MA Week 5 Flashcards
Limits of traditional overhead absorption methods - Multi-product businesses (vs Single-product)
- Traditional costing method = using 1 allocation base
- Overhead absorption should depend on the RESOURCES the products use.
- Traditional cost allocation methods UNIFORMLY assign overhead costs to cost units using 1 COST DRIVER (eg. direct labour hours) & calculates a blanket rate
- Difficulty in multi-product biz: HIGHLY SPECIALISED products (high end) usually absorb less labour/machine hours than less specialised, HIGH-VOLUME products (low end), although they should be absorbing more
- May lead to UNDER-COSTING of highly specialised products, OVER-COSTING of standardised, high-volume products
- HIGH END products consume most of the SUPPORT RESOURCES (ie. overhead costs), eg. after-sales assistance
- Under traditional methods, low end, high-volume products ABSORB MOST of the overheads, even though they don’t cause them
Limits of traditional overhead absorption methods - Modern competitive environments
- Shift from direct-labour intensive to CAPITAL-INTENSIVE & machine-based production
- From mass production to high levels of SPECIALISATION & product diversification (eg. design, customer care, features)
- INCREASE in overhead costs
- Businesses need more accurate cost information for decision making
eg. Tesla made by robots, low human intervention (low direct labour hours?)
When is traditional costing suitable?
Single-product businesses.
eg. Mass production of Ford’s Model T in a standardised way, takes < half a min to manufacture
2 + 3 differences between ABC & Traditional costing
- Activity cost pools/activity centres VS Departments/plants (intermediary)
- Activity cost driver rates VS Overhead absorption rates (both similar in principle)
- More complex
- Higher cost of implementation
- More benefits
What is a cost pool? What is an advantage of using activity cost pool?
A combination of similar costs.
Activity cost pools come from various similar activities.
Bring people together, no walls between departments
4 types of transactions that drive overhead costs
- Logistical (most costs) - movement of materials from 1 location to another
- Balancing - balance supply and demand, by authorising forecasts
- Quality - proper quality checking/certification
- Change - update basic manufacturing information systems to accommodate changes in engineering designs, schedules etc.
Reasons for the development of ABC
by Cooper & Kaplan (1988)
- when using ABC, higher production of low end items is actually more profitable
- Existing cost systems frequently UNDERSTATE profits on high-volume products & OVERSTATE profits on speciality items
- ABC helps managers find out HOW the company designed, produced & delivered products
- focus on which ACTIVITIES don’t add value to biz, then cut costs
5 steps in ABC
*if over- or under-price, can have direct -ve impact on company profits. So, charge diff. prices if we knew the costs better.
- Cost pools - group overheads into activities
- Cost driver for each activity
3, Activity cost driver rate for each activity - Absorb activity costs into the PRODUCT (overheads)
- Full production cost (adding direct costs to 4.)
Activity cost driver rate
Total cost of activity / No. of cost driver units
4 levels of activity / Hierarchy of costs
- ABC won’t add value if most overheads are unit-level & facility-level activities. Traditional vs ABC approach would give similar product costs.
- At bottom level is direct costs only, so don’t need to use ABC
!! ABC add value for BATCH- & PRODUCT-level activities.
- Unit-level (bottom level) - activities w/ a strong correlation between costs and volume of products, eg. DIRECT MATERIAL, DIRECT LABOUR
- Batch-level - each batch has own cost
- Product-level - each product has its own costs, eg. Coke, Pepsi
- Facility-level (top level)
- eg. Nestle’s brand. To sustain the whole organisation. eg. social media to ensure Tesla’s name is not tarnished
7 situations when a company should consider moving on from traditional absorption costing to an ABC system
- Indirect costs are significant in proportion to direct costs
- Goods are complex, requiring many inputs & processes
- Low-volume products are PROFITABLE while high-volume products are not
- Diff. departments believe costs are assigned inaccurately
- Loses bids it thought will win, keeps winning bids it will lose
- Operations have changed (developed) significantly, but the costing system has not changed
- Introduction of new models resulting in HIGHER SALES, but OVERALL NET INCOME declines
Why is ABC not accepted under IAS2?
ABC includes non-mfg costs, or even excludes mfg costs.
Can only use if we make adjustments to the numbers, ie. excludes non-mfg overheads + include mfg overheads
Remember, these costs are to be used for making DECISIONS, not for valuing inventory and cost of goods sold.
Time-driven ABC
+ name of system used to feed data automatically into a TDABC system
Issues in health service
Time-driven ABC has only 1 cost driver - time.
It measures the COSTS to perform an ACTIVITY, & the TIME taken to perform it.
^Regular ABC has several cost drivers.
ERP (enterprise resource planning)
- Managers charging medics by hours worked - Undermine professionals’ skills and time. eg. lecture 2 hours, slides take dozens of hours
- Jeopardising patients’ safety if medics work and keep looking at time
5 advantages of ABC
- MORE EQUITABLE than traditional overhead absorption methods, as overheads are absorbed according to the DIFF. ACTIVITIES
- Good base on which to make mgmt decisions, eg. proper RESOURCE ALLOCATION & DISCONTINUing non-profit- making business
- do not arbitrarily assign ‘organisation-sustaining costs’ (eg. factory security guard’s wages) to products, treated as period costs instead - Recognises the IMPORTANCE of OVERHEAD costs, which are increasing in many biz.s & are often a significantly large cost
- Allows setting of more REALISTIC prices, esp. where selling prices have been MARKED UP -> profit maximisation
- Focuses on the true amount of TIME & resources used by products in SUPPORT ACTIVITY (can also help find EFFICIENCIES in support functions)
11 limitations of ABC
ABC systems are built on strong assumptions:
- Assume LINEAR cost behaviour, b/c we apply cost driver rate
- Assume only 1 cost driver per cost pool. (Could be more than that. Overlapping activities.)
- Very rare that all overhead costs can be allocated to specific activities.
- ABC could still lead to mistakes & over-costing and under-costing, eg. when WRONG cost drivers are assigned, or when cost pool are driven by > 1 activity
- Cost APPORTIONMENT may still be needed for costs that are SHARED, eg. rent, rates, premises depreciation. FACILITY LEVEL costs can’t be absorbed, have to shown still (as not related to products output).
- Only use ABC if the benefits gained from the the accuracy in cost calculations OUTWEIGH the costs of maintaining and updating the system? (have to keep interviewing ppl, do surveys to collect data & maintain)
- In order to use cost drivers, ACTIVITY should be measurable/QUANTIFIABLE, eg. Brands are not.
* *8. Identifying activities & their associated costs may be COMPLEX. - diff. ppl have diff. Judgments, have Discretion, which leads to MANIPULATION in numbers (allocating overhead costs)
- Requires THOROUGH UNDERSTANDING of biz. If not, costing system could be flawed.
- **May be met w/ RESISTANCE to change -Company superstars, top managers and status quo. B/c if change and outcome is not good, their status would suffer
