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10 Activity-based costing . . . . . . Learning objectives . . . . . . . After studying this chapter you . . . should be able to: . . . . . . explain the role of a cost . . . . . . accumulation system for . . . generating relevant cost . . . . . information for decision . . . . . . making; . . . . . . descr describe ibe the diffe differences rences . . . between activity-based and . . . . . . traditional tradit ional costin costing g system systems; s; . . . . . illustrate ate how tradit traditional ional . . . illustr . . costing systems can provide . . . . . . misleading information for . . . . decision-making; . . . . . . explain each of the four . . . . . . stages involved in designing . . . ABC system systems; s; . . . . . . . . . describe the ABC cost . . hierarchy; . . . . . . . . . describe the ABC pro®tability . . . analysis hierarchy; . . . . . describe the ABC resource . . . . . . consumption model; . . . . . justify the choice of practical . . . . . . capacity as the denominator . . . level for estimating cost . . . . . . driver rates. . . . . . . . . . . . . . . .......................... ........................................ ........................... ........................... ............................ ........................... ........................... ............................. ........................... .......................... ........................... ..................... ........ .
The The aim aim of the the prev previo ious us chap chapte terr was was to pro provide vide you you with with an unders understan tanding ding of the princi principle pless that that should should be used used to identif identify y relevant costs and revenues for various types of decisions. It was assum assumed ed that that rele releva vant nt cost costss could could easil easily y be meas measur ured ed but, but, in real realit ity y, it was point pointed ed out that that indir indirec ectt rele releva vant nt cost costss can can be dif®cu dif®cult lt to identif identify y and measur measure. e. The measur measureme ement nt of indirec indirect t relevant relevant costs for decision-maki decision-making ng using activity-ba activity-based sed costing (ABC) techniques will be examined in this chapter. The aim of this chapter is to provide you with a conceptual understanding of ABC. ABC. Some Some of the issues issues explor explored ed are complex complex and theref therefore ore much of the content of this chapter is appropriate for a second year management accounting course. If you are pursuing a ®rst year course the content relating to ABC that was presented in Chapter 3 should meet your requirements. In addition, you may wish to read this chapter and omit those sections that are labelled advanced reading. Our focus focus will will be on an organi organizat zation ion''s existing products products or services. There is also a need to manage future activities to ensure that only pro®table products and services are launched. Here the emphasis is on providing cost information using techniques such as target costing, life cycle costing and value engineering. These issues will be explored in Chapter 22 and the mechanisms for appraising investments in new products, services or locations will be be desc descri ribe bed d in Chap Chapte ters rs 13 and and 14. 14. We shal shalll also also defe deferr our discuss discussion ion of the relev relevant ant cost cost inform informati ation on that that is requir required ed for pricing decisions until the next chapter. Unless otherwise stated we shall assume that products are the cost cost object objectss but the techni technique quess used used, and the princi principles ples established, can also be applied to other cost objects such as customers, services and locations. We begin with an examination of the role that a cost accumulation system plays in generating relevant cost information for decision-making.
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The role of a cost accumulation system in generating relevant cost information for decision-making There are three main reasons why a cost accumulation system is required to generate relevant cost information for decision-making. They are: 1. man many y indire indirect ct costs are relevant relevant for decisio decision-ma n-making; king; 2. an attention-directi attention-directing ng inform information ation system is requir required ed to identif identify y those potentially potentially unpro®table products that require more detailed special studies; 3. produc productt decisions are not independent. independent. There is a dan There danger ger tha thatt onl only y tho those se inc increm rementa entall cos costs ts tha thatt are uniquely uniquely attributa attributable ble to indivi ind ividua duall pro produc ducts ts wil willl be cla classi® ssi®ed ed as rel relev evant ant for dec decisio ision-m n-makin aking. g. Dir Direct ect cos costs ts are transparent and how they will be affected by decisions is clearly observable. In contrast, how indirect costs will be affected by decisions is not clearly observable. There has been a tenden ten dency cy in the pas pastt to ass assume ume that the these se cos costs ts are ®xed and irre irrelev levant ant for dec decisio isionnmaking. In many organizations, however, these are costs that have escalated over the years. The message is clear ± they cannot be assumed to be ®xed and irrelevant for decisionmaking. The costs of many joint resources ¯uctuate in the long term according to the demand for them. The cost of support functions fall within this category. They include activities such as mater materials ials procur procurement ement,, mater materials ials handli handling, ng, produ production ction schedu scheduling, ling, war warehousin ehousing, g, ex pediting pedit ing and custom customer er order proce processing. ssing. The costs of these acti activities vities are either not directly traceable to products, or would involve such detailed tracing, the costs of doing so would far exceed their bene®ts. Product introduction, discontinuation, redesign and mix decisions determine determ ine the deman demand d for support function resources. For example, example, if a decisi decision on resul results ts in a 10% reduction in the demand for the resources of a support activity then we would expect, in the long term, for some of the costs of that support activity to decline by 10%. Therefore, to estimate the impact that decisions will have on the support activities (and their future costs) a cost accumulation system is required that assigns indirect costs, using cause-and-effect allocations, to products. For decision-making it could be argued that relevant costs need only be ascertained when the need arises. For example, why not undertake special studies at periodic intervals to make sure that each product is still pro®table? Estimates could be made only when undertaking a special study of those relevant costs that would be avoided if a product was discontinued. This approach is ®ne for highly simpli®ed situations where an organization only produces a few products and where all relevant costs are uniquely attributable to individual products. However, most organizations produce hundreds of products and the range ran ge of pot potent ential ial dec decisio isions ns to exp explor loree und underta ertakin king g spe specia ciall stu studie diess is eno enormou rmouss and unmanageable. For example, Kaplan (1990) considers a situation where a company has 100 pro produc ducts ts and out outline liness the dif dif®cu ®cultie ltiess of det determ erminin ining g whi which ch pro produc duct, t, or pro produc duct t combinations, should be selected for undertaking special studies. Kaplan states: First how do you think about which product you should even think about making a decision on? There are 100 different products to consider. But think about all the combinations of these products: which two products, three products or groupings of 10 or 20 products should be analyzed? It's a simple exercise to calculate that there are 2100 different combinations of the 100 products F F F so there is no way to do an incremental revenueaincremental analysis on all relevant combinations (p. 13).
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To cop copee with the va vast st num number ber of pote potenti ntial al pro produc ductt com combin binatio ations ns org organi anizat zation ionss nee need d attent att entionion-dir direct ecting ing inf informa ormation tion to hig highlig hlight ht tho those se spe speci® ci®cc pro produc ducts, ts, or com combin binatio ation n of products, that appear to be questionable and which require further detailed special studies to ascertain their viability. Periodic product pro®tability analysis meets this requirement. A cost accumulation system is therefore required to assign costs to products for periodic pro®tability analysis. The third reason for using a cost accumulation system is that many product related decisio dec isions ns are not inde independ pendent ent.. Con Conside siderr aga again in tho those se joi joint nt res resourc ources es sha shared red by mos most t products and that ¯uctuate in the longer term according to the demand for them. If we focus only on individual products and assume that they are independent, decisions will be taken in isolation of decisions made on other products. For joint resources the incrementalaavoidable costs relating to a decision to add or drop a single product may be zero. Assuming that 20 products are viewed in this manner then the sum of the incremental costs will be zero. However, if the 20 products are viewed as a whole there may be a signi®cant change in resource usage and incremental costs for those joint resources that ¯uctuate according to the demand for them. Cooper (1990b) also argues that decisions should not be viewed independently. He states: The decision to drop one product will typically not change `®xed' overhead spending. In contrast, dropping 50 products might allow considerable changes to be made. Stated somewhat tritely, the sum of the parts (the decision to drop individual products) is not equal to the sum of the whole (the realisable savings from having dropped 50 products). To help them make effective decisions, managers require cost systems that provide insights into the whole, not just isolated individual parts (p. 58). Thus, where product decisions are not independent the multiplication of product costs, that include the cost of joint resources, by the units lost from ceasing production (or additional units from introducing a new product) may provide an approximation of the change in the long term of total company costs arising from the decisions. The rationale for this is that the change in resource consumption will ultimately be followed by a change in the cash ¯ow ¯o w pat pattern tern of the org organi anizat zation ion bec becaus ausee org organi anizat zations ions ma make ke pro produc ductt intr introdu oductio ction n or abandonment decisions for many products rather than just a single product. These issues are complex and will be explained in more detail later in the chapter.
Types of cost systems Costing systems can vary in terms of which costs are assigned to cost objects and their level of sophistication. Typically cost systems are classi®ed as follows: 1. dir direct ect costi costing ng syste systems; ms; 2. traditi traditional onal absorption absorption costin costing g systems; systems; 3. acti activity-ba vity-based sed costing costing system systems. s. Direct Dire ct co cost sting ing sy syste stems ms onl only y as assi sign gn di dire rect ct co costs sts to co cost st ob obje jects cts.. He Hence nce th they ey re repo port rt contributions to indirect costs. They are appropriate for decision-making where the cost of those joint resources that ¯uctuate according to the demand for them are insigni®cant. Negative or low contribution items should then be highlighted for special studies. An estimate of those indirect costs that are relevant to the decision should be incorporated within the analysis at the specia speciall study stage. The disadvantage disadvantage of direc directt costing systems is that systems are not in place to measure and assign indirect costs to cost objects. Thus any attempt to incorporate indirect costs into the analysis at the special studies stage must be
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based on guesswork and arbitrary estimates. Direct costing systems can therefore only be recommended where indirect costs are a low proportion of an organization's total costs. Both Bot h tra tradit ditiona ionall and ABC systems systems ass assign ign indi indirec rectt cos costs ts to cos costt obj object ects. s. The maj major or features of these systems were described in Chapter 3 and the assignment of costs to products was illustrated for both systems. In the next section the major features that were described in Chapter 3 are brie¯y summarized but the assignment of costs to products will not be repeated. If you wish to renew your understanding of the detailed cost assignment process you should refer back to Chapter 3 for an illustration of the application of the twostage allocation process for both traditional and ABC systems.
A comparison of traditional and ABC systems Figure 3.3 was used in Chapter 3 to illustrate the major differences between traditional costing and ABC systems. This diagram is repeated in the form of Figure 10.1 to provide you with an overview of both systems. Both use a two-stage allocation process. In the ®rst stage a traditional system allocates overheads to production and service departments and then reallocates service department costs to the production departments. An ABC system assigns overheads to each major activity (rather than departments). With ABC systems, many man y act activ ivityity-bas based ed cos costt cen centre tress (al (altern ternati ativel vely y kno known wn as cos costt poo pools) ls) are est establ ablishe ished d, whereas with traditional systems overheads tend to be pooled by departments, although they are normally described as cost centres. Activities consist of the aggregation of many different tasks and are described by verbs associated assoc iated with objec objects. ts. Typica ypicall support activities activities include include:: sched schedule ule produc production, tion, set-up machines, mach ines, move mater materials, ials, purchase mater materials, ials, inspect items, process supplie supplierr recor records, ds, expedi exp edite te and pro proces cesss cus custom tomer er ord orders ers.. Pro Produc duction tion pro proces cesss act activi ivitie tiess inc includ ludee mac machin hinee products and assemble products. Within the production process, activity cost centres are often identical to the cost centres used by traditional cost systems. Support activities are also sometimes identical to cost centres used by traditional systems, such as when the purchasing department and activity are both treated as cost centres. Overall, however, ABC systems will normally have a greater number of cost centres. The second stage of the two-stage allocation process allocates costs from cost centres (poo (p ools) ls) to pr prod oduc ucts ts or ot othe herr ch chos osen en co cost st ob obje ject cts. s. Tr Trad aditi ition onal al co costi sting ng sy syste stems ms tr trac acee overheads to products using a small number of second stage cost drivers , which vary direct dir ectly ly with the volu volume me pro produc duced. ed. Instead Instead of usi using ng the term `co `cost st dri driver ver'' the term termss `allocation bases' or `overhead allocation rates' tend to be used. Direct labour hours and machine hours are the volume bases that are normally used by traditional costing systems. In con contras trast, t, ABC syst system emss use man many y sec second ond-sta -stage ge cos costt dri driver vers, s, inc includi luding ng non non-vo -volum lumee based drivers, such as the number of production runs for production scheduling and the number of purchase orders for the purchasing activity. A further distinguishing feature is that traditional systems normall normally y alloca allocate te serviceasup support port cos costs ts to pro produc duction tion cen centre tres. s. Their costs are merged with the production cost centre costs and thus included within the production produ ction centre overhead overhead rates. In contrast, ABC system systemss tend to establ establish ish separate cost driver rates for support centres, and assign the cost of support activities directly to cost objects without any reallocation to production centres. Therefore the major distinguishing features of ABC systems are that they rely on a greaterr numbe greate numberr of cost centres and second stage drivers. By using a greater number of cost centres and cost drivers that cause activity resource consumption, and assigning activity costs to cost objects on the basis of cost driver usage, ABC systems can more accurately measure mea sure the res resour ources ces con consum sumed ed by cos costt obj objects ects.. Tr Tradi adition tional al cos costt syst system emss rep report ort les lesss accurate costs because they use cost drivers where no cause-and-effect relationships exist to assign support costs to cost objects.
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F I G U R E 1 0 . 1 An illustration of the two-stage allocation process for traditional and activity-bas activi ty-based ed costin costing g systems systems.. (A) TRADITIONAL COSTING SYSTEMS
Overhead cost accounts (for each individual category of expenses e.g. property taxes, depreciation etc.)
First stage allocations Cost centres 1 (normally departments)
Cost centres 2 (normally departments)
•••••
Cost centres N (normally departments)
Second stage allocations (direct labour or machine hours) Direct costs
Cost objects (products, services and customers)
(B) ACTIVITY-BASED COSTING SYSTEMS
Overhead cost accounts (for each individual category of expenses e.g. property taxes, depreciation etc.) First stage allocations (resource cost drivers) Activity cost centre 1
Activity cost centre 2
•••••
Second stage allocations (activity cost drivers)
Direct costs
Cost objects (products, services and customers)
Activity cost centre N
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The emergence of ABC systems During the 1980s the limitations of traditional product costing systems began to be widely publicized. These systems were designed decades ago when most companies manufactured a narrow range of products, and direct labour and materials were the dominant factory costs. Overhead Overhead costs were relatively relatively small, and the distortio distortions ns arisin arising g from inappropriate inappropriate overhead allocations were not signi®cant. Information processing costs were high, and it was therefore dif®cult to justify more sophisticated overhead allocation methods. Today companies produce a wide range of products; direct labour represents only a small fraction of total costs, and overhead costs are of considerable importance. Simplistic overhead allocations using a declining direct labour base cannot be justi®ed, particularly when information processing costs are no longer a barrier to introducing more sophisticated cost systems. Furthermore, the intense global competition of the 1980s has made decision errors due to poor cost information more probable and more costly. Over the years the increased opportunity cost of having poor cost information, and the decreased cost of operat ope rating ing mor moree sop sophist histica icated ted cos costt sys system tems, s, inc increa reased sed the dem demand and for mor moree acc accura urate te product costs (Holzer and Norreklit, 1991). It is against this background that ABC has emer em erge ged. d. AB ABC, C, ho how wev ever er,, is no nott a re rece cent nt in inno nova vati tion. on. Fi Fift fty y ye year arss ag ago o Go Goet etzz (1 (194 949) 9) advocated ABC principles when he wrote: Each primary [overhead] class should be homogeneous with respect to every signi®cant dimension of management problems of planning and control. Some of the major dimensions along which [overhead] may vary are number of units of output, number of orders, number of operations, capacity of plant, number of catalogue items offered (p. 142). Decreasing information processing costs resulted in a few ®rms in the USA and Europe imple im pleme ment nting ing AB ABC C ty type pe sy syste stems ms du duri ring ng th thee 19 1980s 80s.. In a se seri ries es of ar arti ticl cles es ba base sed d on observations of innovative ABC type systems Cooper and Kaplan conceptualized the ideas underpinning these systems and coined the term ABC. These articles were ®rst published in 1988. They generated a considerable amount of publicity and consultants began to market and implement ABC systems before the end of the decade. In a survey of UK companies Innes and Mitchell (1991) reported that approximately 10% of the surveyed companies had implemented, or were in the process of implementing ABC. Based on their experience of working with early US adopters, Cooper and Kaplan articulated their ideas and reported further theoretical advances in articles published between 1990 and 1992. These ideas and the theoretical advances are described in the remainder of this chapter. ABC ideas have now become ®rmly embedded in the management accounting literature and educational educational course coursess and many practit practitioner ionerss hav havee attend attended ed cours courses es and conferences conferences on the topic.
