24/02/20201LO2 &4: Activity Based Costing(ABC)Dr Fidelis AkangaLearning ObjectivesBy the end of this unit Explain the difference between ABC and TraditionalCosting System Explain why Traditional Costing systems can providemisleading information for decision-making Identify and explain EACH of the four stagesinvolved in designing ABC systems; Demonstrate how ABM can be developed from ABC24/02/20202Determining Costing per unit… • Product CostHow much overhead perunit? All direct costsOH cost perunit• Overhead cannot betraced easily and mustbe assigned withestimates• Absorption costingsystems adopt volumerelated allocation basese.g. direct labour hour,machine hour, labour costsCosting Products…• Product CostAll direct costsOH per unit24/02/20203A Two-Stage Allocation Process(Traditional Costing System)Example 1 Martin Ltd. Manufactures two products and cost of production: Product A Product B Materials cost per unit £130 £130 Direct Labour cost per unit £100 £100 Output (unit produced) 10 100 Total overhead costs £13,500 ActivityCost DriverCost£ABTotalA+bMachineryNo of machineHrs660040400440Set-upNo. of set up48004080120Handling anddispatchNo. of purchaseorders2100347 How much is the product cost under Traditional cost system using machine Hrs as abase for the allocation rate?24/02/20204Workings Overheads absorbed Allocation rate = Overhead costs ÷ machine Hrs =13,500 ÷ 440 = £30.68 / hour Allocated Overhead costs for each product = Rate xmachine Hrs A = 30.68 x 40 = £1,227 B = 30.68 x 400 = £12,272 Per unit Cost = Allocated Overhead costs / No of units A = 1227 / 10 = £123 B = 12272 / 100 = £123(a) Total Cost per unit based onmachine hour Product A Product B£ £ Direct Materials 130 130 Direct labour 100 100 Overheads absorbed Product A= 123 Product B= 123 Product cost per unit £353 £35324/02/20205Limitation of traditional costing Traditional (Absorption) costing systems adopt onlyone volume-related allocation bases e.g. directlabour hour and machine hour. Although differentelements (e.g.- rent, electricity, salary) of total OHgoes up or down for different reasons. High overheads are allocated to the products whichhas high bases but despite not using adequate levelof overhead. As a result, the high-volume simple products may beover-costed while the low-volume complex productsmay be under-costedTraditional Costing: Problems Traditional costing methods may lead to distortedproduct costs which may result in:◦ Fixing prices too low or too high◦ Pushing the wrong product◦ Dropping a profitable product◦ Introducing a loss-making product◦ Buying from outside suppliers under theimpression this is cheaper when this is not so In brief, misleading management and not supportingthe decision making process.24/02/20206The emergence of ABC System Traditional systems were appropriatewhen:1. Direct costs were the dominant costs2. Indirect costs were relatively small3. Information costs were high4. There was a lack of intense globalcompetition5. A limited range of products was produced.Activity-Based Costing (ABC) An overhead cost allocation system that allocatesoverhead to multiple activity cost pools and assignsthe activity cost pools to products or services by means ofcost drivers that represent the activities used. Cost PoolsSuitable cost driverFactory Electricity BillsTotal machine hours usedMachine set up costsNumber of set upsMaterial handling and dispatchcostsNo of orders receivedDesigners costsNo of product designed 24/02/20207ABC System ProcessDesigning an ABC System Identify and define activities and activitypools.Assign costs to activity cost pools. Select appropriate cost driver.Calculate activity rates.Assign costs to cost objects. Prepare management reports24/02/20208Classification of activitiesUnit-level activities:1. Performed each time a unit of the product or service is produced.2. Resources are consumed in proportion to the number of unitsproduced or sold.3. Examples —Direct materials and labour, energy costs andexpenses consumed in proportion to machine processing time.• Batch-related activities:1. Performed each time a batch of goods is produced.2. Costs vary with the number of batches made.3. Examples include set-ups, purchase ordering and first-iteminspection activities.Classification of activities Product/service sustaining activities:1. Performed to enable the production of individual products orservices.2. Examples include activities related to maintaining an accuratebill of materials, preparing engineering change notices. Facility-sustaining (or business-sustaining) activities:1. Performed to support the organization as a whole.2. Examples include plant management, property costs andsalaries of general administrative staff.3. Common to all products and services –.not allocated toproducts/services Customer-level (carried out for each customer, unrelated to aproduct)24/02/20209Activity Based Costing (ABC)Example Martin Ltd. Manufactures two products and cost of production: Product A Product B Materials cost per unit £130 £130 Direct Labour cost per unit £100 £100 Output (unit produced) 10 100 Total overhead costs £13500 ActivityCost DriverCost£ABTotalA+bMachineryNo of machine Hrs660040400440Set-upNo. of set up48004080120handling anddispatchNo. of purchaseorders2100347 How much is the product cost under ABC costing?Activity Based Costing (ABC)SolutionCompute the cost driver rate for each overhead activity =Activity Total cost÷ No of drivers ActivityCost£No of driverscost driver rateMachinery660044015Set-up480012040handling anddispatch21007300 24/02/202010Product A Allocating Activities overhead costs to products =cost driver rate x No of drivers consumed by theproduct Activitycost driverrateNo of driversconsumedCost per costdriverMachinery15x40=600Set-up40x40=1600handling300x3=900Allocatedoverhead costTotal 3100 ÷ 10units = 310 perunit Product B Activitycost driverrateNo ofdriversconsumedCost percost driverMachinery15x400=6000Set-up40x80=3200handling300x4=1200AllocatedoverheadcostTotal 10,400÷ 100 units= 104 perunit 24/02/202011Solution contd…… Total cost per unit = direct material cost + directLabour cost + allocated overhead cost A= 130 + 100 +310 = £540 B= 130 + 100 + 104 = £334 Under the Traditional system the total Product costper unit was (A) £353 (B) £353Additional Uses of ABC ABC is usually used to improve product costingaccuracy by tracing activity costs to the products. ABC can also be used to accurately determine thecosts of customers and suppliers, which could proveto be vital information. Activity Based Management (ABM)– Extends the use of ABC from product costing to acomprehensive management tool that focuses onreducing costs and improving processes anddecision making.24/02/202012Advantages of ABC Simpler concept – doing things costs money Takes account of diversity & complexity ofproducts Based on resource consumption Integrates non-financial and financialsystems Allows management of overheads More ‘accurate’ than absorption costingCompanies may decide not toapply ABC The high cost of operating an ABC system The lack of a “champion” and top management support to promoteABC The lack of sufficient employees with the necessary expertise The resources required to set up an ABC system may not beavailable Difficulty in replacing existing systems that have becomeembedded in the organisation and resistance to change byemployees Employee hostility if it is viewed purely as a cost reductiontechnique that will be accompanied by redundancies A low proportion of costs that can be more effectively controlledand assigned to cost objects using ABC techniques.24/02/202013Criticisms of ABC ABC unit costs must be used with care —They can suggest an inappropriate degree ofvariability. The concept of unused capacity within theresource consumption model is questionablefor physical resources. Reported costs may not significantly differfrom a less costly traditional system ifindirect costs are a low proportion of totalcosts.24/02/202014Reading List Drury, C. (2018), Management & CostAccounting, 10th Edition. Chapter 11.
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