Management Accounting Consultancy Report

MONASH
BUSINESS
SCHOOL

Chapter 8 (including appendix)

Activity Based Costing

For this topic you should be able to:
Recognise problems with traditional product costing systems
Describe the key features of activity-based costing (ABC)
Be able to use the ABC model to calculate product costs
Explain differences between product costs prepared under ABC and those under traditional costing
Recognise what types of organisations benefit from ABC and explain what these benefits are
Outline the impediments to introducing ABC and its limitations, and ways to overcome these.
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Features of traditional product costing systems
Direct material and direct labour costs are traced to products
Overheads are aggregated into very large cost pools, sometimes for individual departments but often for the whole organisation (plant)
Manufacturing overhead costs are allocated to products using a predetermined overhead rate, either plant wide or departmental
Manufacturing overhead rate is calculated using some measures of production volume (for example direct labour hours or machine hours)
Non-manufacturing costs are not assigned to products

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Direct materials
Overhead costs
Indirect materials
Indirect labour
Production facility costs
Etc.

Overhead cost pool
Plant-wide or departmental

Individual products or services
(cost objects)

Direct Labour
Trace
Trace
Allocate
Traditional costing systems
(using volume based cost driver)
Last week’s lecture

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Failure to adapt to the changing business environment
Increasing levels of non-volume-driven manufacturing overhead costs
Increasing proportions of non-manufacturing costs
Problems with traditional product costing systems
Causes of changes in cost structures include:
Increased automation
Increasing product diversity and complexity
Increased emphasis on upstream and downstream areas of the value chain, for example, customer demand for improved service, quality, marketing and customer support

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Indicators of problems with a product costing system

Traditional product costing systems are likely to result in inaccurate product costs when:
product diversity increases
the proportion of direct labour costs decreases and the proportion of manufacturing overhead costs increases
the proportion of manufacturing overhead costs, not related directly to production volume, increases
non-manufacturing costs that are product-related become substantial

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Activity-based costing
A method that can be used to measure both the cost of cost objects and the performance of activities

Can help solve problems such as:
Distorted product costs
Poor cost control

Activity:
A unit of work performed within the organisation

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Traditional approach (from week 6) …

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ABC approach

Resource Drivers
Activity
Drivers

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Direct materials
Transport equipment costs

Testing materials cost pool
Allocated using number of materials tested

Individual products or services or other cost objects

Direct Labour
Overhead costs:
Trace
Allocate using activity cost drivers
Activity Based Costing (ABC)
Supervisors’ salaries
Inspectors’ salaries
Other resource costs

Inspection cost pool
Allocated using number of units inspected

Set-up machines cost pools
Allocated using number of set-ups

Trace or allocate using resource drivers
Activity cost pools:

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Be careful…
Do not confuse overhead costs with activity cost pools (see previous slide)

Overhead costs represent all the manufacturing (and/or non-manufacturing) costs of the organisation
These are allocated to activity cost pools using resource drivers
Activity cost pools are an amalgamation of the overhead costs that are used to carry out a particular activity.
These costs are then applied collectively to cost objects (for example, products) using a common activity cost driver

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Activity-based vs. traditional product costs
Traditional product costing is based on the use of volume-based cost drivers
Not all aspects of manufacturing overhead vary with production volume, for example fixed costs
Activity-based costing recognises both volume-based and non-volume-based cost drivers

In ABC, the quantity of activity drivers consumed by a product often depends on whether the activity is performed for each unit, batch or product line.

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Traditional costing treats all costs as unit level
Ignores product level and facility level costs
Also ignores batch size

Activity-based vs. traditional product costs
Units produced in large batches consume a relatively low cost per unit of batch costs
For example, imagine the setup cost per batch of units is $200 and in August 100 units were produced in each batch ….. Therefore, the setup costs per unit is $2
Scenario 1: In September, the units produced per batch increased to 300 due to higher consumer demand. However, despite the increase in batch size, it still costs $200 to setup the batch leading to a setup cost of $0.67 per unit
Scenario 2: In September, the setup cost per batch of units increased to $250 due to the introduction of more sophisticated machinery. However, despite the increased cost, 100 units per batch are still made leading to a setup cost of $2.50 per unit.

