Activity based costing (abc)

Cost/Management Accounting notes

ABC is a costing method which recognizes that costs are incurred because of the activities which take place within the organization and for each activity a cost driver may be identified. Those costs which are driven or incurred by the same cost drivers are grouped together into cost pools and the cost drivers are then used as a basis for charging the cost of each activity in the product.

A cost pool is a collection of costs which may be charged to products by the use of a common cost driver. A cost driver is any activity or activities, series of which take place within an organization and which cause costs to be incurred. The essence of ABC is that activities are the cost drivers, not products. Products do consume activities. If the cost of activities and their relationship to products is understood, there can be established basis for product costing, performance measurement and profitability analysis.

The development of ABC has been a response to a change in the cost base of many manufacturers over the last decades. In earlier times, most manufacturing was labour intensive. The variable cost of direct labour greatly outweighed all other costs and the overheads were a relatively small component of the total cost. Traditional absorption costing was accurate enough in these circumstances. Nowadays, most manufacturing processes are automated. The fixed overhead cost of depreciation is now an important component of the total cost. At the same time, work forces have been greatly reduced. This means that the variable cost of direct labour is now a much smaller proportion of the total cost. Traditional absorption costing has become inaccurate as a result and misleading product costs have led to poor decision making.

ABC analyses costs as short-term variable cost and long-term variable costs. Short-term variable costs equate with variable costs under the traditional absorption costing. These characteristics are volume related and change proportionately with the volume of production. Long-term variable costs are equivalent to fixed costs under traditional cost accounting. Under ABC, such costs do vary with activity even though there is a time lag e.g. salaried production engineers will not be immediately made redundant if the number of products decline but they may be if decline continues.

In addition the cost classification does not stop with factory overheads. Non-production overheads such as design and marketing costs are included in product costs and profitability analysis by the ABC system. Short-term variable costs can be identified with the products using volume related cost drivers such as direct labour hours, machine hours and direct materials used.

The cost drivers may be different depending on how the cost is driven thus the cost of power will be related to or driven by machine hours. Long-term variable costs, however, using volume related drivers will tend to be inappropriate e.g. the number and cost of salaried production engineers is not a function of direct labour hours or machine hours but a function of the number of times a machine has been set up for a production run. The activity which drives the cost is the number of setups. Costs should thus be allocated to products using this number. This contrasts with traditional practice, which absorbs all overheads based on (often) direct labour hours and has no regard to the activity.
The ABC system generally works on these guidelines;
(i) Identification of the organization’s major activities

(ii) Identification of the cost drivers. These are factors which determine the size of the costs of the activity or causes of the incurrence of costs. Volume related cost drivers are commonly used for costs that vary with the production levels in the short term. Examples of some costs and their cost drivers are shown below

(iii) Collection of the costs of each activity into cost pools. Cost pools are equivalent to cost centers. They are used to describe locations to which overhead costs are initially assigned.

(iv) Charging support overheads 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. The service costs are only allocated to the production department according to the usage of the services provided.
Absorption costing and ABC are similar in many respects. In both systems, direct costs go straight to the product and overheads are allocated to production cost centers/cost pools. The difference lies in the manner in which overheads are absorbed into products.
Advantages of ABC
(i) It is a more equitable method of charging costs to products: The product which uses the activity that causes the cost to be incurred bears those costs associated with the product activities in a more equitable manner. This overcomes the drawback in absorption costing where general overheads are spread over the product range using largely unrelated methods to the ways costs are generated.

(ii) It takes into consideration product complexity: The costs charged to products relate to the production circumstances in which those products are produced. Under ABC, short run and complex products might attract consequently higher levels of unit cost compared to the long run and simple products. This aspect would have considerable impact therefore, in the measurement of relative product profitability compared to absorption costing approach.

(iii) Costs are more closely related to activity level: Those costs which under absorption and marginal costing are traditionally regarded as fixed in total may be treated as variable in the long-term under ABC. As a consequence, ABC encourages the measurement of efficiency levels of administration functions.

(iv) It encourages a more realistic approach to stock policy: ABC does not encourage the buildup of finished goods stock as in absorption costing. In ABC, the over recoveries which encourage stock build up in absorption costing do not arise to the same extent because greater proportion of the costs are treated as variable rather than fixed.

(v) It includes stock control: ABC reflects closely what is happening in the production environment and identifies those elements which would be subject to managerial control. It encourages costs that management can best achieve through the management of those activities which cause costs to be incurred.
Disadvantages of ABC System

(i) A more detailed analysis is required: A more detailed analysis of cost pools and drivers than necessary for absorption costing is usually required for an effective ABC system with the constant increase in the cost of administering the accounting system.

(ii) Some simplification required: Identification of cost pools and drivers is not always a straight forward activity and at times, it is necessary to rationalize the number of cost pools and cost drivers in the interest of reducing complexity and the cost of ABC. This may be regarded as a compromise to the ABC system

(iii) It does not conform to the accounting standard on stock; the ABC system encourages all costs including selling and distribution costs to be charged to work in progress and finished goods as product costs. This cuts across the normal basis of valuing stock for financial purposes. The accounting standard on stock requires that stocks and work in progress be valued at total production cost up to the stage of production reached which usually excludes the selling, distribution and administration overheads.

(iv) It is a more complex system of absorption costing: ABC is regarded by some as not so very different from absorption costing in that absorption rates for each cost driver are still required to be computed under the ABC System in order to recover the cost of each cost pool
Cost allocation
This refers to the distribution or assignment of a group of costs to cost centers. Such costs are assimilated in a similar manner and should be allocated on the same base. Allocation base is the measure of activity used to allocate a cost pool to the cost centers.
Reasons for Cost Allocation
 To facilitate comparison with externally provided services: It assists in assessing whether to continue the service or contact outsiders.

 To provide ideas on the efficiency of service departments: It helps to determine whether a service department is operating efficiently and its size is optimal.

 To discourage unnecessary service by some managers as they know they will be

 To provide opportunity for cost price-quality trade offs: Cost allocation helps to eliminate friction between departments. This is because a user department that demands higher quality knows that it will have to bear higher costs.
Allocation of Service Department Costs to Production departments
Service departments are those departments that provide support to production departments but do not engage directly in the production of the products e.g. the accounting department, maintenance department, and the legal department. Service departments provide services to each other and at the same time to the production department. The methods of allocating service costs include

1. Direct Allocation Method
2. Step-wise Method
3. Reciprocal Method

(i) Direct Method

The service costs are only allocated to the production department according to the usage of the services provided. For example, maintenance services offered to the mixing department will be charged to the mixing department directly.

(ii) Step-wise Method

It is also referred to as elimination method. Some of the costs of the reciprocal services will be recognized although only to some extent. The steps followed include:
Choose one of the service departments and allocate its costs to all the other departments including the other service departments. Normally, the basis of choosing that service department to start with is the service department that provides services to the greatest number of other departments or the greatest percentage of the service costs incurred in that department is attributed to service offered to other departments.
Another service department is chosen and its total costs allocated the remaining
departments excluding the first service departments.
Repeat the process until all the service department costs have been allocated to the
production departments.

(iii) Reciprocal Method

This method fully considers all reciprocal services. It is the most precise in technically finished method. This method employs the following techniques as discussed earlier in this chapter.
a) Simultaneous Equation
b) Matrix Algebra
>>> Illustrations
Assume the following data:

(i) Direct Method allocation to production departments;

(ii) Step wise method (Elimination Method)

Each of the coefficients in the expressions hereunder (used to get cost after recognition) are percentages based on proportional service received by a department from the departments

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