Activity-Based costing

Chapter 8Activity-based costing8-1Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOutlineProblems with conventional product costing systemsActivity-based costingActivity-based costing modelDifferent forms of ABCActivity-based versus conventional product costsWhen to use ABCImpediments to using ABCOther activity-based costing issuesActivity-based costing in service organisations8-2Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithProblems with conventional product costing systemsFeatures of conventional product costing systemsDirect material and direct labour costs are traced to productsManufacturing overhead costs are allocated to products using a predetermined overhead rate, sometimes plant wideManufacturing overhead rate is calculated using some measure of production volume Non-manufacturing costs are not assigned to products8-3(cont.)Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithProblems with conventional product costing systems (cont.)Failure to adapt to the changing business environmentIncreasing levels of non-volume-driven manufacturing overhead costsIncreasing proportions of non-manufacturing costsCauses of changes in costs include increased automation, increasing product diversity, increased customer demand for improved service, quality and customer support8-4Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith8-5Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithIndicators of problems with a product costing systemConventional product costing systems are likely to result in inaccurate product costs when -the proportion of direct labour costs decreasesthe proportion of manufacturing overhead costs increasesthe proportion of manufacturing overhead costs, not related directly to production volume, increasesnon-manufacturing costs that are product-related become substantialproduct diversity increases8-6Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith8-7Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithProblems with costing in service businessesService firms tend to use firm-wide, volume-based overhead ratesOverhead costs are increasing and are increasingly non-volume drivenCustomers are demanding a more diverse range of higher quality servicesIncreases in product diversity and quality increase the level of non-volume-driven overhead costsService costs derived from conventional product costing systems may be inaccurate8-8Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithActivity-based costingA methodology that can be used to measure both the cost of cost objects and the performance of activitiesCan help solve problems such as Distorted product costsPoor cost controlThe form of ABC method adopted depends on the problems that need to be addressed8-9Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAn activity-based costing modelThe costing viewMeasures the cost of activitiesAssigns activity costs or productsActivity management viewProvides information to manage activities, managing costs and other sources of customer valueThe nature of cost driversResource driversActivity driversRoot cause cost drivers8-10Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith8-11Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCosting viewStep one: Measuring the cost of activitiesUse resource drivers to assign costs to separate cost pools for each activityDetermine the total cost for each type of activity Step two: Assigning activity costs to productsCalculate the cost per activity Assign activity costs to cost objects using activity driversDetermine the total cost for each product as the cost of activities used to produce each product8-12Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith8-13Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithActivity-based costing terminologyActivityA unit of work performed within the organisationCost driverA factor or activity that causes a cost to be incurredResource driverA cost driver used to estimate the cost of resources consumed by an activityActivity driverA cost driver used to estimate the cost of an activity consumed by the cost object8-15Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Activity-based costing terminology (cont.)Root cause cost driver The underlying factors that cause activities to be performed and their costs to be incurred Bill of activitiesIdentifies the activities, the activity cost per unit of activity driver, the quantity of activity drivers consumed, and therefore, the cost of the activities consumed by the product8-16Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithDifferent forms of ABCSimple approach: allocates manufacturing overhead costs to productsABC system for indirect costs: allocates manufacturing overhead costs and non-manufacturing costs to productsComprehensive system: allocates all product-related costs, except direct material, to products and is used for activity management8-17Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithWhich costs should be included in an ABC system?Depends on the purpose of the system, which depends on the needs of managementA 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 identified8-18Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith8-19Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithActivity-based hierarchy of costs and activitiesUnit level activitiesPerformed for each unit of productBatch level activities Performed for each batch of productProduct level (or product-sustaining) activitiesPerformed for specific products or product familiesFacility level (or facility-sustaining) activitiesRequired to support to business as a whole, not caused by any particular product, so not usually included in the product cost8-20Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithActivity-based versus conventional product costsConventional product costing assumes product costs are driven by volume-based cost driversAssumes they are all unit level costs Conventional costing ignores batch size Units produced in large batches consume a relatively low cost per unit of batch costsABC may include non-manufacturing costs8-21Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithWhen to use ABCOverhead costs are a significant proportion of total cost, and a large part of overhead is not directly related to production volumeThe business has a diverse product range, and an individual product’s use of resources differs from their use of volume-based cost driversProduction activity involves diverse batch sizes and product complexity8-22Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)When to use ABC (cont.)Proportion of product-related costs incurred outside manufacturing is increasing relative to manufacturing costsThere are likely to be high costs associated with making inappropriate decisions, based on inaccurate product costs The cost of designing, implementing and maintaining the ABC system is relatively low due to sophisticated IT support8-23Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithImpediments to introducing ABCLack of awareness of ABCUncertainty about the potential benefits from ABCConcern about the extensive resource required to implement ABCResistance to change from managers and employees8-24Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOther activity-based costing issuesVariations in types of ABC include whetherActual (past) or budgeted costs are analysedImplementation is a one-off project or an ongoing systemCost objects, other than products, are includedBudgeted costs may be used in an ABC systemABC may be implemented as a one-off project or a systemABC may be used to cost other cost objects, such as the costs of using particular suppliers or the cost of servicing particular customers8-25Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Other activity-based costing issues (cont.)Implications of spare capacityABC estimates the cost of resources used to perform activities to produce and sell products, which may not always equal the cost of resources suppliedCommitted resources are those supplied in advance of being used in productionNeed to account for the costs of unused capacity when budgeted costs have been used to generate activity-based product costs8-26Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Other activity-based costing issues (cont.)Behavioural issues in implementing activity-based costingChange can be perceived as threateningABC may require changes in data that is collected and changes in collection and analysis proceduresBottom-up change management may give employees some degree of ownership of any changes caused by ABCManagement must be seen as committed to the change process8-27Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithLimitations of activity-based costingFacility level costsIf a high level of facility level costs are allocated to products, an arbitrary element enters the product costFacility level costs bear no obvious relationship to productsUse of average costs in decision makingBatch, product and facility level costs that have been divided by the number of units produced can lead to product costs that are of limited use for decision makingDesirable to use cost per unit in the short term, and total product cost in the longer term8-28Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Limitations of activity-based costing (cont.)ComplexityThe cost of updating an ABC system can be very high, but is needed to avoid producing outdated, irrelevant informationThe level of complexity increases when the system is used for both activity management and product costingActivity-based management requires more extensive and detailed analysis of cost and activities8-29Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithActivity-based costing in service organisationsABC can be difficult to implement in service firms because there areHigh levels of facility costs, so fewer costs may be includedIndividual activities are difficult to identify because they are non-repetitiveA non-repetitive production environment makes it difficult to identify service outputsDespite these issues, ABC is used in many major Australian service organisations8-30Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithSummaryConventional costing systems provide distorted costs due mainly to their reliance on volume-based overhead ratesActivity-based costing may be suitable where there are high levels of non-volume based costs, a diverse product range, and substantial non-manufacturing product-related costsThe range of costs included in an ABC system and depends on the purpose of the systemImplementation issues include: budgeted or actual costs; ongoing system or project; identifying cost objects8-31Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith