Management Accounting & Decisions II

N12401
Lecture 6

Activity-Based Costing
by Hung Woan-Ting

Learning Objectives

1. To revisit the cost accumulation system

2. To differentiate traditional costing systems from activitybased costing (ABC) system
3. To appreciating the design and cost flows in ABC system
4. To appreciate the usefulness of ABC system in practice

1.0 Cost accumulation system

Generating cost information relevant to management
In need of a sound cost accumulation system:
Many indirect costs are relevant for decision-making
(Support function resources? Joint resources?)

Attention directing system (Profitability?)

Many product-related decisions are not independent
(demand for resources?)

1.1 Cost accumulation system

Different types of costing systems:
Direct costing systems

Indirect costs are not assigned to cost objects

so that only contributions to indirect costs are
reported
Appropriate where the majority of costs are
direct
Require that indirect costs are incorporated at
the special study stage

Traditional costing systems

Use simplified methods to allocate indirect
costs to cost objects

Activity-based costing systems

Use detailed (sophisticated) methods to

allocate indirect costs to cost objects

1.2 Rationale for development

Cost structure dominance? (Direct costs? Indirect costs?)

Cost drivers? (Volume-based?)

Range of products produced? (Limited? Wide range?)
Information costs?
Level of competition in business environment?

2.0 Traditional vs. ABC

2.0 Traditional vs. ABC

2.0 Traditional vs. ABC

Both systems use a two-stage allocation process
but differently

Traditional systems
allocate costs to
departments

In Stage ONE

ABC systems
allocate costs to
activities that
require resources

(ABC systems tend to

have more cost
centres/cost pools)

In Stage TWO
traditional systems
rely on a small
number of volumebased cost drivers
(typically direct labour
or machine hours)

ABC systems use

many activitybased cost drivers
8

2.1 Traditional vs. ABC

ABC systems seek to
use only cause-andeffect cost drivers
traditional systems
often rely on arbitrary
allocation bases

ABC systems tend to

establish separate cost
driver rates for support
departments

traditional systems
merge support and
production centre
costs

2.2 Traditional vs. ABC

Example:
Products HV (a high volume product) and LV (a low volume
product) are two of several products produced by HWT Plc.
HV is made in large batches and LV is made in small batches

HV consumes 30%of DLHs and LV consumes 5%

Each product consumes 15% of the batch-related indirect costs
The traditional system uses DLH s as the cost driver and the ABC
system uses the number of batches processed
All overheads (total = 1m) are batch-related
10

2.2 Traditional vs. ABC

Traditional System

ABC System

HV

LV

HV

LV

Sales

600K

150K

600K

150K

Direct costs

310K

40K

310K

40K

OH allocated
Profits/Losses
Which product consumes higher level of resources?
If HV is discontinued, by how much will OH decline
Management receives different signals

(in the long tern)?

(which one is more reliable?)

Traditional: Drop HV
ABC: Drop LV

11

3.0 Designing ABC System

Involves four stages:
1. Identify the major activities that take place in an
organization
Activities chosen should be at a reasonable level of
aggregation based on cost/benefit criteria
Choice of activities influenced by total cost of the
activity centre and the ability of a single cost driver to
provide a satisfactory determinant of the cost of the
activity
12

3.0 Designing ABC System

2. Assign costs to cost pools /cost centre for each
activity
Costs assigned to activity cost pools will include
direct and indirect costs

Resource cost drivers used to assign indirect costs

Reliability of cost information will be reduced if
arbitrary allocations are used to assign a significant
proportion of costs to activities

13

3.0 Designing ABC System

3. Determine the cost driver for each major activity
Drivers at this stage called activity drivers: provide a
good explanation of costs of each activity pool, be
easily measurable, data should be easy to obtain and
identifiable with the product
Activity cost drivers consist of transaction and duration
drivers

4. Assign the cost of activities to products

The cost driver must be measurable so that it can be
identified with individual products

14

3.1 Classification of activities

Unit-level activities:
Performed each time a unit of the product or service
is produced
Resources are consumed in proportion to the
number of units produced or sold
E.g.: Direct materials and labour, energy costs consumed in
proportion to machine processing time

Batch-related activities:

