Activity-based costing

After completing this chapter, you should be able to:

• Explain the limitations of traditional costing systems; • Describe the difference between activity-based and traditional costing systems; • Compute product costs using an activity-based system; • Describe the four different categories of activities listed on pages 279-80; • Explain the activity-based profitabil ity analysis approach; • Describe how the activity-based approach differs from the decision-relevant approach.

In the late 1980s a considerable amount of publicity was given to product costing and profitability analysis. In o series of articles Cooper and Kaplan drew attention to the limitations of traditional product costing systems. Their criticisms relate to the methods of allocating overheads to products described in Chapter 4.

You will recall from Chapter 4 that full product costs (i.e. those that include o shore of all manufacturing costs) must be computed to meet financial accounting requirements. It was stressed, however, that full product costs, using financial accounting principles, ore not suitable for decision-making purposes. Instead, it was suggested in Chapter 10 that decisions should be based on o decision-relevant approach incorporating relevant/incremental cash flows. With this approach, decisions such as introducing new products, discontinuing products and special pricing decisions should be based on a study of only those incremental revenues and expenses that will vary with respect to the particular decision. This approach requires that special studies be undertaken when the need arises.

The limited amount of empirical evidence on the use of product costing does, however, suggest that managers use full product costs for decision-making purposes. For example, on the basis of observations of 150 cost systems over the past seven years, Cooper (1990) states that traditional full product costs were used by all

companies as a basis for decision-making. Note that we shall use the te traditional product costs stems· to refer to the method of allocating overheads to products described in Chapter 4.

Cooper and Kaplan (1988) have developed a more refined approach for assinging overheads to products and computing product costs. They call this approach activity-based costmg (ABC). It is claimed that ABC provides product cost information that is useful for decision­making purposes. Articles on ABC were first published in 1988, and since then many articles hove been published on this topic. By the early 1990s many firms were contemplating the implementation of ABC systems. A study by Drury ef of. (1992) reported that 12% of the respondents had, or were, in the process of implementing ABC. A further 38% were considering introducing ABC systems.

In this chapter we explain how ABC systems con be used for product costing and profitability analysis, but note that ABC can also be used for managing and controlling costs. These aspects are considered in Chapter 17. Finally, you should note that most of the literature on ABC, including the content of this chapter, is based on the writings of Cooper and Kaplan. For a more detailed study of the topics covered in this chapter you should therefore refer to the original articles by these writers.

INTRODUCTION ---------------------------------273 C. Drury, Management and Cost Accounting© J.C. Drury 1992

Factors leading to the

emergence of activity-based

costing

Limitations of traditional cost

systems

Traditional product costing systems were designed decades ago when most com­panies manufactured a narrow range of products, and direct labour and materials were the dominant factory costs. Overhead costs were relatively small, and the distortions arising from inappropriate overhead allocations were not significant. Information processing costs were high, and it was therefore difficult to justify more sophisticated overhead allocation methods.

Today companies produce a wide range of products; direct labour represents only a small fraction of total costs, and overhead costs are of considerable importance. Simplistic overhead allocations using a declining direct labour base cannot be justified, particularly when information processing costs are no longer a barrier to introducing more sophisticated systems. Furthermore, the intense global corn­petition of the 1980s has made decision errors due to poor cost information more probable and more costly. Holzer and Norreklit (1991) suggest that over the years the increased opportunity cost of having poor cost information, and the decreased cost of operating more sophisticated cost systems, have increased the demand for more accurate product costs . It is against this background that ABC has emerged.

Traditional systems measure accurately volume-related resources that are consumed in proportion to the number of units produced of the individual products. Such resources include direct labour, materials, energy and machine-related costs . However, many organizational resources exist for activities that are unrelated to physical volume. Non-volume-related activities consist of support activities such as material handling, material procurement, set-ups, production scheduling and first­item inspection activities. Traditional product cost systems, which assume that products consume all resources in proportion to their production volumes, thus report distorted product costs.

