Week 5-Activity-based costing Flashcards
What are the limits of traditional OH absorbiton methods?
• Traditional cost allocation methods uniformly assign cost of
overheads to cost units using one cost driver (e.g. direct
labour hours) and calculates a blanket rate.
• Difficulty in multi-product businesses: Products that are
highly specialised usually absorb not as many labour or
machine hours as less specialised, high-volume products.
Where the more specialised should absorb more. (explained
in the next slide)
• This situation may lead to issue of undercosting of highly
specialised products and overcosting of standardised, highvolume products.
Sophisticated “high end” products consume
most of the support resources (i.e. overhead
costs) e.g. even after sale assistance with
sophisticated products.
• Under traditional methods “low end”, “mass
market”, but high volume products absorb
most of the overheads, even though they do not
cause them. Traditional cost allocation methods
(methods using one allocation base) don’t reflect
this.
Traditional vs modern production and competitive environment
From direct-labour intensive to capital-intensive
and machine-paced production
• From mass production to high levels of
specialisation and product diversification
(e.g. design, customer care, features etc.)
Relative increase in indirect (overhead) costs
Businesses need more accurate cost information
for decision making
What are the main selling points of ABC?
Activity-based costing systems do not arbitrarily
assign certain costs e.g. factory security guard’s
wages, the plant controller’s salary which are called
organisation-sustaining costs, to products.
Activity-based costing treats these types of costs as
period costs rather than product costs.
• Products are not charged for the (idle capacity)
costs of the capacity they do not use. This provides
more stable unit product costs
Type of transactions that drive OH costs
Quality transactions: communication of specifications, the certification that required transactions have taken place as they were supposed to, and the development and recording of relevant data
Change transactions: which uptade basic manifacturing information systems to accommodate changes in engineering designs, schedules
Logistical transactions: which order, execute and confirm the movement of materials from one location to another
Balancing transactions: which ensures that the supplies of materials, labour and capacity are equal to the demand. These result in the movement orders and authorisations that generate logistical transactions
What are the reasons for developing ABC?
“Existing cost systems frequently understate profits on
high-volume products and overstate profits on speciality
items.”
“ABC helps managers unravel the stories about how
the company designed, produced and delivered
products.”
What are the steps in ABC?
1 Group production overheads into activities
(The terms ‘activity’ and ‘cost pools’ are often used
interchangeably).
- Identify cost drivers for each activity
(e.g. Ordering costs of the ordering “activity” or No. of
Japanese guests for Japanese cuisine cooking “activity”) - Calculate Activity cost driver rate for each activity. A
separate Cost driver rate will be calculated for each activity
(Just like we learnt Overhead absorption rate (OAR) in
Absorption costing) - Activity costs are absorbed into the product
using the cost driver rate. - Calculate full production cost.
What are the 4 levels of activity? (hierarchy of cost)
(i) Unit-level activities
Activities where the consumption of resources is very strongly
correlated with the number of units produced e.g. direct material
and direct labour.
(ii) Batch-level activities
Consumption of resources is in proportion to the number of
batches produced, rather than in proportion to the number of units
produced. E.g. machine set-up, materials handling, batch
inspection etc.
(iii) Product-level activities
Consumption of resources may be related to the existence of
particular products e.g. administration, product specification or
purchasing in order to sustain the existence of particular products.
(iv) Facility-level activities
Some costs relate simply to being in business and that therefore
cannot be related in any way to the production of any particular
product line. For example Grounds maintenance, plant security and
property taxes.
3 types of data collection for ABC
INTERVIEWS AND PAPER TRAILS - The information for ABC
systems initially comes from interviews with employees in the
support departments and a review o h tm nt’s records.
STORYBOARDING - A procedure used to develop a detailed
process flow chart, which visually represents activities and the
relationships among activities.
