Chapter06.ppt/Management Accounting-Activity Based Accounting

© McGraw-Hill Education (UK) Limited 2013
Activity-Based
Costing
(ABC)
Chapter 6
1

• LO1 Understand the difference between a
traditional costing system and ABC
• LO2 Understand the process of developing an ABC
system
• LO3 Critically analyse the design stage of an ABC
system
• LO4 Calculate the cost of a cost object using the
ABC method
Learning Outcomes
2

• LO5 To be able to discuss the implications ABC has
for companies using the ABC system
• LO6 Critically discuss the limitations of ABC
• LO7 Illustrate the difference between ABC and TD-
ABC
• LO8 Calculate CPA and analyse the numeric
outcomes
3
Learning Outcomes

• Costing systems should be ‘fit for purpose’
– Designed for the needs of the organization
– Designed to reflect the business model within
which they work
• Traditional Costing Methods (TCMs) have long
been criticized, but the discussion was
highlighted in 1987 by Professor Johnson and
Professor Kaplan
Introduction
4

• Relevance of Management Accounting
– TCMs were designed in the early 21st century by engineers
for small, local, manufacturing companies
– The budgets of these companies were dominated by
labour and machine costs
– The TCMs were designed around the business models and
budgets relevant at that time period
Introduction
5

• Current Business Models / Industry
– Today the Statement of Finance Affairs and
Balance Sheets are not comparable with those
from companies which the TCMs were designed
for
– The majority of companies conduct business in a
wider geographical area
Introduction
6

• Companies today have generally changed:
Introduction
7
Old Business Model New Business Model
Manufacturing industries dominated Service centred companies now have a
significant presence
Small local companies Large international companies
Local competitors, suppliers &
customers
International competitors, suppliers
and customers
Significant costs were labour and
machine costs
Significant costs are logistics,
marketing, selling, admin, etc.......
Direct costs dominated the budgets The proportion of indirect costs has
become significant.
These are a only a few of the differences, the TCMs did not reflect
the complexity of changing business models

• ABC was designed to reflect a more accurate
picture of how cost objects consume resources
from within the activity pools
• It was designed to overcome the problems that
TCMs had, where labour and machine costs were
distorting costs
– TCMs typically overcharged high volume products
and under charged low volume products
Philosophy of ABC
8

Activities: The name of a collection of tasks or
processes which are linked in terms of overheads.
Activity pools: The collection point of resources for
overheads related to specific activities.
Cost drivers: Drivers that connect the activity pools and
cost objects. The cost drivers represent how the cost
object consumes the resources.
Key terms in ABC
9
Philosophy of ABC

• CIMA (2009) found that 46% of larger
companies used ABC and 22% of smaller
companies
• CIMA (2009) suggest that the complexity of
larger organizations explains why more larger
than smaller companies use this system
Relevance of ABC
10

• No matter what size the company is, one of the
most important stages of using the ABC system is
the design stage
• Although the ABC system was designed to
overcome many of the problems of the TCMs, if it
is designed badly the output of the system will be
no more accurate than that of the TCM
Designing the ABC system
11

Designing the ABC system
12

• It is clear from the design process of ABC that
there is a fundamental difference in the way
the two systems treat resources and cost
objects
TMC : Resources Cost objects
ABC: Resources Activities Cost objects
ABC versus other costing systems
13

• Activities and cost drivers can be used to identify
inefficiencies
• When companies can identify inefficiencies they will
strategically decide how to improve the process to
reduce costs
• To improve efficiency and effectiveness of a process
activities can be examined on many levels,
depending on the goals of the company
Activities and cost drivers
14

Activities and cost drivers
15
Hierarchical nature of activities

• Elviso Ltd manufactures parts for medical equipment. The
details of the two parts and relevant information, for one
period, are provided:
Calculating the ABC numbers
16
Alpha Beta
Output in units 12,000 14,000
Costs / cost drivers:
Direct materials £240,000 £350,000
Direct labour £168,000 £147,000
Total machine hours 2,100 2,400
Orders executed 150 110
Number of production runs 90 40
Number of shipments 50 15
Number of product returns 90 40

• The production overhead is currently absorbed by
using units and the total of the production overhead
for the period has been analysed as follows:
17
Activity pool Annual
cost £
Cost driver units
Production 180,000 Machine hours 4,500
Material handling 78,000 Orders executed 260
Quality enhancing and
inspection
130,000 Number of production
runs
130
Delivery 26,000 Number of shipments 65
Production returns
management
runs
130
Total 466,000

• In this exercise we are going to compare the
cost of Alpha and Beta using both the TCM
and ABC.
• Student task: Using your prior knowledge of
TCM and absorption costing, calculate the
overhead absorption rate – using the number
of units.
18

• The overhead rate using the number of units to
absorb the costs would be calculated as follows:
• Total overheads / Total number of units
• £466,000 / (12,000 units + 14,000 units) = £17.92
(note we will have slight rounding issues later
because we have rounded to two decimal places
here)
19

• Therefore the costs of Alpha and Beta using
TCMs is as follows:
20
Workings Alpha Beta
Direct Material From the question £240,000 £350,000
Direct labour From the question £168,000 £147,000
Overhead £17.92** x No. of units £215,040* £250,880*
Total cost £623,040 £747,880
Total cost per unit Total cost / No. of units £51.92 £53.42
* This is where the rounding errors can occur
** This is the overhead rate we calculated on the previous slide