The distortions arising from the use of traditional product costing systems are most pronounced in organizations that produce a diverse range of products which differ in volume and complexity. Cooper and Kaplan (1991) use the following example to illustrate the inability of traditional costing systems to report accurate product costs:

Consider two hypothetical plants turning out a simple product: ballpoint pens. The factories are the same size and have the same capital equipment. Every year plant I makes 1 million units of only one product: blue pens. Plant II, a full-line producer, also produces blue pens, but only 100 000 per year. Plant II also produces a variety of similar products: 80 000 black pens, 30 000 red pens, 5000 green pens, 500 lavender pens, and so on . In a typical year plant II produces up to 1000 product variations, with volumes ranging between 100 and 100 000 units . Its aggregate annual output equals the 1 million pens of Plant I.

The first plant has a simple production environment and requires limited manu­facturing support facilities . With its higher diversity and complexity of operations, the second plant requires a much larger support structure. For example, 1000 different products must be scheduled through the plant, and this requires more people for scheduling machines, performing set-ups, inspecting items, purchasing, receiving and handling materials, and handling a large number of individual re­quests. Expenditure on support overheads will therefore be much higher in the second plant, even though the number of units produced and sold by both plants is identical. Furthermore, since the number of units produced is identical, both plants will have approximately the same amount of direct labour hours, machine hours and material purchases. The much higher expenditure on support overheads in the second plant cannot therefore be explained in terms of direct labour, machine hours operated or the amount of materials purchased. Traditional costing systems, how­ever, use these volume bases to allocate support overheads to products .

Cooper and Kaplan use the two-plant example to illustrate the distortion in product costs that can arise if traditional volume-related bases such as direct labour hours, machine hours or material costs are used to allocate support department

274 -------------------------------- ACTIVITY·BASED COSTING

costs to products. For example, in the second plant the cost system will allocate to blue pens, which represent 10% of the plant's output, approximately 10% of the factory expenses. Similarly, green pens, which represent 0.5% of the plant's output, will be allocated about 0.5% of the factory expenses. In fact, if each pen requires approximately the same number of machine hours, direct labour hours or material cost, the reported cost per pen will be identical. Thus blue and green pens will have identical product costs, even though green pens are ordered, manufactured, packaged and despatched in much lower volumes.

The small-volume products, such as the green and lavender pens, place a much higher relative demand on the support departments than their low share of volume might suggest. Intuitively, it must cost more to produce a low-volume green pen than a high-volume blue pen. Traditional volume-based costing systems therefore tend to overcast high-volume products and undercost low-volume products. To remedy this descrepancy, ABC expands the second-stage assignment bases used for assigning overheads to products.

Activity-based costing emphasizes the need to obtain a better understanding of the behaviour of overhead costs, and thus ascertains what causes overhead costs and how they relate to products. ABC recognize that in the long run most manufacturing costs are not fixed, and it seeks to understand the forces that cause overhead costs to change over time.

ABC systems assume that activities cause costs and that products (and customers) create the demands for activities. Costs are assigned to products based on individual products' consumption or demand for each activity. ABC systems simply recognize that businesses must understand the factors that drive each major activity, the cost of activities and how activities relate to products. An outline of an ABC system is presented in Figure 11.1.

The first stage is to identify the major activities in the organization. Examples of activities include machine-related activities (e.g. machining cost centres), direct labour-related activities (e.g. Assembly departments) and various support activities such as ordering, receiving, materials handling, parts administration, production scheduling, packing and despatching. The second stage is to identify the factors that influence the cost of a particular activity. The term 'cost driver' is used to describe the events or forces that are the significant determinants of the cost of th~ activities. For example, if production scheduling cost is generated by the number of produc­tion runs that each product generates then the number of set-ups would represent the cost driver for production scheduling. ABC recognizes that cost behaviour is dictated by cost drivers, and therefore the tracing of overhead costs to products requires that cost behaviour must be understood so that appropriate cost drivers can be identified. Examples of some of the cost drivers used by ABC systems include the number of receiving orders for the receiving department, the number of production runs undertaken for scheduling and set-up costs, the number of purchase orders for the cost of operating the purchasing department and the number of despatch orders for the despatch department. For those costs that are purely variable with output in the short term, ABC systems use volume-related cost drivers such as direct labour hours or machine hours. For example, power costs can be traced to products using machine hours as the cost driver, since machine hours drive the consumption of power. Thus if production increases by 10%, the con­sumption cost and the number of machine hours will increase by 10% .

