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CHAPTER 12. Activity-based costing. 12 .1a. Generating relevant cost information • There are 3 main reasons why a cost accumulation system is required to generate relevant cost information: Many indirect costs are relevant for decision-making:
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CHAPTER 12 Activity-based costing
12.1a • Generating relevant cost information • • There are 3 main reasons why a cost accumulation systemis required to generate relevant cost information: • Many indirect costs are relevant for decision-making: • • The cost of many joint resources (e.g. support functioncosts) fluctuate according to the demand for them. • • Product introduction, discontinuation, redesigndecisions determine the demand for support functionresources and thus future costs. • • Costs of support functions are difficult to trace directlyto cost objects.
12.1b 2. An attention directing system is required to identify potentiallyunprofitable products that require more detailed special studies: • It is not feasible to periodically undertake special studies for all products orcombination of product mixes. 3. Many product-related decisions are not independent: • Focusing only on individual products ignores impact that the culmination ofmany decisions will have on those joint resources that fluctuate according tothe demand for them.
12.2 Types of cost systems •Direct costing systems: 1. Indirect costs are not assigned to cost objects so that onlycontributions to indirect costs are reported. 2. Appropriate where the majority of costs are direct. 3. Require that indirect costs are incorporated at the special study stage. •Traditional costing systems: 1. Use unsophisticated methods to allocate indirect costs to cost objects. • ABC systems: 1. Use sophisticated methods to allocate indirect costs tocost objects.
12.3 A comparison of traditional and ABC systems • Both systems use the two-stage allocation process. • In the first stage traditional systems tend to allocate costs to departments whereasABC systems allocate costs to activities:(ABC systems tend to have more cost centres/cost pools) • In the second stage traditional systems rely on a small number of volume-basedcost drivers (typically direct labour or machine hours) whereas ABC systems usemany second stage cost drivers. • ABC systems seek to use only cause-and-effect cost drivers whereas traditionalsystems often rely on arbitrary allocation bases. • ABC systems tend to establish separate cost driver rates for support departmentswhereas traditional systems merge support and production centre costs.
12.4 A two-stage allocation process (traditional costing system)
12.5 The two-stage allocationprocess (ABC system)
12.6 • The emergence of ABC systems • •Traditional systems were appropriate when: • Direct costs were the dominant costs. • Indirect costs were relatively small. • Information costs were high. • There was a lack of intense global competition. • A limited range of products was produced.
12.7a Errors from relying on misleading product costs •Traditional costing systems use volume-based (e.g. direct labour andmachine hours)second stage drivers but if volume bases are not the causeof indirect costs reported costs will be misleading. Example Products HV (a high volume product)and LV (a low volume product)are two of several products produced by a company. HV is made in large batches and LV is made in small batches. HV consumes 30%of DLHs and LV consumes 5% but each product consumes 15%of the batch-related indirect costs. The traditional system uses DLHs as the cost driver and the ABCsystem uses the number of batches processed. All overheads(total =£1m) are batch-related .
12.7b •Reported product costs: • Traditional system reports misleading information – in the longer termoverheads will not decline by £300 000 if HV is discontinued. • ABC allocates on a cause-and-effect basis and shows high level ofresources consumed by LV – the 2 costing systems report differentmessages (Traditional = Drop HV ABC = Drop LV). •Traditional system motivates the wrong strategy.
12.9a Exhibit 3 An illustration of cost assignment with an ABC system
12.9b (cont.)
12.10a Designing ABC systems 1. Identify the major activities that take place in an organization: • The activities chosen should be at a reasonable level ofaggregation based on cost/benefit criteria. • Choice of activities influenced by the total cost of the activity centre and the ability of a single cost driver toprovide a satisfactory determinant of the cost of theactivity.
12.10b Designing ABC systems (cont.) 2.Assign costs to cost pools /cost centre for each activity: • Costs assigned to activity cost pools will include directand indirect costs. • Resource cost drivers used to assign indirect costs. • Reliability of cost information will be reduced ifarbitrary allocations are used to assign a significantproportion of costs to activities.
12.10c Designing ABC systems (cont.) 3. Determine the cost driver for each major activity: • Drivers at this stage called activity drivers. They should: (a) provide a good explanation of costs of each activity pool. (b) be easily measurable (c) the data should be easy to obtain and identifiable with the product. • Activity cost drivers consist of three types (transaction, duration and intensity drivers). 4.Assign the cost of activities to products: • The cost driver must be measurable so that it can beidentified with individual products.
12.11a • Classification of activities • •Unit-level activities: • Performed each time a unit of the product or service isproduced. • Resources are consumed in proportion to the number ofunits produced or sold. • Examples – Direct materials and labour, energy costsand expenses consumedin proportion to machineprocessing time. • • Batch-related activities: • Performed each time a batch of goods is produced. • Costs vary with the number of batches made. • Examples include set-ups, purchase ordering and first-item inspection activities.
8.11b • Classification of activities (cont.) • • Product/service sustaining activities: • Performed to enable the production of individual products orservices. • Examples include activities related to maintaining an accurate billof materials, preparing engineering change notices. • • Facility-sustaining (or business-sustaining) activities: • Performed to support the organization as a whole. • Examples include plant management, property costs and salaries ofgeneral administrative staff. • Common to all products and services –.not allocated toproducts/services.
