Chapter 11 : Activity based costing
Introduction :
 Cost information is useful in making many types of decisions
 What should the selling price of a product be relative to the cost incurred ?
 Does the market price allow a profit to be made ?
 Managers may even reduce the selling price of a loss-making product based on
wrong costing information
 ===> Pursuit of a greater cost-accuracy
 Activity based costing and activity based management systems aim to provide
such refinement
Undercosting and overcosting
 Cost Smoothing : costing approach that uses broad averages to assign the cost
of resources to cost objects when the individual products, use those resources in a
non-uniform way.
 ====> Can lead to :
 Product undercosting ====> Losses
 Product overcosting ====> Decrease of competitiveness
Product-cost cross-subsidiarisation
 Product-cost cross-subsidiarisation : at least one miscosted product is resulting in
the miscasting of other products in the organisation. [ When a cost is uniformly
spread across multiple users without recognition of their different resource
demands].
 Example : bill of restaurant, of colleagues having a meal.
 Each dinner is treated as being the same ===> wrong way
 More complex costing issues arise, however, when there are indirect costs.
 Indirect costs require allocation ( Ex : bottle of wine shared by 3 persons).
Costing system at Plastim Limited
 Plastim makes 2 types of lens : Complex Lens CL5 and Simple Lens S3
Design, production and distribution processes
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 Sequence of steps :
1) Design of products and processes
2) Manufacturing operations
3) Shipping and distribution
 A new competitor, who makes only simple lenses, offers Giovanni to supply the S3
lens for 53 €.
 ===> Competitive pressure
 Alternatives available to Plastim Management :
 Give up the Giovanni business
 Reduce the price and accept a lower margin
 Agressively seek to reduce costs
 Plastim’s managers assign all costs, both manufacturing and non-manufacturing to S3
and CL5 lenses.
Existing single indirect-cost pool system
Plastim uses a job-costing system with a single indirect-cost pool rate :
 Step 1 : Identify the choosen cost objects
 Cost objects = 60 000 simple S3 lenses / 15 000 complex CL5 lenses
 Calculate total costs of manufacturing and distributing
 Determine unit costs of each lens, by dividing total costs of each lens by
60 000 and 15 000
 Step 2 : Identify the direct costs of the products
 Step 3 : Select the cost allocation bases to use for allocating indirect
costs to the products
 Plastim uses direct manufacturing labour-hours as the only allocation base to
allocate all indirect costs to S3 and CL5 ( 39 750 direct manufacturing labour
hours)
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 Step 4 : Identify the indirect costs associated with each cost-allocation
base
 Indirects costs = 2 385 000 €
 Step 5 : Compute the rate per unit of each cost-allocation base used to
allocate indirect costs to the products
 Actual indirect-cost rate = Actual total costs in indirect-cost pool / Actual total
quantity of cost-allocation base
 = 2 385 000 € / 39 750 hours = 60 € per direct manufacturing labour hour
 Step 6 : Compute the indirect costs allocated to the products
 Indirect costs = 1 800 000 € ( 60 € l’heure x 30 000) allocated to Simple Lenses
 585 000 € (60 € l’heure x 6750 ) allocated to Complex Lenses
 Step 7 : Compute the total costs of the products by adding all direct and
indirect costs assigned to them
 S3 Lens cost = 58.75 €, which is more than the price of its competitor (53€)
 Plastim’s Managers are surprised that the margins are low on the S3 where the
company has strong capabilities, whereas the margins are high on the new, less-
established product
 Wonder if the costing system overcosts the S3 and undercosts the CL5
 Direct materials and direct manufacturing labour-hours are accurate
 Costing system in measuring the overhead resources is not accurate
Refining a costing system
Refined costing system : reduces the use of broad averages for assigning the cost
of resources to cost objects and provides better measurement of the costs of indirect
resources used by different cost objects
4 principal reasons :
 Increase in product diversity ( customers demanding more customized
products, companies selling more different types of products)
 Increase in indirect costs ( because cost of direct materials and
manufacturing have been lowered).
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 Advances in information technology ( costing system refinements require
more data gathering, decline of the costs of tracking data ===> refinement is
more cost-effective)
 Competition in product markets
3 guidelines for refining a costing system :
 Direct cost-tracing: to reduce the amount of costs classified as indirect
 Indirect-cost pools : Homogeneous cost pool, where all the cost have the same
or similar cause-and-effect relationship with the cost-allocation base. Ex :
machining costs and distribution costs are divided into as many as needed
separate indirect-cost pools using machine hours as the cost allocation base and
number of shipments
 Cost-allocation bases : Use the cause-and-effect criterion, to identify the cost-
allocation base for each indirect-cost pool.