Errors arising from relying on misleading product costs If a large proportion of an organization's costs are unrelated to volume measures, such as direct labour hours or machine hours, there is a danger that traditional product costing systems will report inaccurate product costs. In particular it is claimed that traditional system sys temss ten tend d to over vercos costt high vol volume ume pro produc ducts ts and und underc ercost ost lo low w volu volume me pro produc ducts. ts. Consider the information presented in Example 10.1.
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E X A M P LE 1 0 . 1 Assume that the Balearic company has only one overhead he ad co cost st ce cent ntre re or co cost st po pool ol.. It cu curre rrentl ntly y op oper erat ates es a traditi tra ditiona onall cos costing ting sys system tem usin using g dir direct ect lab labour our hou hours rs to allocate overheads to products. The company produces several products, two of which are products HV and LV LV. Product HV is made in high volumes whereas product LV is made in low volumes. Product HV consumes 30% of the direct labour hours and product LV consumes only 5%. Because of the high volume production product HV can be made in large production batches but the irregular and low level of demand for product LV requires it to be made in small batch batches. es. A det detail ailed ed in inves vestiga tigatio tion n ind indica icates tes tha thatt the num number ber of bat batche chess pro proces cessed sed causes cau ses the dem demand and for ov overh erhead ead res resour ources ces.. The tra traditi ditional onal sys system tem is the theref refore ore replaced with an ABC system using the number of batches processed as the cost driver. You ascertain that each product accounts for 15% of the batches processed during the period and the overheads assigned to the cost centre that ¯uctuate in the long term according to the demand for them amount to £1 million. The direct costs and sales revenues assigned to the products are as follows: Prod Pr oduc uctt HV (£)
Prod Pr oduc uctt LV (£)
310 00 000 600 00 000
40 00 000 150 00 000
Direct costs Sales revenues
Show the product pro®tability analysis Show analysis for produc products ts HV and LV LV using the tradit traditional ional and ABC systems.
The reported product costs and pro®ts for the two products are as follows: Traditional system Prod Pr oduc uctt HV (£)
Prod Pr oduc uctt LV (£)
Direct costs 310 000 40 000 Oveerh Ov rhea eads ds al allo loca cate ted d 300 30 0 00 000 0 (30 30%) %) 5000 50000 0 (5 (5%) %) Reported Report ed pro®tsa(losses) (10 0 00 00) 60 00 000 Sales revenues 600 00 000 150 00 000
ABC system Prod Pr oduc uctt HV (£)
Prod Pr oduc uctt LV (£)
310 000 40 000 150 15 0 00 000 0 (1 (15% 5%)) 150 150 00 000 0 (15 15% %) 140 00 000 (40 0 00 00) 600 00 000 150 00 000
Because product HV is a high volume product that consumes 30% of the direct labour hours whereas product LV, the low volume produc productt consum consumes es only 5%, the tradit traditional ional syste sy stem m tha thatt us uses es dir direc ectt la labo bour ur hou hours rs as th thee al alloc locat atio ion n ba base se al allo loca cate tess si six x ti time mess mo more re overheads to product HV. However, However, ABC systems recognize that t hat overheads are caused c aused by other factors, besides volume. In our example, all of the overheads are assumed to be volume unrelated. They are caused by the number of batches processed and the ABC system sys tem est establ ablish ishes es a cau causese-and and-ef -effec fectt all alloca ocation tion rel relati ations onship hip by usin using g the num number ber of batches processed as the cost driver. Both products require 15% of the total number of batches so they are allocated with an equal amount of overheads.
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With the traditional costing system misleading information is reported. A small loss is reported for product HV and if it were discontinued the costing system mistakenly gives the impression impression that ove overhead rheadss will declin declinee in the longer term by £300 000. Furthermore, Furthermore, the message from the costing system is to concentrate on the more pro®table speciality products like product LV LV. In reality this strategy would be disastrous because low volume products like product LV LV are made in small batches and require more people for scheduling production, performing set-ups, inspection of the batches and handling a large number of customer requests for small orders. The long-term effect would be escalating overhead costs. In contrast, the ABC system allocates overheads on a cause-and-effect basis and more accurately measures the relatively high level of overhead resources consumed by product LV. The message from the pro®tability analysis is the opposite from the t he traditional system; that th at is is,, pr prod oduc uctt HV is pr pro® o®ta tabl blee an and d pr prod oduc uctt LV is unp unpro ro®ta ®table ble.. If pr prod oduc uctt LV is discontinued, and assuming that the cost driver is the cause of all the overheads then a decision to discontinue product LV should result in the reduction in resource spending on overhead ove rheadss by £150 000. Example 10.1 is very simplistic. It is assumed that the organization has established only a single cost centre or cost pool, when in reali reality ty many will be established established with a traditional traditional system, and even more with an ABC system. Furthermore, the data have been deliberately biased biase d to show the superiority superiority of ABC. The aim of the illustr illustration ation has been to highli highlight ght the potential cost of errors that can occur when information extracted from simplistic and inaccurate cost systems is used for decision-making.
Designing ABC systems The discussion so far has provided a broad overview of ABC. We shall now examine ABC in more detail by looking at the design of ABC systems. Four steps are involved. They are: 1. identi identifying fying the major activities that take place in an organization; organization; 2. assigning costs to cost poolsacost centres for each activity; 3. determ determining ining the cost drive driverr for each major activity; activity; 4. assigning assigning the cost of activities to products according to the produc product' t'ss demand for activities. The ®rst two steps relate to the ®rst stage, and the ®nal two steps to the second stage, of the two-stage allocation process shown in Figure 10.1. Let us now consider each of these stages in more detail.
STEP 1: IDENTIFYING ACTIVITIES Activities are composed of the aggregation of units of work or tasks and are described by verbs associated with tasks. For example, purchasing of materials might be identi®ed as a separate activity. This activity consists of the aggregation of many different tasks, such as receiving rece iving a purch purchase ase reque request, st, identi identifying fying suppliers, preparing purchase order orders, s, mailin mailing g purchase orders and performing follow-ups. Activities are identi®ed by carrying out an activity analysis. Innes and Mitchell (1995b) suggest that a useful starting point is to examine a physical plan of the workplace (to identify how all work space is being used) and the payroll listings (to ensure all relevant personnel have been taken into account). This examination normally has to be supple-
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mented by a series of interviews with the staff involved, or having staff complete a time sheet for a speci®c time period explaining how their time is spent. Interviewers will ask managers and employees questions such as what staff work at the location and what tasks are performed by the persons employed at the location. Many detailed tasks are likely to be identi®ed in the ®rst instance, but after further interviews, the main activities will emerge. The activities chosen should be at a reasonable level le vel of aggr aggrega egatio tion n bas based ed on cos costs ts ver versus sus ben bene®t e®tss cri criter teria. ia. For exa exampl mple, e, rat rather her tha than n classifying purchasing of materials as an activity, each of its constituent tasks could be classi®ed as separate activities. However, this level of decomposition would involve the collection of a vast amount of data and is likely to be too costly for product costing purpos purposes. es. Alte Alternat rnative ively ly,, the pur purcha chasin sing g act activi ivity ty mig might ht be mer merged ged wit with h the mat materi erials als recei rec eiving ving,, stor storage age and issu issuing ing act activi ivities ties to for form m a sin single gle mat materi erials als pro procur cureme ement nt and handling activity. This is likely to represent too high a level of aggregation because a single cost driver is unlikely to provide a satisfactory determinant of the cost of the activity. For example, selecting the number of purchase orders as a cost driver may provide a good explanation of purchasing costs but may be entirely inappropriate for explaining costs relating relat ing to rece receiving iving and issuing issuing.. There Therefore, fore, instead of establ establishing ishing materials procurement procurement and handling as a single activity it may be preferable to decompose it into three separate activities; namely purchasing, receiving and issuing activities, and establish separate cost drivers for each activity. In some of the early ABC systems hundreds of separate activity cost centres were established but recent studies suggest that between twenty and thirty activity centres tend to be the norm. The ®nal choice of activities must be a matter of judgement but it is likely to be in¯uenced by factors such as the total cost of the activity centre (it must be of signi®cance to justify separate treatment) and the ability of a single driver to provide a satisfactory determinant of the cost of the activity. Where the latter is not possible further decomposition of the activity will be necessary.
STEP 2: ASSIGNING COSTS TO ACTIVITY COST CENTRES After the activities have been identi®ed the cost of resources consumed over a speci®ed per period iod mu must st be as assig signe ned d to ea each ch ac acti tivi vity ty.. Th Thee ai aim m is to de dete term rmine ine ho how w mu much ch th thee organization is spending on each of its activities. Many of the resources will be directly attributable to speci®c activity centres but others (such as labour and lighting and heating costs) cos ts) ma may y be indi indirec rectt and jointly jointly sha shared red by se sever veral al act activi ivities ties.. The These se cos costs ts sho should uld be assigned to activities on the basis of cause-and-effect cost drivers, or interviews with staff who can provide reasonable estimates of the resources consumed by different activities. Arbitrary allocations should not be used. The greater the amount of costs traced to activity centres by cost apportionments at this stage the more arbitrary and less reliable will be the product cost information generated by ABC systems. Cause-and-effect cost drivers used at resourc urcee cost thiss sta thi stage ge to all alloca ocate te sha shared red res resourc ources es to ind indiv ividua iduall act activi ivitie tiess are cal called led reso drivers.
STEP 3: SELECTING APPROPRIATE COST DRIVERS FOR ASSIGNING THE COST OF ACTIVITIES TO COST OBJECTS In order to assign the costs attached to each activity cost centre to products a cost driver must be selected for each activity centre. Cost drivers used at this stage are called activity cost drivers. Several factors must be borne in mind when selecting a suitable cost driver. First, it should provide a good explanation of costs in each activity cost pool. Second, a
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cost driver should be easil easily y measu measurable rable,, the data should be relati relativel vely y easy to obtain and be identi ide nti®ab ®able le wit with h pro produc ducts. ts. The cos costs ts of me measur asureme ement nt sho should uld the theref refore ore be tak taken en int into o account. Activity cost drivers consist of three types. 1. trans transaction action drivers; drivers; 2. durat duration ion drivers; drivers; 3. intens intensity ity drivers. drivers. Transaction drivers, su such ch as the nu numb mber er of pur purch chas asee or orde ders rs pr proc ocess essed ed,, nu numb mber er of customer orders processed, number of inspections performed and the number of set-ups undertaken, underta ken, all count the number of times an activity is perfo performed. rmed. Transaction Transaction drivers drivers are the least expensive type of cost driver but they are also likely to be the least accurate because they assume that the same quantity of resources is required every time an activity is performed. However, if the variation in the amount of resources required by individual cost objects is not great transaction drivers will provide a reasonably accurate measurement of activity resources consumed. If this condition does not apply then duration cost drivers should be used. Duration Durat ion driv drivers ers re repr pres esen entt th thee am amou ount nt of ti time me re requ quire ired d to pe perf rform orm an ac acti tivi vity ty.. Examples of duration drivers include set-up hours and inspection hours. For example, if one product requires a short set-up time and another requires a long time then using set-up hours as the cost driver will more accurately measure activity resource consumption than the transaction driver (number of set-ups) which assumes that an equal amount of activity resources are consumed by both products. Using the number of set-ups will result in the produ product ct tha thatt req requir uires es a lon long g set set-up -up tim timee bei being ng und underc ercoste osted d whe wherea reass the pro produc ductt tha that t requires a short set-up will be overcosted. This problem can be overcome by using set-up hours as the cost driver, but this will increase the measurement costs. Intensity Inten sity driv drivers ers dir direc ectl tly y ch char arge ge fo forr th thee re reso sourc urces es us used ed ea each ch tim timee an ac acti tivit vity y is performed. Whereas duration drivers establish an average hourly rate for performing an activity, intensity drivers involve direct charging based on the actual activity resources committed comm itted to a product. For example, example, if activ activities ities require unskilled and skilled personnel a duration driver would establish an average hourly rate to be assigned to products whereas an intensity driver would record the actual or estimated time for each type of personnel and assign the speci®c resources directly to the products. Kapl Ka plan an an and d Co Coope operr (1 (199 998) 8) il illus lustr trat atee ho how w du dura ratio tion n an and d int inten ensi sity ty dr driv iver erss ca can n be simula sim ulated ted by usin using g a we weigh ighted ted inde index x app approa roach. ch. This in invol volve vess ask asking ing ind indivi ividua duals ls to estimate the relative dif®culty of performing a task for different types of customers or produ products. cts. An app approp ropriat riatee num numeri erical cal sca scale le is use used d suc such h tha thatt sta standa ndard rd lo low w com complex plexity ity productsacustomers are awarded low scores, medium complexity productsacustomers are awarded medium scores and highly complex productsacustomers attract high scores. The aim is to capture the variation in dema demands nds for an activity by products or custom customers ers without an over-expensive measurement system. Innes and Mitchell (1995b) provide an illustration of the weighting approach where pur purch chasi asing ng is an ac acti tivi vity ty co cost st ce centr ntree an and d th thee num numbe berr of pu purc rcha hase se or orde ders rs re repr pres esen entt a potential cost driver. Orders are made both domestically and overseas but the overseas orders involve considerably more administrative work. Rather than split the purchasing cost centre into two separate centres (home and overseas purchasing) and have separate cost drivers for each (home purchase orders and overseas purchase orders) the costs of measurement can be reduced by weighting the overseas orders relative to the home orders. For example, after undertaking an assessment of the work required to make the respective orders it might be decided that each overseas order be weighted 1.5 (relative to 1 for a
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home order) before determining the total weighted volume of the cost driver to be used in calculating the appropriate cost driver rate. In mo most st sit situa uatio tions ns da data ta wi will ll no nott in init itia iall lly y be ava vail ilabl ablee re rela latin ting g to th thee pa past st co cost stss of activities or potential cost driver volumes. To ascertain potential cost drivers interviews will be required with the personnel involved with the speci®c activities. The interviews will seek to ascertain what causes the particular activity to consume resources and incur costs. The ®nal choice of a cost driver is likely to be based on managerial judgement after taking into account the factors outlined above.
