1. Activity-based Costing

2. Outcomes
Provide advice on the allocation of non-manufacturing overheads in manufacturing & service organisations for decision-making purposes
Allocate inter-service department overheads
Determine cost hierarchies in an ABC system
Apply product profitability analysis using ABC hierarchies
Discuss the application of ABC in service organisations & other management applications

3. Generating relevant cost information
There are 3 main reasons why a cost accumulation system is required to generate relevant cost information:
Many indirect costs are relevant for decision-making
The cost of many joint resources (e.g. support function costs) fluctuate according to the demand for them.
Product introduction, discontinuation, redesign decisions determine the demand for support function resources and thus future costs.
Costs of support functions are difficult to trace directly to cost objects.

4. Generating relevant cost information
An attention directing system is required to identify potentially unprofitable products that require more detailed special studies:
It is not feasible to periodically undertake special studies for all products or combination of product mixes.
Many product-related decisions are not independent:
Focusing only on individual products ignores impact that the culmination of many decisions will have on those joint resources that fluctuate according to the demand for them.

5. A comparison of traditional and ABC systems
Both systems use the two-stage allocation process.
In the first stage traditional systems tend to allocate costs to departments whereas ABC systems allocate costs to activities: (ABC systems tend to have more cost centres/cost pools)
In the second stage traditional systems rely on a small number of volume-based cost drivers (typically direct labour or machine hours) whereas ABC systems use many second stage cost drivers.
ABC systems seek to use only cause-and-effect cost drivers whereas traditional systems often rely on arbitrary allocation bases.
ABC systems tend to establish separate cost driver rates for support departments whereas traditional systems merge support and production centre costs.

6. The emergence of ABC systems
Traditional systems were appropriate when:
Direct costs were the dominant costs
Indirect costs were relatively small
Information costs were high
There was a lack of intense global competition
A limited range of products was produced.

7. Errors from relying on misleading product costs
Traditional costing systems use volume-based (e.g. direct labour and machine hours) second stage drivers but if volume bases are not the cause of indirect costs reported costs will be misleading.
Example
Products HV (a high volume product)and LV (a low volume product)are two of several products produced by a company. HV is made in large batches and LV is made in small batches. HV consumes 30%of DLHs and LV consumes 5% but each product consumes 15% of the batch-related indirect costs. The traditional system uses DLHs as the cost driver and the ABC system uses the number of batches processed. All overheads (total =£1m)are batch-related .

8. Non-manufacturing overheads
Reported product costs:
Traditional system reports misleading information — In the longer term overheads will not decline by £ if HV is discontinued.
ABC allocates on a cause-and-effect basis and shows high level of resources consumed by LV —The 2 costing systems report different messages (Traditional = Drop HV ABC = Drop LV).
Traditional system motivates the wrong strategy.

9. Designing ABC systems
Identify the major activities that take place in an organization:
The activities chosen should be at a reasonable level of aggregation based on cost/benefit criteria.
Choice of activities influenced by the total cost of the activity centre and the ability of a single cost driver to provide a satisfactory determinant of the cost of the activity.

10. Designing ABC systems
Assign costs to cost pools /cost centre for each activity:
Costs assigned to activity cost pools will include direct and indirect costs.
Resource cost drivers used to assign indirect costs.
Reliability of cost information will be reduced if arbitrary allocations are used to assign a significant proportion of costs to activities.

11. Designing ABC systems
Determine the cost driver for each major activity:
Drivers at this stage are called activity drivers. They should:
provide a good explanation of costs of each
activity pool.
be easily measurable
the data should be easy to obtain and identifiable with
the product.
Activity cost drivers consist of transaction and duration drivers.
Assign the cost of activities to products:
The cost driver must be measurable so that it can be identified with individual products.

12. Activity Hierarchies
Manufacturing activities can be classified along a cost hierarchy dimension consisting of:
Unit-level activities
Performed each time a unit of the product or service is produced.
Resources are consumed in proportion to the number of units produced or sold.
Examples — Direct materials and labour, energy costs and expenses consumed in proportion to machine processing time.