Activity based costing systems
 Activity based costing systems : refine costing systems by focusing on
individual activities as the fundamental cost object
 Activity : an event, task or unit of work
 ABC system calculates the costs of individual activities and assign costs to cost
objects such as products, on the basis of the activities undertaken to produce each
product.
 ABC system focus on indirect costs because direct costs can be easily traced
 Key step : identify activities that helps explaining why a lot of costs are incurred as
indirect.
 Plastim’s team identifies 7 major activities :
 Design
 Set up of moulding machines
 Operate machine
 Maintain and clean machines
 Set up batches
 Distribute lenses
 Administer and manage
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 Keep in mind 3 features :
 ABC systems create smaller cost-pools linked to the different activities
===> Plastim partitions the original single overhead cost into 7 activity-
related cost-pools
 For each activity-cost pool, a measure of the activity performed serves as
the cost-allocation base ( Ex : hours===> set-up hours is a cost driver for
set-up costs, etc …)
 In some cases, costs in a cost pool can be traced directly to the products
( ===>improves cost accuracy)
 The logic of ABC systems is that more finely structured activity-cost pools with
activity-specific cost-allocation bases, which are cost-drivers for the cost pool, are
considered to lead to more accurate costing of activities
 But consider the case when the cause-and-effect relationship is weak
 Measuring the direct manufacturing labour-hours used does not capture the
overhead costs demanded by the different products
 Plastim should allocate set-up costs on the basis of set-up hours, because
following guidelines 2 &3, there is a strong cause-and-effect relationship between
set-up related overhead costs and set-up hours
 But there is almost no relationship between set-up related overhead costs and
direct manufacturing labour hour.
 Set-up costs depend on the number of batches and the complexity of the set-ups
and hence, set-up hours drive set-up costs
 Set-up hours are related to batches ( groups ) of lenses made, not individual
lenses.
 Individual units of output VS batches of output ====> Limiting the drivers of
costs to only units of output will weaken the cause-and-effect relationship between
cost pool and cost-allocation base.
Cost hierarchy distinguishes costs by whether the cost driver is a unit of output or a
group of units of output.
Cost hierarchy
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 Cost hierarchy : categorises costs into different cost pools on the basis of the
different types of cost driver. ABC systems commonly uses a 4-art cost hierarchy
 Output-unit-level costs : resources sacrificed on activities performed on each
individual unit of a product or service [ Ex : manufacturing operation costs]
because the cost of these activities increases with each additional unit of output
produced.
 Total moulding machine costs allocated to S3 and CL5 depend on the quantity of
each type of lens produced, regardless of the number of batches in which the
lenses are made
 Batch-level costs : resources sacrificed on activities that are related to a group
of units of products.
 Total set-up costs allocated to S3 and CL5 depend on the total set-up hours
required by each type of lens, not on the number of units of S3 and CL5 produced
 Product-sustaining costs : resources sacrificed on activities undertaken to
support individual products or services ( Ex : design costs ).
 Total design costs allocated to S3 and CL5 depend on the complexity of the
mould, regardless of the number of units or batches in which the units are
produced.
 Facility-sustaining costs : resources sacrificed on activities that cannot be
traced to individual products but which support the organisation as a whole.
 ===> Lack of cause-and-effect relationship, which causes some companies not to
allocate these costs and deduct them from the operating income.
Implementing ABC at Plastim Limited
 Step 1 : Identify the chosen cost objects
 Calculate the total costs of manufacturing and distributing these lenses
 Step 2 : Identify the direct costs of the products
 Cleaning and maintenance costs are direct batch-level costs
 Complex lenses incur more cleaning and maintenance costs
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 Step 3 : Select the cost-allocation bases to use for allocating indirect
costs to the products
 Cost allocation base is pivotal in defining the number of activity pools in an ABC
system. Rather than define the design activities as separate activities, Plastim
defines these activities as part of a combined design activity, because the
complexity of the mould is an appropriate cost driver for costs incurred in all 3
design subactivities.
 Other consideration to take into account: availability of reliable data and
measures.
 Step 4 : Identify the indirect costs associated with each cost-allocation
base
 Overhead costs incurred by Plastim are assigned to activities.
 Some costs can be directly indeitified with a particular activity
 Other costs need to be allocated across activities
 Similarly, other costs are allocated to different activities
 All costs do not fit nearly into activity categories.
 Often, costs may first need to be allocated to activities before they can be
allocated to products.
 Step 5 : Compute the rate per unit of each cost-allocation base used to
allocated indirect costs to the products
 Step 6 : Compute the indirect costs allocated to the products
 Calculate indirect costs of each lens, the total quantity of the cost-allocation base
used for each activity by each type of lens is multiplied by the cost-allocation rate
calculated in Step 5.