STEP 4: ASSIGNING THE COST OF THE ACTIVITIES TO PRODUCTS The ®nal stage involves applying the cost driver rates to products. Therefore the cost driver must be measurable in a way that enables it to be identi®ed with individual products. Thus, if set-up hours are selected as a cost driver, there must be a mechanism for measuring the set-up hours consumed by each product. Alternatively, if the number of set-ups is selected as the cost driver measurements by products are not required since all products that require a set-up are charged with a constant set-up cost. The ease and cost of obtaining data on cost driver consumption by products is therefore a factor that must be considered during the third stage when an appropriate cost driver is being selected.
Activity hierarchies Early Earl y AB ABC C sy syst stem emss wer eree su subj bjec ectt to a nu numb mber er of cr criti iticis cisms ms,, pa parti rticu cula larl rly y re rela lati ting ng to theoretical aspects. As a response to these criticisms a number of theoretical developments emerged during the 1990s. The ®rs ®rstt the theore oretica ticall dev develo elopme pment nt wa wass rep reporte orted d by Coo Cooper per (19 (1990a 90a)) who cla classi ssi®ed ®ed manufacturing activities along a cost hierarchy dimension consisting of: 1. unit-le unit-level vel activities; activities; 2. batch-l batch-leve evell acti activities; vities; 3. produc product-susta t-sustaining ining activ activities; ities; 4. facili facility-susta ty-sustaining ining acti activities. vities. Unit-level activities are performed each time a unit of the product or service is produced. Expenses in this category include direct labour, direct materials, energy costs and expenses that are consumed in proportion to machine processing time (such as maintenance). Unitlevel activities consume resources in proportion to the number of units of production and sales volume. For example, if a ®rm produces 10% more units it will consume 10% more labour cost, 10 % more machine hours and 10% more energy costs. Typical cost drivers for unit level activities include labour hours, machine hours and the quantity of materials proce pr ocesse ssed. d. The These se cos costt dri driver verss are als also o use used d by tra traditi ditiona onall cos costin ting g sys system tems. s. Tr Tradi adition tional al systems are therefore also appropriate for assigning the costs of unit-level activities to cost objects. Batch-related activities , such as setting up a machine or processing a purchase order, are performed each time a batch of goods is produced. The cost of batch-related activities varies with the number of batches made, but is common (or ®xed) for all units within the batch. For example, set-up resources are consumed when a machine is changed from one product to another. As more batches are produced, more set-up resources are consumed. It costs the same to set-up a machine for 10 or 5000 items. Thus the demands for the set-up
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resources are independent of the number of units produced after completing the set-up. Similarly, purchasing resources are consumed each time a purchasing order is processed, but but the re reso sour urce cess co cons nsum umed ed ar aree in inde depen pende dent nt of th thee nu numb mber er of un units its in incl clud uded ed in the purch purchase ase ord order er.. Oth Other er exa exampl mples es of bat batchch-rel relate ated d cos costs ts inc include lude res resour ources ces de devot voted ed to production scheduling, ®rst-item inspection and materials movement. Traditional costing systems treat batch-related expenses as ®xed costs. However, the more the batch-related activities are required the more the organization must eventually spend to supply resources to perform these activities. Thus ABC systems provide a mechanism for assigning some of thee co th costs sts of co comp mple lexit xity y (s (suc uch h as se set-u t-ups ps,, cu cust stom omer er or orde derin ring g an and d pu purc rcha hasin sing) g) to the products or services that cause the activity. Product-sustaining activities or service-sustaining activities are performed to enable thee pr th prod oduc uctio tion n an and d sa sale le of in indi divid vidua uall pr prod oduc ucts ts (o (orr se servi rvice ces). s). Ex Exam ampl ples es of pr produ oduct ct-sustai sus taining ning act activi ivitie tiess pro provide vided d by Kap Kaplan lan and Coo Cooper per (19 (1998) 98) inc include lude mai mainta ntaini ining ng and updating updati ng produc productt speci® speci®cations cations and the technical support pro provided vided for indiv individual idual products and serv service ices. s. Oth Other er exa exampl mples es are the res resourc ources es to pre prepar paree and impl impleme ement nt eng engine ineeri ering ng change notices (ECNs), to design processes and test routines for individual products, and to perform product enhancements. The costs of product-sustaining activities are incurred irrespective of the number of units of output or the number of batches processed and their expenses will tend to increase as the number of products manufactured is increased. ABC uses product-level bases such as number of active part numbers and number of ECNs to assign these costs to products. Kaplan and Cooper (1998) have extended their ideas to situatio situ ations ns whe where re cus custom tomers ers are the cos costt obj object ectss wit with h the equ equiv ivale alent nt ter term m for pro produc ducttsustaining being customer-sustaining activities . Customer market research and support for an individual customer, or groups of customers if they represent the cost object, are examples of customer-sustaining activities. The ®nal activity category is facility-sustaining (or business-sustaining) activities. They are performed to support the facility's general manufacturing process and include general administrative staff, plant management and property costs. They are incurred to support the organization as a whole and are common and joint to all products manufactured in the plant. There would have to be a dramatic change in activity, resulting in an expansion or contraction in the size of the plant, for facility-sustaining costs to change. Such events are most unlikely in most organizations. Therefore these costs are not assigned to products since they are unavoidable and irrelevant for most decisions. Instead, they are regarded as common costs to all products made in the plant and deducted as a lump sum from the total of the operating margins from all products.
Activity-based costing pro®tability analysis The second theoretical development was ®rst highlighted by Kaplan (1990) and Cooper and Kaplan (1991). They apply the ABC hierarchical activity classi®cation to pro®tability analysis. In addition, they stress that the reported ABC product costs do not provide information that can be used directly for decision-making. Instead, they report attention-dir attention-directing ecting information information by highlighting highlighting those potentially potentially unpro®table produ products cts or service servicess that that requir requiree more more detail detailed ed specia speciall studie studies. s. Cooper Cooper (1997) (1997) has stres stresse sed d that that a major major role role of AB ABC C is to deve develo lop p pro® pro®tab tabil ility ity maps maps (i.e (i.e.. peri period odic ic pro®tability analysis by cost objects) that are used to focus managerial attention. He argues that because the cost of special studies are high the number performed has to be carefu carefully lly contro controlle lled; d; hence hence the need need for good good attent attentionion-dir direct ecting ing informa information tion.. He concludes that the primary value of ABC systems lies in the quality of the pro®tability analy analysis sis genera generated. ted. Their Their greate greaterr accura accuracy cy increa increases ses the probab probabilit ility y that that when when the
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specia speciall study study is underta undertaken ken,, its ®ndings ®ndings will support support the message message sent sent by the cost cost syste system. m. In othe otherr word words, s, pro® pro®tab table le prod produc ucts ts will will be foun found d to be pro® pro®ta table ble,, and and unpro®table products will be found to be unpro®table. Traditional cost systems often result in inaccurate pro®tability analysis resulting in special studies being at odds with the message sent by the cost system. In the extreme the cost system may be ignored. Kaplan and Cooper (1998) extended cost hierarchies to develop activity-pro®tability maps by different cost objects. The general principles of activity pro®tability maps (or pro®tability analysis) analysed by different cost objects is illustrated in Figure 10.2. This approach categorizes costs according to the causes of their variability at different hierarchical levels. Hierarchies identify the lowest level to which cost can meaningfully be be as assig signe ned d wi with thou outt re rely lying ing on ar arbit bitra rary ry al alloc locat atio ions. ns. In Fi Figu gure re 10 10.2 .2 th thee lo low wes est t hierarchical levels (shown at the top of the diagram) are product, customer and facility contributions and, ignoring the business unit level the highest levels (shown at the bottom of the diagram) are product lines, distribution channels and country pro®ts. Let us initially focus on products as the cost object. Look at the column for products as the cost object in Figure 10.2. You will see that a unit-level contribution margin is calculated for each individual product. This is derived by deducting the cost of unitlevell acti leve activities vities from sales revenues. revenues. From this unit-le unit-level vel contribution expenses relating to batch-related activities are deducted. Next the cost of product-sustaining activities are deducted. Thus, three different contribution levels are reported at the individual individual product product level. Differentiating contributions at these levels provides a better understanding of the implications of product-mix and discontinuation decisions in terms of cost and pro®t behaviour. In Figure10.2 there are two further levels within the product hierarchy. They are the product brand level and the product line level. Some organizations do not market their pro produ ducts cts by br bran ands ds an and d th ther eref efor oree ha have ve on only ly on onee fu furth rther er le leve vell wi with thin in th thee pr prod oduc uct t hierarchy. A product line consists of a group of similar products. For example, banks have ha ve pro produc ductt line liness suc such h as sa savin vings gs acc accoun ounts, ts, len lending ding serv service ices, s, curr currenc ency y serv service ices, s, insuran insu rance ce serv service icess and bro broker kering ing serv service ices. s. Eac Each h pro produc ductt lin linee con contain tainss ind indivi ividua duall produ product ct va varia riants nts.. The sa saving vingss pro produc ductt line wo would uld inc include lude lo low w bal balanc anceealow intere interest st savings sav ings accou accounts, nts, high balanc balanceeahig high h int intere erest st acc accoun ounts, ts, pos postal tal sa saving vingss acc account ountss and other product variants. variants. The lending services product line wou would ld include perso personal nal loans, house hou se mor mortga tgage ge loa loans, ns, bus busines inesss loa loans ns and oth other er pro produc ductt va varia riants nts wit within hin the pro prodduct line. Somee org Som organi anizat zations ions mar market ket grou grouping pingss of pro produc ducts ts with within in the their ir pro produc ductt lin lines es as separa sep arate te bra brands. nds. A typ typica icall exa exampl mplee of the dif differ ferenc encee bet betwe ween en pro produc ductt bra brands nds and product lines is Procter and Gamble who market some of their products within their detergent product line under the Tide label and others without this label. Where products are marketed by brands, all expenditure relating to a brand, such as management and brand marketing is for the bene®t of all products within the brand and not for any speci®c individual product. Therefore, such brand-sustaining expenses should be attributed to the brand and not to individual products within the brand. The same reasoning can be applied to the next level in the hierarchy. For example, marketing, research and development and distribution expenses might be incurred for the bene®t of the whole product line and not for any speci®c brands or products within the line. Therefore these product line-sustaining expenses should be attributed to the product line but no attempt should be made to allocate them to individual products or brands. Finally, the pro®t for the organizational unit as a whole can be determined by deduct ded ucting ing fac facilit ility-s y-sust ustaini aining ng exp expens enses es fro from m the sum of the ind indivi ividua duall pro produc ductt line contributions. A similar approach to the one described above for products can also be applied to other oth er cos costt obje objects cts.. The two ®na ®nall col column umnss sho shown wn in Fig Figure ure 10.2 illu illustr strate ate how the
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F I G U R E 1 0 . 2 An illustration of hierarchical pro®tability analysis. Lowest cost object
Products
Customers
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Locations
Contribution after deducting unit level costs
Product contributions
Customer contributions
Branch contributions
Contribution after deducting batch-level costs
Product contributions
Customer contributions
Branch contributions
Contribution after deducting individual product, customer or branch sustaining costs
Product contributions
Customer contributions
Branch contributions
Contribution after deducting product brand, customer segment and regional sustaining costs 1
Product brand contributions
Customer segment contributions
Regional contributions
Profits after deducting higher level sustaining costs2
Product line profits
Distribution channel profits
Country profits
Contribution after deducting business unit/ facility-sustaining costs 3
Business unit profits
Business unit profits
Business unit profits
Notes 1 Consists of expenses dedicated to sustaining specific product brands or customer segments or regions but which cannot be attributed to individual products, customers or branches. 2 Consists of expenses dedicated to sustaining the product lines or distribution channels or countries but which cannot be attributed to lower items within the hierarchy. 3 Consists of expenses dedicated to the business as a whole and not attributable to any lower items within the hierarchy.
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approach can be applied to customers and locations. The aim of ABC hierarchical pro®tability pro® tability analysis analysis is to assign all organ organizatio izational nal expenses to a particu particular lar hierarchical hierarchical or organizational level where cause-and-effect cost assignments can be established so that arbitrary allocations are non-existent. The hierarchical approach helps to identify the impact on resource consumption by adding or dropping items at each level of the hierarchy. For example, if a brand is dropped activities at the brand level and below (i.e. above the brand pro®ts row in Figure 10.2) which are uniquely associated with the brand will be affected, but higher level activities (i.e. at the product line level) will be unaffected. Similarly, if a product within a particular brand is dropped then all unit, batch and product-sustaining activities uniquely associated with that product will be affected but higher level brand and product-level activities will be unaffected.
Resource consumption models The third, and possibly the most important theoretical advance in ABC systems was reported by Cooper and Kaplan (1992) in a paper which emphasized that ABC systems are models of resource consumption . The paper showed how ABC systems measure the cost of using resources and not the cost of supplying resources and highlighted the critical role played by unused capacity. To have a good conceptual grasp of ABC it is essential that you understand the content of this section. Kaplan (1994) used the following equation to formalize the relationship between activity resources supplied and activity resources used for each activity:
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approach can be applied to customers and locations. The aim of ABC hierarchical pro®tability pro® tability analysis analysis is to assign all organ organizatio izational nal expenses to a particu particular lar hierarchical hierarchical or organizational level where cause-and-effect cost assignments can be established so that arbitrary allocations are non-existent. The hierarchical approach helps to identify the impact on resource consumption by adding or dropping items at each level of the hierarchy. For example, if a brand is dropped activities at the brand level and below (i.e. above the brand pro®ts row in Figure 10.2) which are uniquely associated with the brand will be affected, but higher level activities (i.e. at the product line level) will be unaffected. Similarly, if a product within a particular brand is dropped then all unit, batch and product-sustaining activities uniquely associated with that product will be affected but higher level brand and product-level activities will be unaffected.
