Management Accounting Week 7 Lecture PDF

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Lecture notes (ACC3200 Week 7) Good notes with written examples...

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Activity Based Costing - Specific features of ABC to calculate product cost. - Differences between traditional and abc features. - Used in Assignment. Features of traditional product costing systems - Direct material and direct labour costs are traced to products. - Overheads are aggregated into very large cost pools, sometimes for individual departments but often for the whole organisation (plant) - Overheads are allocated plant wide (one large cost pool and one universal cost driver) - Departmental, then cost pool for the department and then identify the cost driver. - Manufacturing overhead costs are allocated to products using a predetermined overhead rate, either plant wide or departmental. - Manufacturing overhead rate is calculated using some measures of production volume. - Exclusively used volume based cost drivers to drive overhead costs to products in traditional costing systems. - Drivers have directly associated with production, sales volume, untis, labour hours etc. - Some MOH are not driven by volume. There are fixed costs in manufacturing costs such as depreciation, insurance. - They stay fixed and not influenced by changes in production volume. - This will distort product cost as cost driver used is volume based. - Non-manufacturing costs are not assigned to products. - Only used to allocate manufacturing overhead costs to product. Traditional costing systems restrict themselves to manufacturing costs only. - In the long run you need to set a price that covers the full cost of the product. - You incur design, supply, and customer services cost. - Related to selling and making or product. Can be problematic if the price is only related to manufacturing. - Traditional costing systems are related to job costing, process costing and hybrid costing systems.

Problems with traditional product costing systems - Failure to adapt to the changing business environment - Increasing levels of non-volume driven manufacturing overhead costs. - Largely due to organisations having automation to replace manpower. - Observe more operation costs, insurance and rent associated with machinery. - Increasing proportions of non-manufacturing costs. - Value chain: upstream and downstream costs that are not manufacturing costs. - Proportion of price attributed to marketing (E.g. brands) - Significant costs to customer service and profitability. - Causes of changes in cost structures include: - Increased automation - Increasing product diversity and complexity - Increased emphasis on upstream and downstream areas of the value chain. - E.g. customer demand for improved service, quality, marketing and customer support - Increase of non-volume driver costs and non-manufacturing costs. Indicators of problems with a product costing systems Traditional product costing systems are likely to result in inaccurate product costs when: - Product diversity increases - Not just making a single product. - Range of products that are going through different and complex manufacturing processes. - Indicating that you adopt a contemporary costing system. - The proportion of direct labour costs decreases and the proportion of manufacturing overhead costs increases. - Use advanced costing system. - The proportion of manufacturing overhead costs, not related directly to production volume increases.

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Non-manufacturing costs that are product related become substantial. - Leads to Underestimating the product cost. Special products: need advanced costing system, therefore unsatisfied with traditional costing systems. - When competitors have lower costs and hence you may have underestimated the product cost or distorted the product cost.

Activity Based Costing - A method that can be used to measure both the cost of cost objects and the performance of activities. - Used to cost a product (cost of cost objects) - Summary of any object you want cost on (could be product, department, student, staff member) - ABC to measure cost of the cost object you choose. - Measure the performance of activities - Activity: a unit of work performed within the organisation. - E.g. Chief Examiner >> activities include teaching, administration, research. - E.g. Manufacture forum >> can have various activities related to corporate management, production, sales, etc. - Can help solve problems such as: - Distorted product costs - Allocates manufacturing overheads and non-manufacturing costs. - Figure out products that goes through complex processes vs simple processes. - Poor cost control. Examining the activities to control the cost. - Activity: A unit of work performed within the organisation.

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Identifies the key activities performed within the organisation. - Realistically you cannot capture all activity performed. Some activities are non-repetitive. - ABC will capture the repetitive, key activities. This will form a chain of activities as a basis of ABC. - Around the chain of activities we assign costs from resources accounts to each of the activities. - Once costs are accumulated under each activity then we can use activity driver (type of cost driver) to allocate the cost to the products that pass through the activities.

***For each department we are establishing a departmental cost pool and cost driver. ***

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ABC has activity cost pools. E.g. maintaining equipment, managing quality, machinery related costs such as depreciation. These activities will become activity pool. - First assign cost from general ledger accounts to the activity pools. - Costs allocated pools will identify its activity driver. The driver allocated the costs into final product based on consumption of activity in making the product. Instead of having departmental cost pools and drivers in ABC you establish ABC cost pools. These can be performed by different departments. - You first get a list of the key activities regardless of which department is performing the activity. - Then use activity driver to drive the cost to the products.

Activity Based Costing - Trace material and labour to cost objects as they are directly traceable. - Overhead costs are grouped into activity cost pools. - Use activity driver to drive the cost to the products.