 Step 7 : Compute the total costs of the product by adding all direct and
indirect costs assigned to them
Comparing alternative costing systems
 ABC systems trace more costs as direct costs
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 ABC systems create more cost pools linked to different activities
 For each activity cost-pool, ABC systems seek a cost-allocation base that has a
cause-and-effect relationship with costs in the cost pool.
 Allocating costs to lenses using only and output-unit-level allocation base, direct
manufacturing labour-hours, as in the existing single indirect-cost pool system,
overcosts the S3 lenses and undercosts the CL5 lenses.
Using ABC systems for cost and profit management
Activity based Management : describes management decisions that use activity
based costing information to satisfy customers and manage profitability
Pricing and Product-Mix decisions
 ABC system gives management particular insights into the cost structures.
Focusing on complex lenses would be a mistake.
 The ABC system indicates that the cost of making complex Lenses is much more
higher.
 As Plastim reduces prices on Simple Lenses, they will probably have to negotiate a
higher price for the complex Lenses.
Cost reduction and process improvement decisions
 Managers set cost reduction targets in terms of reducing the cost per unit of the
cost-allocation base in different activity areas.
 Management can evaluate whether particular activities can be reduced or
eliminated by improving processes.
Design decisions
 Management can identify and evaluate new designs to improve performance.
 Ex : creative designs that reduce the complexity of the mould
Planning and managing activities
 Most companies implementing ABC system for the first time analyse actual costs
to identify activity-cost pools and activity-cost rates.
 They specify budgeted costs for activities and use budgeted cost rates to cost
products using normal costing.
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ABC and department-costing systems
 Companies often use costing systems that have features of ABC systems, such a
multiple cost pools and multiple cost-allocation bases.
 Plastim calculates the design activity rate by dividing total Design Department costs
by a measure of the complexity of the mould.
 In contrast, in the Manufacturing Department, Plastim identifies 2 activity-cost pools :
 Because each of these activities has a different driver of costs
 Because S3 and CL5 do not use resources from these 2 areas in the same
proportion
 Using department indirect-cost rates to allocate costs to products results in the same
product costs as activity-cost rates if :
 A single activity accounts for a sizable fraction of the department’s costs
 Significant costs are incurred on different activities within a department but
each activity has the same cost-allocation base
 Significant costs are incurred on different activities with different cost-allocation
bases within a department but different products use resources from the
different activity areas in the same proportions.
 Where any one of these 3 conditions holds, using department indirect-cost rates
rather than activity rates is often adequate.
Implementing ABC Systems
 Some signals about ABC
 Significant amounts of indirect costs are allocated using only 1 or 2 cost pools
 All or most indirect costs 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 show small profits, and vice versa
 Complex products appear to be profitable, and vice versa
 Operations staff have significant disagreements with the accounting staff about
the costs of manufacturing and marketing products and services.
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 Should it choose many finely specified activities, cost drivers and cost pools, or would
a few suffice ?
 ABC Systems require management to estimate costs of activity pools and to identify
and measure cost drivers for these pools to serve as cost allocation bases.
 Very detailed ABC systems are costly to operate and difficult to understand.
ABC and the organisational context
 Organisation are subject to a variety of social and behavioural influences.
 Individuals behave differently when working teams as opposed to operating
individually.
 Organisation have distinct cultures and sub-cultures, and, often, political influence.
 Bureaucraties are more likely to adopt and implement ABC than other types of
organization
 The consequences of implementing an activity based costing system may lead to
unexpected changes.
 Activity based techniques are not merely seen as a set of new procedures for
certain members of the finance function. ====> also a deep change in the
culture of the company.
 It is important to have an ABC system fit the current culture of the organisation.
Yes, let’s be honest about is, if they weren’t prepared to work with us, they’d be sacked.
We will not spend hours trying to convert people to a different way of thinking, we will
change the people
[ Friedman and Lyne, 1995]
 Resistance to accounting systems change is often present
 Resistance is an important source of ABC failure and has different origins.
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 The traditional French full costing method is very similar to ABC.
 Therefore, many French managers perceive little or no incremental benefit from
introducing ABC in their companies
CONCEPTS IN ACTION
 Ex : The cooperative Bank :
 We knew what our costs were but not why
 We knew out profit but not where it was coming from
 Activity based information revealed that some product were creating almost all of
the profits.
Solutions :
 Focus on core entry
 Establish new cost-effective channels
 Work to eliminate inefficiencies
 Deepen relationships with profitable customers
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