Resource consumption models The third, and possibly the most important theoretical advance in ABC systems was reported by Cooper and Kaplan (1992) in a paper which emphasized that ABC systems are models of resource consumption . The paper showed how ABC systems measure the cost of using resources and not the cost of supplying resources and highlighted the critical role played by unused capacity. To have a good conceptual grasp of ABC it is essential that you understand the content of this section. Kaplan (1994) used the following equation to formalize the relationship between activity resources supplied and activity resources used for each activity: Cost of resources Cost of resources Cost of unused supplied used capacity
10X1
To illustrate the application of the above formula we shall use Example 10.2. The lefthand side of the above equation indicates that the amount of expenditure on an activity depe de pend ndss on th thee co cost st of re reso sourc urces es su supp pplie lied d ra rath ther er th than an th thee co cost st of re resou sourc rces es us used ed.. Example 10.2 contains data relating to the processing of purchase orders activity in which the equivalent of ten full-time staff are committed to the activity. You will see that the estimated estimated annual cost is £300 000. This represents represents the cost of resources supplied . Thiss exp Thi expend enditu iture re pro provid vides es the cap capaci acity ty to pro proces cesss 15 000 pur purcha chase se ord orders ers (i. (i.e. e. the quantity of resources supplied of the cost driver) per annum. Therefore the estimated costt of pro cos proces cessin sing g eac each h purc purchas hasee ord order er is £20 (£300 000a15000 orders that can be processed). Perio Pe riodic dic ®na ®nanci ncial al acc accoun ounting ting pro pro®t ®t sta statem tements ents mea measure sure the exp expens enses es inc incurre urred d to make resources available (i.e. the cost of resources supplied) whereas ABC systems measur mea suree the cos costt of res resour ources ces use used d by indi individ vidual ual pro produc ducts, ts, serv service icess or cus custom tomers ers.. During any particular period the number of orders processed will vary. In Example 10.2 it is assum assumed ed that the Etna Company Company expects expects to proce process ss 13 000 purchase orders orders (i.e. the quanti qua ntity ty of res resourc ources es use used). d). The ABC system system will therefor thereforee ass assign ign £26 £260 0 000 (13 000 orde or ders rs at £2 £20 0 pe perr or orde der) r) to the pa parts rts an and d ma mater teria ials ls or orde dere red d du duri ring ng th thee ye year ar.. Th This is represents repre sents the cost of resources used . The cost of unused capacity represents the difference between the cost of resources supplied supplie d and the cost of resour resources ces used. Resources Resources have been acquired to enable 15 000 pur purch chas asee or orde ders rs to be pr proc ocess essed ed bu butt du duri ring ng th thee ye year ar on only ly 13 00 000 0 or orde ders rs wi will ll be processed giving an unused capacity of 2000 purchase orders. Hence the predicted costt of the unu cos unused sed capacit capacity y wil willl be £40 000 (2000 orders orders at £20 per order). order).
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EXAMPLE 10.2 The following information relates to the purchasing activity in a division of the Etna Company for the next year:
(1) Resources supplied 10 ful full-ti l-time me staff at £30 000 per yea yearr (in (inclu cluding ding employment costs) Cost driver Quantity of cost driver supplied per year: (Each member of staff can process 1500 orders per year) Estimated cost driver rate
activity cost £300 000 annual activity Number of purchase orders processed
purchase orders orders 15 000 purchase £20 per purchase order (£300 (£3 00 000a15 000 orders) orders)
(2) Resources used Estimated number of purchase orders to be processed during the year Estimated cost of resources used assigned to parts and materials
000 0 13 00
£2 £260 60 00 000 0 (1 (13 3 00 000 0 Â £20)
(3) Cost of unused capacity Resources supplied (15 000) 7 Resources Resources used use d (13 000) at £20 per order
£40 000 (2000 (2000 Â £20)
Unused capacity arises because the supply of some resources has to be acquired in discret disc retee amo amounts unts in adv advanc ancee of usa usage ge suc such h tha thatt the sup supply ply cannot cannot be con contin tinual ually ly adjusted in the short run to match exactly the usage of resources. Typical expenses in this category include the acquisition of equipment or the employment of non-piecework employees. The expenses of supplying these resources are incurred independently of usage in the short run and this independence has led to them being categorized as ®xed costs. Kaplan and Cooper (1998) describe such resources as committed resources . In contrast, there are other types of resources whose supply can be continually adjusted to match exactly the usage of resources. For example, materials, casual labour and the supply of energy for running machinery can be continually adjusted to match the exact demand. Thus the cost of supplying these resources will generally equal the cost of resources used and the resources will have no unused capacity. Kaplan and Cooper classify these resources as `¯exible resources ' although they have traditionally been categorized as variable costs. The problem of adjusting the supply of resources to match the usage of resources and eliminating unused capacity therefore applies only to committed resources. Where the cost of supplying resources in the short run is ®xed, the quantity used will ¯uctuate each period based on the activities performed for the output produced. Activity-based systems measure the cost of using these resources, even though the cost of supplying them will not vary with short-run usage. Managers make decisions (for example, changes in output volume and mix, process changes and improvements and changes in product and process design) that result in changes in activity resource usage. Assuming that such decisions result in a decline in the demand for activity resources then the ®rst term on the right-hand side of equation 10.1 will decline (the cost of resources used) but the cost of unused capacity (the
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second term on the right-hand side of the equation) will increase to offset exactly the lower resource usage cost. To translate the bene®ts of reduced activity demands into cash ¯ow savings management action is required. They must permanently remove the unused capacity by reducing spending on the supply of the resources. Thus to make a resource resour ce variable in the downward downward direct direction ion requir requires es two management management decisi decisions ons ± ®rst to re redu duce ce the de dema mand nd fo forr the re reso sour urce ce an and d, se seco cond nd,, to lo lowe werr th thee sp spen endin ding g on th thee resource. Demands for activity resources can also increase because of decisions to introduce new products, expand output and create greater product variety. Such decisions can lead to situations where activity resource usage exceeds the supply of resour resources. ces. In the short term the excess demand might be absorbed by people working longer or faster or delay del aying ing pro produc duction tion.. Eve Eventu ntuall ally y, ho howe wever ver,, add additi itiona onall spe spendin nding g wil willl be req require uired d to increase the supply of activity resources. Thus, even if permanent changes in activity resource consumption occur that result in either unused or excess capacity there may be a signi®cant time lag before the supply of activity resources is adjusted to match the revised predicted activity usage. Indeed, there is always a danger that managers may not act to reduce the spending on the supply of resources to match a reduction in demand. They may keep existing resources in place even when there has been a substantial decline in demands for the activities consuming the resources. Consequently, there will be no bene®ts arising from actions to reduce activity usage. However, if decisions are made based on reported ABC costs it is implicitly assumed that predicted changes in activity resource usage will be translated into equivalent cash ¯ow changes for the resources supplied. A maj major or fea feature ture of ABC systems systems is the theref refore ore that rep reporte orted d pro produc duct, t, ser servic vicee or customer costs represent estimates of the cost of resources used. In a period, many decisions are made that affect the usage of resources. It is not feasible to link the required changes in the supply of resources with the change in usage predicted by each individual decision. The periodic reporting of both the predicted quantity and the cost of unused capacity for each activity signals the need for management to investigate the potential for reducing the activity resources supplied. In the case of ¯exible resources cash ¯ow changes will soon follow decisions to reduce activity usage, such as dropping a product, but for committed resources performing one less set-up, ordering one less batch of materials or undertaking one fewer engineering engineering change notice will not resul resultt in an automatic reduction in spending. It will create additional capacity and changes in spending on the supply of resources will often be the outcome of the totality of many decisions decisio ns rather than focusing on a one-o one-off ff product decision. Such ideas are considered considered to be of such vital importance by Kaplan and Cooper that they conclude that managing used and unused capacity is the central focus of ABC.
Selecting the cost driver denominator level In Example 10.2 there are two potential denominator levels that can be used to establish cost driver rates. They are the capacity supplied (described as practical capacity ) and the budgeted activity level. If practical capacity is used the cost driver rate will be £20 per purchase order processed processed (£300 000a15 000 orders) whereas whereas the cost driver rate will be be £2 £23. 3.08 08 (£ (£30 300 0 00 000 0a13 00 000 0 or orde ders rs)) if th thee bu budg dgete eted d ac acti tivi vity ty le leve vell is us used ed as th thee denominator level. Support activity costs are caused by the level of capacity that is made available (i.e. the capacity supplied) rather than the budgeted activity level of usage. Therefore the correct corr ect den denomi ominato natorr act activ ivity ity le level vel to use for cal calcula culatin ting g act activi ivity ty cos costt dri driver ver rat rates es is
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pract practica icall cap capaci acity ty and not the ant antici icipate pated d act activ ivity ity usa usage. ge. Fur Furthe thermor rmore, e, the use of bud budge geted ted ac acti tivit vity y wi will ll me mean an tha thatt the bu budg dget eted ed co cost st of unu unuse sed d ca capa pacit city y ca cann nnot ot be separately reported. This is the mechanism that is used to translate decisions that result in changes in activity usage into alterations in the supply of resources and thus changes in future spending. Using budgeted activity also means that the cost of unused capacity is als also o hid hidden den in the cos costt dri driver ver rat ratee and cha charge rged d to pro produc ducts. ts. Fin Finall ally y, ant anticip icipate ated d capacity usage can lead to higher cost driver rates in periods of low sales demand when capacity is being maintained for an expected upsurge in demand. This will result in the cost of unused capacity being assigned to products and the higher cost driver rates will result in an increase in the reported product costs. Hence, there is a danger that bid prices will be increased when demand is depressed and at the time when a ®rm should be considering lowering prices. In Example 10.2 practical capacity was measured in human resources which can be acquir acq uired ed and red reduce uced d in rel relati ativel vely y dis discre crete te amo amounts unts.. Hum Human an res resour ources ces ten tend d to be ¯exible ¯exib le in the longer term. It is therefore realistic realistic to plan to adjust the practical capacity capacity supplied for an activity to the planned demand for the activity resources. However, physi physical cal res resourc ources es suc such h as mac machine hinery ry and equ equipm ipment ent are les lesss ¯ex ¯exibl iblee bec becaus ausee the they y often can only be acquired in large discrete amounts. It is not possible, even in the longer term, to adjust the supply of capacity resources to exactly match the usage of resources. For example, consider a situation where the maximum demand for a machine might only be 80% of its practical practical maximum capacity. capacity. If the next smaller version of the machine has a capacity of only 60% of the larger machine, the larger machine must be acquired but there will be no expectation of utilizing the practical capacity. In these circumstances Kaplan and Cooper (1998) suggest that if the machine was purchased in the fu full ll kn kno owl wled edge ge th that at the ma maxi ximu mum m uti utili liza zatio tion n wo woul uld d be 80% of its po pote tenti ntial al maximu max imum m cap capaci acity ty the then n the deno denomin minator ator le level vel that sho should uld be use used d for mea measur suring ing practical capacity is the 80% level. Hence, practical capacity should be de®ned as 80% of the machine's maximum capacity. An alternative measure of physical capacity is normal activity. We looked at this measure in Chapter 7 when our objective was to focus on the factors which should in¯uence the choice of capacity levels for pro®t measurement and inventory valuation. Normal activity is de®ned as the capacity required to satisfy average customer demand over a longer-term period of, say, approximately three years after taking into account seasonal and cyclical ¯uctuations. In many situations organizations will have invested in physical assets to provide capacity that is required to match long-run demand (i.e. normal activity). In other words, normal activity may be close to the 80% level for the machine quoted in the preceding paragraph. The end result is that a measure of normal capacity may be approximately similar to the measure of practical capacity as de®ned in the previous paragraph. The message from the above discussion relating to the choice of denominator levels is that practical capacity ought to be used for measuring human resources. For physical resources it is recommended that the modi®ed measure of practical capacity that has been described, or normal activity, should be used. Budgeted activity is not recommended on the grounds that it is a short-t short-term erm measure which which can lead to ¯uctu ¯uctuating ating cost driver rates if budgeted activity varies from period to period. However, a survey by Drury and Tayles (2000) of 186 UK organizations indicated that for both traditional and ABC systems budgeted annual activity was used by 86% of the responding organizations. Only 4% and 8% respectively used practical capacity and normal activity. The preference for budgeted annual activity may re¯ect the fact that the measure is readily available, being determined as part of the annual budgeting process whereas practical capa ca pacit city y an and d no norm rmal al ac acti tivi vity ty ar aree no nott re read adil ily y ava vail ilab able le an and d ca cann nnot ot be pr prec ecise isely ly determined.
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Cost versus bene®ts considerations In Chapter 3 it was pointed out that the design of a cost system should be based on cost versus bene®t considerations. A sophisticated ABC system will clearly generate the most accurate product costs. However, the cost of implementing and operating an ABC system is sign signi®c i®cant antly ly mor moree exp expens ensiv ivee tha than n ope operat rating ing a dir direct ect cos costin ting g or a tra tradit ditiona ionall cos costing ting system. In particular, the training and software requirements may prohibit its adoption by small organizations. The partial costs reported by direct costing systems, and the distorted costs reported by traditional systems, may result in signi®cant mistakes in decisions (such as selling unpro®table products or dropping pro®table products) arising from the use of this information. If the cost of errors arising from using partial or distorted information genera gen erated ted fro from m usin using g the these se syst systems ems exc exceed eedss the add additio itional nal cos costs ts of imp implem lementi enting ng and operating an ABC system then an ABC system ought to be implemented. In other words ABC must meet the cost a bene®t criterion and improvements should be made in the level of so sophi phisti stica catio tion n of th thee co cost stin ing g sys syste tem m up to the po point int wh wher eree th thee ma marg rgin inal al co cost st of improvement equals the marginal bene®t from improvement. The opt optima imall cos costing ting sys system tem is dif differ ferent ent for dif differ ferent ent org organi anizat zation ions. s. A sim simplis plistic tic traditional costing system may report reasonably accurate product costs in organizations that have the following characteristics: 1. lo low w levels levels of compe competiti tition; on; 2. ind indire irect ct costs costs that are a low proportio proportion n of tota totall costs; 3. a fairly standardize standardized d product range all consuming consuming organizational organizational resources resources in similarr proport simila proportions. ions. In co cont ntra rast, st, a so soph phist istic icat ated ed AB ABC C sy syst stem em ma may y be op optim timal al fo forr or orga gani niza zatio tions ns ha havi ving ng following characteristics: 1. intensi intensive ve competition; competition; 2. indirect costs that are a high proportion of total costs; 3. a dive diverse rse range of produc products, ts, all consum consuming ing organizational organizational resources in signi®c signi®cantl antly y different proportions.
Periodic review of an ABC data base The detailed tracking of costs is unnecessary when ABC information is used for decisionmaking.. A data base should be maint making maintained ained that is revi review ewed ed periodically periodically, say once or twice a year. year. In additio addition n period periodic ic cost and pro®tability pro®tability audits (similar to that illustrated in Figur Figuree 10.2) should be undertaken to provide a strategic review of the costs and pro®tability of a ®rm' ®r m'ss pr prod oduc ucts, ts, cu custo stome mers rs an and d sa sale less ou outl tlet ets. s. Th Thee da data ta ba base se an and d pe peri riodi odicc co cost st an and d pro pro®t ®tabi abili lity ty re revi view ew ca can n be ba base sed d on ei eithe therr pa past st or fu futu ture re co cost sts. s. Ea Earl rly y ad adop opte ters rs,, an and d ®rmss sta ®rm startin rting g of offf wit with h ABC initially initially ana analys lysed ed pas pastt cos costs. ts. Bes Beside idess bei being ng hist histori orical cal the disadvantage of this approach is that actual cost driver usage is used as the denominator levell to calcu leve calculate late the cost driver rates. Thus cost driv driver er rates and product costs will includ includee the cost of unused capacity. Hence the cost of unused capacity for each activity is not highlighted highlig hted for manag management ement attention. Nevertheless, Nevertheless, the inform information ation provided for the ®rst time ti me an ins insigh ightt in into to th thee re resou sourc rces es co consu nsume med d by pr produ oduct ctss an and d cu custo stome mers rs an and d th thei eir r pro®tability based on measuring the resource usage rather than arbitrary allocations. However, rather than focusing on the past it is preferable to concentrate on the future pro®tability pro® tability of produc products ts and customers using estim estimated ated activity-based activity-based costs. It is theref therefore ore
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recommended that an activity-cost data base is maintained at estimated standard costs that are updated on an annual or semi-annual basis.
