Lecture outline

• Limits of traditional overhead allocation

methods for Multi-product businesses and
Modern competitive environments
• Introduction to Activity based costing (ABC)
• Seminal work on ABC (Miller & Vollman,1985;
Cooper & Kaplan, 1988)
• ABC Numerical Exercises
• Anaesthesia care and time-driven ABC
• Benefits and limits of ABC

8
 Recap: Overhead allocation and job costing

Materials
+ Wages
Indirect costs
+ Rent
+ Insurance Cost
+ Salaries traceability
+ Depreciation Service I Service II
+…
= Total costs

Operating Operating Operating

A B C

Direct costs Jobs

9
LIMITS OF TRADITIONAL OVERHEAD
ALLOCATION METHODS

10
 Single- product vs. multi-product
businesses
• Traditional cost allocation methods uniformly assign cost of
overheads to cost units using one cost driver (e.g. direct
labour hours) and calculates a blanket rate.

• Difficulty in multi-product businesses: Products that are

highly specialised usually absorb not as many labour or
machine hours as less specialised, high-volume products.
Where the more specialised should absorb more. (explained
on the next slide)

• This situation may lead to issue of undercosting of highly

specialised products and overcosting of standardised, high-
volume products.

11
 Single- product vs. multi-product
businesses
• Sophisticated “high end” products consume
most of the support resources (i.e. overhead
costs) e.g. even after sale assistance with
sophisticated products.
• Under traditional methods “low end”, “mass
market”, but high volume products absorb most
of the overheads, even though they do not
cause them. Traditional cost allocation methods
(methods using one allocation base) don’t
reflect this.

12
 Activity-Based Costing (ABC)
Both manufacturing
and non-manufacturing ABC is a good
costs may be supplement
assigned to to our traditional
products. cost system.

Allocation bases Used in internal

often differ from decision making as well
as in inventory valuation
traditional costing (but with some adjustments)
systems. for external reporting
4-18
 The challenge for management
accounting
• How can we ensure tight management control
over increased overhead amounts?

• How can we ensure a fair absorption of

overheads to products/services?

•Answer: Development of comparatively

modern approaches to overhead analysis and full
costing (e.g. ABC).

25
 Main selling points of ABC
• Activity-based costing systems do not arbitrarily
assign certain costs e.g. factory security guard’s
wages, the plant controller’s salary which are
called organisation-sustaining costs, to
products. Activity-based costing treats these
types of costs as period costs rather than
product costs.

• Products are not charged for the (idle capacity)

costs of the capacity they do not use. This
provides more stable unit product costs
Types of transactions that drive OH costs
(Hidden Factory)

• Logistical transactions, which order, execute,

and confirm the movement of materials from
one location to another.
• Balancing transactions, which ensure that the
supplies of materials, labour, and capacity are
equal to the demand. These result in the
movement orders and authorisations that
generate logistical transactions.
 Types of transactions that drive OH
costs – (Hidden Factory)
• Quality transactions communication of
specifications, the certification that required
transactions have taken place as they were
supposed to, and the development and
recording of relevant data.
• Change transactions, which update basic
manufacturing information systems to
accommodate changes in engineering
designs, schedules etc.
 Steps in ABC
1: Group production overheads into activities, (The terms
‘activity’ and ‘cost pool’ are often used interchangeably).

2. Identify cost drivers for each activity (e.g. Ordering costs of

Ordering “activity” or No. of Japanese guests for Japanese cuisine cooking
“activity”)

3. Calculate Activity cost driver rate for each activity. A

separate Cost driver rate will be calculated for each
activity (Just like we learnt Overhead absorption rate
(OAR) in Absorption costing)
 Steps in ABC
4. Activity costs are absorbed into the product
using the cost driver rate.

5. Calculate full production cost.

 ABC and traditional costing
• Traditional approach
– One or few apportionment bases
for each department or plant.
– Indirect cost allocation bases may
or may not be true cost drivers.
– Risk of over or under-costing
• ABC approach
– Several indirect cost pools
because of many activity areas
(focus on activities)
– Indirect cost allocation bases are
likely to be true cost drivers (that
drive the costs).
– Promises a comparatively more
accurate costing
60
 Uses of ABC in decision-making
Pricing:
Gives insight into cost structures of diverse products.
Leads to more accurate pricing.

Product-mix decisions:
Costs absorbed by complex products are usually better reflected THEREFORE Leads to
more accurate product-mix decisions.

Cost reduction and process improvement:

More opportunities for improving efficiency can be discovered.
Overhead costs can be controlled by managing cost drivers. (true cost drivers could be
focused on)

Design decisions:
Allows to evaluate more accurately costing of new designs because various activities
that assist in designing would be identified (these may be various activities that are
spread between various functions/departments- so identifying true costs)
Development processes can be more efficiently managed if focus remains on activities.

61
 Hierarchy of costs in practice
Cooper and Kaplan (1991) identify four levels of activity, calling them a
hierarchy of cost. These are relevant in practice:

(i) Unit-level activities.

Activities where the consumption of resources is very
strongly correlated with the number of units produced
e.g. direct material and direct labour/ or machine hours and
labour hours.

(ii) Batch-level activities.