You will see from Figure 11.1 that the third stage requires that a cost centre (or cost pool) be created for each activity. For example, the total cost of all set-ups might constitute one cost centre for all set-up related costs. The final stage in Figure 11.1 is to trace the cost of the activities to products according to the product's demand (using cost drivers as a measure of demand) for these activities during the pro­duction process. A product's demand for the activities is measured by the number of transactions it generates for the cost driver. Assume, for example, that the total cost traced to the cost centre for set-up related costs was £100 000 and that there were 100 set-ups during the period . The charging out rate would be £1000 per set-up. To

Activity-based cost systems

ACTIVITY-BASED COST SYSTEMS ----------------------------- 275

An illustration of ABC and

traditional product costing

systems

1. Identify the major activities that take place in the organization

2. Determine the cost driver for each major j act1v1ty

3. Create a cost centre/cost pool for each major activity

4. Trace the cost of activities to products according to a product's demand for activities

Figure 11.1 Outline of an ABC system.

determine the set-up costs for a particular product, the number of set-ups for the product would be multiplied by £1000. Thus the cost per unit for one batch of 20 units will be £50 (£1000/20 units). ABC would trace the costs of other activities to products using a similar approach.

Exhibit 11.1 provides information that we shall use to contrast a traditional product costing system with an ABC system. The aim is to provide a conceptual under­standing of the issues involved. Therefore the situation presented is highly sim­plified. Both approaches trace overhead costs to products using the two-stage allocation process. In the first stage costs are assigned to cost centres. You can see from part (a) of Exhibit 11.1 that A Ltd has only one production centre. Therefore the traditional costing system traces overheads of £440 000 to a single cost centre for product costing purposes. In practice, traditional costing systems trace overheads to several production cost centres, and support (service) department overheads are reallocated to production departments. Overheads are normally allocated to products using two volume-based allocation rates: direct labour rates and machine hour rates. This procedure was illustrated in Exhibit 4.1 in Chapter 4. However, the simplified illustration of the traditional approach will enable you to see more clearly how this approach differs from ABC.

With the ABC system, separate cost centres are created (see part (b) of Exhibit 11.1) for each major activity. Thus three cost centres are created to represent the machine-related activities, set-up activities and purchasing activities. In practice, an organization would have more than three activity cost centres.

The second stage of the allocation process allocates costs from cost centres to products. Traditional costing systems trace overhead costs to products using a small number of allocation bases, which vary directly with the volume of product produced. Direct labour hours and machine hours are the volume-related bases normally used by traditional costing systems. By referring to Exhibit 11.1 (a), you will see that costs have been allocated to products H and L using both machine hours and direct labour hours as the allocation basis. Note that the cost per unit is the same whichever volume base is used, because machine hours and direct labour hours are consumed in the same proportions by each product. Therefore the product cost allocations will be identical.

276 -------------------------------- ACTIVITY·BASED COSTING

Company A produces two products: H and L. Both are produced on the same equipment and use similar processes. The products differ by volume. Product H is a high-volume product while L is a low­volume product. Details of product inputs, output and the cost of activities are as follows:

Direct Total Machine labour

Product L Product H

hours per unit

2 2

hours per unit

4 4

The cost of the activities is as follows:

Volume-related Purchasing-related Set-up-related

(£) 110000 120000 210000

440000

Annual output (units)

1000 10000

(a) Traditional volume-based costing system Cost-centre allocated costs £440000

Total direct machine labour hours hours

2000 4000 20000 40000 -- --22000 44000

Overhead rate per machine hour £20 (£440 000/22 000 hours) Overhead rate per direct labour hour £10 (£440 000/44 000 hours)