ABC in service organizations Kaplan and Cooper (1998) suggest that service companies are ideal candidates for ABC, even more than manufacturing companies. Their justi®cation for this statement is that most of the costs in service organizations are ®xed and indirect. In contrast, manufacturing companies can trace important components (such as direct materials and direct labour) of costs cos ts to indi individ vidual ual pro produc ducts. ts. The Theref refore ore indi indirec rectt cos costs ts are likely likely to be a muc much h sma smaller ller proportion propo rtion of total costs. Service organizations organizations must also supply most of their resources in advanc adv ancee and ¯uc ¯uctua tuation tionss in the usa usage ge of act activi ivity ty res resour ources ces by ind indivi ividua duall serv service icess and customers does not in¯uence short-term spending to supply the resources. Such costs are treate tre ated d by tra traditi ditiona onall cost costing ing sys system temss as ®x ®xed ed and irre irrelev levant ant for mos mostt dec decisio isions. ns. Thi Thiss resulted in a situation where pro®tability analysis was not considered helpful for decisionmaking. Furthermore, until recently many service organizations were either government owned ow ned mon monopol opolies ies or ope operat rated ed in a hig highly hly reg regula ulated ted,, pro protec tected ted and non non-co -compe mpetiti titive ve envir en vironm onment. ent. The These se org organi anizat zations ions we were re not sub subjec jectt to an any y gre great at pre pressur ssures es to imp impro rove ve pro®tability pro®tability by identif identifying ying and eliminating non-pro®t making activ activities. ities. Cost incre increases ases could also be absorbed by increasing the prices of services to customers. Little attention was therefore given to developing cost systems that accurately measured the costs and pro®tability of individual services. Privatizati Priv atization on of gov governme ernment nt own owned ed monop monopolies, olies, dereg deregulatio ulation, n, intensi intensive ve compe competition tition and an expanding product range created the need for service organizations to develop manage man agemen mentt acc account ounting ing syst systems ems tha thatt ena enable bled d the them m to und unders erstan tand d the their ir cos costt bas basee and determine the sources of pro®tability for their productsaservices, customers and markets. Many Man y serv service ice org organi anizat zation ionss ha have ve the theref refore ore onl only y rec recent ently ly imp implem lement ented ed man manage agemen ment t accounting systems. They have had the advantage of not having to meet some of the constr con strain aints ts imp impose osed d on ma manufa nufactu cturin ring g org organi anizat zation ions, s, suc such h as ha havin ving g to mee meett ®na ®nanci ncial al accounting accou nting stock valu valuation ation requirements requirements or the reluctance reluctance to scrap or chang changee existi existing ng cost system sys temss tha thatt mig might ht ha have ve bec become ome emb embedd edded ed in org organi anizat zation ions. s. Fur Furthe thermo rmore, re, serv service ice organi org anizat zation ionss ha have ve bee been n imp implem lement enting ing ne new w cos costin ting g syst systems ems at the sam samee tim timee as the de®ciencies of traditional systems were being widely publicized. Also new insights were begin beginnin ning g to eme emerge rge on ho how w cos costt sys system temss cou could ld be vie viewe wed d as res resourc ourcee con consum sumpti ption on models which could be used to make decisions on adjusting the spending on the supply of resources to match resource consumption. A UK survey by Drury and Tayles (2000) suggests that service organizations are more likely to implement ABC systems. They reported that 51% of the ®nancial and service organizations surveyed, compared with 15% of manufacturing organizations, had implemented ABC. Kaplan and Cooper (1998) illustrate how ABC was applied in The Cooperat ope rative ive Bank, Bank, a med medium ium sized UK ban bank. k. ABC was used for pro produc ductt and customer customer pro®tability analysis. The following are some of the activities and cost drivers that were identi®ed: Activity
Provide ATM services Clear debit items Clear credit items Issue chequebooks
Cost driver
Number Number Number Number
of of of of
ATM transactions debits processed credits processed chequebooks issued
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Computer processing Prep Pr epar aree st stat atem emen ents ts of ac acco coun untt tr tran ansa sact ctio ions ns Administer mortgages
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Number of computer transactions Numb Nu mber er of st stat atem emen ents ts is issu sued ed Number of mortgages maintained
Activity costs were allocated to the different savings and loans products based on their demand for the activities using the cost drivers as a measure of resource consumption. Some expenses, such as ®nance and human resource management, were not assigned to products because they were considered to be for the bene®t of the organization as a whole and not attributable to individual products. These business sustaining costs represented approx app roxima imatel tely y 15% of tot total al ope operat rating ing exp expens enses. es. Pro Pro®ta ®tabili bility ty ana analys lysis is wa wass ext extend ended ed to customer segments within product groups. The study revealed that approximately half of the curr current ent acc accoun ounts, ts, par partic ticular ularly ly tho those se with lo low w bal balanc ances es and hig high h tra transa nsactio ctions ns we were re unpro®table. By identifying the pro®table customer segments the marketing function was able to direct its eff effort ort to attracting more new custom customers, ers, and enhanc enhancing ing relat relationships ionships with those existing customers, whose behaviour would be pro®table to the bank.
ABC cost management applications Our aim in this chapter has been to look at how ABC can be used to provide information for decision-making by more accurately assigning costs to cost objects, such as products, customers and locations. In addition, ABC can be used for a range of cost management applications. They include cost reduction, activity-based budgeting, performance measurement, benchmarking of activities, process management and business process re-engineering. Figure 10.3 illustrates the produc productt costing and cost manag management ement applications applications of ABC. The vertical box relates to product costing where costs are ®rst assigned to activities and then the n to cos costt obje objects. cts. The hor horizo izonta ntall box relates relates to cos costt man manage agemen ment. t. Her Heree a pro proces cesss approach is adopted and costs are assigned to activities which then represent the basis for cost management applications. Thus, ABC can be adopted for both product costing and cost management or applied only to product costing or cost management. If ABC is only applied to cost management the second stage of assigning costs from activities to cost objects is omitted. The decision to implement ABC should not, therefore, be based only on its ability to produce produce more accurate and rele relevant vant decision-making decision-making information. Indeed, Indeed, a surve survey y by Innes Inn es and Mit Mitche chell ll (19 (1995a 95a)) on ABC app applic licati ations ons sug sugges gests ts tha thatt the cos costt man manage agemen ment t applica app licatio tions ns ten tend d to out outwe weigh igh the pro produc ductt cos costin ting g app applic licati ations ons whi which ch we were re cen central tral to ABC's initial development. We shall examine ABC applications to cost management in Chapter 22.
Pitfalls in using ABC information Where unit costs are calculated, ABC systems suffer from the same disadvantages as traditional cost systems by suggesting an inappropriate degree of variability. For example, to calculate unit product costs, batch level activity costs are divided by the number of units in the batch and product sustaining costs are divided by the number of products produced. This unitizing approach is an allocation which yields a constant average average cost per unit of output which will differ depending on the selected output level. For decision-making there is a danger that what started out as a non-volume-related
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F I G U R E 1 0 . 3 Product costing and cost management applications of ABC. Cost assignment view
Resources
Process view
Cost drivers
Activities
Performance measures
Cost objects
Adapted from Turney (1993)
acti activi vity ty cost cost will will be tran transla slate ted d into into a cost cost whic which h vari varies es with with prod produc uctio tion n volu volume me.. Consider a situation where the cost per set-up is £1000 for a standard batch size of 100 units for a particular part, giving an average set-up cost per part of £10. If a special order requiring the part is received for 50 units then the batch size will differ from the standard batch size and the average cost of the set-up for processing the parts of £10 is not the appropriate cost to use for decision-making. decision-making. There There is a danger that costs of £500 could be assigned to the order. However, if the special order requires one set-up then the activity resources consumed will be £1000 for an additional set-up, and not £500. Care must therefore be taken when using ABC information. A further problem is that the concept of managing unused capacity is ®ne for human resources but it does not have the same impact for physical resources, such as the acquisition of plant and equipment. Human resources are more ¯exible and can be adjusted in small increments. Therefore the supply of resources can more easily be adjuste adj usted d to the usa usage ge of res resour ources ces.. In con contra trast, st, ph physi ysical cal res resour ources ces are acq acquire uired d or removed in lumpy amounts and large increments. If resources are supplied to cover a wide range of activity usage there would have to be a dramatic change in activity for the supply to be changed. Therefore changes in resource usage would tend not be matched by a change in supply of resources and spending would remain unchanged. Care must therefore be taken to ensure that the cost of human and physical resources are not merged (so that they can be separately reported) when costs are assigned to activity cost centres within the ®rst stage of the two-stage allocation process. If the changes in physical resource usage arising from potential decisions do not have future cash ¯ow consequences there is unlikely to be a link between resource usage and spending and the future cash ¯ow impact for most decisions will be zero. In other words, the cost of resource usage would be treated as ®xed and unavoidable for most mo st de deci cisi sion onss wh whic ich h is id iden enti tica call to ho how w th thes esee co costs sts wou ould ld be tr trea eate ted d ad adopt optin ing g traditional costing systems. Also traditional costing systems accurately trace the cost of unit-level activities to products and facility-sustaining costs cannot accurately be
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assigned assign ed to cos costt obj object ectss by an any y cos costing ting system. system. Thu Thus, s, for man many y org organi anizat zation ionss the pro propo porti rtion on of co cost stss tha thatt ca can n be mo more re ac accu cura rate tely ly as assig signe ned d to co cost st ob obje ject ctss by AB ABC C systems, and that can be expected to have a future cash ¯ow impact, might be quite small. For such organizations EXHIBIT 10.1 this th is wou ould ld im impl ply y th that at ap appr prop opri riat atee co cost st in info form rmat atio ion n extrac ext racted ted fro from m sim simplis plistic tic cos costing ting sys system temss ma may y be suf suf®®Surveys of ciently accurate for decision-making purposes. company
practice Signi®cant variations in the usage of ABC both within the same country and across differ dif ferent ent cou countr ntries ies ha have ve bee been n rep reporte orted. d. The These se dif differ ferenc ences es ma may y ari arise se fro from m the dif®culty in precisely de®ning the difference between traditional costing systems and ABC sys system temss and the speci®c speci®c tim timee per period iod whe when n the surv survey eyss we were re act actual ually ly undertaken. Survey evidence suggests that over the last decade there has been an increasing interest in ABC. In the UK, surveys in the early 1990s reported adoption rates around 10% (Innes and Mitchell, 1991; Nicholls, 1992; Drury et al., al., 1993). Similar adoption rates of 10% were found in Ireland (Clarke, 1992) and 14% in Canada (Armita (Arm itage ge and Nic Nichol holson, son, 1993). In the USA Green and Ame Amenkhi nkhiena enan n (19 (1992) 92) claimed that 45% of ®rms used ABC to some extent. More recent surveys suggest higher ABC adoption rates. In the UK reported usage was 20% (Innes and Mitchell, 1995a), 22% (Banerjee and Kane, 1996), 21% (Evans and Ashworth, 1996) and 23% (Drury and Tayles, 2000). In the USA Shim and Stagliano (1997) reported a usage rate of 27%. Reported usage rates for mainland Europe are 19% in Belgium (Bruggeman et al.,, 1996) and 6% in Finland in 1992, 11% in 1993 and 24% in 1995 (Virtanen al. (Virtanenet et al., al., 1996). Low usage rates have been reported in Denmark (Israelsen et al., al., 1996), Sweden (Ask et (Ask et al ., ., 1996) and Germany (Scherrer, 1996). Activity-based techniques do not appear to have been adopted in Greece (Ballas and Venieris, 1996), Italy (Barbato et al., al., 1996) or Spain (Saez-Torrecilla et al., al., 1996). Other studies have examined the applications of ABC. Innes and Mitchell (1995) found that cost reduction was the most widely used application. Other widely used applications applic ations includ included ed produc product t aserv service ice pri pricin cing, g, cos costt mod modelli elling ng and per perform formanc ancee measurement aimprovement. ABC was used for stock valuation by 29% of ABC adopters thus suggesting that the majority of ABC users have separate systems for stock valuation and management accounting applications. According to Bjornenak (1997a) there has been little research on who adopts ABC AB C an and d fo forr wh what at re reas ason ons. s. His sur surve vey y in indi dica cate ted d th that at 40% of th thee re resp spond ondin ing g Norwegian companies had adopted ABC as an idea (i.e. they had implemented ABC or pla planne nned d to do so) so).. Dif Differ ferent ent va varia riable bless rel relatin ating g to cos costt stru structu cture, re, com compet petitio ition, n, existing cost systems, size and product diversity were tested as explanatory factors forr th fo thee ad adop opti tion on of AB ABC C bu butt on onlly co cost st st stru ruct ctur uree an and d si size ze wer eree fo foun und d to be statistically signi®cant. The UK study by Drury and Tayles indicated that company size si ze an and d bu busi sines nesss se sect ctor or ha had d a si sign gni®c i®can antt im impa pact ct on AB ABC C ad adopt option ion ra rate tes. s. Th Thee adoption rates were 45% for the largest organizations and 51% for ®nancial and service serv ice org organi anizat zation ions. s. Alt Althou hough gh the ABC ado adopter pterss use used d sig signi®c ni®cant antly ly mor moree cos cost t pools and cost drivers than the non-adopters most adopters used fewer cost pools and drivers compared with what is recommended in the literature. Approximately, 50% of the ABC adopters used less than 50 cost centres and less than 10 separate types of cost driver rates.
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Friedman and Lyne's (1995) case study research of 12 UK companies cited top management support as a signi®cant factor in¯uencing the success or failure of ABC systems. system s. Imple Implementat mentation ion proble problems ms identi® identi®ed ed by the var various ious studie studiess includ included ed the amou am ount nt of wor ork k in se sett tting ing up th thee sy syst stem em an and d da data ta co colle llect ction ion,, di dif® f®cu cult lties ies in identifying activities and selecting cost drivers, lack of resources and inadequate computer comput er software. The bene®ts report reported ed by the studie studiess include included d more accurate cost information for product pricing, more accurate pro®tability analysis, improved cost control and a better understanding of cost causation.
Self-Assessment Question You sho should uld att attemp emptt to ans answe werr thi thiss que questio stion n you yourse rself lf bef before ore loo looking king up the sug suggest gested ed answer, which appears on pages 1110-13. If any part of your answer is incorrect, check back carefully to make sure you understand where you went wrong. The following information provides details of the costs, volume and cost drivers for a particular period in respect of ABC plc, a hypothetical company:
Product X
1. 2. 3. 4.
Production and sales (units) Raw material usage (units) Direct material cost Direct labour hours
5. Machine hours 6. Direct labour cost 7. Number of production runs 8. Number of deliveries 9. Number of receipts (2 Â 7)a 10. Number of production orders 11. Overhead costs: Set-up Machines Receiving Packing Engineering
Product Y
Product Z
Total
30 00 000 5 £25 113
20 00 000 5 £20 2
8000 11 £11 1
£1 238 000 88 000
113
1
2
76 000
£8 3 9 15 15
£12 7 3 35 10
£6 20 20 220 25
30 32 270 50
30 000 760 000 435 000 250 000 373 000 £1 84 848 8 00 000 0
a
The compa company ny operates a justjust-in-ti in-time me inv inventor entory y polic policy y, and recei receives ves each compo component nent once per production run.
