Activity Based Costing Flashcards
Activity Based Costing (ABC)
Why do we need ABC (3)
What is ABC?
What is the aim of ABC?
Why do we need ABC
- Managers require information for decision making
- Absorption costing methods have limitations which often provide inaccurate information for such purposes
- The traditional absorption methods adds overhead to the direct material and labour costs by an arbitrary sometimes single cost driver such as Direct labour hours
- In recent times this is more problematic due to the increasing amount of overheads and because it may result in poor decision making
- ABC is an alternative method first developed by highly technology based manufacturing companies
- The aim of ABC is to accumulate costs by organisational activity and allocate the costs to the product or service causing the activity
Activity Based Costing (ABC)
ABC has the following steps: (7 steps)
ABC has the following steps:
- Identify the different activities performed by the organisation
- Assign costs to activities
- Direct costs such as materials are directly allocated
- Indirect cost require the calculating of the total cost of each activity over the financial period (cost pool)
- Identify a cost driver (causation factor)
- Calculate a cost driver rate
- Assign part of the cost of each activity to different products based on the extent to which each product has caused the activity to occur (apply the cost driver rate)
Activity Based Costing (ABC) - Activities in ABC
What is an activity centre?
What is not feasible and what is the solution to this?
Activities in ABC
- An activity centre for the purposes of ABC is any part of the production process which the management wants a separate reporting of the cost of the activity involved
- It is not feasible to treat every single activity as a separate activity centre so companies will combine related activities into one centre to reduce the amount of detailed recording
Activity Based Costing (ABC) - Identification of activities
What are activities composed of?
How should they be chosen (2)?
Identification of activities guided by a number of factors: (3)
What are cost drivers?
- Activities are composed of the aggregation of units of work or tasks.
- The activities chosen should be at a reasonable level of aggregation based on costs versus benefits.
- Not too detailed, not too generalised.
Identification of activities guided by a number of factors:
- Significance in terms of cost incurred
- Importance to output processes
- Ability to identify single related cost driver
Cost drivers:
- factors that most closely influence the cost of an activity. Factors that cause costs to occur.
Examples of activities and relevant cost drivers (6)
The major distinguishing features of ABC systems are that within the two stage allocation process they rely on:
Therefore there are _____ general levels of activities recognised in ABC (and what are they - with description)
- a greater number of cost centres
- a greater number and variety of second-stage cost drivers.
Therefore there are four general levels of activities recognised in ABC
- Unit level activities
- i.e. every time a unit is produced e.g. machine hours, processing time, labour related activities
- Batch level activities
- i.e. every time a batch is produced e.g. setting up machines, purchase ordering, quality inspection
- Product level activities
- i.e. needed for that particular product, e.g. product testing, product design, inventory management
- Facility level activities
- i.e. relating to the overall production, e.g. plant occupancy, personal administration and training, grounds maintenance.
Examples of cost drivers are: (16)
Examples of cost drivers are:
- Machine set ups
- Purchase orders
- Quality inspections
- Production orders
- Engineering change orders
- Miles driven,
- Power consumed
- Shipments
- Material receipts
- Stock movements
- Maintenance requests
- Scrap/rework orders
- Computer hours logged
- Beds occupied
- Flight hours logged
- Machine time
Example
- Identify the activity –
- What is the activity cost pool?
- What is the cost driver –
- Calculate the cost driver rate –
- Calculate the costs assigned to both products –
- Identify the activity – setting up machinery
- What is the activity cost pool? - £20,000
- What is the cost driver – the number of set-ups
- Calculate the cost driver rate - £100 per machine set up
- Calculate the costs assigned to both products – fountain pen £ 12,000 and ball pen £8,000
Alpha makes many products, one of which is Product B. Alpha is considering adopting an ABC approach for setting its budget, in place of the current practice of absorbing overheads using direct labour hours. The main budget categories and cost driver details for the whole company for October are set out below, excluding direct material costs
a) Calculate the budgeted unit cost of product B for October assuming that a direct labour-based absorption method was used for all overheads
Alpha makes many products, one of which is Product B. Alpha is considering adopting an ABC approach for setting its budget, in place of the current practice of absorbing overheads using direct labour hours. The main budget categories and cost driver details for the whole company for October are set out below, excluding direct material costs
b) Calculate the budgeted unit cost of product B for October using an ABC approach
Costs absorbed by a product using an ABC approach could be higher than those absorbed if a traditional labour-based absorption system were use because:
- Small batch size
- High levels of non manufacturing activity
Benefits of ABC (7)
- Increases accuracy of product costing, therefore setting of selling prices. Traditional costing may result in cost subsidisation.
- Useful for cost comparison purposes
- Results in better product mix decisions
- Can be applied to other costs such as marketing costs to ascertain profitability of a particular customer
- Helps to focus more on cost consumption and what causes costs to be incurred. Can result in better cost management
- Non value adding activities become more visible and can be reduced or eliminated e.g use of electricity in non production areas
- It better supports other management techniques such as the balanced scorecard, activity based budgeting, continuous improvement and performance management
Limitations of ABC (6)
- Implementing ABC is challenging as requires organisational wide buy-in
- Less useful in organisations with high levels of direct materials and labour and minimal overheads
- Analysing processes and ascertaining activities as the basis for ABC is time consuming and arbitrary too
- It is more costly to implement and run ABC compared with the simpler traditional methods. Record keeping and separate calculations can be complex if there are many products.
- ABC still uses arbitrary methods of cost allocation in selecting drivers and combining activities e.g general/non specific overheads at facility level. In some companies these form a substantial part of the overhead costs.
