Activity-Based Costing: Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e

Chapter 8
Activity-based costing
Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 8-1
Outline
• Problems with traditional product
costing systems
• Activity-based costing
• A simple approach to ABC
• Activity-based vs traditional product
costs
• Activity-based costing issues
• Limitations of ABC
• ABC in service organisations
Problems with traditional
product costing systems
• Features of traditional product costing
systems
– Direct costs are traced to products
– Allocation of manufacturing overhead
costs are to products
– Calculation of manufacturing overhead
rate
– Non-manufacturing costs
(cont.)
Problems with traditional
product costing systems (cont.)
• Failure to adapt to the changing
business environment
– Manufacturing overhead is increasing as
a proportion of total manufacturing costs
and becoming more non-volume-driven
– Non-manufacturing costs are increasing
as a proportion of total costs
• Causes of changes in cost structures
include growing automation
(cont.)
Indicators of problems with a
product costing system
• Traditional product costing systems are
likely to result in inaccurate product costs
when:
─the proportion of direct labour costs decreases
─the proportion of related and unrelated
manufacturing overhead costs increases
─non-manufacturing costs that are product-
related become substantial
─product diversity increases (cont.)

Indicators of problems with a
product costing system (cont.)

Costing in service firms
• Service firms tend to use firm-wide,
volume-based overhead rates
• Customer demands are increasing
• Impact of increasing product diversity
and quality on the level of non-volume-
driven overhead costs
• Accuracy of service costs derived from
traditional product costing systems

Activity-based costing
• A methodology that can be used to
measure both the cost of cost objects and
the performance of activities
• Can help solve problems such as
– Distorted product costs
– Poor cost control
• The form of ABC method adopted
depends on the problems that need to be
addressed

An activity-based costing model
• The costing view
– Measures the cost of activities/objects
– Improves the allocation of manufacturing
overhead costs to products
• Activity management view
– Provides information to manage activities,
managing costs and other sources of
customer value
• The nature of cost drivers
– Three different ways (cont.)
An activity-based costing model (cont.)
Source: Adapted from page 96 of Common Cents: The ABC Performance Breakthrough by Dr Peter B.B. Turney, president and CEO of Cost Technology
Inc., a management consulting firm specialising in ABC/ABM implementations, Cost Technology Inc., Beaverton, Oregon, 1991. Reprinted by permission
of the publisher. All rights reserved.

Costing view
• Step one: measuring the cost of
activities
– Use resource drivers to assign costs
– Determine the total cost for each activity
• Step two: assigning activity costs to
products
– Calculate the cost per activity
– Assign activity costs to cost objects
– Determine the total cost for each product
Activity-based costing terminology
• Activity • Resource driver
– A unit of work performed – A cost driver used to
within the organisation
estimate the cost of
• Activity driver resources consumed
– A cost driver used to by an activity
estimate the cost of an • Root cause cost
activity consumed by
the cost object driver
– The underlying factors
• Cost driver
that cause activities to
– A factor or activity that be performed and their
causes a cost to be costs to be incurred
incurred

Different approaches to ABC
• Simple approach: allocates manufacturing
overhead costs to products
• ABC system for indirect costs: allocates
manufacturing overhead costs and non-
manufacturing costs to products
• Comprehensive system: allocates all
product-related costs (except direct
material) to products and for activity
management
A simple approach to ABC
• Step one: measure the cost of manufacturing
overhead activities
– Identify major manufacturing overhead activities
– Determine total (budgeted) cost of each activity
• Step two: assign cost of manufacturing

overheads activities to products
– Select suitable activity drivers for each activity
– Estimate cost per unit of activity driver
– Assign manufacturing cost to products based on the
quantity of activity drivers consumed (cont.)
A simple approach to ABC
(cont.)
(cont.)
A simple approach to ABC (cont.)

