CH 08

Chapter 8
Activity-based costing
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 8-1
Outline
Problems with traditional product
costing systems
A simple approach to ABC
Activity-based vs traditional product
costs
Activity-based costing issues
Limitations of ABC
ABC in service organisations
Problems with traditional
product costing systems
Features of traditional product costing
systems
Direct costs are traced to products
Allocation of manufacturing overhead
costs are to products
Calculation of manufacturing overhead
rate
Non-manufacturing costs
(cont.)
Problems with traditional
product costing systems (cont.)
Failure to adapt to the changing
business environment
Manufacturing overhead is increasing as
a proportion of total manufacturing costs
and becoming more non-volume-driven
Non-manufacturing costs are increasing
as a proportion of total costs
Causes of changes in cost structures
include growing automation
(cont.)
Indicators of problems with a
product costing system
Traditional product costing systems are
likely to result in inaccurate product costs
when:
the proportion of direct labour costs decreases
the proportion of related and unrelated
manufacturing overhead costs increases
non-manufacturing costs that are product-
related become substantial
product diversity increases (cont.)

Indicators of problems with a
product costing system (cont.)

Costing in service firms
Service firms tend to use firm-wide,
volume-based overhead rates
Customer demands are increasing
Impact of increasing product diversity
and quality on the level of non-volume-
driven overhead costs
Accuracy of service costs derived from
traditional product costing systems

A methodology 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
The form of ABC method adopted
depends on the problems that need to
be addressed
An activity-based costing model
The costing view
Measures the cost of activities/objects
Improves the allocation of manufacturing
overhead costs to products
Activity management view
Provides information to manage activities,
managing costs and other sources of
customer value
The nature of cost drivers
Three different ways (cont.)
An activity-based costing model (cont.)
Source: Adapted from page 96 of Common Cents: The ABC Performance Breakthrough by Dr Peter B.B. Turney, president and CEO of Cost Technology
Inc., a management consulting firm specialising in ABC/ABM implementations, Cost Technology Inc., Beaverton, Oregon, 1991. Reprinted by permission
of the publisher. All rights reserved.

Costing view
Step one: measuring the cost of
activities
Use resource drivers to assign costs
Determine the total cost for each activity
Step two: assigning activity costs to
products
Calculate the cost per activity
Assign activity costs to cost objects
Determine the total cost for each product
Activity-based costing terminology
Activity Resource driver
A unit of work A cost driver used to
performed within the estimate the cost of
organisation resources consumed
Activity driver by an activity
A cost driver used to Root cause cost driver
estimate the cost of an The underlying factors
activity consumed by that cause activities to
the cost object be performed and their
Cost driver costs to be incurred
A factor or activity that
causes a cost to be
incurred
Different approaches to 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
material) to products and for activity
management
Step one: measure the cost of manufacturing
overhead activities
Identify major manufacturing overhead activities
Determine total (budgeted) cost of each activity
Step two: assign cost of manufacturing

overheads activities to products
Select suitable activity drivers for each activity
Estimate cost per unit of activity driver
Assign manufacturing cost to products based on the
quantity of activity drivers consumed (cont.)
(cont.)
(cont.)
A simple approach to ABC (cont.)

Which costs should be
included in an ABC system?
Depends on the purpose of the system,
which depends on the needs of
management (Marginal costing or
absorption costing)
A decision to include activity-based
management in an ABC system will
influence the range of costs included in
the system, as well as the type of cost
drivers identified
Marginal costing and
absorption costing
Marginal costing
Variable materials
Variable labour
Variable production overheads
Contribution = Sell Marginal cost
Absorption costing
Variable materials
Variable labour
Variable and fixed production overheads
Hierarchy of activities for ABC
Unit level activities
Performed for each unit of product
Batch level activities
Performed for each batch of product
Product level activities
Performed for specific products or product
families
Facility level activities
Required to support the business as a whole

Activity-based vs traditional
product costs
Traditional product costing assumes
product costs are driven by volume-based
cost drivers
Traditional costing ignores batch size as a
cost driver as large batches consume a
relatively low cost per unit of batch costs
Traditional product costs do not include
non-manufacturing costs
When to use ABC
Overhead costs are a significant
proportion of total cost and a large part of
overhead is not directly related to
production volume
The business has a diverse product
range, and individual products use of
resources differs from their use of
volume-based cost drivers
Production activity involves diverse batch
sizes and product complexity (cont.)
When to use ABC (cont.)
Proportion of product-related costs
incurred outside manufacturing is
increasing relative to manufacturing costs
Likelihood of high costs associated with
making inappropriate decisions based on
inaccurate product costs
The costs associated with the ABC
system is relatively low due to
sophisticated IT support

Impediments to introducing
ABC
Lack of awareness of ABC
Uncertainty about the potential benefits
to be gained from ABC
Concern about the extensive resources
required to implement ABC
Resistance to change from managers
and employees

Other activity-based
costing issues
Variations in types of ABC systems
include whether
direct labour or non-manufacturing costs
are included in an ABC system
actual or budgeted costs are analysed
ABC is implemented as a one-off project
or as an ongoing product costing system
cost objects other than products are
included
(cont.)
Implications of spare capacity
ABC estimates the cost of resources
used to perform activities to produce
and sell products
Committed resources are those
supplied in advance of being used in
production
When budgeted costs are used to
estimate activity costs, the committed
costs supplied will not always equal the
(cont.)
resources used
Behavioural issues in
activity-based costing
Change can be perceived as threatening
and so may be resisted
Bottom-up change management may give
employees some degree of ownership of
any changes associated with ABC
Management must be seen as committed
to the change process by being willing to
allow employees to play a role

Limitations of
activity-based costing
Facility level costs
Some systems arbitrarily assign facility level
costs to products
Use of average costs in decision making
Batch, product and facility level costs are divided
by the number of units produced leading to
product costs that are of limited use for decision
making
Desirable to use cost per unit in the short term;
total product cost in the longer term (cont.)

Limitations of
activity-based costing (cont.)
Complexity
The cost of updating an ABC system can
be very high, but is 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 more
extensive and detailed analysis of cost and
activities
Activity-based costing in
service organisations
ABC can be difficult to implement in
service firms because there are:
High levels of facility costs, so fewer costs
may be included
Individual activities are difficult to identify
because they are non-repetitive
A non-repetitive production environment
makes it difficult to identify service outputs
Despite these issues, ABC is used in many
major Australian service organisations
Summary
Traditional costing systems use broad
volume-based overhead rates which is
likely to distort costs
ABC may be suitable where there are high
levels of non-volume based costs, a
diverse product range and substantial non-
manufacturing product-related costs
The range of costs included in an ABC
system depends on the purpose of the
system
Implementation issues
Appendixa comprehensive
ABC system
Step one: measure the cost of activities
Identify activity centres
Assign costs to activity centres
Identify activities and resource drivers for each
activity centre
Assign activity centre costs to activities using
resource drivers
Step two: assign activity costs to products
Select suitable activity drivers for each activity centre
Estimate cost per unit of activity driver
Assign activity cost to products based on the quantity
of activity drivers consumed (cont.)
Activity-based product costs
(cont.)
Activity-based product costs
(cont.)

Simple vs comprehensive ABC
Comprehensive ABC system
More detailed and possibly more accurate
assignment of direct labour and overhead
to products
More detailed assignment of manufacturing
overheads to products
Inclusion of non-manufacturing product
related costs
More detailed identification and analysis of
activities across the business that may be
useful for activity-based management

CH 08

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 08

Uploaded by

Copyright:

Available Formats

Chapter 8

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Step two: assign cost of manufacturing

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

You might also like