Management Accounting → Topic 6 PDF

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Management Accounting  Topic 6 Activity Based Costing (Chapter 11) Learning Objectives • Explain under-costing and over-costing of products • Present three guidelines for refining a costing system • Distinguish between the traditional and the activity-based costing approaches to designing a costing system • Describe a four-part cost hierarchy • Cost products or services using activity-based costing • Use activity-based costing systems for activity-based management • Compare activity-based costing and department-costing systems • Appreciate the significance of organisational context issues in activity-based costing/ management system design and implementation Strategic Relevance of Costing Systems - Cost system accuracy is critical to a firm’s success - Costing systems help management estimate costs and accurately charge customers - Costing systems help management understand and manage customers - Costing systems affect manager/employee incentives (e.g. allocation affects expense budget and performance reports) - An accurate costing system can provide a competitive advantage

Traditional (Volume-based) Costing - Often use direct labour hours (DLH) or total machine hours (TMH) as the allocation bases; both are volume-related - Volume based costing may be a good strategic choice of some firms o This type of costing system is appropriate generally when direct costs are the major cost of a product or service and the activities supporting its production are relatively simple, low-cost, and homogenous across different product lines - Volume-based costing is often used by paper product manufacturers, procedures of agricultural products, and professional service firms - Problem; a substantial proportion of the overhead is proportional to the number of batch setups, the number of new designs etc, rather than volume Concept of Under/Over-costing and Activity-based costing - Product under-costing; o A product consumes a relatively high level of resources but is reported to have a relatively low total cost o Product over-costing; A product consumes a relatively low level of resources but it’s reported to have a relatively high total cost - Example o Jane, Mercedes and Cherie meet occassionaly for lunch; o Each one orders separate items Janes order amounts to $14 Mercedes Consumed $30 Cherie’s order is $16 $60 - Assuming they divide the bill equally, what is the average cost per lunch o 60/3  20 o Jane and Cherie are over costed o Mercedes is undercosted Activity-Based Costing (ABC) - A costing approach that assigns resource costs to cost objects based on activites performed for the cost objects - The two-stage cost assignment approach for indirect (support) costs; resource costs such as factory overhead are assigned to activity cost pools and then to cost objects (Jobs, clients, products, patients, etc) o Volume based systems assign factory overhead to a single plant or departmental cost pool first and then to products or services using a volumebased rate o ABC systems assign factory overhead costs to activities or activity cost pools using resource consumption cost drivers and then assign these cost to cost objects using activity consumption cost drivers  Activities generate transactions  Transactions generate costs  ABC traces costs to activities Example: Oculus Ltd

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Oculus Ltd manufactures two types of lenses, a normal lens (NL) and a complex lens (CL). Normal lenses sell for £60 each and complex lenses for £142 each. The sequence of steps to design, produce and distribute lenses, whether normal or complex, is as follows; o Design of products and process – The design department designs the moulds and defines processes needed (details of the manufacturing operations) o Manufacturing operations – lenses are moulded, finished, cleaned and inspected o Shipping and distribution – finished lenses are packed and sent to various customers To cost products, Oculus currently uses a single indirect-cost rate job costing system. The cost objects are the total costs of manufacturing and distributing 80,000 normal lenses (NL) and 20,000 complex lenses (CL)

Indirect costs of £2,900,000 are grouped into a single overhead cost pool, using 50,000 direct manufacturing labour-hours as the cost-allocation base. Oculus uses 36,000 direct manufacturing labour-hours to make NL and 14,000 direct manufacturing labour-hours to make CL. How much indirect costs are allocated to each product? o The indirect cost rate = £2,900,000 ÷ 50,000 = £58 o Indirect costs allocated to NL: 36,000 × £58 = £2,088,000 o Indirect costs allocated to CL: 14,000 × £58 = £812,000 Total costs = direct costs + allocated indirect costs o NL: Direct costs £2,320,000 + Allocated costs £2,088,000 = £4,408,000 o CL: Direct costs £1,180,000 + Allocated costs £812,000 = £1,992,000

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Per unit costs = total costs/ units o NL: £4,408,000 ÷ 80,000 = £55.10 o CL: £1,992,000 ÷ 20,000 = £99.60 Profit Margin

