Activity Based Costing - A Case Study

In cost accounting, ABC is of comparative recent origin which attempts to absorb overheads into product costs on a more realistic basis. Supporters of this technique argue that many costs are unnecessarily treated as common costs and are arbitrarily absorbed using a basis such as direct labor hours, machine hours etc. Because of the advent of technology in a big way, many organizations have now adopted, what we call, advanced manufacturing technology. (AMT) It has virtually resulted in increased overheads and reducing the proportion of labor cost in the total cost. Costing systems which absorb overheads on a direct labor basis may thus be not very much relevant in an AMT environment. The basic idea of ABC is that costs are grouped according to what drives them or causes them to be incurred. The cost drivers are then used as an absorption base. FACTS:A division of Hewlett-Packard (HP) that manufactures electronic circuit boards faced an environment that conformed closely to the conditions for which ABC is recommended: (a) Diverse products; (b) Relatively high overhead costs and for some products, higher than the direct costs; (c) Production volumes that vary significantly among products; (d) The belief by the operating managers that the old traditional system did not give meaningful product costs. An ABC system was introduced consisting of ten different cost pools and drivers. The composition of the cost pools and selection of the most appropriate drivers resulted from an intense analysis of the production process and cost behaviour patterns. When the company implemented ABC the costs of the old and new system were compared. One circuit board that would have been assigned with overheads of 5 dollars with the old system had a total reported cost of 25 dollars with ABC- an increase of 400%. Another circuit board that would have been assigned an overhead of 123 dollars with the old system was assigned 45 dollars with ABC. During a six month forecast and budget cycle, the ABC system resulted in shifting millions of dollars of costs between customers and products and thus had a dramatic impact on product design and pricing decisions. Problems: (1)Why do you think the cost of the circuit boards differed between the old and the new costing system? (2) What benefits are likely to be obtained from introducing the ABC system?