1 Bruce Bowhill University of Portsmouth ISBN: © 2008 John Wiley & Sons Ltd.

Chapter 6 Activity-Based Costing © 2008 John Wiley & Sons Ltd.

3 Value chain analysis Primary activities –Inbound logistics –Operations –Outbound logistics –Markeing and sales –Service Secondary activities –Firm infrastructure –Human resource management –Procurement –Technology development/ product or service development © 2008 John Wiley & Sons Ltd.

4 © 2008 John Wiley & Sons Ltd.

5 Cost behaviour and the value chain –Proportion of direct costs in many organisations has fallen –Historically most costs were incurred in operations. Significant costs now involved in ‘upstream’ and ‘downstream’ activities. –Different products and services make different demands of various activities and do not necessarily change in relation to volume. © 2008 John Wiley & Sons Ltd.

6 Steps in an activity-based costing exercise –Identify activities –Assign costs to activities –Identify cost drivers and a cost driver rate –Compute the cost per unit © 2008 John Wiley & Sons Ltd.

7 © 2008 John Wiley & Sons Ltd.

8 Identifying the activities © 2008 John Wiley & Sons Ltd.

9 Step 2 - Assigning costs to activities © 2008 John Wiley & Sons Ltd.

10 Step 3 – Identify cost drivers for each activity and a cost driver rate i) Cost driver Activity centreCost driver MachiningLabour hours worked machining. WeldingLabour hours worked welding tubes to form the frame. Set-up/ progress chasing’ Number of batches. PurchasingThe number of purchase orders. ReceivingThe number of purchase orders Issuing costsThe number of units produced © 2008 John Wiley & Sons Ltd.

11 Cost driver usage given 2,600 units of Alto and 400 Specials produced in the year. Activity AltoSpecialsTotal of cost driver Machining2,600* 1.5 = 3,900 hours 400*2 = 800 hours 4700 labour hours Welding2,600* 2 = 5400 hours 400*3 = 1,200 hours 6400 labour hours Set-up2,600 units/ 50 = 52 batches 400 units / 2 = 200 batches 252 batches Purchasing52 purchase orders 200 Purchase orders 252 purchase orders © 2008 John Wiley & Sons Ltd.

12 Activity AltoSpecialsTotal of cost driver Receiving2,600/ 100 = 26 receipts 400/4 = 100 receipts 126 receipts Issuing2600/25 = 104 issues 400/2 = 200 issues 304 issues © 2008 John Wiley & Sons Ltd.

13 Activity cost driver rate £ ActivityActivity cost pool Quantity of activity cost driver Activity cost driver rate £ Machining£37, £8.06 Welding£46, £7.29 Set-up£21, £83.86 Purchasing components£14, £56.10 Receiving components£10, £84.15 Issuing components£10, £34.88 £141,000 © 2008 John Wiley & Sons Ltd.

14 Identify the cost per item Alto Special activity Activity cost driver rate Use of cost driver Cost for Altos Use of cost driver Cost for Specials £ £ £ Machine shop 8.063,90031, ,446 Welding 7.295,20037, ,748 Set-up , ,771 Purchasing , ,220 Receiving , ,415 Issuing , ,975 Total cost82,425Total cost58,575 Cost per unit31.70 Cost per unit © 2008 John Wiley & Sons Ltd.

15 Cost of Alto £ Machine shop labour 1.5 £6 per hour 9.00 Welding cost centre labour 2 £8 per hour Materials Direct costs Overhead assigned Total cost © 2008 John Wiley & Sons Ltd.

16 Problems with identifying an accurate cost for decision making –Identifying activities –Costing the activities Unit level Batch level Product sustaining level Facility sustaining level –Selecting appropriate cost drivers and a cost per cost driver © 2008 John Wiley & Sons Ltd.

17 Conditions in which ABC may be appropriate –Indirect costs are a high proportion of total costs. –There is a diverse range of products or services provided. –There is competition and accurate costing is needed for pricing and in order to eliminate non-value-adding activities © 2008 John Wiley & Sons Ltd.

18 Applications of ABC –Profitability analysis given a cost hierarchy –Profitability analysis for different cost objects e.g. customer profitability analysis –Activity-based management © 2008 John Wiley & Sons Ltd.

19 Profitability analysis by product and in total © 2008 John Wiley & Sons Ltd.