Performed each time a batch of goods is produced

Costs vary with the number of batches made

E.g.: set-ups, purchase ordering, first-item inspection activities

15

3.1 Classification of activities

Product/service sustaining activities:
Performed to enable the production of individual
products or services

E.g.: activities related to maintaining an accurate bill of materials,

preparing engineering change notices

Facility-sustaining (or business-sustaining) activities:

Performed to support the organization as a whole
Common to all products and services (not allocated to
products/services)
E.g.: plant management, property costs and salaries of general
administrative staff

16

3.2 Practicing with ABC

Case study:
Robot Toy Company manufactures two products, X-O-Tron and
Mechoman.
Robot's overhead costs consist of setting up machines,
$400,000; machining, $900,000; and inspecting, $300,000.
Information on the two products is:
X-O-Tron
Mechoman
Direct labor hours 15,000
25,000
Machine setups
600
400
Machine hours
24,000
26,000
Inspections
800
700
17

3.2 Practicing with ABC

Required:
1. What is the overhead applied to X-O-Tron using traditional
costing based on direct labour hours?
2. What is the overhead applied to Mechoman using traditional
costing based on direct labour hours?
3. What is the overhead applied to X-O-Tron using ABC?
4. What is the overhead applied to Mechoman using ABC?

18

Traditional Costing
Costs
Cost driver (level)
OAR
Assign cost
X-O-Tron
Mechoman
ABC
Step 1: Cost object
Step 2: Costs
Step 3: Cost driver (level)
OAR
Step 4: Assign cost

Total:

X-O-Tron
Mechoman

19

4.0 ABC/M in practice

Some obvious problems if implement ABC:
ABC requires more resources to implement, maintain
and use initial analysis of activities is extensive and
costly; analysis must be updated to maintain the
accuracy of system; greater record keeping
Reported costs may not significantly differ from a less
costly traditional system if indirect costs are a low
proportion of total costs
Institutional resistance both internal and external
personnel may have trouble understanding ABC
20

4.1 ABC/M in practice

Real life example:

The Boeing Company. Although Boeing does not use ABC as part of its
accounting system, it has experimented with Activity Based Management
(ABM). ABM involves the use of ABC data in management decisions. In
2000, Boeing tested ABM in two operations at its Wichita plant.
One of the operations studied was Boeings Phase I preassembly
chemical bath operation. It found that Boeing incorrectly calculated the
in-house cost of that operation at $7 per part.
As a result, Boeing outsourced that operation at a cost of $4 per part.
Boeing found that it could actually conduct some of those outsourced
operations in house at a cost of $3.50 per part.

21

4.1 ABC/M in practice

Real life example (cont):

Boeing identified additional costs that were associated with the
outsourced operation.
Boeings analysis of the activities that made up its Phase II structural
bonding operation highlighted the fact that rework orders were an
important Cost Driver for Manufacturing Overhead costs. An examination
of the rework orders revealed that parts were being unnecessarily
reworked.
By introducing standardized quality criteria, Boeing was able
to reduce the number of rework orders and thereby reduced its rework
cost by 20%.
22

4.1 ABC/M in practice

Real life example:

Mobil Oils implementation of ABC at its US Lubricants Division in the
early 1990s, highlighted thousands of unprofitable product lines and an
inefficient relationship with its suppliers.
As a result of this analysis, the Division reduced the number of its
products from around 12,000 to 5,000 within eight years of adopting
ABC, and cut the number of its suppliers from over 2,000 to around 500
in that same period.
The Divisions after-tax profit increased from zero to $150 million within
that same eight-year period.
23

Readings & Exe.

1.

Read the following chapters in the prescribed textbooks

GNBCY Ch7
Drury Ch11
Optional readings on activity-based management (ABM):
HNS Ch8 for introductory info on ABC/ABM (available in library and in Uni bookstore)
AHM Ch18 for a critical review on ABC/AbM (available in library and in Uni bookstore)
Currie (1998) Corporate Performance & ABM: How the Best Companies Make Their
Systems Work, Int J of Strategic Cost Management, Autumn:25-33 (available via Library
gateway)

2.

Seminar 3 preparations:
Attempt the Question Sets attached at the back of this
handout (indicative solutions in Moodle, please refer
before seminar)
End of Lecture

24