Activity based costing

HP:Ch-5
Activity based costing (ABC)
 Activity based costing (ABC) is an alternative
approach to absorption costing.
 It involves the identification of the factors (cost
drivers) which cause the costs of an organization's
major activities.
The reasons for the development of ABC
Reasons

In the past:
• Most organizations used to produce only a few products.
• Direct labour costs and direct material costs accounted for the largest
proportion of total costs and so it was these variable costs that needed to be
controlled.
• Overhead costs were only a very small fraction of total costs and so it did
not particularly matter what absorption costing bases were used to apportion
overheads to products.

Nowadays:
• Costs tend to be fixed and overheads huge.
• Manufacturing is capital and machine intensive rather than labour
intensive and so direct labour might account for as little as 5% of a product's
cost. For example, furniture is no longer made by skilled workers. Instead
complicated expensive machines are programmed with the necessary skills and
workers become machine minders.
 Many resources are used in support activities such as
setting-up, production scheduling, first item inspection
and data processing.
 These support activities help with the manufacture of a
wide range of products and are not, in general, affected
by changes in production volume. They tend to vary
instead in the long term according to the range and
complexity of the products manufactured.
Problems of using absorption costing in today's
environment
 Overhead absorption rates might be 200% or 300% of unit labour costs.
Unit costs are distorted and so cost information is misleading.
 Overheads are not controlled because they are hidden within unit
production costs rather than being shown as individual totals. Products bear
an arbitrary share of overheads which do not reflect the benefits they
receive.
 Absorption costing assumes all products consume all resources in proportion
to their production volumes.
 It tends to allocate too great a proportion of overheads to high volume
products (which cause relatively little diversity and hence use fewer support
services).
 It tends to allocate too small a proportion of overheads to low volume
products (which cause greater diversity and therefore use more support services).

Activity based costing (ABC) attempts to

overcome these problems.
Activity based costing (ABC)
 Activity based costing (ABC) is an 'approach to the
costing and monitoring of activities which involves tracing
resource consumption and costing final outputs.
 Resources are assigned to activities, and activities to
cost objects based on consumption estimates. The latter
utilise cost drivers to attach activity costs to outputs.' --
CIMA Official Terminology
ABC and using it to calculate product costs
 Major ideas behind ABC

The costs of an activity

are assigned to products
The costs of an activity
on the basis of the
are caused or driven by
number of the activity's
factors known as cost
cost driver products
Activities cause costs drivers. (The cost of the
generate. (If product A
(Activities include ordering activity might be
requires 5 orders to be
ordering and driven by the number of
placed, and product B 15
despatching.) orders placed, the cost of
orders, ¼ (ie 5/(5 + 15))
the despatching activity
of the ordering cost will
by the number of
be assigned to product A
despatches made.)
and ¾ (ie 15/(5 + 15)) to
product B.)
Cost drivers
 A cost driver is 'a factor influencing the level of cost'. -
-CIMA Official Terminology
For those costs that vary with
production levels in the short
term, ABC uses volume-
related cost drivers such as
labour hours or machine hours.
The cost of oil used as a
lubricant on machines would
therefore be added to products
on the basis of the number of
machine hours, since oil would
have to be used for each hour
the machine ran.
For costs that vary
with some other
activity and not
volume of production,
ABC uses
transaction-related
cost drivers such as
the number of
production runs for
the production
scheduling activity.
 Calculating product costs using ABC
• Identify an organisation's major activities.
Step 1

• Identify the factors (cost drivers) which cause the

Step 2 costs of the activities.

• Collect the costs associated with each activity into

Step 3 cost pools. (Cost pools are equivalent to cost centres used with traditional absorption costing.)

• Charge the costs of activities to products on the basis of

their usage of the activities. A product's usage of an
activity is measured by the number of the activity's
Step 4 cost driver it generates. (Suppose the cost pool for the ordering activity totalled $100,000
and that there were 10,000 orders (orders being the cost driver). Each product would therefore be charged with $10
for each order it required. A batch requiring five orders would therefore be charged with $50.)
ABC Example1
Suppose that Cooplan Co manufactures four products, W, X,Y and Z. Output and cost data for the
period just ended are as follows.
Machine
Output No of production runs Material cost Direct labour hours
Units in the period per unit hours per unit per unit
$
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14
Direct labour cost per hour is $5.
Overhead costs are as follows. $
Short-run variable costs 3,080
Set-up costs 10,920
Production and scheduling costs 9,100
Materials handling costs 7,700
30,800

Required
Calculate product costs using absorption costing and ABC.
A. Using absorption costing

Using absorption costing and an absorption rate

based on either direct labour hours or machine hours,
the product costs would be as follows.
W X Y Z Total
$ $ $ $ $
Direct material 200 =20*10 800=80*10 2,000=20*100 8,000=80*100 11,000
Direct labour 50=5*1*10 150=5*3*10 500=5*1*100 1,500=5*3*100 2,200
700 2,100 7,000 21,000 30,800
Overheads * =70*1*10 =70*3*10 =70*1*100 =70*3*100
Total cost 950 3,050 9,500 30,500 44,000

