ACC 301

Cost and Management

Accounting

By: Patrick DarkwaA

Lecture 7

Activity-Based
Costing
 Lesson Objectives
 In this lecture you will learn the following
 Concept of ABC.
Traditional Costing V/s ABC.
Treatment of cost under ABC.
Steps of ABC.
Benefits.
Limitations.
Activity Based Management: ABM.
Relation between ABC & ABM.
 Why to Choose the Right Way of
Costing
• In business, arriving at the correct cost is
very important, because it:
• Identifies money-makers and money losers;
• Finds an economic break-even point;
• Facilitates opportunities for cost control.
• Permits comparison of different options; and
• Enables strategic decision making.
 Why Overheads Should Be Fairly
Distributed In An Organisation
Overhead should be fairly be shared in an organisation in
order to:
 remind profit centre managers about the existence of
indirect costs
 enhance control of service cost or support
department costs
 encourage efficient use of common services
 fix accountability and responsibility
 evaluate profit centres
 determine cost accurately
 allocate cost per unit for usage
 foster cost awareness or consciousness
 promote more effective utilisation of resources
 The Concept of ABC
 ABC is a costing system, which focuses on
activities performed to produce products.
 ABC relates cost (resources consumed) to work
accomplished (outputs produced).
 ABC is a management tool that provides better
allocation of resources.
The ABC or unit cost goal is a benchmark that
represents an expectation of the cost incurred for
the production of an output.
ABC aligns costs to outputs thereby increasing
cost visibility, and is useful in forecasting financial
baselines.
 Cont’d
Activity-Based Costing system is an innovative approach
of overhead cost allocation deemed to provide a more
accurate cost per unit.
Just like the concept of ABM, JIT, TQM, process
improvement, TOC etc. all of which are believed to be
improved cost management systems which, when properly
implemented will:
Enhance quality
Reduce operational cost
Increase output or productivity
Eliminate unnecessary delays in meeting customer need
and satisfaction
Increase profits which is the ultimate goal of every
organisation
 ABC – A Decision Support Tool
 Accurate unit or standard cost emanating from ABC
system is very critical for many decisions
 ABC systems help companies make better:
 pricing decision,
 product mix decisions
 inventory valuation
 bidding decisions
 accept or reject special order decision
 add or drop continue or shutdown as well as
 assists in cost management decisions by
improving processes and product designs and
production layouts.
 Traditional Costing V/s ABC
Fixed overheads are traditionally spread or shared
among cost units using the 3A’s allocation,
apportionment and absorption.
Common basis of allocating fixed overhead under
the conventional approach are labour hours and
machine hours.
Based on that, budgeted OAR or predetermined
overhead recovery rate(s) are calculated using
(e.g. total overheads/total labour hours =
OAR/labour hour, thus, the traditional costing
approach)
 Problems with Traditional Approach
 Basis of overhead allocation,
apportionment, and absorption are usually
arbitrary
 Distribution of fixed overheads are often
inaccurate
Absorption of fixed overheads cost may
includes costs that are irrelevant for
decision-making
 Consequences of Arbitrary OAR
 Under-absorbed overheads occur – thus, when the absorbed amount
of indirect costs in an accounting period is less than the actual
overheads incurred.
 Over-absorbed overhead costs – thus, when the absorbed amount of
indirect costs in an accounting period is greater than the actual
overheads incurred.
 Usually predetermined rates may mislead for costing purposes
 In a minor tone, it is administratively and clerically cumbersome to
deal with as eventually, actual rate(s) will have to be calculated to
contrast the predetermined rate(s).
 You might therefore ask why the problem of the under and over
absorption is worth mentioning?.
 Certainly, it is, in that, it would be better to use the actual overhead
cost incurred in order to avoid under or over absorption completely
as well as guarantee an accurate cost and profit determination over
a period.
 And that is what ABC system seeks to tackle.
 ABC’s Basic Premise
 ABC system is built on:
 whether there is a cause and effect relationship
between overheads cost and unit-based cost driver
used
(i.e. labour or machine hours as traditionally accepted
and applied in absorption or full costing method).