In the past the company has allocated overheads to products on the basis of direct labour hours. However, the majority of overheads are more closely related to machine hours than direct labour hours. The company has recently redesigned its cost system by recovering overheads using two tw o volu volumeme-rel relate ated d bas bases: es: ma machi chine ne hou hours rs and a mat materi erials als han handli dling ng ov overh erhead ead rat ratee for recovering overheads of the receiving department. Both the current and the previous cost system reported low pro®t margins for product X, which is the company's highest-selling product. The management accountant has recently attended a conference on activity-based costin cos ting, g, and the ov overh erhead ead costs for the last per period iod ha have ve bee been n ana analys lysed ed by the major activities in order to compute activity-based costs. From the above information you are required to: (a) Compute Compute the product costs using a tradit traditional ional volume-rela volume-related ted costing system based on the assumptions that: (i) all overhe overheads ads are reco recovered vered on the the basis of direct direct labour hours hours (i.e. the the company' company'ss past product costing system); (ii) the overhead overheadss of the receiving receiving department department are recovered recovered by a materials materials handling
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overhead rate and the remaining overheads are recovered using a machine hour rate (i.e. the company's current costing system). (b) Comp Compute ute product costs using an activity-based activity-based costing system. (c) Brie Brie¯y ¯y explain the differences differences between between the produc productt cost computations computations in (a) and (b).
Summary Indirect relevant costs can be dif®cult to identify and measure. This chapter has shown how ABC system sys temss can ide identi ntify fy and mea measure sure rel relev evant ant cost costs. s. ABC systems do not report relevant costs for all possible situations but they do provide a superior way wa y of de dete term rmini ining ng re rele leva vant nt co cost sts. s. Th Thee ma major jor disting dis tinguish uishing ing fea featur tures es bet betwe ween en ABC and tra tradidition ti onal al co cost stin ing g sy syst stem emss wer eree co comp mpar ared ed.. AB ABC C systems rely on a greater number of cost centres and second stage cause-and-effect cost drivers. An ABC system involves the following four stages: 1. identify identify the major activities activities which which take place in an organization; 2. create create a cost centre centreacost pool for each major activity; 3. determine the cost driver for each major activity; 4. trace the cost of activities to products according to a product's demand (using cost drivers as a measure of demand) for activities. Early ABC systems were subject to a number of criti cr iticis cisms ms,, pa parti rticu cula larl rly y re rela lati ting ng to the theore oretic tical al asp speect cts. s. As a re resp spon onse se to th thes esee cr crit itic icis ism ms a numb nu mber er of the theor oret etica icall de deve velop lopme ments nts em emer erge ged d during the 1990s. The ®rst theoretical development classi® cla ssi®ed ed man manufa ufactu cturin ring g act activi ivitie tiess alo along ng a cos cost t hier hi erar arch chy y di dime mens nsion ion co cons nsist istin ing g of uni unitt-le leve vel, l, batch-level, product-sustaining and facility-sustaining activitie activities. s. The second second wa wass to app apply ly the cos cost t hierar hie rarch chy y to pro pro®ta ®tabili bility ty ana analy lysis. sis. The aim is to assign ass ign all org organi anizat zation ional al exp expens enses es to a par partic ticula ular r hierarchical hierar chical or organ organizatio izational nal leve levell where causeand-effect cost assignments can be established so thatt arb tha arbitra itrary ry all alloca ocation tionss are nonnon-exi existe stent. nt. It wa wass also als o emp emphas hasize ized d tha thatt ABC pro pro®ta ®tabili bility ty ana analys lysis is
provides provides attent attention-dir ion-directing ecting informa information tion by highlighting those potentially unpro®table products or services that require more detailed studies. The third, and most important, theoretical development, opmen t, empha emphasized sized that ABC systems are model modelss of resource consumption. consumption. They measur measuree the cost of using re reso sour urce cess an and d no nott th thee co cost st of supplying reso re sourc urces es.. Th Thee dif diffe fere renc ncee be betw twee een n th thee co cost st of resources supplied and the cost of resources used represents the cost of unused capacity. The cost of unused capacity for each activity is the reporting mechanism for identifying the need to adjust the supply of resourc rcees to matc tch h the usage of resourc res ources. es. Ho Howe wever ver,, to tra transla nslate te the ben bene®ts e®ts of reduce red uced d act activ ivity ity dem demand andss into cas cash h ¯o ¯ow w sa savin vings gs mana ma nage geme ment nt ac acti tion on is re requ quir ired ed to re remo move ve the unused capacity by reducing the spending on the supp su pplly of th thee re reso sour urce ces. s. Th Thee AB ABC C re reso sour urce ce consumption model requires that practical capacity is used as the denominator level to establish cost driver rates. ABC must meet the cost a bene®t criterion and impr im pro ove veme ment ntss sh shou ould ld be ma made de in th thee le leve vell of soph so phist istic icat ation ion of th thee co cost stin ing g sy syste stem m up to the poi point nt wh wher eree th thee ma marg rgina inall co cost st of im impr pro ove veme ment nt equals equ als the mar margina ginall ben bene®t e®t fro from m imp impro rovem vement ent.. Sophisticated ABC systems are likely to be optimal in organizations having the following characteristics ± intensive competition, a high proportion of indirect costs and a diverse product range. Thiss cha Thi chapte pterr has em emphas phasize ized d the con concep ceptua tuall aspects of ABC. For an illustration of the application of ABC and a computation of product costs you yo u sh shou ould ld re reffer to Cha hapt pter er 3 an and d th thee se self lf-assessment question and answer at the end of this chapter. In the next chapter we shall illustrate how ABC information can be used for pricing decisions and customer pro®tability analysis.
Key Terms and Concepts activities (p. 338) activity cost drivers (p. 343) batch-related activities (p. 345)
brand-sustaining expenses (p. 347) business and sustaining activities (p. 346) committed resources (p. 350)
A C T I V I T Y - B A SE SE D C O S T I N G
cost drivers (p. 338) cost of resources supplied (p. 349) cost of resources used (p. 349) cost of unused capacity (p. 349) customer-sustaining activities (p. 346) duration drivers (p. 344) facility-sustaining activities (p. 346) ¯exible resources (p. 350) intensity drivers (p. 344)
361
models of resource consumption (p. 349) normal activity (p. 351) practical capacity (p. 351) product-line sustaining activities (p. 347) product-sustaining activities (p. 346) resource cost drivers (p. 343) service-sustaining activities (p. 346) transaction drivers (p. 344) unit-level activities (p. 345)
Recommended Reading Kaplan and Cooper have been the major contributors to the development of activity-based costing. Much of this chapter has therefore drawn off their ideas. For a detailed description of activity-based cost co stin ing g wh whic ich h in inco corp rpor orat ates es al alll of Ka Kapl plan an an and d
Cooper' Coope r'ss id idea eass yo you u sh shou ould ld co cons nsul ult t Co Cost st an and d Effect: Using Integrated Systems to Drive Pro®tability and Performance (1998). You should refer to the bibliography at the end of this book for the detailed reference.
Key Examination Points ABC di ABC did d no nott em emer erge ge un unti till th thee la late te 19 1980 80s, s, an and d theref the refore ore fe fewe werr que questi stions ons ha have ve bee been n set on thi thiss topic. As a result result,, only a small number of questions are included in this chapter. It is likely that most ques qu estio tions ns wi will ll re requ quire ire yo you u to co comp mpute ute pr prod oduc uct t
costs fo costs forr a tr trad adit ition ional al sys syste tem m an and d an ac acti tivi vityty based system and explain the difference between the product costs. It is also likely that examiners will require you to outline the circumstances circumstances where ABC systems are likely to prove most bene®cial.
Questions * Indicates that a suggested solution is to be found in the Student Students' s' Manual .
solely on the basis of the direct labour involved in thei th eirr ma manu nufa fact ctur ure. e. An And d as di dire rect ct la labo bour ur as a propo proportio rtion n of tota totall man manufa ufactu cturing ring cos costt con contin tinues ues to fall, this leads to more and more distortion and misre mi srepr pres esen enta tatio tion n of th thee im impa pact ct of pa parti rticu cula lar r products on total overhead costs.' (From an article in The Financial Times) Times) You ar aree re requ quir ired ed to di disc scus usss th thee ab abo ove an and d to sugg su gges estt wh what at ap appr proa oach ches es ar aree be bein ing g ad adop opte ted d by mana ma nage geme ment nt ac acco coun unta tant ntss to ove verc rcom omee su such ch criticism. (15 marks) CIMA Stage 2 Cost Accounting
10.1 Inter Intermediat mediatee The tra traditi ditional onal met method hodss of cos costt all alloca ocation tion,, cos cost t apporti app ortionm onment ent and abs absorpt orption ion into pro produc ducts ts are being challenged by some writers who claim that much information given to management is misleading in g wh when en th thes esee me metho thods ds of de deal alin ing g wi with th ®x ®xed ed overheads are used to determine product costs. You are required to explain what is meant by cost allocation, allocation, cost apportionment and apportionment and absorption absorption and to describe brie¯y the alternative approach of activity-bas activi ty-based ed costin costing g in or orde derr to as asce certa rtain in to tota tall Intermedia mediate te product costs. (15 marks) 10.3 Inter `Attribu Attributing ting direct costs and absor absorbing bing ov overhea erhead d CIMA Stage 2 Cost Accounting costs to the product aserv service ice thr throug ough h an act activi ivityty10.2* Inter Intermediat mediatee bas based ed co cost stin ing g ap appr proa oach ch wi will ll re resu sult lt in a be bett tter er `It is now fairly widely accepted that conventional understanding of the true cost of the ®nal output.' costt acc cos accoun ounting ting dis distort tortss man manage agemen ment' t'ss vie view w of (Source: a recent CIMA publication on costing in a business through unrepresentative overhead allocaservice environment.) tion and inappropriate product costing. You are required to explain and comment on the This is because the traditional approach usually above statement. (15 marks) absorbs overhead costs across products and orders CIMA Stage 2 Cost Accounting
362
I N F O R M A T IO IO N F O R D E C I S I O N - M AK AK I N G
10.4 Adv Advanced anced The basic ideas justifying the use of Activity Based Cost Co sting ing (A (ABC BC)) an and d Ac Acti tivi vity ty Ba Base sed d Bu Budg dget eting ing (ABB (A BB)) ar aree wel elll pu publ blic icis ised ed,, an and d th thee nu numb mber er of applica app licatio tions ns has inc increa reased sed.. Ho Howe wever ver,, the there re are appare app arentl ntly y stil stilll sig signi® ni®can cantt pro proble blems ms in cha changin nging g from existing systems.
Requirements: (a) Exp Explai lain n which charac character teristi istics cs of an org organi anisasation, such as its structure, product range, or envir en vironm onment ent,, ma may y mak makee the use of act activi ivity ty based techniques particularly particularly useful. (5 marks) (b) Ex Expl plai ain n th thee pr prob oble lem ms th thaat may ca caus usee an organisation to decide not to use, or to abandon use of, activity based techniques. (8 marks) (c) Som Somee categoris categorisati ations ons of cos costt dri driver verss provide provide hierarchical models: (i) uni unit-l t-leve evell act activi ivitie ties, s, (ii) bat batch ch act activi ivitie ties, s, (iii) produc productt sustaining activities, activities, (iv) facil facility ity sustaining sustaining activities. activities. Other Oth er ana analy lyses ses foc focus us on `v `valu aluee add adding' ing' and `non-value adding' activities. Requirement: Explain what is meant by `non-value adding activities', and discuss the usefulness of this form of analysis. (7 marks) (Total 20 marks) CIMA Stage 4 Management Accounting Control Systems 10.5* Adv Advanced anced Large Lar ge ser servic vicee org organi anisat sation ions, s, suc such h as ban banks ks and hospitals, used to be noted for their lack of standard costing systems, and their relatively unsophisticate tic ated d bud budget geting ing and cont control rol sys system temss com compar pared ed with large manufacturing organisations. But this is changing and many large service organisations are now revising their use of management accounting techniques.