MULTIDISCIPLINARY ABC PROJECT TEAMS – To gather
information from all facets of an o n s t on’s operations, it is
essential to involve personnel from a variety of functional areas. A
typical ABC project team includes ACCOUNTING, FINANCE,
PRODUCTION, OPERATIONS, ENGINEERS, MARKETING etc.
Time-driven Activity-based costing
One of the issues with traditional ABC is the need for lengthy
employee interviews and surveys to collect data.
Time-driven Activity-based costing is used to measure costs
to perform an activity, and the time it takes to perform it.
The ERP (enterprise resource planning) systems allow crucial data to be fed automatically into a Time-driven Activity-based costing (TDABC) system.
ERP software
enterprise resource planning
ERP integrates finance, HR, manufacturing, supply
chain, services, procurement, and others into a single
system.
In the modern day ERP systems latest technologies
are incorporated e.g. machine learning and AI.
These days cloud based ERPs are quite common.
Others could be within the data centre; or some
could be a combination (hybrid type ERP)
A company is likely to have some form of ERP
systems. The time-driven ABC software imports
the data from ERP systems on all transactions,
which would include time features of transactions.
Using the data, the software calculates the
product/customer/regional/branch Income
statement in real time.
• Using TDABC system, a company without ERP can
import data from separate systems e.g. monthly
general ledger, a production scheduling system, a
customer order file etc.
Activity cost-driver
Activity cost driver= total costs in activity cost pool/activity cost driver
Disadvantages of time-driven AC
• TDABC calculates only direct patient contact time.
When reviewing the process map, documented times
do not include time, the salaried anesthesia providers
work but not conducting direct patient care.
• Assigning costs based solely on time spent for direct
patient care could lead to underestimation of provider
work load, eventually reducing reimbursement and
compensation to the health provider (e.g. hospital).
• If done carelessly, such costing could compromise
patient safety.
• Clinicians’ stress levels may rise significantly as they
may be asked to do more in less time.
When should a company decide to
move on from traditional absorption
costing to ABC system?
Indirect costs are significant in proportion to
direct costs.
Goods are complex, requiring many inputs and
processes.
Complex, low-volume products are profitable
while standard, high-volume products are not.
Different departments believe costs are assigned
inaccurately
loses bids it thought were low, and wins bids it
thought were high.
Operations have changed (developed)
significantly, but the costing system has not
changed.
ABC advantages
More equitable than traditional overhead absorption
methods, as overheads are absorbed on the level of
activity of a number of different activities (ie cost
pools)
• Good base on which to make management decisions
such as resource allocation or even discontinuing
some products or business units.
• Recognises the increasing importance of
overheads in many businesses is increasing and is
very often a significantly large cost
For more realistic pricing, especially where
selling prices are set by adding a profit mark-up
to cost
• Focuses on the true amount of time and
resources used by the products in the major
area of support activity – (Can help finding
efficiencies in support functions also)
Limitations of ABC
ABC systems are built on strong assumptions:
– Assumption of linear cost behaviour (because we
apply cost driver rate just as OAR)
– Assumption that one cost pool is driven by one cost
driver only. A single cost driver may not explain the
cost behaviour of all items in a cost pool.
– Very rare that all overhead costs could be allocated
to specific activities.
– Mistakes, and undercosting and overcosting, can still
occur under ABC: e.g. when wrong cost drivers are
assigned, or when cost pools are driven by more
than one activity.
• Cost apportionment may still be needed for costs that are
shared e.g. rent, rates and premises depreciation (e.g.
Facility level costs by Cooper and Kaplan, 1991).
Apportionment can be an arbitrary way of sharing costs.
• Do benefits gained in pursuit of mere accuracy in cost
calculations overweigh the costs of maintaining and
updating the system?
• In order to use cost drivers, activity should be
measurable/quantifiable.
• Identifying activities and their associated costs may be a
complex task.
• Allocating overhead costs may be strongly
influenced by policies, points of view and
judgements (could even be emotive and
politically sensitive between segments)
• Requires thorough understanding of the
business
• May be met by resistance to change
