F5 Performance Management

2 Section A: Specialist Cost and Management Accounting Techniques Designed to give you knowledge and application of: A1. Activity based costing A2. Target costing A3. Life-cycle costing A4. Throughput accounting A5. Environmental accounting A1. Activity based costing A2. Target costing A3. Life-cycle costing A4. Throughput accounting A5. Environmental accounting

3 Learning outcomes A1: Activity based costing (ABC)  Identify appropriate cost drivers under ABC. [1]  Calculate cost per driver and per unit, using ABC. [2]  Compare ABC and traditional methods of overhead absorption based on production units, labour hours or machine hours. [2]

4 Direct cost Identifiable easily Indirect cost Has to be linked to product using suitable base Cost of product / service Traditional costing Indirect cost Linked using a volume-related basis e.g. labour hours, machine hours etc. Introduction If indirect costs are high & organisation activities are complex Not all of them will vary with units produced They are affected by different factors & these factors must be recognised ABC

5 ABC is an approach to costing that identifies individual activities as fundamental cost objects. Appropriate cost drivers under ABC A cost driver is any factor which causes a change in the cost of an activity, e.g. the cost of placing an order will be governed by the number of orders placed and not by the units produced. Commonly used terms in ABC Allocation base Cost pool Cost object Factor used for allocation of overhead costs to the products or services (called cost driver under the ABC system) Anything for which a measurement of cost is necessary (same as cost centre or cost unit) Collective cost of manufacturing / service department or activity

6 Types of cost drivers Resource cost drivers used as an allocation base in order to assign the cost of a resource activity treated as cost pool e.g. staff salary, electricity, advertising Example Resources Cost Drivers for Axis Telecom ResourcesResources Cost Drivers PersonnelNumber of workers in shop StoreroomNumber of “Pick” used by shop EngineersTime worked in or for shop Material ManagementTime worked in or for shop AccountingTime worked in or for shop Research & DevelopmentNew codes developed for production QualityTime worked in or for shop UtilitiesSquare-footage

7 Activity cost drivers used as an allocation base in order to assign the activity costs to the cost objects i.e. products or services Example Activities & Cost Drivers at John Deere Component Works Sources: Robin Cooper & Robert S. Kaplan, The Design of Cost Management Systems ActivityDrivers Material purchasingMaterial cost Direct labour supportDirect labour cost Machine operationMachine-hours SetupSetup hours Production orderNumber of orders Materials handlingNumber of loads Part administrationNumber of parts General & administrativeAmount of value-added Types of cost drivers

8 Example If one unit of production requires two hours of machine time, then if production volume increases from 1,000 units to 2,000 units, the machine time required will also increase from 2,000 hours to 4,000 hours. Example Machine set-up normally takes place once, before each batch of production commences. The number of machine set- ups required will vary with the number of batches of production. However, they will not vary with the batch size. Volume-based Refers to activities which have a high correlation with number of units produced e.g. number of machine hours, direct labour hours, units output, etc. Non-volume based Refers to activities which have a high correlation with number of batches of production, number of purchases e.g. number of batches, purchases, etc. Classification of cost drivers Refer to Test Yourself 1 on page 5 Try this to test your knowledge on selecting a proper cost driver

9 Steps for the calculation of cost per driver Identify components of total overhead costs Identify the appropriate cost driver Calculate cost per driver: cost component/approp riate cost driver Calculate costs per driver & per unit using ABC Refer to Example on pages 6 & 7 Calculation of costs per unit 1. Calculate the costs per driver 2. Know how the activities relate to the manufacture of the product (or service) The extent to which each activity contributes to the production of a product 3. Allocate overheads to the products as (Cost per driver x Volume of driver) Ultimately, overhead cost per unit is derived as ‘total overhead cost allocated to a product/number of units produced’

10 Assigns the cost of support activities to cost objects Volume-based as well as non volume- based cost drivers are used Production process activities and support activities are the cost centres Many activity-based cost centres are established First assigns costs to the major activities then reallocate these costs to products / services Allocates service department costs to production cost centres Only volume based overhead allocation bases are used Activities are not recognised as cost centres Overheads tend to be pooled by departments First allocates costs to departments and then reallocates departmental costs to products / services Comparison ABC systemTraditional methods ABC and traditional methods of overhead absorption based on production units, labour hours or machine hour

11 RECAP  Identify appropriate cost drivers under ABC. [1]  Calculate cost per driver and per unit, using ABC. [2]  Compare ABC and traditional methods of overhead absorption based on production units, labour hours or machine hours. [2]