Which costs should be
included in an ABC system?
• Depends on the purpose of the system,
which depends on the needs of
management
• A 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 identified
Hierarchy of activities for ABC
• Unit level activities
– Performed for each unit of product
• Batch level activities
– Performed for each batch of product
• Product level activities
– Performed for specific products or product
families
• Facility level activities
– Required to support the business as a whole

Activity-based vs traditional
product costs
• Traditional product costing assumes
product costs are driven by volume-based
cost drivers
• Traditional costing ignores batch size as a
cost driver as large batches consume a
relatively low cost per unit of batch costs
• Traditional product costs do not include
non-manufacturing costs

When to use ABC
• Overhead costs are a significant
proportion of total cost and a large part of
overhead is not directly related to
production volume
• The business has a diverse product
range, and individual products’ use of
resources differs from their use of volume-
based cost drivers
• Production activity involves diverse batch
sizes and product complexity (cont.)
When to use ABC (cont.)
• Proportion of product-related costs
incurred outside manufacturing is
increasing relative to manufacturing costs
• Likelihood of high costs associated with
making inappropriate decisions based on
inaccurate product costs
• The costs associated with the ABC
system is relatively low due to
sophisticated IT support

Impediments to introducing
ABC
• Lack of awareness of ABC
• Uncertainty about the potential benefits
to be gained from ABC
• Concern about the extensive resources
required to implement ABC
• Resistance to change from managers
and employees

Other activity-based
costing issues
• Variations in types of ABC systems
include whether
– direct labour or non-manufacturing costs
are included in an ABC system
– actual or budgeted costs are analysed
– ABC is implemented as a one-off project
or as an ongoing product costing system
– cost objects other than products are
included
(cont.)
Implications of spare capacity
• ABC estimates the cost of resources
used to perform activities to produce and
sell products
• Committed resources are those supplied
in advance of being used in production
• When budgeted costs are used to
estimate activity costs, the committed
costs supplied will not always equal the
resources used
(cont.)
Behavioural issues in
activity-based costing
• Change can be perceived as threatening
and so may be resisted
• Bottom-up change management may give
employees some degree of ownership of
any changes associated with ABC
• Management must be seen as committed
to the change process by being willing to
allow employees to play a role

Limitations of
activity-based costing
• Facility level costs
– Some systems arbitrarily assign facility level
costs to products
• Use of average costs in decision making
– Batch, product and facility level costs are divided
by the number of units produced leading to
product costs that are of limited use for decision
making
– Desirable to use cost per unit in the short term;
total product cost in the longer term (cont.)

Limitations of
activity-based costing (cont.)
• Complexity
– The cost of updating an ABC system can be
very high, but is needed to avoid producing
outdated, irrelevant information
– The level of complexity increases when the
system is used for both activity
management and product costing
– Activity-based management requires more
extensive and detailed analysis of cost and
activities
Activity-based costing in
service organisations
• ABC can be difficult to implement in service
firms because there are:
– High levels of facility costs, so fewer costs may
be included
– Individual activities are difficult to identify
because they are non-repetitive
– A non-repetitive production environment makes
it difficult to identify service outputs
– Despite these issues, ABC is used in many
major Australian service organisations
Summary
• Traditional costing systems use broad
volume-based overhead rates which is likely
to distort costs
• ABC may be suitable where there are high
levels of non-volume based costs, a diverse
product range and substantial non-
manufacturing product-related costs
• The range of costs included in an ABC
system depends on the purpose of the
system
• Implementation issues
Appendix—a comprehensive
ABC system
• Step one: measure the cost of activities
– Identify activity centres
– Assign costs to activity centres
– Identify activities and resource drivers for each activity
centre
– Assign activity centre costs to activities using resource
drivers
• Step two: assign activity costs to products
– Select suitable activity drivers for each activity centre
– Estimate cost per unit of activity driver
– Assign activity cost to products based on the quantity of
activity drivers consumed (cont.)
Activity-based product costs
(cont.)
Activity-based product costs
(cont.)

Simple vs comprehensive ABC
• Comprehensive ABC system
– More detailed and possibly more accurate
assignment of direct labour and overhead to
products
– More detailed assignment of manufacturing
overheads to products
– Inclusion of non-manufacturing product
related costs
– More detailed identification and analysis of
activities across the business that may be
useful for activity-based management

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Chapter 8

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

• Step two: assign cost of manufacturing

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

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