Requirements: (a) Exp Explai lain n whi which ch feature featuress of large-sc large-scale ale service service organi org anisat sation ionss enc encour ourage age the app applica lication tion of activ act ivityity-bas based ed app approa roache chess to the ana analys lysis is of cost information. (6 marks) (b) Exp Explai lain n whi which ch features features of serv service ice organis organisaations may create problems for the application of activity ty--based costi tin ng. (4 marks) (c) Explai Explain n the uses uses for for activity-b activity-based ased cost cost inforinformat atio ion n in se serv rvic icee in indu dust stri ries es.. (4 mar arks ks))
(d) Many Many large service service organi organisat sations ions were were at one timee sta tim statete-ow owned ned,, but ha have ve bee been n pri priva vatise tised. d. Exampl Exa mples es in som somee cou countr ntries ies inc include lude ele electr ctriicity supply and telecommunications. They are often regulated. Similar systems of regulation of prices by an independent authority exist in many countries, and are designed to act as a surrogate surrog ate for mark market et compe competition tition in industr industries ies wher wh eree it is di dif® f®cu cult lt to en ensu sure re a ge genu nuine inely ly competitive market. Explain which aspects of cost information and sys system temss in serv service ice org organi anisat sation ionss wo would uld particularly interest a regulator, and why these feat fe atur ures es wou ould ld be of in inte tere rest st.. (6 ma mark rks) s) (Total 20 marks) CIMA Stage 4 Management Accounting Control Systems 10.6* Inter Intermedia mediate: te: Comparison of tradi traditional tional product costing with ABC Having attended a CIMA course on activity-based costing (ABC) you decide to experiment by applying in g th thee pr prin inci ciple pless of AB ABC C to th thee fo four ur pr prod oduc ucts ts currently made and sold by your company. Details of the four products and relevant information are given below for one period: Product
Output in units Costs per unit: Direct material Direct labour Machine hours (per unit)
A
B
C
D
120 (£) 40 28 4
100 (£) 50 21 3
80 (£) 30 14 2
120 (£) 60 21 3
The fo The four ur pr prod oduc ucts ts ar aree si simi mila larr an and d ar aree us usua uall lly y produced in production runs of 20 units and sold in batches of 10 units. The production overhead is currently absorbed by using a machine hour rate, and the total of the pro produ duct ctio ion n ove verh rhea ead d fo forr th thee pe peri riod od ha hass be been en analysed as follows: (£)
Machine department costs (rent, business rates, depreciation and supervi supervision) sion) Set-up costs Stores receiving InspectionaQuality control Materials handling and despatch
10430 5 250 3 600 2 100 4 6 20 20
A C T I V I T Y - B A SE SE D C O S T I N G
You have ascertained that the `cost drivers' to be used us ed ar aree as li list sted ed be belo low w fo forr th thee overh verhea ead d co cost stss shown: Cost
Cost Driver
Set up costs
Number of production runs Stores receiving Requisitions raised InspectionaQuality ccontrol ontrol Number of of production production runs Materials handling Orders executed and despatch
The number of requisitions raised on the stores was 20 fo forr ea each ch pr prod oduc uctt an and d th thee nu numb mber er of or orde ders rs executed was 42, each order being for a batch of 10 of a product. You are required (a) to calcul calculate ate the the total total costs costs for each each product product if all overhead costs are absorbed on a machine hour basis; (4 marks) (b) to calcula calculate te the total costs costs for each produc product, t, usin us ing g ac acti tivi vity ty-b -bas ased ed co cost stin ing; g; (7 ma mark rks) s) (c)) to ca (c calc lcul ulat atee an and d li list st th thee un unit it pr prod oduc uctt co cost stss from your ®gures in (a) and (b) above, to show the differences and to comment brie¯y on any conclusions which may be drawn which could have pricing and pro®t implications. (4 marks) (Total 15 marks) CIMA Stage 2 Cost Accounting 10.7 Inter Intermediat mediate: e: Calculation of ABC prod product uct costs and a discussion of the usefulness of ABC Trimake Limited makes three main products, using broadly the same production methods and equipment me nt fo forr ea each ch.. A co con nve vent ntio iona nall pr prod oduc uctt co cost stin ing g syste sy stem m is us used ed at pr pres esen ent, t, al alth thoug ough h an ac acti tivi vityty based costing (ABC) system is being considered. Details of the three products for a typical period are: Hours Hou rs per unit unit Materi Materials als Volu olumes mes per Labour Machine unit hours hours £ Units
112
20
750
Product Y
1 2 112
1
12
1250
Product Z
1
3
25
7000
Product X
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Direct Dire ct la labo bour ur co costs sts £6 pe perr hou hourr an and d pr prod oduc uctio tion n overheads are absorbed on a machine hour basis. The rate for the period is £28 per machine hour. (a) You are require required d to calculate calculate the the cost per per unit for each product using conventional methods. (4 marks)
Further analysis shows that the total of production overheads can be divided as follows:
(%)
Costs relating to Costs relating to Cost Co stss re rela lati ting ng to Costs relating to Total production
set-ups machinery mate ma teri rial alss ha hand ndli ling ng inspection overhead
35 20 15 30 100%
The fol follo lowin wing g act activi ivity ty vol volume umess are ass associ ociate ated d with the product line for the period as a whole. Total activities for the period:
Number of Number of Number of set-ups movements inspections of materials
Product X Product Y Product Z
75 115 480 670
12 21 87 120
150 180 670 1000
You are required (b) to calcula calculate te the cost cost per unit unit for each each product product using ABC principles; (15 marks) (c) to comment comment on the reasons reasons for for any any differen differences ces in the costs in your answers to (a) and (b). (3 marks) (Total 22 marks) CIMA Stage 3 Management Accounting Techniques
10.8* Inter Intermedia mediate: te: Preparation Preparation of conventional costing and ABC pro®t statements Thee fo Th follo llowi wing ng bud budge geted ted in info form rmat atio ion n re rela late tess to Brunti plc for the forthcoming period:
364
I N F O R M A T IO IO N F O R D E C I S I O N - M AK AK I N G
Products XYI YZT ABW (000 (0 00)) (0 (000 00)) (0 (000 00))
Sales and production (units)
50 (£) 45 32
Selling price (per unit) Prime cost (per unit)
Machine department (machine hours per unit) Assembly department (direct labour hours per unit)
40 (£) 95 84
30 (£) 73 65
Hours Hours Hours 2 5 4
7
3
2
Overheads allocated and apportioned to production departments depart ments (including service cost centre costs) were to be recovered in product costs as follows: Machine department at £1.20 per machine hour Assembly department at £0.825 per direct labour hour
Required: (a) Pre Prepar paree and present present pro®t pro®t statement statementss using: (i) con conven vention tional al abso absorptio rption n costin costing; g; (5 marks) (ii) (i i) act ctiivi vity ty-b -baase sed d cos osti ting ng;; (10 (1 0 mark rks) s) (b)) Co (b Comm mmen entt on wh why y ac acti tivit vityy-ba base sed d co cost sting ing is cons co nsid ider ered ed to pr pres esent ent a fa faire irerr va valua luatio tion n of the product cost per unit. (5 marks) (Total 20 marks) ACCA Paper 8 Managerial Finance 10.9* Adv Advanced anced:: Computation Computation of ABC and traditional product costs plus a discussion of ABC Repa Re pak k Lt Ltd d is a war areh ehou ousi sing ng an and d di dist stri ribu buti tion on company which receives products from customers, stor st ores es the pr prod oduc ucts ts an and d th then en re re-p -pac acks ks th them em fo for r distribution as required. There are three customers forr wh fo whom om th thee se serv rvic icee is pr pro ovi vide ded d ± Jo John hn Lt Ltd d, George Ltd and Paul Ltd. The products from all three customers are similar in nature but of varying degrees of fragility. Basic budget information has been gathered for the year to 30 June and is shown in the following table: Products handled (cubic metres)
You ascertain that the above overheads could be reanalysed into `cost pools' as follows:
Cost pool
£000 Cost driver
Machining 357 357 services Assembly 318 services Set-up costs 26 Order Or der pr proc oces essi sing ng 15 156 6 Purchasing 84 941
Quantity for the period
Machi Mac hine ne ho hour urss
420 42 0 00 000 0
Direct labour Direct labour 530000 hours Set-ups 520 Custo Cu stome merr or orde ders rs 32 000 Supplie Suppl iers rs'' or orde ders rs 11 200
You ha have ve als also o bee been n pro provid vided ed with the fol follo lowin wing g estimates for the period: Products
Number of set-ups Customer orders Suppliers' orders
John Ltd George Ltd Paul Ltd
XYI
YZT
ABW
120 8000 3000
200 8000 4000
200 16 00 000 4200
Packaging materials (see note 1) Labour ± basic ± overtime Occupancy Administration and management
30 000 45 000 25 000 Costs (£000) 1950 350 30 500 60
Note 1: Packaging materials are used in re-packing each cubic metre of product for John Ltd, George Ltd Lt d an and d Pa Paul ul Ltd in the ra ratio tio 1 : 2 : 3 re resp spec ecti tive vely ly.. This ratio is linked to the relative fragility of the goods for each customer. Additio Add itional nal inf informa ormation tion has bee been n obt obtaine ained d in order to enable unit costs to be prepared for each of the th thre reee cu custo stome mers rs us using ing an ac acti tivi vityty-ba base sed d costing approach. approach. The additional information for the year to 30 June has been estimated as follows: (i) Lab Labour our and and overhe overhead ad costs costs have have been been identiidenti-
A C T I V I T Y - B A SE SE D C O S T I N G
®ed as at ®ed attr trib ibut utab able le to ea each ch of th thre reee wor ork k centres ± receipt and inspection, storage and packing as follows:
and cost control in Repak Ltd. Make reference to your answer to part (a) of the question, as appropriate. (10 marks) (Total 30 marks) ACCA Level 2
Cost allocation proportions Receipt and inspection inspe ction Stora Storage ge Pac Packing king % % %
Labour ± basic ± overtime Occupancy Administration and management
15
10 50
20 40
75 15
60 10
35 20 50
(ii) (i i) Stud Studie iess ha have ve re reve veal aled ed th that at th thee fr frag agil ility ity of different goods affects the receipt and inspection tio n tim timee ne need eded ed fo forr th thee pr prod oduc ucts ts fo forr ea each ch custom cus tomer er.. Sto Storag ragee req requir uired ed is rel relate ated d to the avera av erage ge siz sizee of the bas basic ic inc incomin oming g pro produc duct t units from each customer. The re-packing of good go odss fo forr di dist stri ribu buti tion on is rel elat ated ed to th thee comple com plexity xity of pac packag kaging ing req requir uired ed by eac each h cust cu stom omer er.. Th Thee re rele leva vant nt re requ quire ireme ment ntss pe per r cubi cu bicc me metr tree of pr prod oduc uctt fo forr ea each ch cu cust stom omer er have been evaluated as follows:
Receipt and inspection (minutes) Stor St orag agee (s (squ quar aree me metr tres es)) Packing (minutes)
John Ltd
George Ltd
Paul Ltd
5
9
15
0Á3 36
0Á3 45
0Á2 60
Required: (a) Calcu Calculate late the the budgeted budgeted avera average ge cost cost per cubic cubic metre of packaged products for each customer for each of the following two circumstances: (i) whe where re only only the the basic basic budge budgett informa informatio tion n is to be used, (6 marks) (ii) wher wheree the additio additional nal information information enabl enables es an activity-based costing approach to be applied. (14 marks) (b)) Co (b Comm mmen entt on th thee ac acti tivi viti ties es an and d co cost st dr driv iver erss which have been identi®ed as relevant for the implementatio implem entation n of activ activity-ba ity-based sed costin costing g by Repak Ltd and discuss ways in which activity based costing might improve product costing
365
10.10* Adv 10.10* Advanced anced:: Comparison of ABC with traditional product costing (a) In th thee co cont nteext of act ctiivi vity ty--ba base sed d cos osti ting ng (ABC), it was stated in Management Accounting ± Evo Evoluti lution on not Revoluti Revolution on by Bromwich and Bhimani, that `Cost drivers attempt to link costs to the scope of output rather than the scale of output thereby generating less arbitrary product costs for decision making.' You are req requir uired ed to exp explain lain the term termss `ac `activ tivityity based costing' and `cost drivers'. (13 marks) (b) XYZ plc plc manufactu manufactures res four four products, products, namel namely y A, B, C an and d D, us usin ing g th thee sa same me pl plan antt an and d processes. The following information relates to a production period: Material cost Product Volume per unit Product
Direct labour per unit
Machine Labour time cost per unit per unit
A B C D
1 2 1 2
1 4 1 4
500 5000 600 7000
£5 £5 £16 £17
hour hour 2 hours 1 12 hours
hour hour 1 hour 1 12 hours
£3 £3 £12 £9
Tota otall pro produc duction tion over verhea head d rec record orded ed by the cos cost t accounting system is analysed under the following headings: Factory ove overhead rhead applic applicable able to mach machine-ori ine-oriented ented activi act ivity ty is £37 424 Set-up costs are £4355 The cost of ordering materials is £1920 Handlin Han dling g mat materi erials als ± £75 £7580 80 Adminis Adm inistra tration tion for spa spare re part partss ± £86 £8600. 00. These overhead costs are absorbed by products on a machine hour rate of £4.80 per hour, giving an overhead cost per product of: A £1.20
B £1.20
C £4.80
D £7.20
However, investigation into the production overhead activities for the period reveals the following totals:
366
I N F O R M A T IO IO N F O R D E C I S I O N - M AK AK I N G
Number of Number times Number Number of material of of material was spare Product set-ups orders handled parts
A B C D
1 6 2 8
1 4 1 4
2 10 10 3 12 12
2 5 1 4
You are required: (i)) to co (i comp mput utee an ove verh rhea ead d co cost st pe perr pr prod oduc uct t using usin g act activi ivityty-bas based ed cos costing ting,, tra tracin cing g ov over er-heads hea ds to pro produc duction tion units by mea means ns of cos cost t drivers. (6 marks) (ii ii)) to comment brie¯y on the differences disclose disc losed d bet betwe ween en ov overh erhead eadss tra traced ced by the prese present nt syst system em and tho those se tra traced ced by act activi ivitytybased costing. (6 marks) (Total 25 marks) CIMA Stage 4 Management Management Accounting Accounting ± Control and Audit
Overhead Cost Analysisa (£000s)
Material handling Material procurement Set-up Maintenance Quality control Machinery (machinery power, depreciation etc.) b Fitting (machine, depreciation, power etc.) b
Production details: Components Annu An nual al vo volu lume me pr prod oduc uced ed Annual direct labour hours: Mach Ma chiine nery ry dep epar arttme ment nt Fitting department
Product A
Product B
Parts 1, 2 300 00 300 000 0 un unit itss
Parts 3, 4 300 00 300 000 0 un unit itss
500 50 0 000 DLH 150 000 DLH
600 000 DLH 200 000 DLH
2500 2000 15000
a
It ma may y be ass assume umed d tha thatt the these se rep repres resent ent fai fairl rly y hom homoogeneous activity-based cost pools. b It is assumed these costs (depreciation, power etc.) are prima primaril rily y pro produc ductio tion n vol volum umee dri driven ven and tha thatt dir direct ect labour lab our hou hours rs are an app approp ropria riate te surr surrog ogate ate mea measur suree of this.
Cost Driver Analysis Annual Cost Driver Volume per Component Cost Driver
10.11 Adv Advanced anced:: Compa Comparison rison of trad traditional itional product costing with ABC Duo plc produces two products A and B. Each has two tw o co com mpo pone nent ntss sp spec eci® i®ed ed as se sequ quen enti tial allly numbered parts i.e. product A (parts 1 and 2) and product B (parts 3 and 4). Two production departments (machinery (machinery and ®tting) are supporte supported d by ®ve service acti activities vities (mate (material rial procu procuremen rement, t, mater material ial handling, handlin g, maintenance, maintenance, quality control and set up). Product A is a uniform product manufactured each year in 12 monthly high volume production runs. Prod Pr oduc uctt B is ma manuf nufac actur tured ed in lo low w vol volum umee cu cusstomised batches involving 25 separate production runss ea run each ch mo month nth.. Ad Addi ditio tiona nall in info form rmati ation on is as follows:
1 500 2 00 000 1 500 2 500 3 000
Part 1
Part 2
Part 3
Part 4
Material 180 160 1 00 000 1 20 200 movements Number of 200 300 2 00 000 4 00 000 orders Number of 12 12 300 300 set-ups Maintenance 7 00 000 5 00 000 10 00 000 8 00 000 hours Number of 360 360 2 40 400 1 00 000 inspections Direct labour 150 150 00 000 0 350 350 00 000 0 200 200 00 000 0 400 400 00 000 0 hours Direct labour 50 000 100 100 000 60 000 140 140 000 hours
You ar aree re requi quire red d to co comp mpute ute the un unit it co costs sts fo for r products A and B using (i) a traditional volume based product costing system and (ii) an activity based costing system. (Adapted from Innes, J. and Mitchell, F., Activity Based Costing: A Review with Case Studies, Chartered Charte red Institute of Manage Management ment Accoun Accountants tants,, 1990)
A C T I V I T Y - B A SE SE D C O S T I N G
10.12 Adv Advanced anced:: Pro Pro®tabil ®tability ity analysis using ABC as traditional cost allocation bases ABC plc, a group operating operating retai retaill stores, is compiling its budget statements for the next year. In this exercise revenues and costs at each store A, B and C are predicted. Additionally, all central costs of warehousing and a head of®ce are allocated across the three stores in order to arrive at a total cost and net pro®t of each store operation. In earlier years the central costs were allocated in total based on the total sales value of each store. But as a result of dissati dissatisfactio sfaction n expressed by some store managers alternative methods are to be evaluated. The predicted results before any re-al re-allocati location on of central costs are as follows: A B C (£00 (£ 000) 0) (£00 (£000) 0) (£00 (£000) 0)
Sales Costs of sales Gross margin Local operating expenses Variable Fixed Operating pro®t
5000 2800 2200
4000 2300 1700 17
3000 1900 1100 11
660 700 840
730 600 370
310 500 290
The central costs which are to be allocated are: (£000)
Warehouse costs: Depreciation Storage Ope pera rati ting ng an and d de desp spat atch ch Delivery Head of®ce: Salaries Advertising Establishment Total
100 80 120 12 0 300 200 80 120 1000
The ma The mana nage geme ment nt ac acco coun unta tant nt ha hass ca carr rrie ied d ou out t discussions with staff at all locations in order to identify more suitable `cost drivers' of some of the cen entr traal co cost sts. s. So fa farr th thee fo foll llo owi wing ng ha hass be beeen revealed.
