ACCA F5

Performance Management

8th and 14th July 2011

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ACCA F5 Performance Management

Activity Based Costing (ABC)

Chapter 2

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Performance Management ABC: Introduction

Products consume activities, Activities consume resources
Manufacturing costs generally consist of: Direct costs & Indirect costs Traditional: higher portion direct costs than indirect costs Traditional absorption costing system acceptable since indirect cost portion is small accuracy Recent year changes (advanced manufacturing technology ATM) indirect cost is getting higher accuracy? ABC introduced for accuracy in costing and tool for PM
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Performance Management ABC: Introduction

The emergence of ABC systems
Traditional

systems were appropriate when:

1.Direct costs were the dominant costs 2.Indirect costs were relatively small 3.Information costs were high 4.There was a lack of intense global competition 5.A limited range of products was produced.
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Performance Management ABC Concept

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Performance Management ABC: Introduction

Activity-Based Costing Involves the identification of cost drivers which cause the costs of a companys activities, and The allocation of indirect costs to individual product or service on the basis of the usage of cost drivers
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Performance Management ABC

Activities
Aggregation of tasks that consume resources Resources are assigned to activities Activities are assigned to cost objects Assignment to cost objects by cost drivers Support activities: production scheduling, setup machine, move materials, inspect items, process purchase orders, process customer orders Production activities: machine products, assemble products
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Performance Management ABC

Cost drivers:
ABC systems seek to use only cause-andeffect cost drivers Traditional systems often rely on arbitrary allocation bases (volume based). A cost driver is a factor which causes the cost of an activity (a factor which causes a change in the cost of an activity) Example: no of orders handled for despatch costs, no of store requisitions for materials

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Performance Management ABC

Examples of cost drivers:
Activity Material purchases Material handling quality control maintenance line set-up Patient movement booking appointment patient reception x-ray equipment preparation Cost driver no of POs no of movements no of inspections no of break-downs no of set-ups no of in-patients no of patients no of patients time taken

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Performance Management ABC v Traditional Systems

Types of costing systems
Costing system varies in terms of : Which cost are assigned to cost units Accuracy depends on level of sophistication Classification: Marginal costing system Traditional absorption costing system Activity-based costing system (ABC)
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Performance Management ABC: Introduction

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Performance Management ABC: Introduction

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Performance Management ABC: Introduction

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Performance Management ABC v Traditional Systems

Types of costing systems (cntd)
Traditional

absorption costing systems: 1. Assign indirect cost to cost unit 2. Use unsophisticated methods to assign indirect costs.

ABC systems: 1. Assign indirect cost to cost unit 2. Use sophisticated methods to assign indirect costs
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Performance Management ABC v Traditional Systems

Both systems use the two-stage allocation process
Traditional systems:
Stage 1: allocates OHs to production & service departments, then reallocates service department costs to production departments (cost pools) Stage 2: allocates costs from cost centres/pools to products/cost units using small number of 2nd stage cost drivers (volume based OAR)
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Performance Management ABC v Traditional Systems

Both systems use the two-stage allocation process
Traditional systems: cntd
Cost

drivers usually known as allocation basis; OH allocation rates Normally use direct labour hours or machine hours Normally allocate service /production costs to production centres Merged with production centre costs cost pools Then allocate to cost objects based on OAR
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Performance Management ABC: Steps

1. Identify an organisations major activities that take place in an organization 2. Identify the factors which determine the size of the costs of an activity. These are known as cost drivers 3. Collect the costs of each activity into what is known as cost pools, equivalent to cost centres under traditional costing methods 4. Charge costs to products on the basis of their usage of the activity. A products usage of an activity is measured by the number of the activitys cost driver 17 it generates ACCA - F5 Performance Management

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Performance Management ABC v Traditional Systems

Both systems use the two-stage allocation process
Major difference:
ABC relies on greater number of cost centres & 2nd stage drivers that cause activity resource consumption ABC assigns activity costs to cost units on basis of cost driver usage ABC measures resources consumed by cost units more accurately Traditional system reports less accurate cost as cost drivers used do not have cause-and-effect relationships exist between support cost and cost objects
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Performance Management Traditional Systems

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Performance Management ABC

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Performance Management ABC

Assigning the cost of activities to products:
Example 1: Cost pool for sales order handling Cost driver = no of orders processed Total in cost pool = $300,000 Total orders in the year = 1,000 orders Cost per Driver = $300 per order

Product A with 200 orders for the year Order processing cost to charge to Product A = $60,000 ($300 x 200)

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Performance Management ABC

Assigning the cost of activities to products:
Example 2: 4 departments use purchasing function Total purchasing dept costs = $10,000,000 per year Usage of purchasing function: Department A (10M/300x200K) B (10M/300x50K) C (10M/300x40K) D (10M.300x10K) No of orders 200,000 50,000 40,000 10,000 300,000 Cost allocation 6,666,667 1,666,667 1,333,333 333,333 10,000,000

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Performance Management ABC

Assigning the cost of activities to products:
Example 3: Product X
Function Quality control Process set-up Purchasing Customer orders Occupancy cost Ind cost-$ 90,000 135,000 105,000 120,000 150,000 600,000 cost drivers no 450 inspections 450 set-ups 1,000 Pos 2,000 customers 75,000 machine hrs

cost driver
Rate $ / unit

200 300 105 60 2

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Std product cost: Unit material 0.50 Unit labour 0.40 Total production for coming year 1,000,000 units No of production runs 50 (inspect once at end of each production run) No of PO required 50 No of customer order 10 Unit machine time3 minutes
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Performance Management ABC

Assigning the cost of activities to products:
Example 3: Std cost of Product X
Function Quality control Process set-up Purchasing Customer orders Occupancy cost rate x usage$ 200 x 50 300 x 50 105 x 50 60 x 10 2 x 50,000
(1M x 3min / 60 = 50,000)

allocated cost $ 10,000 15,000 5,250 600 100,000 130,850

Allocated cost per unit = 130,850 / 1,000,000 units = $0.14 Std unit cost for Product B: Material $0.50 Labour 0.40 Ohead 0.14 $1.04
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Performance Management ABC: Advantages

Product costs are more accurate Allows company to assess product profitability realistically competitive market Cost behaviour is better understood Facilitates cost control enable ultimate cost reduction Enhances better decisions Recognises the current complexity in manufacturing with multiple cost drivers (wider product range, shorter life cycles, complex processes)

BA

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Performance Management ABC: Advantages

Cost of implementation may exceed its benefits Not significant where indirect costs are low, small product range

BA

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Performance Management ABC

May cause distortion to pricing strategy over-priced or under-priced profitability v competitive market Product strategy encourages focus on products with higher profit margin Helps in identifying value added and non-value added items/activities with a view to elimination Forces managers to evaluate drivers that effect costs and what these drivers contribute to the final product

CBA

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Modern Business Applications ABC

Decision making Accurate cost enhances management decisions such as make-or- buy, expansion or discontinuing business line

BA

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Performance Management ABC

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