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98 views24 pagesUMACRQ-15-M Strategic Management Accounting: Session 6: Activity-Based Costing (ABC) Revisited
The document discusses activity-based costing (ABC), an alternative approach to traditional overhead allocation methods. ABC assigns overhead costs to products based on their use of activities and cost drivers, rather than volume. It identifies activities, calculates activity costs, determines cost drivers, and assigns costs to products based on their consumption of each activity. While more accurate than traditional methods, ABC has issues with complexity and reliance on historic costs. Activity-based management takes ABC a step further to identify process improvements.
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0% found this document useful (0 votes)
98 views24 pagesUMACRQ-15-M Strategic Management Accounting: Session 6: Activity-Based Costing (ABC) Revisited
The document discusses activity-based costing (ABC), an alternative approach to traditional overhead allocation methods. ABC assigns overhead costs to products based on their use of activities and cost drivers, rather than volume. It identifies activities, calculates activity costs, determines cost drivers, and assigns costs to products based on their consumption of each activity. While more accurate than traditional methods, ABC has issues with complexity and reliance on historic costs. Activity-based management takes ABC a step further to identify process improvements.
Uploaded by
Ahmed MunawarCopyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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UMACRQ-15-M
Strategic Management
Accounting
Session 6: Activity-based Costing (ABC) Revisited
Session Objectives
• Examine issues with traditional approaches to overhead allocation
• Discuss the development of ABC
• Identify the ABC process
• Examine the issues, challenges and development of ABC
• Apply ABC to costing scenarios
• https://www.youtube.com/watch?v=ho7796-au8U
The Premise of Activity-Based Costing (ABC)
• ABC is a means of providing more meaningful management
accounting information, when traditional methods of allocating
overheads might be misleading to users of product cost information
(Smith, 1997, p.109).
• ABC recognises that many overheads are related to activities which
are independent of volume. ABC attempts to identify those cost
drivers which consume resources to determine process and product
costs.
Traditional Costing Systems
•Costing systems help us assign indirect costs to the cost of making
a product. The traditional/historical approach is through
absorption costing.
•Absorption costing was designed in manufacturing industries,
where most companies produced a narrow product range –
therefore, direct labour/materials were dominant costs
•There was little spent on overheads (e.g. personnel/administrative
services) – it was therefore acceptable to allocate them in an
arbitrary manner
Industrial Changes
• Absorption costing systems not always appropriate in today’s post-
manufacturing industrial environment, due to:
• Increased automation – Fewer direct labour hours
• The structure of costs has changed from mainly direct to indirect
(overhead) costs
• Production is no longer driven by volume, but by complexity of products
Increasingly, it is inappropriate to use recovery rates based on labour costs to
allocate overheads to product costs (labour costs are not the cause of all
overhead costs)
Problems with Absorption Costing
•The way costs are assigned to products (i.e. allocation bases) are
typically based on duration (labour hrs/machine hrs). This means high
volume products will absorb more overheads than low volume
products
•However, volume of output may be an unreliable guide to time/effort
spent by service depts. on each product (service departments
generate indirect costs). What if high and low volume products place
equal demands on service departments?
A New Approach
In modern production and service operations. there are many ‘support’
activities not related to output, e.g. Setting up machines/order
processing
These ‘activities’ actually cause COSTS
Cost objects create demand for activities, but not necessarily in relation
to volumes manufactured
Developing a New Approach –
The ABC Approach
ABC is based on:
• Products cause activities to take place
• Activities cause costs to be incurred
• Therefore – Products should be charged for their use of activities
rather than the volumes they are produced in
The ABC Process
1. Identify the different activities performed by business
2. Calculate total cost of each activity over financial period (activity cost
centres/pools)
3. Identify appropriate activity ‘cost drivers’ for each activity (the
causation factor)
4. Calculate cost driver rate (cost of 1 occurrence of cost driver)
5. Assign costs of activities to each product based on the amount each
product caused the activity to occur (Apply cost driver rate)
What are Cost Drivers?
•Cost Drivers are ‘Factors’ which cause the amount in the activity cost
centre to increase
E.g. The cost of ordering raw materials is DRIVEN by the number of
orders placed.
