1. Activity-based costing
Chapter 8
Activity-based costing

2. Problems with conventional product costing systems
General features of conventional 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  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

3. Slides prepared by Kim Langfield-Smith
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

4. 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
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

5. Indicators of problems with a product costing system
Product costing systems are likely to result in inaccurate product cost when…
Proportion of direct labour costs decrease
Proportion of manufacturing overhead costs increase
Proportion of manufacturing overhead costs, not related directly to production volume, increases
Non-manufacturing costs which are product-related become substantial; and
Product diversity increases
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

6. Slides prepared by Kim Langfield-Smith
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

7. 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 in overhead costs
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

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
Distorted product costs
Poor cost control
The ABC method adopted, depends on the problems that need to be addressed
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

9. Slides prepared by Kim Langfield-Smith
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

10. An activity-based costing model
The costing view
Measures the cost of activities
Assign activity costs or products
Activity management view
The nature of cost drivers
Resource drivers
Activity drivers
Root cause cost drivers
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

11. Slides prepared by Kim Langfield-Smith
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

12. Slides prepared by Kim Langfield-Smith
The costing view of ABC
Measuring the cost of activities
Assign costs to activity centres
Identify and cost the activities performed in each activity centre
Assigning activity costs to products
Calculate the activity cost per unit of activity driver
Prepare a bill of activities for each product
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

13. Slides prepared by Kim Langfield-Smith
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

14. Activity-based costing terminology
Activity: a unit of work performed with the organisation
Cost driver: a factor or activity that causes cost to be incurred
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
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

15. 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  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

16. Slides prepared by Kim Langfield-Smith
Different forms of ABC
Simple approach: allocates manufacturing overhead to products
ABC system for indirect costs: allocates manufacturing overhead and non-manufacturing costs to products
Comprehensive system: all product-related costs, except direct material, are included in the ABC system
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

17. Slides prepared by Kim Langfield-Smith
Different forms of ABC
Which costs should be included in an ABC system?
The decision to include activity based management an in ABC systems will influence the range of costs included in the system as well as the type or cost drivers
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

18. Slides prepared by Kim Langfield-Smith
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

19. Activity-based hierarchy of costs and activities
Unit level activities
Performed for each batch of product
Batch level activities
Performed for each batch of products
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  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

20. Activity-based vs. 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 may include non-manufacturing costs
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

21. The benefits of ABC are greatest when…
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
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

22. The benefits of ABC are greatest when...
Production activity involves diverse batch sizes and product complexity
Proportion of product-related costs incurred outside manufacturing is increasing relative to manufacturing costs
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

23. The benefits of ABC are greatest when…
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  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

24. 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  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

25. 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 on-going 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
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

26. Other activity-based costing issues
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
Need to account for the costs of unused capacity when budgeted costs have been used to generate activity-based product costs
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

27. Other activity-based costing issues
Behavioural issues
Change can be perceived as threatening
ABC may require changes in data collected and 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  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

28. Limitations of activity-based costing
Facility level costs
If a high level of facility-level costs are allocated to products, an arbitrary element enters into the product cost
Use of average costs
Unitised batch, product and facility-level costs can lead to product costs that are of limited use for decision making
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

29. 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 systems is used for activity management
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

30. Activity-based costing in service organisations
ABC can be difficult to implement in service firms, because
High levels of facility costs so fewer cost 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
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith