1. Cost Allocations and Activity-Based Costing and Activity-Based Management

2. Preface
The use of modern manufacturing practices (such as automation, computer control machines, robotics, JIT) can significantly change the structure of the cost production.
Management accounting literature has seen the development of an alternative approach for allocating costs to individual products in 1980; this is commonly known as ABC or activity-based costing, or more recently as ABM or activity-based management.

3. How do organization allocate the cost to products and services?
Traditional cost systems use volume-driven allocation bases, such as direct labor hours and machine hours, to assign common organizational expenses to individual products or services.
In practice, many of the organizational resource demands by individual products and customers aren’t proportional to the volume of units product or sold (Cooper and Kaplan, 1992).

4. How do organization allocate the cost to products and services?
Consequently, the above conventional cost allocation practice suffers from the following limitations:
Ignores non-volume related support activities, such as material handling, material procurement, set-ups, production scheduling, and inspection
Assumption that products consume all resources in proportion to their production volumes my result in distorted product costs.
It’s inappropriate in today’s organizational environment where companies produce a wide range of products and experience intense global competition.

5. How do organization allocate the cost to products and services?
Traditional manufacturing involves routine manufacturing with high-labor content which are relatively simple.
In a highly technical manufacturing environment, the labor content is declining rapidly. Consequently, product costing based on traditional costing systems involve very high overhead allocation rates.

6. ABC: What is it and what does it offer?
The Chartered Institute of Management Accountants (CIMA) defines ABC as:
Cost attribution to cost units on the basis of benefit received from indirect activities, e.g. ordering, setting-up, assuring quality.
ABC endeavours first to establish the cost of the activities going on in the various factory department, which are creating the overheads and then relating these activities to the products.

7. STEPS IN ABC METHODOLOGY
ORGANIZATIONAL ACTIVITY
Identify the organization’s major activities
COST DRIVER
Identify the cost driver for each major activities
COST CENTER
Establish cost center for each major activities
COST OF ACTIVITIES
Allocate the cost of activities according their demand for activities

8. CLASSIFICATION OF ORGANIZATIONAL ACTIVITIES FOR ABC SYSTEM
Under an ABC system, the following activities can be identified (Cooper, 1990)
UNIT LEVEL ACTIVITIES
Relate to the number of units products.
Setting up a machine or processing purchase order
BATCH RELATED ACTIVITIES
Supporting activities to different products in the product line
PRODUCT-SUSTAINING ACTIVITIES
FACILITY SUSTAINING ACTIVITIES
Relate to administration, plant management, accounting services and lighting and heating of the factory that can’t be traced to individual products or services

9. POTENTIAL COST DRIVERS
Manufacturing Activity
Potential Cost Drivers
Unit level
Weight of direct material used
Number of direct labour hours
Number of machine hours
Number of kilowatt-hours used
Batch level
Amount of material handling
Number of setups
Number of inspections
Amount of production scheduling
Product-sustaining level
Hours of engineering labour
Equipment maintenance hours
The time spent by designers
Facility-sustaining level
General administration hours
Building security and rent

10. Review Example
Gamma Products manufacture product A and product B. The following information is available from this company:
Product A
Product B
Materials ($)
120,000
125,000
Direct Labour ($)
60,000
75,000
Units Produced
10,000
15,000
Direct Labour Hours
3,000
5,000
Machine Hours
1,200
2,500
Engineering Labour House
125
250
Set-ups 60 70

11. Review Example
The overheads have been absorbed on the direct labour cost method: $4 per direct labour hour. The following details are also available:
Machine-related overhead
$ 350,000
Set-ups
$ 120,000
Engineering costs
$ 220,000
Traditional costing system:
Overhead allocation:
Product A: 3,000 direct labor hours x $4.00 per hour = $12,000
Product B: 5,000 direct labor hours x $4.00 per hour = $20,000

12. Review Example Company’s total cost to produce the products:
Product A:
Direct Material $120,000 + Direct Labor $60,000 + Overhead $120,000= $300,000
Product B:
Direct Material $125,000 + Direct Labor $75,000 + Overhead $200,000= $400,000
ABC System:
Cost pool rates:
Machine-related overhead rate:
Total machine overhead $350,000/(Machine hours for A and B 1,200+2,500) = $94.60
Set-ups rate:
Total set-ups costs $120,000/(Set-ups for A and B 60+70) = $923.08
Engineering rate:
Total engineering costs $220,000/(Engineering hours for A and B ) = $586.67

13. Review Example Cost assigned to products: Product A Product B Total
Machine-related overhead
(Machine hours x $94.60)
$113,520
$236,500
$350,020
Set-ups costs
(No. of setups x $923.08)
$55,385
$64,616
$120,001
Engineering costs
$73,334
$146,668
$220,002
Total costs
$242,239
$447,784
$690,023

14. Limitations of ABC
An ABC systems, suffers from practical deficiencies. In theory, it should be possible to trace all overheads, but in practice it’s quite likely that there will be some costs that can’t be traced, for example the cost of the head office administrative staff. Consequently, arbitrary allocations are likely to remain (Hoque, 2000a)

15. Activity-based Management: What is it and what does it offer?
Activity-based management (ABM) has been defined (Hansen and Mowen, 1997) as a system-wide, integrated approach that focuses management’s attention on activities with the objective of improving customer value and the firm’s profit.

16. Activity-based Management: What is it and what does it offer?
The ABM philosophy contends that management must focus on the performance criteria that all global competitors can use as common denominators – the productivity and efficiency of activities that support value-adding business processes, which must deliver the highest value at the lowest cost (Digman, 1999)

17. Activity-based Management: What is it and what does it offer?
Process Value Analysis (PVA) is rooted in philosophy that management must focus on accountability for activities such as driver analysis, activity analysis, and performance evaluation.

18. Activity-based Management: What is it and what does it offer?
Driver Analysis helps identify the root cause of activity costs.
Activity Analysis is concerned with identifying, describing, and evaluating an organization’s activities
Activity-based Performance Evaluation tend to measuring performance that is critical to strategic management and control.

19. Summary
ABC is simply based on the premise that businesses must understand the factors that drive each major activity, the cost of activities and how activities relate to products in order to run the business efficiently and effectively.
ABM or activity-based management, where emphasis is not only costs, but also activity analysis, activity-based budgeting, activity performance management and the like.

20. Thank You