• Now we can examine the difference of using
ABC by applying it to the same scenario
• Instead of calculating one overhead rate, this
time you will calculate a rate per activity
• Therefore by the end of this part of the
calculation you will have 5 rates
21

You need to refer back to the following table:
22
Activity pool Annual
cost £
Cost driver units
Production 180,000 Machine hours 4,500
Material handling 78,000 Orders executed 260
Quality enhancing and
inspection
runs
130
Delivery 26,000 Number of shipments 65
Production returns
management
runs
130
Total 466,000
Focus on the two columns with values in.
Take an annual activity cost £180,000
Then divide by the relevant cost driver £180,000 / 4,500 = £40.00ph

• You are now to calculate the remaining four cost
driver rates.
23
Activity Annual cost Cost driver Cost driver rate
Production £180,000 4,500 machine hrs £40 per hour
Material handling £78,000 260 orders executed £300 per order
Quality enhancing
and inspection
£130,000 130 production runs £1,000 per run
Delivery £26,000 65 shipments £400 per
shipment
Product return
management
£52,000 130 production returns £400 per return

• Now we will take the cost driver rate and apply them
to the individual products
• The process is very simple, you take the cost driver
rate and multiply it by the cost drivers related to the
products
• At this point you need to return to the question and
extract the following information plus the cost driver
rates you have calculated on the previous slide
24

Alpha Beta
Total machine hours 2,100 2,400
Orders executed 150 110
Number of production runs 90 40
Number of shipments 50 15
Number of product returns 90 40
25
Activity Annual cost Cost driver Cost driver rate
Production £180,000 4,500 machine hrs £40 per hour
To calculate the overheads to be allocated to Alpha for the activity
‘Production’ you take the number of cost drivers for Alpha and multiply it
by the relevant cost driver rate:
2,100 x £40.00 = £84,000

Alpha Beta
Production costs £84,000 £96,000
Material handling £45,000
Quality improvement and
product inspection
£90,000 £40,000
Delivery £6,000
Production returns
management
£36,000
Total Overhead £191,000
26
Student task: Complete the missing data

• We now need to add the prime costs to the
overhead unit cost we have just calculated
27
Alpha Beta
Direct material £240,000 £350,000
Direct labour £168,000 £147,000
Total overhead costs £275,000 £191,000
Total cost £683,000 £688,000
Number of units 12,000 14,000
Unit cost £56.92 £49.14

• We can now examine the difference between the
units costs using TCMs and ABC
Comparing TCMs and ABC
28
Alpha (cost per unit) Beta (cost per unit)
TCM £51.92 £53.42
ABC £56.92 £49.14

• ABC is a system used internationally, there are
many documented case studies from around
the world, two that you should read:
– Lui, L. & Pan, F. (2011) Activity based costing in China: a
case study of Xu Ji Electric Co Ltd. CIMA research executive
summary series 7 (13) www.cimaglobal.com/resources
– Nassar, M. Al Khadash, H. & Sangster, A (2011) The
diffusion of activity based costing in Jordanian industrial
companies. Qualitative research in Accounting and
management. 8 (2) 180-200
The textbook provides more suggested reading
ABC in practice
29

• ABC can help organizations streamline their
work processes by identifying inefficiencies
–Shared services
–Internal markets
–Outsourcing
Shared services, internal markets and outsourcing
30

• There are significant numbers of well-
documented problems with companies using
ABC, some of the identified issues include:
– Design problems
– Distortion of data collected
– Employee rejection of a new system
– Too complex and time consuming
– Companies not maintaining systems so they become out of
date
Problems with ABC
31

• Kaplan & Anderson (2004) examined the problems of
ABC and offered an alternative to the traditional ABC
system. It is called Time-Driven ABC (TD-ABC)
• Rather than gathering the data needed for ABC
through lengthy and expensive employee surveys
and interviews (which can provide distorted
information), the manager estimates the time used
for each activity
Time-Driven ABC
32

• Customer profitability Analysis (CPA) uses all the
principles of ABC
• However, rather than a product or service being the
object of cost analysis the customer becomes the
object
• The aim is to track how many activities (and the cost
of those activities) that each customer uses
Customer Profitability Analysis
33

• The analysis can also be used for customer segments
• The main intention of CPA is to reduce inefficiencies
and increase the profitability of each customer/
segment
• The calculations for CPA are the same as ABC except
you apply the cost driver rate to a customer rather
than a product or service
Customer Profitability Analysis
34

• ABC can be a very useful costing system if
designed and updated as required.
• ABC is part of a larger management system
included budgeting and customer profitability
systems.
• ABC has been criticized for being too
complicated and time consuming; therefore
TD-ABC has been introduced.
Summary
35

• CIMA (2009) Management Accounting tools
for today and tomorrow. www.cimaglobal.com
• Kaplan, R. & Anderson, S. (2004) Time-driven
activity based costing. Harvard Business
Review. November pp 131-138
References
36

Chapter06.ppt/Management Accounting-Activity Based Accounting

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