No. of purchase No. of orders set-ups

80 40 160 60

240 100

Cost per unit: L £40 (2 machine hours at £20 or 4 DLHs) H £40 (at £10 per hour)

Total cost allocated to products: L £40000 (1000 x £40) H £400000 (10000 X £40)

(b) ABC system Activities

Volume-related Purchasing-related Set-up related

Costs traced to activities £110000 £120000 £210000 Consumption of activities

(cost drivers) 22 000 machine hrs 240 purchase orders 100 set-ups Cost per unit of

consumption £5 per machine hr Costs traced to products:

L £10 000 (2000 X £5)

H £100000 (20000 X £5)

Cost per units:

£500 per order

£40000 (80 X £500)

£80000 (160 X £500)

Product L = £134 (£10000 + £40000 + £84000)/1000 units Product H = £30.60 (£100000 + £80000 + £126000)/10000 units

£2100 per set-up

£84000 (40 X £2100)

£126000 (60 X £2100)

With an ABC system, we use the cost drivers to relate the activities (and thus assign the cost of the activities) to the products. This is illustrated in Exhibit 11.1(b). Note that in practice the ABC system uses many drivers as allocation bases in the second stage of the cost allocation system whereas the traditional cost systems tend to use, at the most, two second-stage allocation bases. ABC cost driver rates should therefore be more closely related to the causes of overhead costs . In our example the ABC system uses three second-stage allocation bases (machine hours, number of set-ups and number of purchase orders) while the traditional system uses one allocation base (either machine hours or direct labour hours). The product costs (See Exhibit 11.1 (a) and (b) for calculations) using each system are as follows:

Exhibit 11.1 A comparison of ABC with traditional costing systems

ILLUSTRATION OF ABC AND TRADITIONAL PRODUCT COSTING ------------------------------------- 277

(a) Traditional produd costing system

Stage 1: Overheads assigned to production departments Stage 2: Overheads allocated to products

Production departments

I I I I

I I I

Overhead cost I

I I I I I I I

Departmental overhead allocation rates Products

(b) Adlvity-based produd costing system

Stage 1: Overheads assigned to cost centres/cost pools Stage 2: Overheads assigned to products using I cost driver rates

Overhead cost

278----

Activity cost pools I Activity -:ost driver rates Products

I

I~ I I I

I I I

i

~ I I I I I I

Figure 11.2 Comparison of traditional (a) and activity-based {b) costing systems. (Adapted from Innes and Mitchell (1990).)

Product L (low-volume product) Product H (high-volume product)

Traditional costing system

(£) 40 40

ABC System (£)

134 30.60

With the traditional system, the high-volume product H costs the same to produce as the low-volume product L. This is because the high-volume products in total

--• ACTIVITY-BASED COSTING

consume ten times the number of machine hours required by their low-volume counterparts. Consequently, £400 000 overheads are allocated to product H and £40000 to L, but, since the volume for product His ten times higher, the unit costs are the same.

Figure 11.2 provides an overview of traditional and ABC systems. You can see that both systems adopt the two-stage allocation process. In the first stage tradi­tional cost systems allocate overheads to production departments whereas ABC systems assign overheads to each major activity (rather than departments). With ABC systems, many activity-based cost pools (cost centres) are established, whereas, with traditional systems, overheads tend to be pooled by departments. This can result in extensive reapportionments of service department costs to ensure that all overheads are allocated to production departments. Therefore traditional costing systems use fewer cost pools. ABC systems establish separate cost pools for support (service) activities such as materials handling and maintenance. The costs of these activities are assigned directly to products through cost driver rates. Thus reappor­tionment of service department costs is avoided.

Traditional costing systems use only volume-related bases to trace overheads to products. This approach will result in distorted product costs whenever the costs of some product-related activities are unrelated to volume. To trace costs deriving from activities that are unrelated to volume requires allocation bases that themselves are independent of volume. The ABC system recognizes that some activities are un­related to volume by using allocation bases that are independent of production volume.