Be Careful - Do not confuse overhead costs with activity cost pools - Overhead costs are taken from general ledger accounts. - This is the first stage to group them to activity pools. - Activity cost pool is a collection of the overheads that are used to carry out a particular activity. - We assume that for his cost to be grouped into the same activity cost pool it must share the same cost driver (activity driver) - Overhead costs represents all the manufacturing (and/ or non-manufacturing) costs of the organisation. - These are allocated to activity cost pools using resource drivers. - Activity cost pools are an aggregation of the overhead costs that are used to carry out a particular activity. - These costs are then applied collectively to cost objects (E.g. products) using a common activity cost driver. Activity based vs Traditional product costs - Traditional product costing is based on the use of volume based cost drivers - Not all aspects of manufacturing overhead vary with production volume. - E.g. fixed costs. - Activity based costing recognises both volume based and non-volume based cost drivers. - In ABC the quantity of activity drivers consumed by a product often depends on whether the activity is performed for each unit, batch or product line. - ABC uses both volume and non-volume cost drivers. - Different type of activities incurred in ABC. - We classify the cost as unit, batch, product and facility levels. - Only unit level costs are driven by volume based cost drivers. - Performed for each unit produced therefore use hours or units produced as a unit level cost.

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There are other levels that are all driven by non-volume based cost drivers. - E.g. Batch, product and facility level costs.

Activity based vs Traditional product costs - Traditional costing treats all costs as unit level. - Ignores product level and facility level costs. - Also ignores batch size. - Machine setup costs are batch level cost. Irrespective of how many units are produced in that batch. - Units produced in large batches consume a relatively low cost per unit batch costs. - E.g. setup costs per batch of units is $200 and 100 units were produced in each batch. Therefore the setup costs per unit is $2. - Scenario 1: The units produced per batch increased to 300 due to higher consumer demand. - However despite the increase in batch size, it still costs $200 to setup the batch leading to a setup cost of 67 cents per unit - Units increase but batch cost remains the same. - Cost per unit decreases. - Scenario 2: the setup cost per batch of units increase to $250 due to the introduction of more sophisticated machinery. However despite the increase cost, 100 units per batch still made leading to a setup cost of $2.50 per unit. - Batch cost increased - Cost per unit increases. - Distort product cost. Activity based vs Traditional product costs - Traditional costing systems tend to overcost high volume, relatively simple products and undercost volume, complex products. - High volume, simple products may use less activities - 100 units easily made and only uses 1 or 2 processes. - The overhead resource consumption at per unit level, each unit will consume less. - Low volume, complex products may use more activities. - It would involve more resources and activities. - At unit level you need to allocate more overhead resources to this product. - Traditional costing does not recognise these differences. - It simply uses production volume as a cost driver irrespective of whether the one unit is high volume simple product or low volume highly complex product. - Both counts as one unit. - Averaging out overhead costs through different products. - Activity based costing has an advantage as it does not undercost or overcost as it is based on this activities involved. Activity based costing model - ABC has two functions. To cost products or manage costs; results in two views of ABC.

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The costing view (ABC) - Measures the cost of activities - Assigns activity costs to cost objects (E.g. product) Activity based management view (ABM) - Provides information to manage activities, managing costs and other sources of customer value. - Cost control view. - Identify the information to manage activities. - E.g. some activities incur a lot of costs. Then reduce cost of activity by reducing consumption of activity therefore reduce product cost. Three types of cost drivers: - Resource drivers (ABC) - Activity drivers (ABC) - Root cause cost drivers (ABM) - The underlying factors that driver a cost to be incurred. - E.g. cost of loading (truck parked at loading dock) - A cost driver to predict the cost of loading will be labour hours. Cost prediction using cost driver. - If loading cost is very high: figure out the underlying reason for the long period for this high activity. - To reduce the cost: there may be more things you find that are the underlying reasons. - E.g. type of truck used, design of loading dock, labour not trained. - Hard to measure these factors but the facts can be worked out to reduce loading hours. - Can’t use for this factor for cost prediction purpose (i.e training of employees) but they will reduce the loading cost. - To manage cost and activities you need the root cause cost drivers. You can take corrective actions so the activities can be reduced. ABM view and costing view - Costing view: Assign costs from resource accounts to activity pool - From activity pools use activity driver to allocate costs to cost objects

Activity based costing terminology - Resource driver - A cost driver used to estimate the cost of resources (I.e overhead costs) consumed by an activity. - Assign costs from resource accounts to activity pools. - Activity driver - A cost driver used to estimate the cost of an activity consumed by the cost object - To allocate costs from activity pools to cost objects - Bill of activities - Identifies the activities, the activity cost per unit of activity driver, the quantity of activity drivers consumed and therefore the cost of the activities consumed by the product. - Summaries the key activities and allows you to calculate the activity cost per unit of the activity driver. - Based on this consumption of the activity to make each product then you can allocate costs to a particular product. Root cause cost driver - The underlying factors that cause activities to be performed and their costs to be incurred. Used to monitor and control what is happening in a business. - Provide information about root causes of activities, their value to customers and appropriate performance measures to use. - Can potentially be different to the activity driver. - E.g. Research department sends out blood samples for examination. What is the cost driver of this activity? - For cost estimation purpose - Number of blood samples sent - For cost management purposes - Skill level of staff - Why do we fundamentally need to send out the blood samples for someone else to do the examination.

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This is the root cause of the cost.