Refining the Costing System: Moving Towards ABC Considerations; - Direct-cost tracing; o Classify as many of the total costs as direct costs as is economically feasible - Indirect cost pools o Expand the number of cost pools until each off these pools is homogenous - Cost-allocation basis o Identify the preferred cost-allocation base for each indirect-cost pool Basis of implementing ABC - ABC systems refine costing systems by focusing on individual activities as the fundamental cost object o Calculates the cost of individual activities and assigns costs to cost objects such as products and services on the basis of the activities undertaken to produce each product or service - Major stages of implementation o Identify proper cost objects/ activities (Activity analysis and activity-based management) o Identify the right cost pools o Identify good cost drivers (allocation bases) o Cost assignment according to activities consumed for each cost pool Activity-based management - An activity is an even that causes the consumption of overhead resources - ABM focuses on activities incurred during production process, and make decisions to satisfy customers and improve profits based on activity-based information o Product Pricing and Mix decisions  ABC gives management insight into the cost structures for making and selling diverse products  It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs o Cost reduction and process improvement decisions  Manufacturing and distribution personnel use ABC systems to focus on cost reduction efforts  Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base

o Design decisions  Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs  Companies can work with their customers to evaluate costs and prices of alternative design choices Identifying cost pools - Cost pool is a “bucket” in which costs relating to a single activity measure in the ABC system are accumulated Cost pools and Cost hierarchies - A cost hierarchy is a categorisation of costs into different cost pools on the basis of different types of cost drivers (cost-allocation bases) or different degrees of difficult in determining cause-and-effect relationships - Four-part cost hierarchies o Output unit-level cost  Resources are sacrificed on activities performed on each individual unit of product or service e.g. energy, machine depreciation, repairs o Batch level costs  Resources are sacrificed on activities that are related to a group of units of product(s) or service (s) rather than to each individual unit of product or service e.g. set-up hours, procurement costs o Product-sustaining costs  Product-sustaining or service-sustaining costs are resources sacrificed on activities undertaken to support individual products or services e.g. design costs, engineering costs o Facility-sustaining costs  resources sacrificed on activities that cannot be traced to individual products or services but support the organisation as a whole e.g. general administration, rent, building security Identifying cost drivers (Allocation bases) - Cost drivers are factors that have a direct cause-effect relationship to a cost o An important qualitative difference between traditional costing vs ABC costing - Characteristics of a good cost driver o Cost of measurement should not exceed benefit of using cost driver o Easy to understand o Directly related to activity being performed - Identify cost drivers are used to produce the allocation rates (or cost driver rates) for cost assignment

Example: Occulus Ltd (continued) - A cross-functional team at Oculus Corporation identified key activities o Design products and processes o Set up moulding machine o Operate machines to manufacture lenses o Maintain and clean the moulds o Set up batches of finished lenses for shipment o Distribute lenses to customers o Administer and manage all processes at Oculus - Set-up data for the normal lens and the complex lens:

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Total set-up costs are $409,200 What is the set-up cost per set-up hour? o £409,200 ÷ 2,640 hours = £155 What is the set-up cost per direct manufacturing labour hour? o £409,200 ÷ 50,000 = £8.184 Cost allocation using direct manufacturing labour-hours

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Cost allocation using set-up hours

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Question: How should Oculus allocate set-up costs?

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o Set-up costs should be allocated on the basis of set-up hours because there is a strong cause-and-effect relationship between set-up related overhead costs and set-up hours.

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$1,600,000

Additional Information Activity DLH Setups Inspections Changes

Product 1 8,000 100 100 12

Product 2 2,000 20 4 4

Fabrication Product 1 Product 2 Total

DLH Hours 8,000 2,000 10,000

Rate $53 $53

Total $424,000 $106,000 $530,000

Assembly Product 1 Product 2 Total

DLH Hours 2,000 8,000 10,000

Rate $7 $7

Total $14,000 $56,000 $70,000

Setup; Product 1 Product 2 Total

DLH Hours 100 20 120

Rate $4,000 $4,000

Total $400,000 $80,000 $480,000

Quality control Product 1 Product 2 Total

DLH Hours 100 4 104

Rate $3,000 $3,000

Total $300,000 $12,000 $312,000

Engineering Product 1 Product 2 Total

DLH Hours 12 4 16

Rate $13,000 $13,000

Total $156,000 $52,000 $208,000

Distortion in Product costs

Evaluation of ABC - ABC is most beneficial when: o significant amounts of indirect costs are allocated using only one or two cost pools. o all or most costs are identified as output unit-level costs. o products make diverse demands on resources (overheads in particular) because of differences in volume, process steps, batch size or complexity. o products that a company is well suited to make and sell show small profits while products for which a company is less suited show large profits. o complex products appear to be very profitable and simple products appear to be losing money. o operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services. o increase in market competition. - Implementing ABC is costly o ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools. o Activity-cost rates also need to be updated regularly. o Very detailed ABC systems are costly to operate and difficult to understand. o Resistance for change o ABC does not conform with GAAP ABC for Merchandising and Servicing Companies - The general approach to ABC in the service and merchandising areas is very similar approach in manufacturing - Costs are divided into homogenous costs pools and classified as output unit-level, batch level, product or service-sustaining and facility-sustaining costs - The cost pools correspond to key activities - Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool...