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.

Introducing Activity Based Costing: https://www.youtube.com/watch?v=xdXw4OxJt8E

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.

A transaction driver = the number of holes we put in with our hole making machine.

 

Daft example to put it into context.

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

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

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 any apparently simple product. How many activities do you identity? How would you put them into cost pools?

In this example, it is all done on one machine, but pretend they are all done by different people. How many different steps are there?

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

 

Some interesting non-business examples in this explanatory video.

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.

A worked example showing how a company may think it is making a profit when it isn’t.

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.

https://youtu.be/XI1maoAi3qMhttps://youtu.be/XI1maoAi3qM

Further Reading.

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

The Cost Hierachy

How Cost Drivers vary depending upon the level of production you are looking at.

https://www.accountingtools.com/articles/2017/5/5/cost-hierarchy

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The business situation that lead to the development of Activity Based Costing.

It all boils down to traditional methods of overhead allocation giving a misleading view of what the actual costs are as discussed in this chapter from a book published in 1995.

No Customer – No Business: True Value of Activity Based Cost Management. Robin Bellis-Jones , Nick Develin.

See the list of criticisms of traditional costing on pages 4 and 5.

And their comment on the impact on industry of poor decision making.

‘Rarely do companies fail or lose competitive edge through lack of commitment and hard work from their management and staff. Rather, they fail because they make consistently worse decisions than their competitors. The consequences in human terms are dismal enough, but the consequences in national terms are nothing less than catastrophic. In Britain we have lost the competitive advantage we once held in industries such as motorcycles, shipbuilding, textiles, electrical goods and many more.’ page 3.

That was 1995, so how many more industries could we add to that list now? Is that because ABC has failed to achieve what was anticipated?

How much is due to poor information as they discuss on page 4?

‘Good information – knowledge – is the life-blood of good decisions. We contend that management accounting, as practised today in many British companies, is failing management, often by not providing adequate information for decision making, and sometimes by providing information that is actually misleading. Nobody comes to work deliberately to make mistakes. Nobody consciously makes bad decisions. While good information cannot guarantee good decisions, poor information does guarantee poor decisions. In the absence of good information, profit is more a matter of luck than judgement, and is unlikely to be either consistent or sustained.’ Page 4.

 

 

 

 

Problems with the use of Activity Based Costing.

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?

 

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. 

Outline the four steps followed when implementing Activity Based Costing for the first time in 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.

Outline the possible advantages and disadvantages of using an Activity Based Costing (ABC) system.
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.

       Explain the meaning of Cost Pools in Activity Based Costing.

Discuss the principles behind the Cost Hierarchy and its relevance to Activity Based Costing.

Assess the merits of Activity Based Budgeting over implementing a system of recording actual Activity Based Costing in terms of decision making by management.

Discuss the limitations of the traditional absorption costing system in the modern manufacturing environment and explain how ABC may overcome these limitations.