ACTIVITY BASED COSTING (ABC)

WHAT R IT?

A different method of allocating fixed overheads to inventory (takes into account batch related costs)

The problem with absorption costing (traditional costing system (TCS)) allocation is fixed costs that could be
product specific are allocated equally to all products

Factory 1: 1000 red pens

Factory 2: 800 red pens ; 100 blue pens ; 50 black pens ; 50 green pens

These two processes will not have the same fixed costs. Factory 2 will have additional costs relating to the
different products, for example set up costs required to prepare for the production of a different product

In absorption costing these costs will be allocated to the products evenly, however, this is incorrect. 4 set up
costs are incurred, if allocated evenly 80% of these costs will be allocated to red pens, however, only 25% of
the costs relate to red pens.

Therefore, activity-based costing

Here costs are allocated based on activities, activity in question here is setup of production for a different
colour. Total costs of setup are divided between the four set up activities. Therefore, each pen colour
receives 25% of the costs.

Notice that with ABC red pens will be the cheapest and black/green the most expensive. (25% of costs
spread over 800 pens vs 25% of costs spread over 50 pens)

ABC therefore provides more valuable inventory valuations for managers to make decisions. ABC highlights
areas where inefficiencies / excessive costs are being incurred. Management can then take actions to
address these.

Under absorption costing this information would not be available, management would make incorrect
decisions sending them into a “death spiral”
ACTIVITIES

These are actions taken within the production process, e.g. set up costs, cleaning costs.

Are not linked to departments

If only one product
Ask why the activity is necessary ; what value is the activity adding
TCS == ABC
 Overhead cost accounts relate to the general overheads, such as packaging, cleaning etc.

In TCS these costs are assigned to each cost centre (eg manu 1 (labour intensive) manu 2 (machine
intensive)). Then allocated along with the cost centre fixed overheads based on labour hours or machine
hours
- This can relate to overheads being allocated to products which do not actually incur any of these
costs. Such as packaging costs getting allocated to a product that is transferred internally and does
not require packaging costs

In ABC more detailed activities are determined. The costs centres will most likely remain the same but only
the overheads incurred in those processes will be allocated. Additional activities will be created eg
packaging, cleaning, set up. Costs are allocated to these activities and then to the products based on the
amount of time spent in this activity
- Now no packaging costs will be allocated to a product unless that product actually spends time in
that activity
- Also, think pen example. The set up costs will be allocated to each colour separately, spreading it
evenly over the different colour options instead of over all pens produced

WHY ABC?

Due to weaknesses in traditional costing system

In historical times:

• Direct costs  Dominant

• Overheads  minimal

• Modern times due to manufacturing processes direct costs are less and overheads are more,
therefore, a need arises to better track the usage of overheads

• Fewer products

• A company would focus on one / two products meaning allocation of o/hs was less
important. The more products the more important correct allocation is

• Low competition

• Think original ball point pen producer. No one else was there to compete, therefore, the
price charged was not important, as long as costs were covered. Modern days its highly
competitive, therefore, companies need to know the lowest price they can charge while still
achieving an acceptable margin

• Information was expensive

• Prior to technology it was very hard to keep track of detailed information in manufacturing
processes. Everything would have to be tracked manually. Now computerized systems
automatically track manufacturing information, it is therefore, much cheaper to have
detailed information on which to base allocations

• Limited number of service organisations

• Service organisations are very overhead driven. Prior it was government run, they only cared
about providing the service and covering costs. As privatization occurred it became more
 important to maximise profit and stay competitive, therefore, a need for accurate allocation
methods arose

COST v BENEFIT

Very important to consider if the benefit of tracking activities is greater than the cost. This
determines how much detail activities will be tracked in. The more activities the more accurate the
valuation

FOUR STAGES INVOLVED IN DESIGNING AN ABC SYSTEM

- Also used for answering ABC questions

STAGE 1
Identify activities within the organisation

- Groups of similar tasks – purchasing, setup, receiving

o # of activities = # of different drivers
- Based on value chain

STAGE 2
Assigning costs to activity centres

- Keep the costs as direct as possible

STAGE 3
Select appropriate cost drivers

- Measurable
- Obtainable
- Identifiable with products
o Transaction driver (frequency of activity)
o Duration driver (time used for activity)

STAGE 4
Assigning activity costs to products

- Based on the products demand for the activity

ABC PROFITABILITY ANALYSIS

Draw up a SPL based on the activity hierarchy, getting different levels of profit based on these costs.

Activity hierarchy:

1. Unit level (direct variable)

2. Batch level (ABC FC)
3. Product sustaining (not really
avoidable)
4. Facility sustaining (Head office)

RESOURCE CONSUMPTION MODELS

Essentially over/under recoveries

Cost of resource supplied = cost of resource used + unused capacity

- Cost of resources supplied = actual

- Cost of resources used = ABC allocated
- Unused capacity = under/over-recovery

BENEFITS / PITFALLS OF ABC

BENEFITS
• Great in service organisations – where most costs are fixed

• Leads to more accurate product costs, and hence better decisions

• Better understanding of the various costs accumulated in completing the value chain

• Focused around the customer – cost accumulation in the value chain identifies non-value-added
activities

PITFALLS
• It is an absorption costing system, as it entails the allocation of fixed overheads

ACTIVITY BASED MANAGEMENT

All steps are done except for allocation to products

- ABC normally identifies products which should be discontinued

- If all products are essential then there is no need to allocate costs to products, activity based
measures are then used for performance management and cost control purposes

Value chain analysis to determine places for cost savings

ACTIVITY BASED BUDGETING

Working from number