After going through this module, you will be able to:
- Understand the concept of Activity Based Costing
- Distinguish between Cost drivers and Cost pool
- Know the various steps involved in using the method to prepare the Statement of Profit/Loss
- Understand the criticism and problems of the approach
- Explain how organisations switch to and implement Activity Based Costing
An alternative to absorption costing is activity based costing (ABC).
Activity based costing (ABC) involves the identification of the factors (cost drivers) which cause the costs of an organisation’s major activities. Support overheads are charged to products on the basis of their usage of an activity.
- For costs that vary with production level in the short term, the cost driver will be volume related (labour or machine hours).
- Overheads that vary with some other activity (and not volume of production) should be traced to products using transaction-based cost drivers such as production runs or number of orders received.
Activity based costing (ABC) involves the identification of the factors which cause the costs of an organisation’s major activities. Support overheads are charged to products on the basis of their usage of the factor causing the overheads.
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The major ideas behind activity based costing are as follows.
(a) Activities cause costs. Activities include ordering, materials handling, machining, assembly, production scheduling and despatching.
(b) Producing products creates demand for the activities.
(c) Costs are assigned to a product on the basis of the product’s consumption of the activities.
1.2. Outline of an ABC system
An ABC system operates as follows:
Step 1: Identify an organisation’s major activities.
Step 2: Identify the factors which determine the size of the costs of an activity/cause the costs of an activity. These are known as cost drivers.
A cost driver is a factor which causes a change in the cost of an activity.
Look at the following examples:
Cost Possible cost driver
Ordering costs Number of orders
Materials handling costs Number of production runs
Production scheduling costs Number of production runs
Despatching costs Number of despatches
Step 3: Collect the costs associated with each cost driver into what are known as cost pools.
Step 4: Charge costs to products on the basis of their usage of the activity. A product’s usage of an activity is measured by the number of the activity’s cost driver it generates.
The steps to be followed are as follows:
- identify the major activities that give rise to overheads (e.g. machining; despatching of orders)
- determine what causes the cost of each activity – the cost driver (e.g. machine hours; number of despatch orders)
- calculate the total cost for each activity – the cost pool (e.g. total machining costs; total costs of despatch department)
- calculate an absorption rate for each cost driver
- calculate the total overhead cost for each product manufactured
- calculate the overhead cost per unit for each product
Una manufactures three products: A, B, and C.
Data for the period just ended is as follows:
A B C
Production (units) 20,000 25,000 2,000
Sales price (per unit) $20 $20 $20
Material cost (per unit) $5 $10 $10
Labour hours (per unit) 2 hours 1 hour 1 hour
(Labour is paid at the rate of $5 per hour)
Overheads for the period were as follows:
Set-up costs 90,000
Cost driver data:
A B C
Machine hours per unit 2 2 2
Number of set-ups 10 13 2
Number of deliveries received 10 10 2
Number of orders despatched 20 20 20
(a) Calculate the cost (and hence profit) per unit, absorbing all the overheads on the basis of labour hours.
(b) Calculate the cost (and hence profit) per unit absorbing the overheads using an Activity Based
(a) Total overheads $190,000
Total labour hours
A 20,000 × 2 = 40,000
B 25,000 × 1 = 25,000
C 2,000 × 1 = 2,000
O.A.R. = = $2.836 per hour
A B C
Materials 5 10 10
Labour 10 5 5
Overheads (at $2.84 per hr.) 5.68 2.84 2.84
20.68 17.84 17.84
Selling price 20 20 20
Profit / Loss $(0.68) $2.16 $2.16
(b) Total A B C
(Cost per set up =) 90,000 36,000 46,800 7,200
(Cost per delivery =) 30,000 13,636 13,636 2,728
(Cost per order =) 15,000 5,000 5,000 5.000
(Cost per machine hour 🙂 55,000 23,404 29,256 2,340
190,000 78,040 94,692 17,268
Number of units 20,000 25,000 2,000
Overheads p.u. $3.90 $3.79 $8.63
A B C
Materials 5 10 10
Labour 10 5 5
Overheads 3.90 3.79 8.63
18.90 18.79 23.63
Selling price 20 20 20
Profit / Loss $1.10 $1.21 $(3.63)
1.3. Merits and criticisms of ABC
Merits of ABC are as follows:
(a) The complexity of manufacturing has increased, with wider product ranges, shorter product life cycles and more complex production processes. ABC recognises this complexity with its multiple cost drivers.
(b) In a more competitive environment, companies must be able to assess product profitability realistically. ABC facilitates a good understanding of what drives overhead costs.
(c) In modern manufacturing systems, overhead functions include a lot of non-factory-floor activities such as product design, quality control, and production planning and customer services. ABC is concerned with all overhead costs and so it takes management accounting beyond its ‘traditional’ factory floor boundaries.
Criticisms of ABC
It has been suggested by critics that activity based costing has some serious flaws.
(a) Some measure of (arbitrary) cost apportionment may still be required at the cost pooling stage for items like rent, rates and building depreciation.
(b) Can a single cost driver explain the cost behaviour of all items in its associated pool?
(c) Unless costs are caused by an activity that is measurable in quantitative terms and which can be related to production output, cost drivers will not be usable. What drives the cost of the annual external audit, for example?
(d) ABC is sometimes introduced because it is fashionable, not because it will be used by management to provide meaningful product costs or extra information. If management is not going to use ABC information, an absorption costing system may be simpler to operate.
(e) The cost of implementing and maintaining an ABC system can exceed the benefits of improved accuracy.
(f) Implementing ABC is often problematic.
1.4. Implications of switching to ABC
Switching to ABC has implications for pricing, sales strategy, performance management and decision making.
Switching to ABC is often problematic. Recent journal articles have highlighted the following issues.
(a) The incorrect belief that ABC can solve all an organisation’s problems
(b) Lack of the correct type of data
(c) Difficulty in determining appropriate cost drivers
An ABC system gives management a good understanding of the cost structures of making and selling a wide range of products. Switching to ABC can change cost per unit calculations substantially. If an organisation determines prices based on cost i.e. using cost-plus pricing, greater costing information will be very useful and prices will change.
As we have seen, the introduction of ABC has implications for the cost per unit, price and profit margin. For example, a product with few set-ups, material movements or inspections will have lower costs under ABC than traditional absorption costing. The organisation could decide to reduce the product’s selling price but if it is a high volume product, the number of units sold may not increase sufficiently to compensate for the loss in total revenue and contribution.
The information provided by analysing activities can support performance management provided it is used carefully and with full appreciation of its implications.
Before an ABC system can be implemented, management must analyse the organisation’s activities, determine the extent of their occurrence and establish the relationships between activities, products/services and their cost.
The information database also provides an insight into the way in which costs are structured and incurred in service and support departments. Traditionally it has been difficult to control the costs of such departments because of the lack of relationship between departmental output levels and departmental cost. With ABC, however, it is possible to control or manage the costs by managing the activities which underlie them by monitoring a number of key performance measures.
Many of ABC’s supporters claim that it can assist with decision making in a number of ways.
- Provides accurate and reliable cost information
- Establishes a long-run product cost
- Provides data which can be used to evaluate different ways of delivering business.
It is therefore particularly suited to the following types of decision.
- Promoting or discontinuing products or parts of the business
- Redesigning products and developing new products or new ways to do business
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