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Activity-based vs. traditional product costs
Traditional costing systems tend to overcost high-volume, relatively simple products and undercost low-volume, complex products
High-volume, simple products may use less activities
Low-volume, complex products may use more activities
Traditional costing does not recognise these differences

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An activity-based costing model
The costing view (ABC)
Measures the cost of activities
Assigns activity costs to cost objects (e.g. products)
Activity-based management view (ABM)
Provides information to manage activities, managing costs and other sources of customer value
Three types of cost drivers
Resource drivers (ABC)
Activity drivers (ABC)
Root-cause cost drivers (ABM)

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The ABC framework

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Activity-based costing terminology
Resource driver
A cost driver used to estimate the cost of resources (i.e. overhead costs) consumed by an activity
Activity driver
A cost driver used to estimate the cost of an activity consumed by the cost object
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

STEP ONE
STEP TWO
STEP THREE

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The ABM framework

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Activity-based management terminology
Root-cause cost drivers
The underlying factors that cause activities to be performed and their costs to be incurred
Used to monitor and control what is happening in a business
Provide information about root causes of activities, their value to customers, and appropriate performance measures to use.
Can potentially be different to the activity driver

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The research department sends out blood samples for examination to an external pathology lab.
What is the cost driver of this activity?

For cost estimation purposes: Number of blood samples sent
For cost management purposes: Skill level of staff

Research Cost – $1.5 million – Pharmaceutical Company

Remember Week 2??

The costing view
Step one: Measuring the cost of activities
Use resource drivers to assign overhead costs to separate cost pools (for example, activity centres) for each activity
Determine the total cost for each type of activity
Step two: Assigning activity costs to products
Choose an appropriate activity driver for each activity
Calculate cost per unit of activity driver
Assign activity costs to cost objects using activity drivers
Prepare a bill of activities for each major product
Determine the total cost for each product (equals the cost of activities used to produce each product)
Total Cost of activity
Total quantity of its activity driver

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Activity-based hierarchy of costs and activities
Unit level activities
Performed for each unit of product
Batch level activities
Performed for each batch of product
Product level (or product-sustaining) activities
Performed for specific products or product families
Facility level (or facility-sustaining) activities
Required to support the business as a whole, not caused by any particular product (so arbitrary calculation may still be inevitable unfortunately)
Doesn’t matter if there are 100 or 150 units in the batch – same cost!

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The costing view: Bill of activities

Product: Hensley Tooth

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Lecture illustration

Yummy’s Bakery makes a number of different cakes and pastries. Two of its best-selling products are the Lamington and the Vanilla Slice.

It has a budgeted overhead amount of $425,000 for the coming year. It anticipates 2,000 direct labour hours.

400 Lamingtons can be produced an hour. 500 Vanilla Slice can be produced an hour.

The prime cost for a Lamington is $0.30 and $0.50 for a Vanilla Slice.

On the next slide is a list of the main activities performed at Yummy and their annual costs. These costs represent an allocation of all the bakery’s overhead costs. They were allocated to activities using resource drivers.

Five potential activity cost drivers and the annual quantity of each activity driver are also listed.

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Lecture illustration contd….

Activity Activity Cost
Process Receivables $15,000
Process Payables $25,000
Program Production $28,000
Load mixer $14,050
Operate mixer $45,900
Clean mixer $6,900
Fill trays $16,000
Set up ovens $50,000
Bake cakes $130,000
Pack cakes $80,000
Activity cost drivers Quantity
Kg processed 200,000
No. batches 1,000
No. cakes produced 800,000
No. invoices 5,000
No. purchase orders 2,500
 

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Lecture illustration contd….

The data for the Lamington and the Vanilla Slice is as follows:
 
 
 
 

The bakery also spent $2,150 in development and testing costs, of which $860 was spent on developing the Lamington and $1,290 spent on developing the Vanilla Slice. The rent of the facility that makes the Lamingtons and Vanilla Slices is $12,000.