13. Activity Hierarchies Batch related activities
Performed each time a batch of goods is produced.
Costs vary with the number of batches made.
Examples include set-ups, purchase ordering and first-item inspection activities.

14. Activity Hierarchies Product/service sustaining activities
Performed to enable the production of individual products or services.
Examples include activities related to maintaining an accurate bill of materials, preparing engineering change notices.

15. Activity Hierarchies
Facility-sustaining (or business-sustaining) activities
Performed to support the organization as a whole.
Examples include plant management, property costs and salaries of general administrative staff.
Common to all products and services – not allocated to products/services.

16. Resource consumption models
ABC systems measure the cost of using resources and not the cost of supplying resources:
Cost of resources = Cost of resources Cost of unused supplied used capacity
Periodic financial statements measure the cost of resources supplied (i.e orders at a cost of £ in Example11.2).
ABC systems measure the cost of resources used (i.e orders at a cost of £20 per order in Example 11.2 shown on sheet 11.13).
The difference between the cost of resources supplied and the cost of resources used represents the cost of unused capacity (i.e orders at £20 per order =£40 000)

17. Resource consumption models
Unused capacity arises with committed resources because they must be acquired in discrete amounts in advance of usage.
With flexible resources supply can be continually adjusted to match exactly the usage of resources.
Managers make decisions that will result in a change of activity usage (e.g. discontinuation decisions reduce cost of resources used and increase the cost of unused capacity).
Cash flow consequences will only arise if action is taken to remove unused capacity by reducing spending on the supply of resources.
The periodic reporting of unused capacity signals the need for a change in the spending on the supply of resources

18. Activity 2.2 – Q 11.2 (Drury)
Product A B C D
Output in units
120
100 80
Costs per unit R
Direct material 40 50 30 60
Direct labour 28 21 14
Machine hours (per unit) 4 3 2
The four products are similar and are usually produced in production runs of 20 units and sold in batches of 10 units.
The production overhead is currently absorbed by using a machine hour rate and the total of the production overhead for the period has been analysed as follows:

19. Activity 2.2 – Q 11.2 (Drury)
Machine dept costs (rent, business rates, depreciation & supervisor
10 430
Set-up costs
5 250
Stores receiving
3 600
Inspection / quality control
2 100
Materials handling and dispatch
4 620
The cost drivers to be used are as listed below for the overhead costs shown:
Cost
Cost Driver
Set up costs
Number of production runs
Stores receiving
Requisitions raised
Inspection/quality control
Materials handling & dispatch
Orders executed
The number of requisitions raised on the stores was 20 for each product & the number of orders executed was 42, each order being for a batch of 10 of a product.

20. Activity 2.2 – Q 11.2 (Drury) = = = =
Total machine hours = (120 x 4) + (100 x 3) +(80 x 2) (120 x 3)
= 1300 hrs
Machine hour Total overheads
overhead rate Total Machine hours
1 300 hours
26 000/1300hrs £20 per machine hr = = = =

21. Activity 2.2 – Q 11.2 (Drury) Product A B C D Costs per unit R
Direct material 40 50 30 60
Direct labour 28 21 14
£20 per machine hr
(4x20) 80
(3x20)
(2x20)
Total Cost per unit
148
131 84
141
Units of output
120
100
Total cost
£17 760 £
£6 720
£16 920

22. Activity 2.2 – Q 11.2 (Drury) (b)
Machine dept costs
10 430
Machine Hours
1300
£8.02
Set-up costs
5 250
Production runs 21
250
Stores receiving
3 600
Requisitions raised
20 x 4 45
Inspection / quality control
2 100
100
Materials handling and dispatch
4 620
Number of orders executed 42
110
Cost
Cost Driver
Set up costs
Number of production runs
Stores receiving
Requisitions raised
Inspection/quality control
Materials handling & dispatch
Orders executed
The

23. Activity 2.2 – Q 11.2 (Drury) (b) Activity-based costing