Management Accounting & Decisions II N12401

Lecture 6

Activity-Based Costing

by Hung Woan-Ting

2

Learning Objectives

1. To revisit the cost accumulation system

2. To differentiate traditional costing systems from activity-based costing (ABC) system

3. To appreciating the design and cost flows in ABC system

4. To appreciate the usefulness of ABC system in practice

3

1.0 Cost accumulation system

Generating cost information relevant to management

In need of a sound cost accumulation system:

Many indirect costs are relevant for decision-making (Support function resources? Joint resources?)

Attention directing system (Profitability?)

Many product-related decisions are not independent (demand for resources?)

4

1.1 Cost accumulation system

Different types of costing systems:

Direct costing systems

Indirect costs are not assigned to cost objects so that only contributions to indirect costs are reported

Appropriate where the majority of costs are direct

Require that indirect costs are incorporated at the special study stage

Traditional costing systems

Use simplified methods to allocate indirect costs to cost objects

Activity-based costing systems

Use detailed (sophisticated) methods to allocate indirect costs to cost objects

5

1.2 Rationale for development

Cost structure dominance? (Direct costs? Indirect costs?)

Cost drivers? (Volume-based?)

Range of products produced? (Limited? Wide range?)

Information costs?

Level of competition in business environment?

6

2.0 Traditional vs. ABC

7

2.0 Traditional vs. ABC

Both systems use a two-stage allocation process but differently

8

2.0 Traditional vs. ABC

Traditional systems allocate costs to departments

ABC systems allocate costs to activities that

require resources (ABC systems tend to

have more cost centres/cost pools)

traditional systems rely on a small

number of volume-based cost drivers (typically direct labour

or machine hours)

ABC systems use many activity-

based cost drivers

In Stage ONE In Stage TWO

9

2.1 Traditional vs. ABC

ABC systems seek to use only cause-and-effect cost drivers

traditional systems often rely on arbitrary allocation bases

ABC systems tend to establish separate cost driver rates for support departments

traditional systems merge support and production centre costs

Example:

Products HV (a high volume product) and LV (a low volume product) are two of several products produced by HWT Plc.

HV is made in large batches and LV is made in small batches

HV consumes 30%of DLHs and LV consumes 5%

Each product consumes 15% of the batch-related indirect costs

The traditional system uses DLH s as the cost driver and the ABC system uses the number of batches processed

All overheads (total = 1m) are batch-related

10

2.2 Traditional vs. ABC

Which product consumes higher level of resources?

If HV is discontinued, by how much will OH decline (in the long tern)?

Management receives different signals (which one is more reliable?)

Traditional: Drop HV

ABC: Drop LV 11

2.2 Traditional vs. ABC

Traditional System ABC System

HV LV HV LV

Sales 600K 150K 600K 150K

Direct costs 310K 40K 310K 40K

OH allocated

Profits/Losses

12

3.0 Designing ABC System

Involves four stages:

1.Identify the major activities that take place in an organization

Activities chosen should be at a reasonable level of

aggregation based on cost/benefit criteria Choice of activities influenced by 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

13

3.0 Designing ABC System

2.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

14

3.0 Designing ABC System

3. Determine the cost driver for each major activity

Drivers at this stage called activity drivers: provide a good explanation of costs of each activity pool, be easily measurable, data should be easy to obtain and identifiable with the product

Activity cost drivers consist of transaction and duration

drivers 4. Assign the cost of activities to products

The cost driver must be measurable so that it can be identified with individual products

15

3.1 Classification of activities

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 E.g.: Direct materials and labour, energy costs consumed in

proportion to machine processing time

Batch-related activities:

Performed each time a batch of goods is produced Costs vary with the number of batches made E.g.: set-ups, purchase ordering, first-item inspection activities

16

3.1 Classification of activities

Product/service sustaining activities:

Performed to enable the production of individual products or services

E.g.: activities related to maintaining an accurate bill of materials, preparing engineering change notices

Facility-sustaining (or business-sustaining) activities:

Performed to support the organization as a whole Common to all products and services (not allocated to

products/services) E.g.: plant management, property costs and salaries of general

administrative staff

17

3.2 Practicing with ABC

Case study:

Robot Toy Company manufactures two products, X-O-Tron and Mechoman.

