11. • Activity-based costing (ABC) is a cost accounting method that aims to
allocate the costs of an organization's resources more accurately to
the products, services, or activities that consume those resources.
• Traditional cost accounting methods typically allocate indirect costs
based on a single cost driver, ABC, on the other hand, identifies the
activities that drive costs and assigns those costs to the products,
services, or activities that consume them.
• The idea is to identify the cost drivers, which are the activities that
consume resources, and allocate costs based on the actual amount of
resources consumed by each activity.
Limitations
• ABC can be a useful tool for companies to identify the true costs of
their products and services and make informed decisions about
pricing, product mix, and process improvement. However, it can also
be complex and time-consuming to implement, requiring a significant
investment in data collection and analysis.
12.
13.
14. Numerical on Activity-based-costing
Let's consider a company that manufactures two products, Product A
and Product B, using two machines, Machine 1 and Machine 2. The
company has identified three cost drivers, which are machine setups,
machine hours, and quality inspections. The following information is
available for the year:
Total overhead costs: $1,500,000
Number of setups: 100
Total machine hours: 10,000
Number of quality inspections: 200
Total direct labor costs: $500,000
Total direct material costs: $1,000,000
The following table shows the activity rates for each cost driver:
15. Cost Driver Activity Rate
Machine setups $5,000 per setup
Machine hours $50 per hour
Quality inspections $2,500 per inspection
Product Machine setups Machine hours
Quality
inspections
A 30 5,000 100
B 70 5,000 100
:
The following table shows the usage of each cost driver for each product
Using the activity rates and the usage of each cost driver, calculate
the overhead cost allocated to each product ?
16. Solution
Product A:
Machine setup cost: 30 x $5,000 = $150,000
Machine hours cost: 5,000 x $50 = $250,000
Quality inspection cost: 100 x $2,500 = $250,000
Total overhead cost: $150,000 + $250,000 + $250,000 = $650,000
17. Product A:
Machine setup cost: 30 x $5,000 = $150,000
Machine hours cost: 5,000 x $50 = $250,000
Quality inspection cost: 100 x $2,500 = $250,000
Total overhead cost: $150,000 + $250,000 + $250,000 = $650,000
Product B:
Machine setup cost: 70 x $5,000 = $350,000
Machine hours cost: 5,000 x $50 = $250,000
Quality inspection cost: 100 x $2,500 = $250,000
Total overhead cost: $350,000 + $250,000 + $250,000 = $850,000
18. Therefore, the total cost of producing Product A is:
Total cost = Direct labor cost + Direct material cost + Overhead cost
Total cost = $500,000 + $1,000,000 + $650,000 Total cost = $2,150,000
And the total cost of producing Product B is:
Total cost = Direct labor cost + Direct material cost + Overhead cost
Total cost = $500,000 + $1,000,000 + $850,000 Total cost = $2,350,000
This shows that even though Product B uses the same amount of
machine hours as Product A, it incurs higher overhead costs due to its
higher number of machine setups.
Note: This information can be useful for the company to make
informed decisions about pricing and product mix.
21. Outline of an ABC system
An ABC system operates as follows.
Step 1 Identify an organisation's major activities.
Step 2 Identify the factors which determine the size of the costs of an
activity/cause the costs of an activity. These are known as cost drivers. A cost
driver is a factor which causes a change in the cost of an activity.
Look at the following examples.
Costs Possible cost driver
Ordering costs Number of orders
Materials handling costs Number of production runs
Production scheduling costs Number of production runs
Dispatching costs Number of dispatches
Step 3 Collect the costs associated with each cost driver into what are known as
cost pools.
Step 4 Charge costs to products on the basis of their usage of the activity. A
product's usage of an activity is measured by the number of the activity's cost
driver it generates.
22. Question
Which of the following definitions best describes a cost driver?
A Any activity which causes an increase in costs
B A collection of costs associated with a particular activity
C A cost that varies with production levels
D Any factor which causes a change in the cost of an activity
23. Merits and criticisms of ABC:
ABC has both advantages and disadvantages, and tends to be more
widely used by larger organisations and the service sector.
Merits of ABC are as follows.
(a) The complexity of manufacturing has increased, with wider product
ranges, shorter product life cycles and more complex production
processes. ABC recognises this complexity with its multiple cost
drivers.
(b) In a more competitive environment, companies must be able to
assess product profitability realistically. ABC facilitates a good
understanding of what drives overhead costs.
