Activity-Based Costing: Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e

Chapter 8
Activity-based costing
Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 8-1
Outline
• Problems with traditional product
costing systems
• Activity-based costing
• A simple approach to ABC
• Activity-based vs traditional product
costs
• Activity-based costing issues
• Limitations of ABC
• ABC in service organisations
Problems with traditional
product costing systems
• Features of traditional product costing
systems
– Direct costs are traced to products
– Allocation of manufacturing overhead
costs are to products
– Calculation of manufacturing overhead
rate
– Non-manufacturing costs
(cont.)
Problems with traditional
product costing systems (cont.)
• Failure to adapt to the changing
business environment
– Manufacturing overhead is increasing as
a proportion of total manufacturing costs
and becoming more non-volume-driven
– Non-manufacturing costs are increasing
as a proportion of total costs
• Causes of changes in cost structures
include growing automation
(cont.)
Indicators of problems with a
product costing system
• Traditional product costing systems are
likely to result in inaccurate product costs
when:
─the proportion of direct labour costs decreases
─the proportion of related and unrelated
manufacturing overhead costs increases
─non-manufacturing costs that are product-
related become substantial
─product diversity increases (cont.)

Indicators of problems with a
product costing system (cont.)

Costing in service firms
• Service firms tend to use firm-wide,
volume-based overhead rates
• Customer demands are increasing
• Impact of increasing product diversity
and quality on the level of non-volume-
driven overhead costs
• Accuracy of service costs derived from
traditional product costing systems

Activity-based costing
• A methodology that can be used to
measure both the cost of cost objects and
the performance of activities
• Can help solve problems such as
– Distorted product costs
– Poor cost control
• The form of ABC method adopted
depends on the problems that need to be
addressed

An activity-based costing model
• The costing view
– Measures the cost of activities/objects
– Improves the allocation of manufacturing
overhead costs to products
• Activity management view
– Provides information to manage activities,
managing costs and other sources of
customer value
• The nature of cost drivers
– Three different ways (cont.)
An activity-based costing model (cont.)
Source: Adapted from page 96 of Common Cents: The ABC Performance Breakthrough by Dr Peter B.B. Turney, president and CEO of Cost Technology
Inc., a management consulting firm specialising in ABC/ABM implementations, Cost Technology Inc., Beaverton, Oregon, 1991. Reprinted by permission
of the publisher. All rights reserved.

Costing view
• Step one: measuring the cost of
activities
– Use resource drivers to assign costs
– Determine the total cost for each activity
• Step two: assigning activity costs to
products
– Calculate the cost per activity
– Assign activity costs to cost objects
– Determine the total cost for each product
Activity-based costing terminology
• Activity • Resource driver
– A unit of work performed – A cost driver used to
within the organisation
estimate the cost of
• Activity driver resources consumed
– A cost driver used to by an activity
estimate the cost of an • Root cause cost
activity consumed by
the cost object driver
– The underlying factors
• Cost driver
that cause activities to
– A factor or activity that be performed and their
causes a cost to be costs to be incurred
incurred

Different approaches to ABC
• Simple approach: allocates manufacturing
overhead costs to products
• ABC system for indirect costs: allocates
manufacturing overhead costs and non-
manufacturing costs to products
• Comprehensive system: allocates all
product-related costs (except direct
material) to products and for activity
management
A simple approach to ABC
• Step one: measure the cost of manufacturing
overhead activities
– Identify major manufacturing overhead activities
– Determine total (budgeted) cost of each activity
• Step two: assign cost of manufacturing

overheads activities to products
– Select suitable activity drivers for each activity
– Estimate cost per unit of activity driver
– Assign manufacturing cost to products based on the
quantity of activity drivers consumed (cont.)
A simple approach to ABC
(cont.)
(cont.)
A simple approach to ABC (cont.)