Robot's overhead costs consist of setting up machines,

$400,000; machining, $900,000; and inspecting, $300,000. Information on the two products is: X-O-Tron Mechoman Direct labor hours 15,000 25,000 Machine setups 600 400 Machine hours 24,000 26,000 Inspections 800 700

18

3.2 Practicing with ABC

Required:

1. What is the overhead applied to X-O-Tron using traditional costing based on direct labour hours?

2. What is the overhead applied to Mechoman using traditional costing based on direct labour hours?

3. What is the overhead applied to X-O-Tron using ABC?

4. What is the overhead applied to Mechoman using ABC?

19

ABC

Step 1: Cost object

Step 2: Costs

Step 3: Cost driver (level)

OAR

Step 4: Assign cost Total:

X-O-Tron

Mechoman

Traditional Costing

Costs

Cost driver (level)

OAR

Assign cost

X-O-Tron

Mechoman

20

4.0 ABC/M in practice

Some obvious problems if implement ABC:

ABC requires more resources to implement, maintain and use initial analysis of activities is extensive and costly; analysis must be updated to maintain the accuracy of system; greater record keeping

Reported costs may not significantly differ from a less costly traditional system if indirect costs are a low proportion of total costs

Institutional resistance both internal and external personnel may have trouble understanding ABC

4.1 ABC/M in practice

Real life example: The Boeing Company. Although Boeing does not use ABC as part of its accounting system, it has experimented with Activity Based Management (ABM). ABM involves the use of ABC data in management decisions. In 2000, Boeing tested ABM in two operations at its Wichita plant. One of the operations studied was Boeings Phase I preassembly chemical bath operation. It found that Boeing incorrectly calculated the in-house cost of that operation at $7 per part. As a result, Boeing outsourced that operation at a cost of $4 per part. Boeing found that it could actually conduct some of those outsourced operations in house at a cost of $3.50 per part.

21

22

4.1 ABC/M in practice

Real life example (cont): Boeing identified additional costs that were associated with the outsourced operation. Boeings analysis of the activities that made up its Phase II structural bonding operation highlighted the fact that rework orders were an important Cost Driver for Manufacturing Overhead costs. An examination of the rework orders revealed that parts were being unnecessarily reworked. By introducing standardized quality criteria, Boeing was able to reduce the number of rework orders and thereby reduced its rework cost by 20%.

23

4.1 ABC/M in practice

Real life example: Mobil Oils implementation of ABC at its US Lubricants Division in the early 1990s, highlighted thousands of unprofitable product lines and an inefficient relationship with its suppliers. As a result of this analysis, the Division reduced the number of its products from around 12,000 to 5,000 within eight years of adopting ABC, and cut the number of its suppliers from over 2,000 to around 500 in that same period. The Divisions after-tax profit increased from zero to $150 million within that same eight-year period.

24

1. Read the following chapters in the prescribed textbooks

GNBCY Ch7

Drury Ch11

Optional readings on activity-based management (ABM): HNS Ch8 for introductory info on ABC/ABM (available in library and in Uni bookstore)

AHM Ch18 for a critical review on ABC/AbM (available in library and in Uni bookstore)

Currie (1998) Corporate Performance & ABM: How the Best Companies Make Their Systems Work, Int J of Strategic Cost Management, Autumn:25-33 (available via Library gateway)

2. Seminar 3 preparations:

Attempt the Question Sets attached at the back of this handout (indicative solutions in Moodle, please refer before seminar)

End of Lecture

Readings & Exe.