(c) In modern manufacturing systems, overhead functions include a lot
of non-factory-floor activities such as product design, quality control,
production planning and customer services. ABC is concerned with all
overhead costs and so it takes management accounting beyond its
'traditional‘ factory floor boundaries.
50. What is Target costing
Target costing is a cost management process which
involves setting a target cost by subtracting a desired
profit margin from a competitive market price.
51. Summary of the steps in the implementation of the
target costing process.
Step 1 Determine a product specification of which an
adequate sales volume is estimated.
Step 2 Set a selling price at which the organisation will be able
to achieve a desired market share.
Step 3 Estimate the required profit based on return on sales
or return on investment.
Step 4 Calculate the target cost = target selling price – target
profit.
Step 5 Compile an estimated cost for the product based on
the anticipated design specification and current cost levels.
Step 6 Calculate target cost gap = estimated cost – target cost.
52. Example: Target Costing
A car manufacturer wants to calculate a target cost for a new car, the price of
which will be set at $17,950.
The company requires an 8% profit margin.
Required
What is the target cost?
Solution
Profit required = 8% $17,950 = $1,436
Target cost = $(17,950 – 1,436) = $16,514
The car manufacturer will then need to carefully compile an estimated cost for
the new car.
ABC will help to ensure that costs allocated to the new model are more
accurate.
53.
54. What are life cycle costs?
Life cycle costing tracks and accumulates costs and revenues attributable to each product over the entire
product life cycle.
A product's life cycle costs are incurred from its design stage through development to market launch,
production and sales, and finally to its eventual withdrawal from the market.
The component elements of a product's cost over its life cycle could therefore include the following.
Research & development costs
– Design
– Testing
– Production process and equipment
The cost of purchasing any technical data required
Training costs (including initial operator training and skills updating)
Production costs
Distribution costs. Transportation and handling costs
Marketing costs
– Customer service
– Field maintenance
– Brand promotion
Inventory costs (holding spare parts, warehousing and so on)
Retirement and disposal costs. Costs occurring at the end of a product's life
Life cycle costs can apply to services, customers and projects as well as to physical products.
55.
56. Summary
Traditional cost accumulation systems are based on the financial
accounting year and tend to dissect a product's life cycle into a series of
12-month periods. This means that traditional management accounting
systems do not accumulate costs over a product's entire life cycle and
do not therefore assess a product's profitability over its entire life.
Instead they do it on a periodic basis.
Life cycle costing, on the other hand, tracks and accumulates actual
costs and revenues attributable to each product over the entire
product life cycle. Hence the total profitability of any given product can
be determined.
Thus Life cycle costing is the accumulation of costs over a product's
entire life.
58. • The Marketing Director believes that customers will be prepared to pay $500 for a
solar panel but the Financial Director believes this will not cover all of the costs
throughout the lifecycle.
• Required
• Calculate the cost per unit looking at the whole life cycle and comment on the
suggested price.
66. Theory of constraints
Theory of constraints (TOC) is an approach to
production management which aims to maximise
sales revenue less material and variable overhead
cost. It focuses on factors such as bottlenecks which
act as constraints to this maximisation.
Bottleneck resource or binding constraint – an
activity which has a lower capacity than preceding or
subsequent activities, thereby limiting throughput.
67. Throughput accounting (TA)
• TA is an approach to accounting which is largely in sympathy
with the JIT philosophy.
• In essence, TA assumes that a manager has a given set of
resources available. These comprise existing buildings,
capital equipment and labour force.
• Using these resources, purchased materials and parts must
be processed to generate sales revenue.
• Given this scenario the most appropriate financial objective
for doing this is the maximisation of throughput which is
defined as: sales revenue less direct material cost.
69. • Again factory hours are measured in terms of use of the
bottleneck resource. Businesses should try to maximise
the throughput accounting ratio by making process
improvements or product specification changes.
• This measure has the advantage of including the costs
involved in running the factory. The higher the ratio,
the more profitable the company. (If a product has a
ratio of less than one, the organisation loses money
every time it is made.)
70. Illustration
Growler manufactures computer components. Health and safety regulations
mean that one of its processes can only be operated 8 hours a day. The hourly
capacity of this process is 500 units per hour. The selling price of each
component is $100 and the unit material cost is $40. The daily total of all
factory costs (conversion costs) is $144,000, excluding materials. Expected
production is 3,600 units per day.
Required
Calculate
1. Total profit per day
2. Return per factory hour
3. Throughput accounting ratio