LAMINGTON
Activity cost drivers Quantity used
No. batches 100
No. purchase orders 200
No. invoices 500
Kg processed 30,000
No. cakes produced 100,000
VANILLA SLICE
Activity cost drivers Quantity used
No. batches 200
No. purchase orders 800
No. invoices 1,000
Kg processed 50,000
No. cakes produced 100,000

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Lecture illustration contd…

Required:

Using traditional costing, with direct labour hours as a cost driver, calculate the product cost for the Lamington and Vanilla Slice.

Select an appropriate driver for each of the activities identified.

Calculate cost per unit of activity driver for the activities listed.

Use the information in parts 2 and 3 to determine a cost per unit for the Lamington and Vanilla Slice.

After all this: Reflect on the difference of calculating product costs using
this method and what we did last week!

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Lecture illustration solution
Question One
Budgeted overhead $425,000
Budget volume of cost driver 2,000 DLHrs
Predetermined overhead rate $212.50 per DLH

Lamington Vanilla Slice
400 produced/ hour = 0.0025 DLHrs 500 produced/ hour = 0.002 DLHrs
per unit per unit
Applied overhead $0.53 Applied overhead $0.43
plus prime cost $0.30 plus prime cost $0.50

Total cost $0.83 Total cost $0.93

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Lecture Illustration Solution (cont’d)
Question Two

Activity Activity Driver
Process Receivables No. invoices
Process Payables No. purchase orders
Program Production No. batches
Load Mixer No. batches
Operate Mixer Kg processed
Clean Mixer No. batches
Fill Trays No. cakes produced
Set up Ovens No. batches
Bake Cakes No. batches
Pack Cakes No. cakes produced

Cake Driver – get it?!

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Lecture illustration solution
Question Three
Activity Activity Cost Activity Driver Quantity Cost/unit of activity driver
Receivables $15,000 No. invoices 5000 $
Payables $25,000 No. purchase orders 2500 $
Program Production $28,000 No. batches 1000 $
Load Mixer $14,050 No. batches 1000 $
Operate Mixer $45,900 Kg processed 200000 $
Clean Mixer $6,900 No. batches 1000 $
Fill Trays $16,000 No. cakes produced 800000 $
Set up Ovens $50,000 No. batches 1000 $
Bake Cakes $130,000 No. batches 1000 $
Pack Cakes $80,000 No. cakes produced 800000 $

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Question Four
Activity Activity Driver Cost/unit of Lamington quantity Annual Cost
activity driver
Process Receivables No. invoices $3.00 500 $1,500
Process Payables No. purchase orders $10.00 200 $2,000
Program Production No. batches $28.00 100 $2,800
Load Mixer No. batches $14.05 100 $1,405
Operate Mixer Kg processed $0.23 30,000 $6,885
Clean Mixer No. batches $6.90 100 $690
Fill Trays No. cakes produced $0.02 100,000 $2,000
Set up Ovens No. batches $50.00 100 $5,000
Bake Cakes No. batches $130.00 100 $13,000
Pack Cakes No. cakes produced $0.10 100,000 $10,000

Develop and Test $ 860
Rent $6,000
$52140
Production volume 100,000
Overhead cost/unit $0.52
Prime cost per unit $0.30
Total cost per Lamington $0.82

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Question Four
Activity Activity Driver Cost/unit of Vanilla Slice Annual Cost
activity driver quantity
Process Receivables No. invoices $3.00 1,000 $ 3,000
Process Payables No. purchase orders $10.00 800 $ 8,000
Program Production No. batches $28.00 200 $ 5,600
Load Mixer No. batches $14.05 200 $ 2,810
Operate Mixer Kg processed $0.23 50,000 $11,475
Clean Mixer No. batches $6.90 200 $ 1,380
Fill Trays No. cakes produced $0.02 100,000 $ 2,000
Set up Ovens No. batches $50.00 200 $10,000
Bake Cakes No. batches $130.00 200 $26,000
Pack Cakes No. cakes produced $0.10 100,000 $10,000

Develop and Test $ 1,290
Rent $ 6,000
$87555
Production volume 100,000
Overhead cost/ unit $0.88
Prime cost per unit $0.50
Total Cost per Vanilla Slice $1.38

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Lecture illustration solution
Compare costs

