Activity Based Costing systems. PDF

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Activity Based Costing systems....

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Managerial Accounting

12.10.20

Costing systems: Activity based costing

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Different activity cost pools and cost drivers

ABC 2 stages: Stage 1: o The cost of an organisations significant activities is first isolated into cost pools (an area that performs a significant activity for which costs can be accumulated) o Cost pools (and related cost) fall into the following broad categories, which collectively are known as a cost hierarchy: - Unit level (each unit produced) – Direct labour, materials - Batch level (A packet rather than individual) – Machine set up - Product line – Product engineering, marketing, product development - Distribution channel - Customer level - Facility sustaining – depreciation, rent, management

Managerial Accounting

12.10.20

Stage 2: o Involves identification of a cost driver for each pool (Cost driver represent activities that affect costs) o Use cost driver to allocate costs based on activity o Volume based cost drivers or transaction-based cost drivers o System then assigns overhead costs by using the cost drivers and assessing the relative proportion of the activity consumer by a product o This process results in the calculation of a pool rate, a cost for each ‘product line’ and an eventual cost per unit o Interested in cost per unit for products produced to identify appropriate mark up to add in order to set the right price Selection of cost driver o Firms should consider: - Degree of correlation (consumption of an activity and consumption of the cost driver) - Cost of measurement (using the second-best alternative for the cost driver if the first is not readily available or is too expensive) - Behavioural effects (how the cost driver selected will affect the behaviour of the individuals involved in the activity related to the cost driver) o ABS and information sources: - Interviews - Top-down approach How can ABC be used? o ABC assigns both manufacturing and non-manufacturing costs to products o Multiple activity cost pools and use multiple cost drivers to allocate costs o Allocation bases used usually differ from traditional costing systems - Uses more than one cost driver to allocate costs accurately o Can be used in internal decision-making as well as for inventory

Managerial Accounting

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Allocate costs Budgeted machine hours = cost driver Higher machine hours, higher machinery related costs – good cost driver Multiply pool rate by number of hours

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Cost per unit

12.10.20

Managerial Accounting

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Pool rate per hour calculated - £4.30/hour

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Mode 1: 1.2+4.2+8.42+1 = 14.82

12.10.20

Managerial Accounting

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12.10.20

Direct material and labour costs do not need to be allocated Can easily measure these costs and can assign the costs accordingly

o Both original and ABC target selling process are based on (Cost x 125%) – the mark-up is times by the costs

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Traditional costing caused cost distortion. Using the wrong system can lead to cost distortion

Managerial Accounting

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12.10.20

Traditional only uses 1 cost driver and all overheads placed into 1 cost pool

Absorption costing vs ABC costing o Similarities: - Direct and unit-level costs are allocated the same o Differences: - ABC allocates more indirect costs to products with smaller production volume and more complex set-up (because it explicitly takes into account the complexity when creating a product) ABC and decision-making o ABC improves pricing decisions because product costs are more accurate estimates of opportunity cost o Low volume high complexity products should get higher prices or be dropped

Managerial Accounting

12.10.20

o ABC focuses attention on reducing use of activities that are most associated with costs ABC and decision control o ABC requires more monitoring; this will have an impact on: - Time to identify and measure activities - Meetings to resolve disputes between managers, employees over activity drivers o ABC shifts decision rights over activity drivers to lower-level managers with specialised knowledge of the relation between costs and activities - Delegating decision making - Departmental managers could pick cost drivers that maximise their performance Costing systems and firm profitability o Traditional and ABC costing result in different cost figures o This will have an impact on: - Pricing decisions - Predict discontinuation decisions o Measuring product costs accurately enables a company to evaluate product profitability ABC in the service industry o ABC has been adopted now in the service industry as well as its origins in manufacturing firms

Correlation between cost and cost driver needs to be high

Cost incurred/Number calls

Managerial Accounting

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12.10.20

The more frequently the customer changes orders, the higher the costs incurred by the company Set right prices based on costs incurred based on different types of customers and costs incurred

When should ABC be used? Indirect costs are significant in proportion to direct costs – accuracy Good are complex requiring many inputs and processes Produces more than one product Sales are increasing, but profits declining – indicates something is wrong with current costing system o Product-line profit margins are difficult to explain o Different departments think costs are assigned inaccurately o Operations have changed significantly but the costing system hasn’t o o o o

Implementation issues o o o o

Lack of clear business purpose Lack of senior management commitment/support Delegating the project to consultants Individual and organisation resistance to change

o Cagwin and Bouwman: Positive association between ABC and improvement in ROI when: - ABC used with other strategic initiatives - Implemented in complex and diverse firms - Used in environments where costs are relatively important - There are limited numbers of intra-company transactions...