A comparison of the two sets of product costs demonstrates how traditional volume-based costing systems overcast high-volume products (H) in relation to their low-volume counterparts (L). The reason for this is that the high-volume products consume ten times as many machine hours and direct labour hours as the low­volume products. But the high-volume products are ordered only twice as often (160 purchase orders compared with 80) and set-up only 1! times as often (60 set-ups compared with 40) as the low-volume products. The traditional volume-based system ignores these differences in relative consumption of overhead resources. The result is that high-volume products are overcosted and low-volume products undercosted.

The ABC system recognizes the differences in relative input consumption, and traces the appropriate amount of input to each product. As a result, the low-volume products incur higher reported product costs because they consume more of the volume-unrelated input per item than their high-volume counterparts. Thus if volume-related bases are used, high-volume products will be allocated with an excessively high proportion of costs whenever overhead costs are driven by forces that are not proportional to the volume of output. Therefore the high-volume products will subsidize the low-volume products whenever volume-based allocation methods are used. The more the low-volume specialized products are emphasized, the more the overhead costs will grow in the long run. With a volume­based allocation system, most of this growth will be charged to the higher-volume smooth running products. In the:>e circumstances the high-volume products will progressively show diminishing product margins. There is a danger that firms may make incorrest produCt mix decisions by expanding the range of low-volume products at the expense of the high-volume products. The result will be a growth in overhead costs and a decline in long-run profitability.

Cooper (1990) has classified activities into three major categories that drive expenses at the product level. They are unit-level activities, batch-related activities and prodict-sustaining activities.

Unit-level activities are performed each time a unit of the product is produced. They are consumed in direct proportion to the number of units produced. Expenses in this category include direct labour, direct materials, energy costs and expenses that are consumed in proportion to machine processing times (such as machine

Classification of activities

CLASSIFICATION OF ACTIVITIES ------------------------------ 279

depreciation and maintenance). Unit-level activities consume resources in pro­portion to the number of units produced. For example, if a firm produces 10% more units, it will consume 10% more labour hours, 10% more machine hours and 10% more energy costs.

Batch-related activities, such as setting up a machine or processing a purchase order, are performed each time a batch of goods is produced. The cost of batch­related activities varies with the number of batches made, but is common (or fixed) for all units within the batch. For example, set-up resources are consumed when a machine is changed from one product to another. As more batches are produced, more set-up resources are consumed. It costs the same to set-up a machine for 10 or 5000 items. Thus the demands for the set-up resources are independent of the number of units produced after completing the set-up. Similarly, purchasing resources are consumed each time a purchasing order is processed, but the re­sources consumed are independent of the number of units included in the purchase order. Other examples of batch-driven costs include resources devoted to pro­duction scheduling, first-item inspection and materials movement.

Product-sustaining activities are performed to support different products in the product line. They are performed to enable individual products to be produced and sold, but the resources consumed by these activities are independent of how many units or batches of the product are produced. Cooper and Kaplan (1991) identify engineering resources devoted to maintaining an accurate bill of materials and routing each product as an example of product-sustaining activities. Other examples are the resources to prepare and implement engineering change notices (ECNs), to design process and test routines for individual products, and to perform product enhancements. The expenses of product-sustaining activities will tend to increase as the number of products manufactured is increased. ABC uses product level bases such as number of active part numbers and number of ECNs to assign these costs to produds.

Cooper identifies one additional expense category that cannot be directly attri­buted to individual products. Facility-sustaining activities are performed to sustain a facility's general manufacturing process. Examples of facility-sustaining activities include administration, plant management, accounting services, and lighting and heating of the factory. These activities are necessary to sustain the manufacturing process, and are common and joint to all products manufactured in the plant. Therefore these costs are not assigned to products. Instead, they are regarded as com­mon costs to all products made in the plant and deducted in a lump sum from the total of the operating margins from all product lines.