Lamington Vanilla Slice Traditional $0.83 $0.93
Activity Based $0.82 $1.38

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When to use ABC?
When overhead costs are a significant proportion of total cost, and a large part of overhead is not directly related to production volume

When the business has a diverse product range, and an individual product’s use of resources differs from its use of volume-based cost drivers

When production activity involves diverse batch sizes and product complexity

Proportion of product-related costs such as research and development, customer support and so on are increasing relative to manufacturing costs

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

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When to use ABC – four key questions
1. Does the organisation make more than one product?
2. Does the organisation make multiple products using different processes?
3. Does the organisation have a high proportion of non-unit level costs?
4. Are overheads a significant proportion of total costs?
The organisation should definitely use ABC!

No
Yes

No
Yes

No
Yes

No
Yes

If an organisation makes one product, overhead cost per unit is simply total overhead costs divided by units produced.
If different products are made using similar processes, then the overhead costs relating to those processes will be largely identical, negating the need for ABC.
If most overhead costs are unit based, then overhead drivers will probably be volume-based drivers – traditional costing systems are usually able to capture these reasonably effectively
Though the organisation exhibits all the prior characteristics aligned with ABC use, if overhead costs are not significant then the implementation of ABC potentially outweighs the benefits

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Different forms of ABC
Simple approach: allocates manufacturing overhead costs to products

ABC system for indirect costs: allocates manufacturing overhead costs and non-manufacturing costs to products

Comprehensive system: allocates all product-related costs, except direct materials, to products and is used for activity management

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Which costs should be included in an ABC system?
Depends on the purpose of the system, which depends on the needs of management and on the problems that need to be addressed.

A decision to include activity-based management (ABM) in an ABC system will influence the range of costs included in the system, as well as the type of cost drivers identified

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Variations in forms of ABC
Actual (past) or budgeted costs are analysed

Cost objects, other than products, are included
For example, the costs of using particular suppliers or the cost of servicing particular customers
Implementation of ABC is a one-off project or an ongoing system

ABC is used to cost just one part of a business, with other parts relying on more traditional methods

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Impediments to introducing ABC
The benefits of ABC can be significant but the take-up rate has been relatively slow. Why?

Lack of awareness of ABC

Uncertainty about the potential benefits of ABC

Concerns about the extensive resources required to implement ABC

Resistance to change from managers and employees

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Impediments to introducing ABC
Behavioural issues in implementing activity-based costing
ABC may require substantial changes to:
The way businesses are managed
The type of data that is collected
Collection and analysis procedures
Implementation requires the time and effort of many people across the organisation (not just accountants!)
These changes can be perceived as threatening and therefore may be resisted

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Overcoming impediments of ABC
ABC must be accompanied by a change management plan that takes into account the extent of change needed and the personalities involved

Bottom-up change management (as opposed to top-down) may give employees some degree of ownership of any changes caused by ABC

Management must be seen as committed to the change process, but also willing to let their employees play a major role in developing and implementing ABC.

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Limitations of activity-based costing
Facility level costs
When a high level of facility level costs is allocated to products, an arbitrary element enters the product cost
These costs bear no obvious relationship to products
In lecture illustration: rent was split equally between products. Could we do better? Allocate based on square footage used to make products? Is that feasible/necessary?

Use of average costs in decision making
Batch, product level and facility level costs that have been divided by the number of units produced (as in lecture illustration) can lead to product costs that are of limited use for decision making if there is any element of customisation

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Limitations of activity-based costing
Complexity
The cost of updating an ABC system can be very high although it may be needed to avoid producing outdated, irrelevant information

The level of complexity increases when the system is used for both activity management and product costing

Activity-based management requires extensive and detailed analysis of costs and activities

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Limitations of activity-based costing
ABC can be difficult to implement in service firms
High levels of facility costs, so potential for many arbitrary allocations
Individual activities are difficult to identify because they are non-repetitive
A non-repetitive production environment makes it difficult to identify service outputs (so what is the cost object?)

Despite these issues, ABC is used in many major Australian service organisations

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Acknowledgement
Some of the slides contained in this presentation were adapted from:

PowerPoint slides to accompany Management Accounting: Information for managing and creating value 8e
Copyright © 2018 McGraw-Hill Australia Pty Ltd

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