4. Activity-based Costing

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LEARNING OUTCOMES

Describe the reasons for the development of activity-based costingSelect appropriate cost pools and cost drivers

Calculate product costs using activity-basedcostingApply activity-based costing in a range of costingsituations

Evaluate the use of activity-based costingCompare and contrast the use of absorption,marginal and activity-based costing

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WH AT IS ABC?

Activity-based costing (ABC) is an approach to thecosting and monitoring of activities whichinvolves identifying the activities that areresponsible for the generation of costs.

Provides a different approach of treatingoverheads when calculating a product cost.In the long-run, many fixed costs can turn intovariable.In the short-run, many variable costs can actuallybe fixed.

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WHY ABC?Treatment of overheads has become a major problemas manufacturing processed become more automatedand less labour intensive.Production and non-production overheads (mostly are

fixed costs) have become a large proportion of totalcosts.Machine-related fixed costs become more significantas compared to labour costs, which are mainlyvariable.

Increasing amount of machine-related expenditure isallocated to units of production based on a decliningamount of labour hours or labour costs.The traditional methods produced inappropriate, non-relevant unit costs.

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COST DRIVERS & COST BEH AVIOUREssential principles of ABC are that:

± Activities (not products) generate costs ± Products consume activities

An activity is a process which adds value andconsumes resources.A cost driver is any factor which causes a changein the cost of an activity.

± Cost driver represent the allocation bases in an ABC

system. ± Different types of costs will have different cost driver.

A cost pool results from the pooling oraccumulation of overhead cost which relate to aspecific activity.

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CALCULATING PRODUCT COSTS USING ABCAn ABC system operates as follows:

Identify anorganisation¶s

major activities

Identify thefactors which

determines thesize of the costsof an activity or cause the costs

of an activity(cost driver)

Collect thecosts of eachactivity into

what areknown ascost pools

Chargesupport

overheads toproducts onthe basis of

their usage of the activity

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APPLICATION OF ABC

ABC is most beneficial to a company when thereare: ± Vey high amounts of overheads ± Multiple products ± Differing activities ± Products that make different use of different activities

The extra time and costs involved in using ABCwill be outweighed by the benefits which arisefrom the improved accuracy of the overheadallocation.Accurate costs will lead to better decisions beingmade especially regarding selling prices andproduct mix.

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APPLICATION OF ABCAccurate costs will improve decision-makingprocess especially concerning selling prices andproduct mix.The service industry has found that ABC

approach is useful in dealing with problem of identifying the cost of individual services with acommon base.Banks, insurance companies and the hotel andleisure industry have been some of the majorusers of ABC techniques in an attempt to improvethe accuracy of their costing information.

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ADVANTAGES OF ABCThe unit costs should reflect more accuratefigures based on the activities performed andresources used.Effective in identifying customers who areunprofitable to service and products which areunprofitable to produce.H elps to identify activities that add more valuethan to cost. Non-value added items can

therefore be minimised or eliminated.Better understanding of the costs of productionand the costs of activities performed by thecompany.

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DISADVANTAGES OF ABCA new technique which is not familiar withthe management. (only 4% of firms actuallyadopted ABC).

A complex and costly technique to set up andto operate.ABC is unlikely to relate all overheads tospecific activities and ignores the potential forconflict especially where there is more thanone potential cost driver.Problem of what the cost driver is for a given

cost pool. 10



COMPARISON

MarginalCosting

Product costs are calculated as variable cost only. Fixed costs arewritten off to the income statement as period costs. Useful for short-term decision making because it highlights the difference betweenvariable and fixed costs. Used in CVP analysis, limiting factor analysisand short-term pricing decisions.

AbsorptionCosting

All production costs (fixed and variable) are allocated to products.

Overheads are allocated based on a single activity criteria. Used forinventory valuation and financial reporting which require products tobe valued at their full production costs.

Activity-based

Costing

All production costs (fixed and variable) are allocated to products.Overheads are allocated based on a number of different activitiesdepending upon how individual costs are generated. Develops the

principles of absorption costing and produces a full production costwhich is more accurate. Useful when company has a high level of production overheads not related to volume of production and widevariety of products. Used for inventory valuation and financialreporting. Useful for long-term decision-making especially planningand control.

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4. Activity-based Costing