Costing view - Step one: Measuring the cost of activities - Use resource drivers to assign overhead costs to separate activity cost pools - (E.g. activity centres) for each activity - From general ledger accounts to cost pools - Determine the total costs for each type of activity - Step two: Assigning Activity costs to products - Choose an appropriate activity driver for each activity pool - Calculate cost per unit of activity driver (Total cost of activity/ Total quantity of its activity driver) - Assign activity costs to cost objects using activity drivers - Allocation = Consumption rate x cost per unit of activity driver - Prepare a bill of activities for each major product - Determine the total cost of each product (equals the cost of activities used to produce each product) - Aggregate all the activity costs for a product you will get the product cost. Activity based hierarchy of costs and activities - Unit level activities - Performed for each unit of product - Cost incurred for each extra unit - Particular activity performed for each extra unit produced - Batch level activities - Performed for each batch of product - Doesn’t matter if there are 100 or 1000 units in the batch, it is the same cost - Machine setup, delivery, quality control - Product level (or product sustaining) activities - Performed for specific products or product families - Cost of design for product - Trace the cost directly to a product. - Facility level (or facility sustaining) activities - Required to support the business as a whole, not caused by any particular product (so arbitrary calculation may still be inevitable unfortunately) - Salary of corporate managers, all activities they perform to oversee the whole manufacturing activities of the organisation is facility level. - The cost is incurred as the activities are performed for the organisation as a whole and not for the product itself. - Sometimes need to find an arbitrary way to allocate the costs.

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The list of key activities performed in the organisation - Some are volume and non-volume based Level of activity of activity driver is identified. Identified cost per unit of activity - Total cost of activity/ total cost driver of the activity Annual cost of product = This rate x actual consumption of the activity in making product Total activity cost per unit = total activity cost / number of units Total cost per unit = activity cost per unit + DM per unit Can incorporate non-manufacturing activities as well.

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Performed stage 1:Assign cost from general ledger accounts to activity pools For each activity we already know the total cost of the annual basis. Activity cost driver already known. - Need to know which activity uses which activity driver. Development and testing cost is product level cost. - Easily trace them to products being tests Renting factory - Facility based cost. Performed for the organisation as a whole.

Traditional Approach

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ABC

Get a predetermined overhead rate. One cost driver with direct labour hours as cost driver. Predetermined overhead rate =Total overhead / total direct labour hours = 212.50 per DLH Cost per unit of cost driver: How long it takes to make one unit of each product - 1 hour / 400 = 0.0025 DLH per unit (Lamington) - 1 hour / 500 = 0.002 DLH per unit Consumption of cost driver per unit =how much of the cost driver is used when creating one unit. Apply the overhead costs by multiplying the consumption of cost driver per unit x predetermined overhead rate. Then add the prime cost (DL + DM)

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Activity driver matched to each activity Unit based activity: - For each extra unit you will incur a standard amount of extra activity. Decide the cost driver for a particular activity. - You can decide the most appropriate cost driver. - Knowledge required for this judgement. Cost per unit of activity driver - Total quantity of activity/ total activity driver = cost per unit of activity driver. Based on the consumption of activity for each product, you accumulate the costs for each product. - Consumption of cost drivers = Cost per unit of activity driver x activity consumed per unit. Annual annual cost. - Also have to add the product costs. - Add proportion of the rental cost (facility cost). Allocated half of the rent (subjective) - Number of units produced: expected to make 100,000 units of both products therefore equally distribute the rental cost. - It can also be based on rental space used. - Product level costs are directly traceable to the product. - Add up this and to the facility level cost. - Facility cost goes directly to the product. - Subjective judgement on management. Number of units produced of both products. - Management decision and could be arbitrary and not fair. - It also could be allocated based on floor space. - Facility level cost must be subjectively allocated to the products. - Consumption of the cost driver (activity cost for product) plus all the other costs then divided by the number of costs produced. - Prime cost per unit needs to be determined as well. Traditional and activity based cost comparison. - Distortion for vanilla slice. - Consumption of the cost driver are different between the two products. - Distorted the cost of vanilla slice more than lamington as the production volume is only the cost driver for some activity. There are three other cost drivers that are non-volume based cost drivers. - Vanilla slice uses more of this cost driver than lamington. - Actual calculation of costs there is a significant difference due to the batch level costs consumed. - Production volume used as a cost driver when it is driven by batch level then the products cost will be more distorted. - This is because you chose the wrong cost driver (volume based driver) for a product that is supposed to consume a lot of batch level costs therefore should be using a batch level cost driver.

When to use ABC? - Specific conditions exists when you choose to use ABC. 1. When overhead costs are a significant proportion of total cost

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Manufacturing overhead costs are a large proportion of total manufacturing costs. Large part of overhead is not directly related to the production volume. - This is because the overhead costs that are indirect will be derived by nonvolume based cost driver. Significant increase with non-manufacturing costs along the value chain then ABC costing systems is preferred. When the business has a diverse product range and an individual’s product’s use of resources differs from its use of volume based cost drivers. - Simply average the cost over product volume for traditional costing systems. When production act...