* $30,800 ÷ 440 hours = $70 per direct labour or machine hour

B. Using activity based costing
Using activity based costing and assuming that the number of production runs is the cost driver for set-up costs,
production and scheduling costs and materials handling costs and that machine hours are the cost driver for short-run variable
costs, unit costs would be as follows.
W X Y Z Total
$ $ $ $ $
Direct material 200 800 2,000 8,000 11,000
Direct labour 50 150 500 1,500 2,200
Short-run variable overheads (W1) 70=7*1*10 210=7*3*10 700=7*1*100 2,100=7*3*100 3,080
Set-up costs (W2) 1,560=780*2 1,560=780*2 3,900=780*5 3,900-780*5 10,920
Production and scheduling costs (W3) 1,300=650*2 1,300=650*2 3,250=650*5 3,250=650*5 9,100
Materials handling costs (W4) 1,100=550*2 1,100=550*2 2,750=550*5 2,750=550*5 7,700
Total Cost 4,280 5,120 13,100 21,500 44,000

Workings

$3,080 ÷ 440
W1 machine hours = $7 per machine hour
$10,920 ÷ 14
W2 production runs = $780 per run

$9,100 ÷ 14
W3 production runs = $650 per run

$7,700 ÷ 14
W4 production runs = $550 per run
C. Comparison

Absorption costing ABC

Product Unit cost Unit cost Difference
$ $ $
W=10 95 428 +333
X =10 305 512 +207
Y =100 95 131 +36
Z =100 305 215 -90
 The figures suggest that the traditional volume-based
absorption costing system is inconsistent.
 It under allocates overhead costs to low-volume products (here,
W and X) and over allocates overheads to higher-volume
products (here Z in particular).
 It under allocates overhead costs to less complex products (here
W and Y with just one hour of work needed per unit) and over
allocates overheads to more complex products (here X and
particularly Z)
Example 2
Having attended a Manac II course on activity based costing (ABC) you decide to experiment by
applying the principles of ABC to the four products currently made and sold by your company.
Details of the four products and relevant information are given below for one period.

Product P1 P2 P3 P4
Output in units 120 100 80 120
Costs per unit: $ $ $ $
Direct material 40 50 30 60
Direct labour 28 21 14 21

The four products are similar and are usually produced in production runs of 20 units.
The total of the production overhead for the period has been analyzed as follows.
$
Set up costs 5,250
Stores receiving 3,600
Inspection/quality control 2,100
Materials handling and despatch 4,620
You have ascertained that the following 'cost drivers' are to be used for the costs shown.
Set up costs Number of production runs
Stores receiving Requisitions raised
Inspection/quality control Number of production runs
Materials handling and despatch Orders executed
The number of requisitions raised on the stores was 20 for each product and the number of orders executed was
42, each order being for a batch of 10 of a product.

Required : The total costs and per unit for each product using activity based costing
 P1 P2 P3 P4
$ $ $ $
Direct material 4,800 5,000 2,400 7,200
Direct labour 3,360 2,100 1,120 2,520
Production overhead *
Set up costs(D1) 1,500 1,250 1,000 1,500
Stores receiving(D2) 900 900 900 900
Inspection/quality control(D1 600 500 400 600
Material handling and despatch(D3) 1,320 1,100 880 1,320

* Overhead costs will be divided in the following ratios, depending upon the number of
production runs, requisitions or orders per product.
P1 P2 P3 P4
D1-Production runs 6=120/20 5=100/20 4=80/20 6=120/20
D2-Requisitions raised (as given) 20 20 20 20
D3-Orders executed 12=42*6/21 10=42*5/21 8=42*4/21 12=42*6/21
Analytics of costing system design
 Costing as an approximation exercise:
 In most organizations costing systems serve many different needs such as
 product costing,
 pricing,
 product line decisions,
 capacity planning and allocation,
 performance measurement and control,
 project scheduling, project selection, and
 benchmarking, among other uses.
 In order to assess the cost implications of their short- and long-term planning
and control functions, managers try to understand how costs behave and how
cost objects consume resources by means of cost functions.

