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 Chapter 8 Activity-based costing

2 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 Problems with conventional product costing systems  General features of conventional systems ÙDirect material and direct labour costs are traced to products ÙManufacturing overhead costs are allocated to products using a predetermined overhead rate ÙManufacturing overhead rate is calculated using some measure of production volume ÙNon-manufacturing costs are not assigned to products continued

3 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 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 Problems with conventional product costing systems  Failure to adapt to the changing business environment ÙIncreasing levels of non-volume-driven manufacturing overhead costs ÙIncreasing proportion of non-manufacturing costs ÙCauses of changes in costs ÙChanging product structures

5 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 Indicators of problems with a product costing system  Product costing systems are likely to result in inaccurate product cost when… ÙProportion of direct labour costs decrease ÙProportion of manufacturing overhead costs increase ÙProportion of manufacturing overhead costs, not related directly to production volume, increases ÙNon-manufacturing costs which are product- related become substantial; and ÙProduct diversity increases

6 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 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 Problems with costing in service businesses  Service firms tend to use firm-wide volume- based overhead rates ÙOverhead costs are increasing in importance and are increasingly non-volume driven  Customers are demanding more diverse and higher quality services ÙIncreases in product diversity and in overhead costs

8 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 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 ÙDistorted product costs ÙPoor cost control  The ABC method adopted, depends on the problems that need to be addressed

9 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 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 An activity-based costing model  The costing view 1.Measures the cost of activities 2.Assign activity costs or products  Activity management view  The nature of cost drivers ÙResource drivers ÙActivity drivers ÙRoot cause cost drivers

11 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 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 The costing view of ABC  Measuring the cost of activities ÙAssign costs to activity centres ÙIdentify and cost the activities performed in each activity centre  Assigning activity costs to products ÙCalculate the activity cost per unit of activity driver ÙPrepare a bill of activities for each product

13 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 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 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

15 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 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

16 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 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

17 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 Different forms of ABC  Which costs should be included in an ABC system? ÙThe 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

18 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 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 Activity-based hierarchy of costs and activities  Unit level activities ÙPerformed for each batch of product  Batch level activities ÙPerformed for each batch of products  Product level (or product-sustaining) activities ÙPerformed for specific products or product families  Facility level (or facility-sustaining) activities ÙNot usually included in product costs

20 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 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

21 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 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

22 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 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

23 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 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

24 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 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

25 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 Other activity-based costing issues  Variations in types of ABC include whether ÙActual (past) or budgeted costs are analysed ÙImplementation is a one-off project or an on- going system ÙCost 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

26 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 Other activity-based costing issues  Implications of excess capacity ÙABC estimates the cost of resources used to perform activities to produce and sell products, which may not always equal the cost of resources supplied ÙNeed to account for the costs of unused capacity when budgeted costs have been used to generate activity-based product costs continued

27 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 Other activity-based costing issues  Behavioural issues ÙChange can be perceived as threatening vABC may require changes in data collected and collection and analysis procedures ÙBottom-up change management may give some degree of ownership of any changes caused by ABC ÙManagement must be seen as committed to the change process

28 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 Limitations of activity-based costing  Facility level costs ÙIf a high level of facility-level costs are allocated to products, an arbitrary element enters into the product cost  Use of average costs ÙUnitised batch, product and facility-level costs can lead to product costs that are of limited use for decision making continued

29 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 Limitations of activity-based costing  Complexity ÙThe cost of updating an ABC system can be very high, but is needed to avoid producing outdated, irrelevant information ÙThe level of complexity increases when the systems is used for activity management

30 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 Activity-based costing in service organisations  ABC can be difficult to implement in service firms, because ÙHigh levels of facility costs so fewer cost can be included ÙIndividual activities are difficult to identify because they are non-repetitive ÙA non-repetitive production environment makes it difficult to identify service outputs