 Note: For such allocation or cost attribution base to
be correct, overhead costs would need to be linearly
variable with labour or machine hours.
 Cost objects or units consume activities.
 Activities consume resources.
 This consumption of resources is what drives costs.
Understanding this cause and effect relationship is
critical to successful cost management.
 Treatment of Costs under ABC
 ABC allocates overheads using a number of cost
drives rather than just one such as labour or machine
hours.
 It attempts to identify a series of causes and effects
relationships.
 Thus, those in favour of ABC argue that:
Activities generates transactions
Transactions generates costs
ABC traces costs to activities.
In ABC, products are assigned the overhead costs that
are supposed to be related to the allocation base.
Define the terms cost drivers and cost pools
 ABC’s Basic Steps
 Analyze activities.
 Gather cost data.
 Trace costs to activities.
Establish output
measures.
Analyze costs.
 Cont’d
While cost are likely to be caused by multiple factors,
the accuracy of any ABC system will depend greatly
on both the number of factors selected and the
appropriateness of each of these activities as a driver
for costs.
Each cost driver should be appropriate to the pool of
overheads to which it relates.
As rightly pointed out from the beginning, there
should ideally be a direct cause and effect relationship
between the cost driver and the relevant overhead
cost pool, but this should also be a linear relationship
In other words costs increase proportionately with the
number of activities operated)
 ABC’s Basic Benefits
Makes it possible to determine:
Production cost traced to outputs.
Targets areas needing management attention.
Encourages the consideration of alternative
methods of production.
Highlights operational efficiency.
Identifies financial benchmarks for activity
performance.
Generates more information to measure and
reward performance, and prioritizes activities for
cost reductions.
Provides a common managerial framework
among support activities.
 Limitations of ABC
• Trade-off between expense and accuracy.
• Need for more precise data.
• Need of full support of top level management,
and support of ABC based performance review.
• Cases of overstated costs and under-stated
margins and mistakes in pricing and other critical
• decisions.
 Activity Based Management (ABM)
ABM involves any use of ABC information to
support the organization’s:
 strategy,
 improve operations, or
 manage activities and their resulting costs.
Activity Based Costing
 establishes relationships between overhead costs
and activities so that we can better allocate
overhead costs.
Activity-based management
 focuses on managing activities to reduce costs.
 Relation ABC and ABM
• Eliminating non-value added costs using ABM
• Identifying Activities.
• Identifying non-value added activities.
• Understanding activity linkage, root causes and
triggers.
• Establishing performance measures.
• Reporting non value added costs.
 ABM seeks to satisfy following customers needs
 Lower costs.
 Higher quality.
 Faster response time.
 Greater innovation.
 Customer Profitability Analysis
 Customer profitability analysis uses activity-
based costing to determine the activities,
costs and, profit associated with serving
particular customers.
 ABC Systems are More Beneficial When:
Significant amount of indirect costs are allocated using
only one or two cost pools
All or most cost are identified as output unit-level costs
Products make diverse demands on resources because of
differences in volume, process steps, batch size, or
complexity
Products that a company is well-suited to make and sell
show small profits while products for which a company is
less suited show huge profits
Complex products appear to be profitable and simple
products appear to be losing money.
Operations staffs have significant disagreements with
accounting staff about the cost of making and marketing
products and services.
 An Illustration
Q1. XYZ Ltd manufactures the following products:
Product A Product B
Quantity produced 5,000 7,000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set ups in period 10 40
Order made in period 15 60
Overhead costs GHc
Relating to machine activity 220,000
Relating production set ups 20,000
Relating to handling of orders 45,000 285,000

You are required to calculate the production overhead to be absorbed in each

unit of product A and B using:

Labour hours to absorb overheads

ABC approach (i.e. using appropriate cost drivers)

Thank
you