F5 Performance Management

Prepared by Faheem Ahmad

Overheads can also be absorbed into cost units using the following absorption bases:
Machine hour rate (when production is machine intensive)
Labour hour rate (when production is labour intensive)
Percentage of prime cost
Percentage of direct wages.
The overhead absorption rate (OAR) may be calculated as follows:
Budgeted overhead

Budgeted level of activity

The absorption basis is most commonly units of a product, labour hours, or machine
hours.
OAR =

Question 1: Ballard Ltd makes three products A, B and C. Each passes through two
departments: Machining and Assembly.
Labour hours used in each department by each product
Product A
Product B
Product C

Machining
1 hr
2 hrs
None

Assembly
1 hr
1/2 hr
4 hrs

Production is expected to be as follows:

Product A 1,000 units
Product B 2,000 units
Product C 500 units
Overheads are budgeted as follows:
Machining Assembly
$100,000 $150,000
Required: Calculate overhead cost/unit for all of the products.
Activity based costing
Definition
Activity based costing involves identification of the factors, which cause the costs of an
organization major activities. Support overheads are charged to products on the basis of
their usage of factor causing the overheads.
For any overhead absorption system to be accurate, there should be a direct relationship
between the overhead cost and its activity level.
Why ABC or
1

Reasons for the development of ABC

Traditional absorption costing system was developed in a time when most organizations
produced only a narrow range of products (so that products underwent similar operations
and consumed similar proportion of overheads). Overhead costs were only a small fraction
of total costs; direct material and direct labour hours were the largest proportion of total
costs. At that time information processing costs were high, therefore benefits of more
accurate system for overhead allocation would probably have been relatively small. At that
time, absorption of overheads on the basis of labour hours was appropriate because there
was a direct relationship between the overhead costs and labour hours.
In recent years, there is a dramatic fall in the costs of processing information due to
advancement in IT systems. With the advent of advanced manufacturing technology(AMT),
overheads are likely to be far more important and direct labour costs may account for as a
little proportion of products cost. Therefore it appears difficult to justify the use of direct
labour, direct material as the basis for absorbing overheads.
Support activities such as setting up, production scheduling, inspection and data processing
assist the efficient manufacture of a wide range of products. These activities are not
affected by changes in production volume. Now product range is wide and products are
complex in nature, and these products require more support activities. Producing goods
creates demand for activities. Ordering, material handlings, setups, number of devilries are
activities which cause costs. Under ABC, costs are assigned to products on the basis of the
products consumption of activities.
Major ideas behind activity based costing are as follows
1. Activities cause costs. Activities such as ordering, material handling, setup,
production scheduling and dispatching.
2. Producing products creates demand for the activities.
3. Costs are assigned to a product on the basis of the products consumption of the
activities.
The accuracy of any ABC system will depend of the appropriateness of the cost drivers.
There should be a direct relationship between the overhead cost and its selected cost
driver.
Cost Driver is a factor, which causes a change in the cost of an activity
Under ABC costs are driven by activities and not by production volume.
Some of the examples are as follows

Setup costs driven by number of manufacturing setups.

Order processing costs driven by number of orders.
Packing department costs . Driven by the number of packing orders
Engineering department costs .. number of production orders
Air condition maintenance . Number of air conditioning units

Question
Identify for a hospital x-ray department possible cost drivers for the following activities:
2

Equipment preparation
Patient preparation
Patient aftercare
Film processing
Film reporting

Cost Pool: Total (aggregate) cost of an activity is called cost pool.

June 2010 Past paper
Dec 2010 Past paper
Merits of ABC/ advantages of ABC
Merits of ABC are as follows.
1. ABC can be applied to all overhead costs, Not just the production overheads
2. Today complexity of manufacturing has increased with wider product range, shorter
product life cycles and complex production processes. ABC recognizes this complexity
with its multiple cost drivers.
3. It can be used to derive realistic costs in a complex business environment.
4. ABC focuses on the relationship b/w costs and their reasons i.e. cost drivers
5. ABC can be used just as easily in service costing as in product costing.
6. ABC assists in improving decision making and performance measurement process
ABC assists in decision as to which

New product/services to develop

Existing products/services to curtail or drop
Products/services should be promoted
Overhead costs to target

7. In many businesses, overhead costs are a significant proportion of total costs, and
management needs to understand the drivers of overhead costs in order to manage
business properly. Over head costs can be controlled by managing cost drivers
8. ABC helps in identification of value added and non value added costs so that non
value added items can be eliminate.
Disadvantages of ABC/ Criticism of ABC
1. The benefits obtained from ABC might not justify the costs.
2. It is impossible to allocate all overhead costs to specific activities. There may be no
suitable cost driver for particular overhead cost. It would be difficult to find a cost
driver for property cost (rent). What will be the cost driver for external audit cost or
chief executive salary? In that case, again apportionment on the basis of absorption
costing may be required.
3. There may be more than one cost drivers for one cost pool.
4. ABC can be more complex to explain to the stakeholders (accounts staff) of the
costing exercise. There may be lack of understanding. Many managers may not fully
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5.
6.
7.
8.

understand the concept of ABC and, as a result, they may fail to accept it as a means
of cost control.
Implementing ABC is often problematic. ABC needs new set of accounting records.
This necessitates sophisticated IT systems. Overall implementation of ABC may be
time consuming.
ABC is sometimes introduced because it is fashionable, in that case it will not be
beneficial. If overhead costs in an organization are nominal then absorption costing
system will be more suitable.
It is possible that ABC do not take into account some financial and non-financial
factors. There may be interdependencies of sales of different products,
interdependencies between costs and revenues.
The relationship between costs and activities may be based on historic observation,
which may not be a reliable guide to the future.

The implications of switching to ABC

The use of ABC has potentially significant commercial implications:
1. Pricing can be based on more realistic cost data

The traditional method of absorption of overheads into unit costs on a volume basis may
be misleading; with the result that product cost can, potentially, be materially
under/over stated.
There are two possibilities in relation to pricing
1. Cost plus pricing
2. Prices determined by market

Thus, where cost plus pricing is in use, products that have been materially under-costed
may be priced at levels that generate a loss whilst products that have been materially
over-costed may be priced at levels that are uncompetitive.
Alternatively, one could take the view that prices are determined by the market and
therefore if a company switches to ABC, it is not the price that would change but the
profit or margin per unit that would change. This can change attitudes within the
business. Previously high margin products (under a traditional overhead absorption
system) would be shown as less profitable. Salesmen (possibly profit motivated) can
begin to push the sales of different products seeking higher personal rewards.
(Assuming commission based on profits per unit sold)
It must always be remembered that if overheads are essentially fixed then they should
be ignored in business decision making. Switching to ABC can change reported profits
per unit but it is contribution per unit that is perhaps more important.
2. Sales strategy can be more soundly based.
More realistic product costs as a result of the use of ABC may enable sales staff to

Target customers that appeared unprofitable using absorption costing may be

profitable under ABC
4

Stop targeting customers or market segments that are now shown to offer low
or negative sales margin.

Front line sales staff will be able to negotiate prices with greater confidence
ABC can be used to review the profitability of products and services with a view to focusing
the efforts of sales staff upon those products and services, which offer the highest sales
margins.
3. Performance management and decision making can be improved
Research, production and sales effort can be directed towards those products and services
which ABC has identified as offering the highest sales margins.
ABC can influence decisions as to which

New product/services to develop

Existing products/services to curtail or drop
Products/services should be promoted
Overhead costs to target