3.1 Activity-based costing

Question 1

Modern production environments now have

Answer 1

• More machinery and computerized manufacturing systems - results in production overheads such as machine depreciation being a larger proportion of total cost in comparison to direct costs
• Smaller batch sizes with increased diversity in product ranges - overheads are high in relation to direct costs and a high proportion of overhead activities (production scheduling, order handling and quality control) are not related to production volume
• Less use of direct labour due the the higher use of computerised systems

Question 2

The modern production environment has had the following impact on production costs:

Answer 2

• More overheads
• Less direct labour costs

Question 3

Issues with absorption costing in a modern bus environment

Answer 3

Overheads are charged to products in an arbitrary way on basis of volume of production, this can result in:
- Too little detail on most significant cost - largest cost of production is overheads but these are categorised together in one figure (lacks detail and not useful to management)
- Cost control is more difficult - management doesn’t know what the components are of production overheads and therefore can’t implement proper cost control
- Allocation of overheads is unrepresentative - often allocated based on direct labour hours which are becoming a smaller proportion and therefore doesn’t fairly reflect the relationship between products and overheads
- Poor pricing and decision making can result - This can all lead to total production cost being wrong which leads to poor pricing and production decisions

Question 4

Issues with marginal costing in a modern business environment

Answer 4

Products are valued at their marginal cost and fixed costs treated as period costs, this is useful when variable costs are large proportion of total costs, however in modern manufacturing environments and service sector:
- Variable costs might be small in relation to fixed costs
- Fixed costs might be fixed in relation to production volume, but might vary with other activities that are not volume-related or production-related (making this method inappropriate)

Question 5

Activity-based costing (ABC) is a

Answer 5

• Full product absorption costing method which allocates overheads to cost pools before absorbing them into units using cost drivers
• It identifies the activities (cost pools) of the production process and the extent to which individual products make use of those activities
• Costs are then estimated for each activity
• The number of times which the activity is expected to be carried out is also estimated and a cost driver calculated

= Estimated cost of pool / Estimated number of times activity is to be performed

Question 6

A cost pool is an

Answer 6

• Activity that consumes resources and for which overhead costs are identified and allocated
• For each cost pool there should be a cost driver

Question 7

A cost driver is a

Answer 7

• Unit of activity that consumes resources
• Or a factor influencing (or driving) the level of cost

Question 8

Three types of cost drivers:

Answer 8

• Transaction drivers - affected by the number of times a particular action is undertaken
• Duration drivers - affected by the length of time that it takes to perform the action
• Intensity drivers - determine what resources used in making of a product and apply a weighting to activities that reflect extra work

Question 9

There are five basic steps to calculating an activity based cost

Answer 9

Step 1: Group production overheads into activities, according to how they are driven
Step 2: Identify cost drivers for each activity, ie. what causes these activity costs to be incurred (choose most appropriate)
Step 3: Calculate a cost driver rate for each activity (activity cost / cost driver info)
Step 4: Absorb the activity costs into the product (apply the cost driver rate into individual products)
Step 5: Calculate the full production costs and profit or loss

Question 10

ABC could provide much more meaningful info about product costs and profits when:

Answer 10

• Overheads are high relative to direct costs
• Products or services are complex
• There is diversity in the product range
• Products are tailored to customer specifications
• Some products are sold in large numbers and others in small numbers

Question 11

The difference between traditional costing and ABC will also be dependent on the make up of the overhead cost - four types:

Answer 11

• Unit level activities - where the consumption of resources is very strongly correlated with the number of units produced (direct material & direct labour)
• Batch level activities - where the consumption of resources is very strongly correlated with the number of batches produced (machine set up)
• Product level activities - where the consumption of resources may be related to the existence of particular products (administration)
• Facility level activities - where the cost cannot be related in any way to the production of any particular product line (grounds maintenance)

Question 12

Advantages of ABC

Answer 12

• Improved accuracy of product costs
• Better understanding of overhead costs and the factors that drive them
• Fairer allocation of costs to products and services
• Facilitates better cost control
• Can be used in complex situations
• Can be applied beyond production
• Can be used in service and digital industries

Question 13

Disadvantages of ABC

Answer 13

• Not always relevant
• Still need arbitrary cost allocations
• Need to choose appropriate drivers and activities
• Complex
• Expensive to operate

Question 14

The implications of switching to ABC

Answer 14

• Pricing decisions can be improved because based on more realistic cost data
• Sales strategy can be more soundly based allowing sales staff to
  
  • target customers that appeared unprofitable under absorption costing but may be profitable under ABC
  • stop targeting customers that are now shown to offer low or negative sales margins
• Decision making can be improved - research, production and sales efforts can be directed towards those products identified as having higher sales margins
• Performance management can be improved - through focus on selling most profitable products, control of cost drivers and can be basis of budgeting and longer term forwarding planning

Question 15

Factors that should be considered when selecting cost drivers

Answer 15

• The cost driver for a particular activity is the factor that causes a change in the cost of the activity
• For the cost driver to be useful there must be an identifiable relationship between the cost and the cost driver
• Another consideration is the ease of accurately recording the number of cost drivers incurred (benefits must outweigh costs)