Number of despatches
A
B
C
550
450
520
Total delivery distances (thousand miles) Storage space occupied (%)
367
70
50
90
40
30
30
1. An analysis of senior management time revealed that 10% of their time was devoted to warehouse issu is sues es wi with th th thee re rema main inde derr sh shar ared ed eq equa uall lly y between the three stores. 2. It was agreed that the only basis on which to allocate alloca te the advertising costs was sales rev revenue. enue. 3. Esta Establi blishm shment ent cos costs ts we were re mai mainly nly occ occupa upancy ncy costs of senior management. This analysis has been carried out against a background of developments in the company, for exam ple, automated warehousing and greater integration with supplie suppliers. rs. Required: (a)) As th (a thee ma mana nage geme ment nt ac acco coun unta tant nt pr prep epar aree a repo re port rt fo forr th thee ma mana nage geme ment nt of th thee gr grou oup p which: (i)) Co (i Comp mput utes es th thee bu budg dget eted ed ne nett pr pro® o®tt of each ea ch st stor oree ba base sed d on th thee sale saless val value ue alloca all ocation tion bas basee ori origina ginally lly ado adopte pted d and expla ex plains ins `c `cos ostt dr driv iver er', ', `v `vol olum ume' e' an and d `compl `co mplexi exity' ty' iss issues ues in rel relati ation on to cos cost t alloca all ocation tion com commen mentin ting g on the poss possibl iblee impl im plic icat atio ions ns of th thee di diss ssat atis isfa fact ctio ion n expressed. (6 marks) (ii) (i i) Co Comp mput utes es th thee bu budg dget eted ed ne nett pr pro® o®tt of each store using the additional information ti on pr pro ovi vide ded d, di disc scuss usses es th thee ex exte tent nt to which an improvement has been ach chie ieve ved d in th thee in info form rmat atio ion n on th thee costs co sts an and d pr pro® o®tab tabil ility ity of run runni ning ng the stores and comments on the results. (11 marks) (b) Exp Explain lain brie¯y brie¯y how regressio regression n ana analys lysis is and 2 coef®cient of determination (r ) could be used in con®rming the delivery mileage allocation method used in (a) above. (3 marks) (Total 20 marks) ACCA Paper 8 Managerial Finance 10.13 Adv Advanced anced:: Unit cost computation computation based on traditional and ABC systems Excel Ltd make and sell two products, VG4U and VG2. Both products are manufactured through two consecutive consec utive processes processes ± makin making g and packing. Raw mate ma teri rial al is in inpu putt at th thee co comm mmen ence ceme ment nt of th thee making process. The following estimated information is available for the period ending 31 March:
368
I N F O R M A T IO IO N F O R D E C I S I O N - M AK AK I N G
(i)
Making (£000)
Packing (£000)
350 210
280 140
Conversion costs: Variable Fixed
40% of ®xed costs are product speci®c, the remainderr ar de aree co comp mpan any y ®x ®xed ed co cost sts. s. Fi Fixe xed d co cost stss wi will ll rema re main in un unch chan ange ged d thr throug ougho hout ut a wi wide de ac acti tivi vity ty range. (ii ii))
Prod odu uct information:
VG4U
Making process: moulding (60%); trimming (40%) Pack Pa ckin ing g pr proc oces ess: s: co con nve vers rsio ion n (7 (70% 0%); ); packing material (30%) (iii) An in (iii) inve vest stiga igatio tion n in into to th thee ef effe fect ct of the cost drivers on costs has indicated that thee pr th prop opor orti tion onss in whi hicch th thee to tota tall pro produ duct ct sp spec eci® i®cc co con nve vers rsio ion n co cost stss ar aree attr at trib ibut utab able le to VG4 G4U U an and d VG2 ar aree as follows:
VG2
Production time per unit: Making (minutes) 5Á25 5Á25 Packing (minutes) 6 4 Productionasales (units) 5000 3000 Selling price per unit (£) 150 180 Direct mate terria iall cos ostt per unit (£) 30 30 (iii) (ii i) Conver Conversion sion cos costs ts are abs absorbe orbed d by pro produc ducts ts using estimated time based rates. Required: (a) Usi Using ng the abo above ve infor informat mation, ion, (i)) ca (i calc lcul ulat atee un unit it co cost stss fo forr ea each ch pr prod oduc uct, t, analysed as rele lev vant. (10 marks) (ii) com commen mentt on a man manage agemen mentt sugg suggest estion ion that the production and sale of one of the pro produ duct ctss sh shou ould ld no nott pr proc ocee eed d in th thee per perio iod d en endi ding ng 31 Ma Marc rch. h. (4 ma mark rks) s) (b)) Ad (b Addi ditio tiona nall inf inform ormat atio ion n is ga gathe there red d fo forr the period ending 31 March as follows: (i)) Th (i Thee ma maki king ng pr proc oceess co cons nsis ists ts of tw two o cons co nsec ecuti utive ve ac acti tivi vitie ties, s, mo mould uldin ing g an and d trim tr immi ming ng.. Th Thee mou ould ldin ing g vari riab able le conversion costs are incurred in proportion tio n to the temperat temperature ure required required in the moulds.. The variable trimming con moulds converversion costs are incurred in proportion to the consistency of the material when it emerges from the moulds. The variable pac packi king ng pr proc oces esss co con nve vers rsio ion n co cost stss ar aree incu in curr rred ed in pr prop opor orti tion on to th thee ti time me required for each product. Packing materia er ials ls (w (whi hich ch ar aree pa part rt of th thee va vari riab able le packi packing ng cos cost) t) req require uiremen mentt dep depend endss on the complexity of packing speci®ed for each product. (ii) (i i) Th Thee pr prop opor orti tion onss of pr prod oduc uctt sp spec eci® i®cc con co nve vers rsion ion co cost stss (v (var aria iable ble an and d ®x ®xed ed)) are analysed as follows:
Temperature (moulding) Material consistency (trimming) Time (packing) Packing (complexity)
VG4U
VG2
2 2 3 1
1 5 2 3
(iv) Company Company ®xed ®xed costs are apportioned apportioned to produc products ts at an ov overa erall ll av avera erage ge rat ratee per pro produ duct ct un unit it ba base sed d on th thee es esti tima mate ted d ®gures. Required: Calc Ca lcula ulate te am amen ende ded d un unit it co cost stss fo forr ea each ch pr prod oduc uct t where activity based costing is used and company ®xed costs are apportioned as detailed above. (12 marks) (c)) Co (c Comm mmen entt on th thee re rele leva vanc ncee of th thee am amen ende ded d unit un it co cost stss in ev eval alua uatin ting g th thee ma mana nage geme ment nt suggestion that one of the products be discontinued in the period ending 31 March. (4 marks) (d) Man Manage agemen mentt wish to ach achie ieve ve an overall overall net pro®t margin of 15% on sales in the period ending 31 March in order to meet return on capital targets. Required: Explain how target costing may be used in achieving the requir required ed return and suggest speci®c speci®c areas of investigation. (5 marks) (Total 35 marks) ACCA Paper 9 Information for Control and Decision Deci sion Making 10.14* Adv 10.14* Advanced anced:: ABC product product cost computation and discussion relating to ABC, JIT and TQM Durin Du ring g the la last st 20 ye year ars, s, KL's ma manu nufa fact ctur urin ing g oper op erati ation on ha hass be beco come me in incr crea easi sing ngly ly au auto toma mate ted d with compu computer-c ter-control ontrolled led robots replac replacing ing opera opera-tives. KL currently manufactures over 100 products of varying levels of design complexity. A single,
A C T I V I T Y - B A SE SE D C O S T I N G
plant-wide overhead absorption rate (OAR), based on direct labour hours, is used to absorb overhead costs. In the quarter ended March, KL' KL's manufacturing overhead costs were:
(£000)
Equipment operation expenses Equipment maintenance expenses Wages paid to technicians Wages paid to storemen Wages paid to dispatch staff
125 25 85 35 40 310
369
During the quarter
a total of 2000 direct labour hours were worked (paid at £12 per hour),
980 component consignments were received from suppliers,
1020 production runs were set up, 640 quality inspections were carried out, and 420 goods orders were dispatched to customers. Part One KL's pr prod oduc uctio tion n du duri ring ng the qu quart arter er in incl clud uded ed components r , s and t . The following information is available: Component Component Component r s t
During the quarter, RAPIER Management Consultants were engaged to conduct a review of KL's cost accounting accou nting system systems. s. RAPIE RAPIER' R'ss report include includess the following statement: `In KL's cir circum cumsta stances nces,, abs absorbi orbing ng over verhea head d costs cos ts in ind indivi ividua duall pro produc ducts ts on a lab labour our hour absorption absorpti on basis is meani meaningless. ngless. Overhead Overhead costs should be attributed to products using an activity based costing (ABC) system. We have identi®ed the following as being the most signi® signi®cant cant activities: (1) receiv receiving ing com compone ponent nt con consign signmen ments ts fro from m suppliers (2) set setting ting up equipm equipment ent for produc productio tion n runs (3) qua quality lity ins inspec pection tionss (4) dis dispatc patching hing goods goods orders orders to customers customers.. Our re Our rese sear arch ch ha hass in indi dica cate ted d th that at,, in th thee sh short ort term, KL' KL's ov overhea erheads ds are 40% ®xed and 60% variable. Approximately half the variable overhead he adss va vary ry in re rela latio tion n to di dire rect ct la labo bour ur ho hour urss worked and half vary in relation to the number of quality inspections. This model applies only to relatively small changes in the level of output during a period of two years or less.' Equipment operation and maintenance expenses are apportionable as follows:
component stores (15%), manufacturing (70%) and goods dispatch (15%). Technician wages are apportionable as follows:
Direct labour hours worked Direct material costs Component consignments received Production runs Quality inspections Goods orders dispatched Quantity produced
25
480
50
£1 20 2 00 42
£2 90 9 00 24
£1 80 8 00 28
16 10 22
18 8 85
12 18 46
560
12 80 800
2 40 400
In April 2001 a potential customer asked KL to quote for the supply of a new component ( z ( z ) to a give gi ven n sp spec eci®c i®cat ation ion.. 10 1000 00 un units its of z are to be supplied each quarter for a two-year period. They will be paid for in equal instalments on the last day of ea each ch qu quart arter er.. Th Thee jo job b wi will ll in invo volv lvee an in initi itial al design cost of £40 000 and production will involve involve 80 direct labour hours, £2000 materials, 20 component consignments, 15 production runs, 30 quality inspect insp ection ionss and 4 good goodss disp dispatc atches hes per qua quarter rter.. KL's Sales Director comments: `Now we have a modern ABC system, we can quote selling prices with con®dence. The quarterl te rly y ch char arge ge we qu quot otee sho should uld be th thee fo fore reca cast st ABC AB C pr prod oduc ucti tion on co cost st of th thee un unit itss pl plus us th thee design cost of the z depreciated on a straightline li ne ba basi siss ove verr th thee tw two o ye year arss of th thee jo job b ± to whic wh ich h we sh shou ould ld add a 25 25% % mar arkk-up up for pro®t. We can base our forecast on costs experienced in the quarter ended March.
equipment maintenance (30%), setting up equipment for production runs (40%) and quality inspections (30%).
Requirements: (a) Cal Calcula culate te the unit unit cost cost of comp compone onents nts r , s and
370
I N F O R M A T IO IO N F O R D E C I S I O N - M AK AK I N G
t , using KL's exist existing ing cost accou accounting nting system (single factory factory labour labour hour OAR). OAR). (5 marks) marks) (b) Explai Explain n how an ABC system woul would d be develdeveloped using the information given. Calculate Calculate the unit cost of components r , s and t , using this ABC system. (11 marks) (c) Calcu Calculate late the the charge charge per per quarter quarter that should should be be quoted for supply of component z component z in in a manner consistent with the Sales Director's comments. Advise KL' KL's management on the merits of this sell se lling ing pr pric ice, e, ha havi ving ng re rega gard rd to fa fact ctor orss you consider relevant. Note: KL's cost of capital is 3% per quarter. (9 marks) Part Two `It is oft often en cla claime imed d tha thatt ABC provide providess bet better ter information concerning product costs than traditional management accounting techniques. It is also al so so some metim times es cl claim aimed ed th that at AB ABC C pr pro ovi vide dess bet bette terr in info form rmat atio ion n as a gu guid idee to de deci cisi sion on-maki ma king ng.. Ho How wev ever er,, on onee sh shou ould ld tr trea eatt th thes esee claims with caution. ABC may give a different impression of product costs but it is not necessarily a better impression. It may be wiser to try impr im pro ovin ving g th thee use of tr trad aditi ition onal al te tech chniq nique uess before moving to ABC.' Comment by KL's management accountant on the t he RAPIER report Requirements: (a) Exp Explai lain n the ideas ideas con concern cerning ing cost behavio behaviour ur which underpin ABC. Explain why ABC may be better attuned to the modern manufacturing envi en viro ronm nmen entt tha than n tr trad adit ition ional al te tech chniq nique ues. s. Explain why KL might or might not obtain a mo more re me mean aning ingfu full im impr pres essio sion n of pr prod oduc uct t cost co stss thr throug ough h the the us usee of of ABC ABC.. (10 (1 0 mar marks ks)) (b) Exp Explai lain n ho how w the traditio traditional nal cost accounti accounting ng system being used by KL might be improved
to provide more meaningful product costs. (6 marks) (c) Cr (c) Criti itica call lly y ap appr prais aisee th thee re repo porte rted d cl clai aim m tha that t ABC gives better information as a guide to decision-mak decisi on-making ing than do traditi traditional onal produc product t costing techniques. (9 marks) (Total 25 marks) Part Three `The lean enterp enterprise rise [characterised by just-intimee (JI tim (JIT), T), tota totall qua quality lity man manage agemen mentt (TQ (TQM) M) and an d su supp pport ortiv ivee su supp pplie lierr re rela latio tions ns]] is wi wide dely ly considered a better approach to manufacturing. Some So me ha have ve su sugg gges este ted d, ho howe weve verr, tha thatt AB ABC C hind hi nder erss th thee sp spre read ad of the le lean an en ente terpr rprise ise by making apparent the cost of small batch sizes.' Comment by an academic accountant Requirements: (a) Exp Explain lain the roles roles that that JIT, JIT, TQM and supporsupportive supplier relations play in a modern manufact fa ctur urin ing g man anaage gem men ent. t. Ho How w mi migh ghtt th thee adop ad opti tion on of su such ch pr prac actic tices es im impr pro ove KL's performance? (10 marks) (b) Explain what the the writer writer of the above above statement statement mean me anss by `t `the he co cost st of sm smal alll ba batc tch h si size zes' s'.. Critically appraise the manner in which this cost is treat treated ed by KL's existi existing ng (single OAR based based)) cos costt acc accoun ounting ting sys system tem.. Exp Explain lain the bene®ts that KL might obtain through a full knowledge and understanding of this cost. (10 marks) (c) Ex Expl plai ain n an and d di disc scus usss th thee ex exte tent nt to whi hich ch academic research in the area of management accounting is likely to in¯uence the practice of ma mana nage geme ment nt acc ccou ount ntin ing. g. (5 mark rks) s) (Total 25 marks) CIMA Stage 3 Management Accounting Applications
