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KNGX NOTES
ACCT2522

4. MANAGING COSTS II – ACTIVITY


BASED COSTING
4.0 IMPORTANCE OF PRODUCT COSTING

Concept is simple … practical reality of the computation is complex because:

- What is meant by “total product cost”?


- How do we measure the costs to be assigned?
- How do we assign costs to the product?

Unit cost information is used for multiple purposes such as:

- Product pricing
- Competitive bidding
- Keeping or scraping a product/service (is it profitable?)
- Introducing new product/services
- Make or buy decisions

ACCT2522 considers 2 types of product costing systems:

1. Traditional/volume based costing (VBC) systems


2. Activity based coting (ABC) systems

4.1 TRADITIONAL VOLU ME BASED COSTING SYSTEMS (VBC)

Unit level cost drivers i.e. based on production volume e.g. #DL, #units produced

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ACCT2522

FEATURES OF TRADITIO NAL/VBC SYSTEMS

- Direct material and direct labour costs are traced to products


- Manufacturing overhead costs are allocated to products using a predetermined overhead rate (MOH)
- Manufacturing overhead rate is calculated using some measure of production volume – unit level
cost drivers
o E.g. Number of products, direct materials, direct labour hours or direct machine hours
- Non-manufacturing costs are not assigned to products

INDICATORS OF PROBLEMS WITH TRADITIONAL COSTING SYSTEM

- Proportion direct material and direct labour costs to total manufacturing cost decreases
- Proportion of MOH costs increase
- Non-Volume driven MOH costs increases

o Costs that do not vary in proportion to production volume
o Using only unit level cost drivers no longer appropriate
- Non-manufacturing product related costs increases
o Increase in upstream and downstream activities
o Consider the value chain
- Product diversity increases
o Products consume a diverse range of resources
o Products consume resources differently
 o Indicator: consumption ratios (discussed later)

4.2 ACTIVITY BASED COSTING SYSTEMD (ABC)

Activity Based Costing: a methodology that can be used to measure both the cost of cost objects and the
performance of activities

FEATURES OF ABC

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ACCT2522

Addresses issues relating to:

- Non-volume driven MOH costs


- Non-manufacturing product
related costs
- Product diversity

COSTING VIEW OF ABC

1. Measuring the cost of activities


- Identify and cost the activities performed in each activity cost pools
- Assign costs to activity cost pools
2. Assigning activity costs to products
- Calculate the activity cost per unit of activity driver
- Prepare a bill (list) of activities for each product

ABC TERMINOLOGY

- Resources: inputs required to produce an output


- Activity: a unit of work performed
- Bill of Activities: list of activities performed
- Cost driver: a factor or activity that causes cost to be incurred (LS p331):
o Resource drivers are used to estimate the cost of the resources consumed by an activity.
o Activity drivers are used to estimate the cost of an activity consumed by cost objects
o Root cause cost drivers: the underlying factors that cause activities to be performed and their
costs incurred

ACTIVITY BASED HIERARCHY OF COSTS AND ACTIVITIES

- Unit level costs: costs of activities that are performed for each unit
- Batch level costs: cost of activities performed for a group of produced units
- Product level costs: cost of activities performed for specific products or product families
- Facility level costs: costs of activities incurred to support the business as a whole

ASSIGNING OVERHEAD COSTS USING ABC

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ACCT2522

1. Stage 1: assign resources to activities


2. Stage 2: assign activities to cost objects

MEASURE COST OF ACTIVITIES

1. Resources:
o Identify the resources
o Identify resource drivers
o Identify cost per resource driver
2. Activities
o Identify activities
o Identify resource drivers consumed by activity
3. Measure resources consumed by activities

ALLOCATE ACTIVITIES TO PRODUCTS

1. Activities
o Identify activity drivers
o Calculate cost per activity driver
2. Product
o Identify activities consumed by product
o Allocate activities to product
3. Calculate cost of product

4.3 COMPARE VBC AND ABC

VBC – only manufacturing costs are included in product costs


ABC – manufacturing and product related non-manufacturing costs are included in product costs

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ACCT2522

Consumption Ratios:

- Determine if the products’ consumption of overhead activities are systematically different


- The consumption ratio indicates the proportion of each activity consumed by a product
- Volume based OH allocation uses unit level cost drivers => assigns more cost to high volume products
(product lines with more
units produced)

4.4 EVALUATE THE APPROPRIATENESS OF ABC

When to use ABC?

1. MOH costs are a significant proportion of total manufacturing costs AND a large part of MOH are not
directly related to unit level activities (production volume).
o VBC not appropriate  it uses unit level cost drivers (volume based)
2. Diverse consumption ratios i.e. production activities involve diverse batch sizes, diverse activity
o Production activities involve diverse batch sizes, diverse activity consumption patterns and
product complexity
o VBC not appropriate  it uses unit level cost drivers (volume based)
3. Significant proportion of non-manufacturing product-related costs
o VBC not appropriate => does not allocate non-manufacturing costs
o Non-manufacturing overhead costs e.g. advertisements
4. The “costs” associated with making inappropriate decisions based on inaccurate product costs are
high
o Consider cost benefit analysis  ABC is a lot more expensive

NOTE: for ACCT2522 purposes, the significance threshold will be 10% of costs

APPLICATIONS OF ABC TO DECISION MAKING

Managing costs for customer value

- Cost management

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ACCT2522

- Application of ABC to manage cost and customer value


- Product Life Cycle
- Target costing

COST MANAGEMENT

Improve cost management through understanding and managing the real causes of cost

- What are the main activities driving costs?


o Are they value adding or non-value adding?
- Managing activities  manage costs

Main focus is on cost reduction, but also focus on improving other aspects of performance such as quality and
delivery

- Identify areas for process improvement

4.5 LIMITATIONS AND DIFFICULTIES OF ABC

BEHAVIOURAL ISSUES

Negative behavioural effects:

- Change can be perceived as threatening


o ABC may require changes in data collected and collection and analysis procedures
- Bottom-up change management may give some degree of ownership of any changes caused by ABC

LIMITATIONS OF ABC

Facility level costs:

- No relationship with product


- If a high level of facility-level costs are allocated to products, an arbitrary element enters into the
product cost… can distort product cost
- If not allocated how do we recover cost?
- … include in mark-up %?

Complexity

- Detailed data collection recording


- Constant updating required if company is changing rapidly
- Very expensive