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Activity-Based Costing

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Page 1: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

Activity-Based Costing

Page 2: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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WHAT IS ABC?

• Definition:

Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves identifying the activities that are responsible for the generation of costs.

Page 3: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Principles of ABC

The essential principles of ABC are that:

• Activities (not products) generate costs– Definition: An activity is a process which adds

value and consumes resources.

• Products consume activities

Page 4: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Cost drivers

• The important events in a business that generate costs are known in ABC terminology as cost drivers.

• A cost driver is any factor which causes a change in the cost of an activity.

Page 5: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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THE USE OF COST DRIVERS

• Short-term variable costs can be traced to products using volume related cost drivers such as direct labour hours, machine hours or direct materials used. The cost drivers may be different depending upon how the cost is generated or driven. For example, the cost of power will be generated by (‘driven by’) the number of machine hours.

• This analysis is similar to traditional cost accounting.

Page 6: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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THE USE OF COST DRIVERS

• For long-term variable costs however, volume related cost drivers will tend to be inappropriate. For example, the number and cost of salaried production engineers does not depend on direct labour hours or machine hours but (in the long-term) depends on the number of times a machine has to be set up for a production run. The activity which drives the cost is the number of set ups.

• Production engineer costs should thus be allocated to products based on the number of set ups.

• This contrasts with traditional practice which often absorbs all overheads based on direct labour hours and does not take into account that different activities have different cost drivers.

Page 7: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Types of activity measures

Simple countof the number oftimes an activity

occurs.

Transactiondriver

A measureof the amountof time neededfor an activity.

Durationdriver

Two types of activity measures:

Page 8: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Differences…

Traditional Costing The predetermined overhead rate is based on budgeted activity.

This results in applying all overhead costs

including unused, or idle capacity costs to

products.

Traditional Costing The predetermined overhead rate is based on budgeted activity.

This results in applying all overhead costs

including unused, or idle capacity costs to

products.

ABC Products are charged

for the costs of capacity they use – not

for the costs of capacity they don’t

use. Unused capacity costs are treated as

period expenses.

ABC Products are charged

for the costs of capacity they use – not

for the costs of capacity they don’t

use. Unused capacity costs are treated as

period expenses.

Page 9: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Examples of activity cost pools and activity measures:

Page 10: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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ExampleSyarikat ABC produces Product X. The cost data are as follows:

DM per unit RM15

DL per unit RM20

OH RM100,000

OH is allocated to relevant activities as follows:

OH (RM) Total activities

No. of activity required to

produce 1 unit of Product X

20,000 20,000 set-ups 1 set-up30,000 15,000 inspections 3 inspections40,000 20,000 quality controls 2 quality controls10,000 10,000 direct labour hours 4 DLH

Required: Calculate unit cost of Product X using (i) Conventional method, (ii) ABC method.

Page 11: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Product Cost using Conventional method

Page 12: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Mechanism of ABC

Page 13: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Product Cost using ABC method

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Example (continued)With reference to previous example, Syarikat ABC also produced another product known as Product Y. Product Y is an advanced version of Product X and hence, the production process of Product Y is more complicated than Product X. As a result, activities required to produce Product Y are different from Product X. To produce Product Y will involves the following activities:

3 set-up9 inspections6 quality controls2 DLH

Required: Calculate unit cost of Product Y using (i) Conventional method, (ii) ABC method.

Page 15: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Product Cost using Conventional method

Page 16: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Mechanism of ABC

Page 17: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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Product Cost using ABC method

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Conclusion of the Example:

Different Costs Lead to Different Selling Price

X Y X Y(RM) (RM) (RM) (RM)

DM 15 15 15 15DL 20 20 20 20OH 15 35 40 20Unit Product Cost 50 70 75 55

ABC Conventional

What’s the impact ?

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Conclusions• Each method is mathematically correct

• Each method is acceptable

• Each method yields a different cost figure, which will lead to different Gross Margin calculations

• Only Overhead is involved. Total Costs for the firm remain the same – they are just allocated to different cost objects within the firm

• Selection of the appropriate method and drivers should be based on experience, industry practices, as well as a cost-benefit analysis of each option under consideration

Page 20: Activity-Based Costing 2 WHAT IS ABC? Definition: Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves

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ABC vs. Simple Costing Schemes

• ABC is generally perceived to produce superior costing figures due to the use of multiple drivers across multiple levels

• ABC is only as good as the drivers selected, and their actual relationship to costs. Poorly chosen drivers will produce inaccurate costs, even with ABC

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A Cautionary Tale• A number of critical decisions can be made

using this information:– Should one product be “pushed” over another?– Should one product be dropped?

• Accounting for overhead costs is an imprecise science. Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable.

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Characteristics of SuccessfulABC Implementations

Strong topmanagement support

Strong topmanagement support

Cross-functionalinvolvement

Cross-functionalinvolvement

Link to evaluationsand rewards

Link to evaluationsand rewards

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ABC LimitationsSubstantial resourcesrequired to implement

and maintain.

Resistance tounfamiliar numbers

and reports.

Desire to fullyallocate all costs

to products.

Potentialmisinterpretation ofunfamiliar numbers.

Does not conform toGAAP. Two costing

systems may be needed.

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THE ENDTHE END

ADVISE & REMINDER: Now, your reading time….it’s your responsibility to read relevant chapters in the main text and additional recommended references !