Kaplan (1990) illustrates an hierarchical approach applying the activity-based clas­~~liiiiiil sification to profitability analysis. Figure 11.3 is an adaptation of the approach • advocated by Kaplan. You can see from the figure that a unit-level contribution

Activity-based profitability

analysis margin is calculated for each individual product by subtracting unit level expenses from revenues. From this unit-level margin batch-related and product-sustaining expenses are deducted to compute a product-level contribution margin for each individual product in the product line (Line 3 of Figure 11.3). No allocations are required to obtain this product-level margin.

Some expenses are incurred at the product-line level, and are common to all products within the product line. The activity-based analysis classifies these ex­penses as product-line-sustaining expenses, and traces them to product lines but not to individual products within the line. Examples of product-line-sustaining expenses include advertising, research and development activities and distribution expenses. A product-line contribution margin is computed in line 4 by deducting product-line­sustaining expenses from the sum of the individual product-level contributions sold within the line. This calculation shows whether the products sold within the line earn a sufficient contribution to cover the expenses of activities performed to sustain the product-line. At the final level a profit for the plant is computed by deducting the facility-sustaining expenses from the product-line contribution.

The approach outlined in Figure 11.3 should not be limited to products and

280 -------------------------------- ACTIVITY-BASED COSTING

1. Unit-level product contributions ~

2. Product contributions after deducting ~ batch-related expenses

3. Product contribution after deduction product-sustaining expenses

4. Product-line contributions after deducting product line sustaining expenses

5. Plant profit after deducting facility sustaining expenses

Figure 11.3 Activity-based profitability analysis.

Product lines (product line 1)

Plant profit

Product line 2

product lines. We should also focus on customers and distribution channels by summing the product-level margins of the products sold to each customer or through each channel, and then deducting expenses incurred for individual customers or channels of distribution.

The analysis should also include marketing and distribution expenses. For example, marketing resources should be traced to activities performed for products, product lines, distribution channels and customers, and analysed along a hierarchy similar to that used for production expenses. Some marketing and distribution resources are consumed by individual products and others by product lines. The activity-based analysis assigns the consumption of marketing and distribution resouirces to the appropriate level of the hierarchy, and aggregates the associated expenses down the hierarchy to compute contribution margins by product, product line, customer and distribution channel.

You will have noted that this approach is similar to the decision-relevant ap­proach for segmental profitability analysis described in Figure 10.1 in Chapter 10. Note, however, that the decision-relevant approach classifies the fixed costs dif­ferently from the activity-based approach. Later in this chapter ABC is compared with the decision-relevant approach.

Ideally, cost systems should compute unit product costs, which can be deducted from the selling price to compute a unit profit margin for each product. It is misleading, however, to compute unit product costs, since this implies that costs are directly proportional to the number of units produced. Consider a situation where the output of a single product is 20 000 units, short-term volume-related costs are £5 per unit and costs that are unrelated to volume are £100000. These costs are classified by traditional systems as fixed costs. If we unitize these 'fixed costs', the cost per unit will also be £5 (£100 000/20 000) and the total unit cost will be £10. If output declines to 10 000 units, those costs that are unrelated to volume may remain unchanged in the short run, and the revised unit cost will be £15 per unit (£5 variable cost plus £100 000 non-volume related costs divided by 10 000 units).

We have noted that the non-volume-related costs vary with factors other than volume, such as the number of batches (batch-related expenses) or the range of products produced (product-sustaining expenses). Therefore computing unit

PROBLEMS ARISING WITH COMPUTING UNIT COSTS ------------------------ 281

Resource _consumption

models

A comparison of activity-based systems with

decision­relevant costs

product costs gives a misleading impression of the variability of the cost structure of a product . Kaplan (1990) suggests that managers should resist the temptation to compute unit product costs. Instead, he advocates the hierarchical approach outlined in Figure 11.3, which aggregates all product expenses (unit, batch and product-sustaining) into a total product expense figure. This approach does not imply that expenses are variable with the number of units produced.

Kaplan also suggests that the hierarchical activity-based product expense model can be used to approximate the changes in expenses as a consequence of particular decisions. If a proposed decision will increase the number of batch-level activities and/or increase the number of products in the plant, the increase in demands for resources to perform batch-related and product-sustaining activities can be estimated and linked to subsequent demands for increased resource spending.

