Activity Based Costing

What’s it all about?

A technique for allocating overheads to products that is believed to be the most accurate (‘fairest’ way) of doing it as it takes in to account the amount of overhead that each product is ‘responsible’ for. It is more complicated to do than the traditional methods.

 

Download the PDF file .

ABC = Australian Based Costing?

Cost Drivers typically fall into one of three categories.

Transaction Drivers.

Simply the number of times something is done = e.g the number of holes drilled in each product per unit.

Duration Drivers.

Another easy one; how long we spend doing something. The hours or minutes we spend on that activity per unit of each of the products.

Intensity Drivers

A more complicated driver for more complicated situations. Intensity drivers reflects how hard it is to do something.

Let’s say that as part of our pet business, we clean pets before we give them to our customers. The overhead for the pet washing activity is £3,000 and we will wash 100 each of goldfish, ducks and chickens. If we did it on a straight per unit basis, that would be £3,000/300 pets = £10 per pet washed.

Some pets are easier to wash than others though.

goldfish

Goldfish are easy to wash, they are already wet, so let’s give them a difficulty score of 1.

 

7074327d_6962_wet_silkie_6-29-2009_8-49-36_pm

Chickens are harder to wash and a nuisance to get dry afterwards, so let’s give them a difficulty score of 3.

wet duck

Ducks are a real nuisance, you just can’t get them wet. They get a difficulty score of 5.

Looking at our total difficulties:

100 goldfish x 1 = 100

100 chickens x 3 = 300

100 ducks x 5 = 500

We add the three scores and get a total of 900.

Going back to our overhead of £3,000, we now divide by 900 to get £3.33 per unit of difficulty (our intensity driver).

The overhead was going to be £10 per pet, but now we can work out an exact cost based on how difficult it is to wash each type of animal.

Goldfish = 1 x  £3.33 = £3.33

Chicken = 3 x  = £3.33 = £9.99

Duck = 5 x   = £16.65

The overhead charged to each pet now reflects the difficulty (intensity) of the activity of washing it.

There were 100 of each. Multiplying 100 x £3.33 and adding 100 x £9.99 and adding 100 x £16.65 brings us back to the £3,000 overhead we started with. (Well almost, it’s £2,997 because we worked to two decimal places. Try it with three decimal places, you’ll be even closer).

Identifying the activities.

Take a look at the manufacture of an apparently simple product like a razor blade.

How many activities do you identity? How would you put them into cost pools?

We wouldn’t need to do ABC here of course, because there is only one product using the equipment, but it does illustrate the issue of activities.

 

General introduction with worked example.

General introduction with worked examples.

Variance Analysis in Activity Based Costing

A worked question.

An example of a lengthy worked question here, I couldn’t fully read the data when looking at the screen, but you may be able to. Perhaps one to follow rather than to try and do yourself.

Another worked question with comparison to Traditional methods.

Another worked example

A worked example

More worked examples comparing Traditional and ABC.

A worked example. More complex than an examination question is likely to be, but it illustrates the principles.

Further Reading.

(Articles and news items related to this topic to put it in context for you).

Download the PDF file .

We know that it can be difficult to do in practice; here’s discussion of the approach.

http://www.huffingtonpost.com/marquis-cabrera/avantgarde-health_b_9332036.html

So why don’t we all do it?

The possible advantages and disadvantages.

The main reason for doing ABC is that you will get a more accurate matching of products to the factory overheads needed to produce them. A ‘fairer’ way of sharing the costs. If there is a greater relationship between product and overhead charge then there is a benefit to be achieved by reducing the total overhead for that cost pool – it becomes worth your while to control overheads in a way that you would never get the benefit of if it were just a blanket rate across a whole factory. there should be greater control of factory overhead costs.

It is also useful in situations where we might not have identifiable departments (when everything is done in one room) so we can’t use Departmental Allocation of Overheads and we want to share overheads appropriately across a variety of products some of which use the same processes/machines.

But as we can see, it is a lot of work and time to set up, so it is expensive to switch to ABC. Plus, once you are using ABC you will need to make sure that the cost pools and activities are reviewed regularly = more cost. If your products or processes change, you might have to do the whole exercise again.

It can be difficult to get the ABC process to work properly anyway; identifying activities when there could be thousands of them; finding a sensibly small number of cost pools into which all those activities will fit, apportioning and allocating the costs accurately to each cost pool.  Sounds like a lot of work to me.

It is often difficult to identify an appropriate cost driver that will apply to all the products that ‘use’ that cost pool. If there isn’t one, then using ABC isn’t really any better than using a blanket rate for that part of the factory overhead anyway – so what’s the point?

What do you do if you have exceptions, products that don’t meet the normal pattern of activities? Do you give them costs they don’t deserve, or no overhead cost at all?

Illustrating  the complexity of doing ABC.

This is a video of a meeting at California State University where there is a discussion about using ABC to determine the costs of providing tuition. Note the complexity of what they are discussing, how Excel isn’t up to the task, discussion of cost drivers around minute 34 and marginal costs/stepped costs around minute 41. Sadly, we couldn’t see the PowerPoint slides, but the presentation does give information on how this is being done in a service industry.

Possible Written Questions.

(No indication of marks – the more marks a question gets, the more you are expected to write – detail that is, not just words!) If you can’t answer these, you need to do some more reading. I do ‘find’ questions elsewhere, so these aren’t all questions I have used myself.

Write a memo to the Board to explain the possible advantages and disadvantages of adopting an Activity Based Costing (ABC) approach for a company.

Discuss the rationale for using an Activity Based Costing (ABC) system instead of the traditional absorption costing system approach.

Briefly discuss some of the advantages and disadvantages of implementing Activity Based Costing in a small to medium sized enterprise.

Highlight the various stages of the implementation of an Activity Based Costing system and discuss the issues that might be encountered when introducing ABC to an organisation.

Describe the four stages of an Activity Based Costing system.

Explain the meaning of Cost Pools in Activity Based Costing.

Discuss the advantages of using an Activity Based Costing (ABC) system over the traditional absorption costing system approach and outline the various stages of implementation and discuss the difficulties which can arise in introducing an Activity Based Costing into an organisation.

Give one example of a Cost Driver that could be described as:

i) A Duration Driver, ii) An Intensity Driver, iii) A Transaction Driver.

        
Discuss the implications of a switch to ABC on pricing and profitability.    

Explain the stages required to implement Activity Based Costing. 

Discuss the advantages and disadvantages of Activity Based Costing. Your discussion should include some comparison with traditional absorption costing.  

Discuss why Activity Based Costing is considered to present a fairer valuation of the product cost per unit rather than traditional overhead absorption methods.

1 Response to Activity Based Costing

  1. Jonathan Rooks says:

    References for Activity Based Costing.

    Compton, T.R.(1996), “Implementing activity-based costing”, The CPA Journal, 66 (3), 20-27.

    Cooper, R. (1988), “The Rise of Activity‐Based Costing ‐ Part One: What is an Activity‐Based Cost System?”, Journal of Cost Management, pp. 45‐54

    Cooper, R. & Kaplan, S. (1988). Measure Costs Right: Make the Right Decisions, Harvard Business Review, September-October, pp. 96-103.

    Cropper, P. and R. Cook (2000), “Activity‐Based Costing in Universities – Five Years On”, Public Money and Management, 20, pp. 61‐8

    Pierce, B. & Brown, R. (2006) Perceived success of costing systems, The Journal of Applied Accounting Research, 8, pp. 101-161

    Tatikonda, L.U. & Tatikonda, R.J. (2001). Activity-based costing for higher education institutions, Management Accounting Quarterly, Winter, pp. 18-27.

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