Consumption of resources is in proportion to the number of
batches produced, rather than in proportion to the number of
units produced. E.g. costs of machine set-up, materials handling,
batch inspection, purchase orders. etc.
 Hierarchy of costs in practice
(iii) Product-level activities.
Consumption of resources may be related to the existence of particular products
e.g. with regards to administration, product specification or purchasing in order
to sustain the existence of particular products.
These activities that support an entire product line. E.g. engineering changes in
the assembly line, product design changes, and warehousing and storage costs
for each product line.

(iv) Facility-level activities.

Some costs relate simply to being in business and that therefore cannot be
related in any way to the production of any particular product line. For example
Grounds maintenance, plant security and property taxes.

If the bulk of the overhead is made up of (i) (Unit level) and (iv) (Facility level)
the traditional approach and the ABC approach will give similar product
costs.

If majority of overhead cost falls into (ii) (Batch level) and/or (iii) Product
level, there will be a notable difference between traditional approach and
the ABC approach.
3-65
Hierarchy of Activities
Level Activities
Unit-level Processing units on machines
Processing units by hand
Consuming factory supplies
Batch-level Processing purchase orders
Processing production orders
Setting up equipment
Handling materials
Product-level Testing new products
Administering parts inventories
Designing products
Facility-level General factory administration
Plant building and grounds
Activity Measure e.g.
Machine-hours
Direct labor-hours
Units produced
Purchase orders processed
Production orders processed
Number of setups
Pounds of material handled
Hours of testing time
Number of part types
Hours of design time
Direct labor-hours
Direct labor-hours
3-67

Activity-Based Costing
Critical Assumption
The cost in each activity pool is strictly
proportional to its activity measure. When this
assumption is violated, the accuracy of ABC
data can be called into question.

For example, managers should be particularly

alert to product costs that contain allocated
facility-level costs.
 Situations when a company should
consider using ABC
Indirect costs are significant in proportion to direct costs.
Goods are complex, requiring many inputs and processes.
Complex, low-volume products are profitable while standard,
high-volume products are not.
Different departments believe costs are assigned
inaccurately.
The company loses bids it thought were low, and wins bids it
thought were high.
Operations have changed (developed) significantly, but the
costing system has not changed.
Introduction of new models resulting in higher sales (because
of higher demand) higher profits per unit; but the overall
income declines.
 Failure in transitioning from ABC to
ABM
A study by the Institute of Management Accountants disclosed that 80 per cent of
ABC users reported that ABC had not yet resulted in any profit increase.

One problem identified by researchers is that the information generated by ABC has
to be used effectively in order to achieve the expected results.

An ABC implementation failure could be defined as the inability of a company to

move from simply generating ABC information towards actually using the
information.

Roberts & Silvester, ‘Why ABC failed and why it may yet succeed’, JCM 1996

Academics and the profession have noted that the organisations can contain
structural barriers to change that make it difficult to progress from ABC to ABM.

The design and installation of sophisticated accounting systems is pointless if the

information from those systems is not used.
 ABC is NOT for statutory financial
reporting
Strictly speaking, non-manufacturing costs are excluded from
product costs under Generally Accepted Accounting Practice -
GAAP. (Unless necessary adjustments are made e.g. excluding
non-manufacturing overheads and including manufacturing
overheads then that adjusted amount could be reported under
GAAP)

Remember, these costs are to be used for making decisions, not

for valuing inventory and cost of goods sold.

‘Other’ costs type should not be allocated to products,

customers, or other cost objects. This activity cost pool is
supposed to capture costs of idle capacity and organisation-
sustaining costs. But in practice, these costs are somehow
allocated to cost objects using some logical basis.
 ABC: Advantages
• More equitable than traditional overhead absorption
methods, as overheads are absorbed on the level of
activity of a number of different activities (ie cost pools)

• Good base on which to make management decisions such

as resource allocation or even discontinuing some
products or business units.

• Recognises the increasing importance of overheads in

many businesses is increasing and is very often a
significantly large cost

99
 ABC: Advantages
• For more realistic pricing, especially where
selling prices are set by adding a profit mark-
up to cost

• Focuses on the true amount of time and

resources used by the products in the major
area of support activity – (Can help finding
efficiencies in support functions also)

100
 Limitations of ABC
• ABC systems are built on strong assumptions:
– Assumption of linear cost behaviour (because we apply cost
driver rate just as OAR)
– Assumption that one cost pool is driven by one cost driver
only. A single cost driver may not explain the cost
behaviour of all items in a cost pool.
– Very rare that all overhead costs could be allocated to
specific activities.
– Mistakes, and undercosting and overcosting, can still occur
under ABC: e.g. when wrong cost drivers are assigned, or
when cost pools are driven by more than one activity.

101
 Limitations of ABC
• Cost apportionment may still be needed for costs that are
shared e.g. rent, rates and premises depreciation (e.g.
Facility level costs by Cooper and Kaplan, 1991).
Apportionment can be an arbitrary way of sharing costs.

• Do benefits gained in pursuit of mere accuracy in cost

calculations overweigh the costs of maintaining and
updating the system?

• In order to use cost drivers, activity should be

measurable/quantifiable.

• Identifying activities and their associated costs may be a

complex task.
102
 Limitations of ABC
• Allocating overhead costs may be strongly
influenced by policies, points of view and
judgements (could even be emotive and
politically sensitive between segments)
• Requires thorough understanding of the
business
• May be met by resistance to change

103