1 Activity-based costing

2 Introduction In the past, overhead costs were relatively small, and the problems arising from inappropriate overhead allocations were not so significant But nowadays, factories are highly automated, resulting in increasing depreciation charges, maintenance cost and machinery set-up cost Errors in overhead absorption may seriously affect the management decisions

3 The Activity-based costing (ABC) system is developed to provide better approach for assigning overheads to products and computing product costs

4 Limitation of traditional costing Traditional systems adopt volume-related allocation bases e.g. direct labour hour and machine hour. However, different resources are used in non-volume related support activities e.g. materials ordering, machinery set-up, production scheduling and first-item inspection

5 Traditional systems allocate overheads to products in proportion to their production volumes. High overheads are allocated to the high-volume products. As a result, the high- volume simple products may be over-costed while the low-volume complex products may be under-costed

6 Introduction to Activity-based costing The activity-based costing system asserts that products create demand for activities and activities bring about the costs to be incurred

7 What steps? 1. Identity major activities performed by the business 2. Calculate the total cost of each activity over the period (i.e. cost centre or cost pool) 3. Determine the cost driver for each activity. Cost drivers are the factors which cause the activity cost pool to increase 4. Calculate the cost driver rate (i.e. total cost in a cost pool/ no. of cost driver) 5. Assign the cost-centre overheads to the products according to their cost driver rates

8 Example

9 Martin Ltd. Manufactures tow products. Product A is a high- Volume product while Product B is a low-volume product. Details of production are shown as follows: Product AProduct B Materials cost per unit$130$130 Direct Labour cost per hour$50$50 Direct machine hour per unit4 hrs4 hrs Direct labour hour per unit2 hrs2 hrs Output No. of purchase orders34 No. of set up4080 Overhead costs are shown as follows:$ Factory power6600 Machinery set-up costs4800 Materials handling and dispatch

10 Required Calculate the product costs using: (a)Absorption costing based on machine hour (b)Activity-based costing

11 (a) Absorption costing based on machine hour Product AProduct B$ Direct Materials Direct labour Overheads ($13500*4/440) Product cost per unit *10+100*4

12 (b) Activity based Costing Product AProduct B$ Direct Materials Direct labour Overheads Factory power (6600*4/440)6060 Machinery set-up cost (4800*40/120*1/10)160 (4800*80/120*1/10)32 Materials handling & dispatch (2100*3/7*1/10)90 (2100*4/7*1/100)12 Product cost per unit540334

13 TraditionalActivity based Objective Ensure all overheads are absorbed into the total production cost The product cost enable the production cost and stock valuation Focus on the activities incurred Assign to each product only those costs that would be avoided if the production was discontinued Allocation of overhead the basis volume- related criteria e.g. machine hours and direct labour hours The basis of non- volume-related activities e.g. the no. of purchase order, production runs and deliveries

14 TraditionalActivity based Assignment of overhead Overheads cost are assigned to each department Overheads are assigned to the cost centre for each activities Adoption of overhead rate a single absorption rates is used Numerous cost drivers are used for different activities

15 Cost driver analysis Traditional costing systems assume that all overheads increase in proportion to the number of units produced In a complex manufacturing environment, a greater number of cost drivers are used for cost accumulation

16 Unit-level activities Costs are incurred for each unit Produced. For example, Direct materials Direct labour Factory power Cost per unit Batch-level activities Costs are incurred for each batch produced. For example, Purchase orders Production runs Number of inspection Cost per unit in batch Production -level activities Costs are incurred to support a product Types or process. For example, Engineering change orders Product development Process design Test routines Cost per unit in batch

17 Advantages of Activity-based costing More realistic cost assignment Better decision-making Better control over cost

18 Limitation of Activity-based costing Difficult to apportion common costs Difficult to implement Inconsistent with the generally accepted accounting principles (GAAP)