A cost function is a mathematical

description of how cost changes with
changes in volume or in the level of an
activity or process relating to that cost.
What to approximate: the marginal
versus full costing debate
 According to economic theory, decisions (e.g. pricing) are
made such as to have marginal revenues equate with marginal
costs.
 The costing system therefore should focus on finding the
marginal cost for each decision.
 This cost is termed the relevant cost as it differs between
alternatives in a particular decision.
 Given that some costs are not changed by the decision, they
are not relevant.
 Likewise sunk costs should not be regarded as relevant.
 Fixed costs fall into this category.
 In practice, however, we observe the extensive use of full costing,
whereby fixed costs get allocated (Drury and Tayles 1994; Brierley et
al. 2001).
 The accounting literature has tried to reconcile the use of
full costing in practice with economic theory via a variety
of routes.
 First, the ABC advocates have argued that in the long-term
all costs are variable and that (at least for long-term
decisions) all costs (i.e. full costs) should be included in the
decision-making process (Cooper and Kaplan 1992).
 Second, others argue that full cost-based pricing and capacity
planning are used as heuristics where the cost allocations are
valuable because they approximate the opportunity cost of the
resource based on expected use at the time of resource
acquisition.
 Balakrishnan and Sivaramakrishnan (2002) provide an
excellent overview of the research literature in this area.
 Third, in an agency context, others have written about the
incentive effects of cost allocations (Zimmerman 1979).
 Fourth, the behavioral literature has indicated other factors
that may result in the inclusion of sunk cost for decision-
making purposes, such as reputation of the decision maker and
loss aversion (see e.g. Buchheit 2004).
How to approximate: activity-based costing
versus Traditional costing
 Johnson and Kaplan (1987), Cooper and Kaplan (1987),
and others have claimed that the traditional costing
methods used before the birth of ABC were
systematically distorting product costs, leading to wrong
decisions being taken on the basis of these costs.
 Traditional costing over costs high volume/low complexity
products and under costs low volume/high complexity
products.
 Misallocations under traditional costing favour low
volume specialty products.
 They critiqued the exaggerated use of direct labour hours
as an allocation base in a ‘new’ production environment
where fewer hours of direct labour were used. Also, a
bigger share of the costs in this ‘new’ production
environment was indirect and therefore had to be
allocated using some allocation base.
 Picking the wrong allocation base in this setting made for
disastrous consequences.
 ABC was then posed as a more accurate costing method
whereby allocation bases are chosen better to reflect the
cause-and-effect relationships in resource consumption
patterns.
 Where the traditional costing methods estimate cost as a
linear function of volume, Figure 1 shows how ABC
estimates changes in cost as a function of changes in level
of activity. New cost drivers, other than volume-based
drivers such as direct labour hours and direct machine
hours, were now used.
Figure 1 Costing as an approximation exercise
 Examples are:
 NUMBER OF SET-UPS,
 NUMBER OF PURCHASING ORDERS,
 NUMBER OF MACHINE INSERTIONS,
 NUMBER OF INSPECTIONS, AND
 NUMBER OF DIFFERENT COMPONENTS.
 Another novel feature of ABC at the time was that the focus of the
costing system was no longer solely on product costing, but that
anything could be a ‘cost object’:
 PRODUCTS,
 SERVICES,
 CLIENTS,
 DISTRIBUTION CHANNELS,
 SUPPLIERS, ETC.
 Figure 2contrasts the two approaches.
Figure 2 Traditional costing versus ABC
A costing example
Panel A: Data for example
Product A Product B Product C Total
Unitssold 20,000 15,000 5,000
Directmaterialcost(£) 2,500 2,300 2,000
Directlabourcost(£) 1,400 2,100 700
Labourhoursperunit 2 3 1 90,000
Machinehoursperunit 1 2 5 75,000
Productionbatches 2 4 6 12
Salesorders 10 18 20 48
Purchaseorders 20 15 25 60

Indirectcosts:
indirect wages(£) 33,000,000
depreciation(£) 85,000,000
material and tools(£) 17,000,000
Total: 135,000,000
 A costing example
Panel B: Traditional costing with direct labour hours as allocation base
Product A Product B Product C
Direct material cost(£) 2,500 2,300 2,000
Direct labour cost(£) 1,400 2,100 700
Indirect cost(£) 3,000 4,500 1,500
Total 6,900 8,900 4,200

Panel C: Activity-Based Costing: additional information on indirect costs needed

Material and
Activity Activity driver Indirect wages(£) Depreciation(£) tools(£) Total(£)
Automatic Assembly Machine Hours 12,000,000 58,000,000 5,000,000 75,000,000
Reception Purchase orders 9,000,000 2,000,000 1,000,000 12,000,000
Set-upMachines Production batches 6,000,000 15,000,000 3,000,000 24,000,000
Wrapping Sales orders 6,000,000 10,000,000 8,000,000 24,000,000
Total 33,000,000 85,000,000 17,000,000 135,000,000
A costing example
Panel D: Activity-based product costs (£)
Product A Product B Product C
Directmaterialcost 2,500 2,300 2,000
Directlabourcost 1,400 2,100 700
Assembly 1,000 2,000 5,000
Receptioncosts 200 200 1,000
Set-upcosts 200 533 2,400
Wrapping 250 600 2,000
Total 5,550 7,733 13,100

Panel E: Comparison of ABC and traditional product costs (£)

Product A Product B Product C
Traditional 6,900 8,900 4,200
ABC 5,550 7,733 13,100
%difference -20 -13 +212