ABC systems are model of resource con umption, not spending. They attempt to model the consumption of resources throughout the organization. For some resources such as materials and energy there is a close link between resource consumption and spending. When output is expanded, the consumption of energy and material resources increases, and this is soon followed by increases in spending. Consumption and spending are closely related for those short term variable costs that vary with the volume of products produced.

For those expenses that do not vary with volume in the short term, such as direct labour and the salaries of indirect workers, there is a lag between changes in consumption and changes in spending. When production expands, these resources are utilized more intensely, or some activities are deferred, in order to cope with the increased activity. Eventually, however, pressure builds up to acquire additional resources (people and equipment), and it is at this point that spending on resources changes. Similarly, when production activity declines, indirect resources tend to remain in place in the hope that a decline in demand will be temporary. However, if there is no upsurge in demand, spending will eventually be changed to match the reduced resource consumption. The activity-based approach attempts to measure the total organizational resources required to produce a product. It recognizes that in the longer term changes in the consumption of resources are eventually followed by the corresponding changes in the spending on the resources. To predict future spending trends, ABC systems estimate the quantity of resources consumed by each product.

So far, we have compared activity-based costing systems with traditional costing systems. Most of the ABC literature has shown how ABC systems are superior to the traditional product cost systems described in Chapters 3 and 4. Piper and Walley (1990) argue that the literature adopts a 'straw man' approach to make the case for the superiority of ABC product costs. A 'straw man' approach consists of estab­lishing a weak or non-viable option (i.e. traditional product costing) and then demonstrating the superiority of the proposed option (ABC product costs) over the 'straw man' alternative. Piper and Walley claim that ABC is rarely compared with viable alternatives such as the decision-relevant approach described in Chapter 10. Cooper (1990), however, disputes this claim, and states that traditional product costs are widely used in practice for decision-making and therefore the straw man argument cannot be justified.

Cooper and Kaplan (1991) do contrast activity-based systems with the decision­relevant approach . They question the feasibility of generating uniquely relevant costs for each decision because the range of possibilities faced by managers is enormous. For example, Kaplan (1990) considers a situation where a company has only 100 products and outlines the difficulties of determining which product, or product combinations, should be selected for undertaking decision-relevant" special studies.

He states:

First how do you think about which product you should even think about making a decision on? There are 100 different products to consider. But think

282 -------------------------------- ACTIVITY-BASED COSTING

about all the combinations of these products: which two products, three products or groupings of 10 or 20 products should be analysed? It's a simple exercise to calculate that there are 2100 different combinations of the 100 products . .. so there's no way to do an incremental revenue/incremental analysis on all relevant combinations .

To cope with the vast number of product combinations, Cooper and Kaplan argue that a general purpose activity-based system is required that reports long-run average product costs. The product costs reported are not designed to be used directly for decision-making. They provide attention-directing information and highlight problem areas that require more detailed analysis and the attention of management. Thus activity-based product cost data pinpoints those products where losses are reported and that therefore require special studies to ascertain whether they are likely to be profitable in the long run .

It could be argued that the decision-relevant profitability analysis approach illustrated in Figure 10.1 in Chapter 10 provides similar information. However, only specific fixed costs are assigned to products, and attention is not focused on ascertaining what causes fixed costs to change over time. In contrast, activity-based costing seeks to obtain a better understanding of overhead costs, and, by ascer­taining what causes overheads and how they relate to products, it is possible to measure more accurately the overhead resouces consumed by products. Thus more of the so called non-specific fixed costs can be assigned to products.

Activity-based systems report long-run average product costs. They do not measure the consequences of individual decisions. Cooper (1990) says that ABC evolved to support decisions where the number of products is large and decisions are not independent. He states:

In such settings the consequences of decisions taken independently can be quite different from the sum of the effects of individual decisions. For example, the decision to drop one product will typically not change 'fixed' overhead spending. In contrast dropping fifty products might allow con­siderable savings to be made . Stated somewhat tritely, the sum of the parts (the decision to drop individual products) is not equal to the sum of the whole (the realisable savings from having dropped 50 products) . To help them make effective decisions, managers require cost systems that provide insights into the whole, not just isolated individual parts.

