Activity Based Costing Management Accounting

Review of Costing so far In the last lectures we have assumed that Overheads are ‘Plantwide’ – Meaning that all indirect (Fixed Costs) apply to all of the factory Overheads are costs which are not DIRECT This is a fairly simple way to view cost behaviour and as we have seen cost do not really behave in such a linear manner

Problems with Standard Costs Too Simple Changes to the methods of Production Reduction of Labour as a major cost of manufacturing More diverse products from a single company Overheads increasing/Labour Decreasing Therefore it is important that our methodology of cost accounting changes to reflect this

Activity Based Costing (ABC) Developed in the 1980’s by Kaplan and Johnson Rather than the Direct and Indirect cost distinction, ABC focuses on the Activities of the organisation In Standard Costing we use the unit of Production (Cost Object) as the basis of measuring cost In ABC we use the Activity as the basis of measuring cost

What are Activities Activities are anything that happens in the factory Setting up Machinery Scheduling Production Maintaining Equipment Ordering Materials Inspecting Materials

Cost Objects, Activities and Resources The Cost Object is the Product or Service that is Produced The Activity is anything that happens in producing the Cost Object Resources are consumed in producing the Cost Object

ABC in Operation A customer places and order Cost Object A customer places and order The order will require both activity and resources Activities All of the activities, both direct and indirect (Fixed and Variable) that go to produce the cost object Resources Resources are consumed to provide the product or service

The Overhead Cost Pool All of the Overheads that go into making a product are placed in an Overhead Cost Pool These replace the Indirect or Fixed Costs of standard costing This is then used as the allocation base of the Total Factory Overheads

Worked Example Page 125

What happens to the overhead costs? Costs change or shift when we move from Standard to Activity costing Worked Example page 127

Process Improvements Activity Based Costing provides much richer information to managers for the purposes of control Therefore as opposed to standard costing the managers can effect change to make the processes more effective This has developed into Activity Based Management (ABM) and Activity Based Budgeting (ABB)

The benefits of ABC ABC can provide much more information to managers ABC can be used to make efficiency changes to the production process and the overheads ABC is more accurate for costing products because it mirrors more accurately cost behaviour

The Limitations of ABC ABC requires the production process to be redesigned ABC is very expensive to implement ABC like Standard Costing does not necessarily cost the products in the right way Many firms which have implemented ABC have since abandoned it as it is too complex

The assumptions of ABC ABC makes a number of assumptions Cost is strictly proportional to its activity measure There is no real evidence for this Cost is not subject to economies of scale or diseconomies of scale This is definitely not true