Which costs should be
included in an ABC system?
• Depends on the purpose of the system,
which depends on the needs of
management
• A decision to include activity-based
management in an ABC system will
influence the range of costs included in
the system, as well as the type of cost
drivers identified
Hierarchy of activities for ABC
• Unit level activities
– Performed for each unit of product
• Batch level activities
– Performed for each batch of product
• Product level activities
– Performed for specific products or product
families
• Facility level activities
– Required to support the business as a whole

Activity-based vs traditional
product costs
• Traditional product costing assumes
product costs are driven by volume-based
cost drivers
• Traditional costing ignores batch size as a
cost driver as large batches consume a
relatively low cost per unit of batch costs
• Traditional product costs do not include
non-manufacturing costs

When to use ABC
• Overhead costs are a significant
proportion of total cost and a large part of
overhead is not directly related to
production volume
• The business has a diverse product
range, and individual products’ use of
resources differs from their use of volume-
based cost drivers
• Production activity involves diverse batch
sizes and product complexity (cont.)
When to use ABC (cont.)
• Proportion of product-related costs
incurred outside manufacturing is
increasing relative to manufacturing costs
• Likelihood of high costs associated with
making inappropriate decisions based on
inaccurate product costs
• The costs associated with the ABC
system is relatively low due to
sophisticated IT support

Impediments to introducing
ABC
• Lack of awareness of ABC
• Uncertainty about the potential benefits
to be gained from ABC
• Concern about the extensive resources
required to implement ABC
• Resistance to change from managers
and employees

Other activity-based
costing issues
• Variations in types of ABC systems
include whether
– direct labour or non-manufacturing costs
are included in an ABC system
– actual or budgeted costs are analysed
– ABC is implemented as a one-off project
or as an ongoing product costing system
– cost objects other than products are
included
(cont.)
Implications of spare capacity
• ABC estimates the cost of resources
used to perform activities to produce and
sell products
• Committed resources are those supplied
in advance of being used in production
• When budgeted costs are used to
estimate activity costs, the committed
costs supplied will not always equal the
resources used
(cont.)
Behavioural issues in
activity-based costing
• Change can be perceived as threatening
and so may be resisted
• Bottom-up change management may give
employees some degree of ownership of
any changes associated with ABC
• Management must be seen as committed
to the change process by being willing to
allow employees to play a role

Limitations of
activity-based costing
• Facility level costs
– Some systems arbitrarily assign facility level
costs to products
• Use of average costs in decision making
– Batch, product and facility level costs are divided
by the number of units produced leading to
product costs that are of limited use for decision
making
– Desirable to use cost per unit in the short term;
total product cost in the longer term (cont.)

Limitations of
activity-based costing (cont.)
• Complexity
– The cost of updating an ABC system can be
very high, but is needed to avoid producing
outdated, irrelevant information
– The level of complexity increases when the
system is used for both activity
management and product costing
– Activity-based management requires more
extensive and detailed analysis of cost and
activities
Activity-based costing in
service organisations
• ABC can be difficult to implement in service
firms because there are:
– High levels of facility costs, so fewer costs may
be included
– Individual activities are difficult to identify
because they are non-repetitive
– A non-repetitive production environment makes
it difficult to identify service outputs
– Despite these issues, ABC is used in many
major Australian service organisations
Summary
• Traditional costing systems use broad
volume-based overhead rates which is likely
to distort costs
• ABC may be suitable where there are high
levels of non-volume based costs, a diverse
product range and substantial non-
manufacturing product-related costs
• The range of costs included in an ABC
system depends on the purpose of the
system
• Implementation issues
Appendix—a comprehensive
ABC system
• Step one: measure the cost of activities
– Identify activity centres
– Assign costs to activity centres
– Identify activities and resource drivers for each activity
centre
– Assign activity centre costs to activities using resource
drivers
• Step two: assign activity costs to products
– Select suitable activity drivers for each activity centre
– Estimate cost per unit of activity driver
– Assign activity cost to products based on the quantity of
activity drivers consumed (cont.)
Activity-based product costs
(cont.)
Activity-based product costs
(cont.)

Simple vs comprehensive ABC
• Comprehensive ABC system
– More detailed and possibly more accurate
assignment of direct labour and overhead to
products
– More detailed assignment of manufacturing
overheads to products
– Inclusion of non-manufacturing product
related costs
– More detailed identification and analysis of
activities across the business that may be
useful for activity-based management

Activity-Based Costing: Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e

Uploaded by

Copyright:

Available Formats

Activity-Based Costing: Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Activity-Based Costing: Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e

Uploaded by

Copyright:

Available Formats

Chapter 8

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

• Step two: assign cost of manufacturing

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

You might also like