In this instance,
•Activity: Ordering materials
•Cost Driver: Orders placed
Activity Cost Centres and Cost Drivers: Examples
Activity Cost Centre Activity Cost Driver
Material Handling Quantities/value used
Purchasing No. of purchase orders
Design Costs Engineering hours
No. of engineering changes
Production scheduling No. of production runs
Production set-up No. of production set-ups
Production running costs Machine/run/cycle times
Cost Drivers
1. Volume-Based
• These are also used in absorption costing systems
• These are costs that vary with production levels, e.g. Direct
labour and machine hours
• It is assumed that a product’s consumption of overhead
resources is directly related to units produced. E.g.: Production
running costs (activity), No. of machine hours (cost driver)
2. Non-Volume-Based: Transaction Drivers
These are costs that vary with some other activity – not with the
volume of production.
e.g. Production scheduling (activity) – No. of production runs
(cost driver)
The ABC Process
1. Activity: Setting up machinery each time a batch of products is made
2. Total cost of activity: £9,000 per year
3. Activity cost driver: Each ‘set up’ performed
4. Cost driver rate: £100 per set up
5. If 60 batches of product X & 30 of product Y are made per year and each
batch requires a set up, the costings will be:
Product X: 60 x £100 = £6,000 Full £9,000 has been
Product Y: 30 x £100 = £3,000 assigned to the products
Absorption v Activity Based Costing
Absorption Costing Activity Based Costing
Assigns overheads to production Assigns overheads to each major
departments (cost centres) activity (activity cost centres)
Small number of cost centres Large number of activity cost
centres
Small number of allocation bases Large number of cost drivers
Production overheads only Product-related administrative costs
Less accurate costs More accurate costs (reflecting
cause-and-effect relationships)
Benefits of ABC
• ABC raises awareness of the activities which are driving overhead
costs.
• Improved cost control
• Facilitates the use of non-financial indicators to measure cost-drivers.
• Identification of non-value added activities
Worked Example: Job XYZ
Direct materials £200
Direct Labour £500
Machine Hours 14 hours
Activity Info:
Number of customer orders 25
Number of machine set ups 4
Cost of activities:
Order processing £7 per order
Machining services £12 per machine hour
Set up costs £5 per set up
Required: Calculate the cost of job XYZ
Solution: Job XYZ
Direct materials £200
Direct Labour £500
Direct Cost: £700
Activity Info:
Number of customer orders (25 x £7) £175
Number of machine set ups (4 x £5) £20
Machining Services (14 x £12) £168
Total Cost: £1063
Test Yourself
Direct Costs:
The Tardis Light as a Feather
Direct Material £100 £120
Direct Labour £50 £65
Activity based information for the budgeted level of production:
The Tardis Light as a Feather
Number of machine hours 5 6
Number of customer orders 102 135
Number of production set ups 2 3
Number of inspections 3 4
The cost driver rates of activities are:
Production run time £5 per machine hour
Order processing £6 per customer order
Production set up £10 per production set up
Inspection £7 per inspection
Solution
Tardis Light as a Feather
Direct Materials 100 120
Direct Labour 50 65
Production run time 5x5 = 25 6 x 5 = 30
Customer orders 102 x 6 = 612 135 x 6 = 810
Production set ups 2 x 10 = 20 3 x 10 = 30
Inspections 3 x 7 = 21 4 x 7 = 28
Total Cost £828 £1083
Issues with ABC
• ABC is still concerned with historic costs
• It may increase the number of apportionments, making it unwieldly
and complex in practice
• A single cost driver may not be sufficient in explaining the cost
behaviour of a whole pool
Also, see Hiromoto Approach: https://hbr.org/1988/07/another-
hidden-edge-japanese-management-accounting
Activity-Based Management
• Seal (2006, p.311) notes that ABC can be used to identify areas that would
benefit from process improvements. When used in this way, it is often
referred to as Activity-Based Management (ABM).
• ABM focuses on managing activities as a way of eliminating waste,
reducing delays and eliminating defects.
• Smith (1997, p.113) states that ABM requires a wider appreciation of the
concept of drivers. Focusing on cost drivers alone is insufficient, but
requires an investigation into how resources are consumed in “non-dollar”
areas
ABM
The focus for ABM becomes:
• Cost: Cost behaviour
• Quality: factors inhibiting performance
• Time: Bottlenecks and inertia
• Innovation: New product flexibility
(Smith, 1997, p.114)
Activities
• Attempt the questions on the sheet