ABC thus attempts to approximate the cost of resources consumed in the production of a given product. It presents attention-directing information and is not a decision­making tool. Thus ABC systems are designed to identify priorities for managerial attention and not to provide decision-relevant costs.

Articles on ABC were first published in 1988 and, by 1991, only a few companies had implemented ABC systems. In a survey of 300 UK manufacturing companies Drury et al. (1992) reported that 3% of the respondents had introduced activity­based costing systems. ABC is in its infancy and, as such, the time is not ripe for its evaluation. However, the growth in ABC literature and the great interest which practitioners and consultants have shown suggests some dissatisfaction with existing systems and the need for a system that measures average long-run product costs more accurately.

Since 1988, numerous articles explaining and justifying the concept of ABC have been published. Some advocates of ABC have made extravagant claims about its uses and benefits in their mission to establish it as the new manufacturing accounting system. It has been claimed by some writers that all costs (including facility-sustaining costs) can be accurately traced to products, and the resulting product costs represent decision-relevant costs that can be used directly as an input for decision-making purposes. Hence there is a danger that ABC will be seen as a panacea that provides truly accurate product costs and cost driver rates that can be used to predict the outcomes of various decisions accurately. Incremental overhead

An evaluation of activity-based costing

AN EVALUATION OF ACTIVITY-BASED COSTING --------------------------- 283

spending (for expansion decisions) cannot be ascertained directly by multiplying the existing cost drivers rate by the cost driver volume.

Many issues relating to the operation of ABC systems have not yet been resolved. For example, should ABC product costs and profitability analysis consist of 'one-off investigations or should ABC product costs and profitability analysis be reviewed and modified at frequent intervals? A further issue relates to whether an ABC analysis should use past or future costs. According to Cooper and Kaplan (1991), early adopters of ABC systems have used prices derived from the company's historical cost accounting system. Using historical costs enables the sum of the product costs computed by activity-based systems to be reconciled with costs computed by the traditional system. The issue as to whether historical activity-based product costs can also be used for financial accounting and inventory valuation has received relatively little attention in the literature. Historical costs may, however, represent out-of-date information for highlighting problem areas for managerial attention, but there is no reason why future prices cannot be used.

The literature on ABC is somewhat unclear as to which information should be used for decision-making purposes. For example, Kaplan (1990) states:

We need an 'attention-directing' system that points us in the general direction and says, look, here are 80 per cent of the products that collectively generate 15 per cent of the revenues, but look like they're losing 200 per cent of the profits. The ABC analysis does not say drop all the apparently unprofitable products. But it does raise for management's attention why those products are being designed, produced, and sold the way they are. The system highlights prob­lem areas that deserve management's attention and more detailed analysis. Many actions are possible, on pricing, on process technology, on product design, on operational improvements, and on product mix, once management realises that a large number of its products and customers may be breakeven or unprofitable. The ABC systems seem to be useful in setting priorities for managerial attention and action. Thus we view this approach more as an issue of design, not of analysis. The activity-based approach is not problem solving and it's not decision-making.

It is unclear what action should be taken if investigations indicate there is no scope for redesign or other cost savings and the ABC analysis reports that the product is unprofitable. Should the product be discontinued on the basis of the ABC analysis? Cooper and Kaplan (1991) appear to suggest that special studies should be undertaken. They state:

Product cost data from companies' cost systems is frequently analysed in greater depth to obtain information relevant for a particular decision. The desired cost adjustments frequently require an expensive special study.

The ABC literature does not indicate what information should be included in the special studies. Presumably, such studies would adopt a decision-relevant approach and report incremental revenues and incremental costs. However, the ABC analysis separately reports costs at the unit, batch and product-sustaining levels, and thus provides a better understanding of cost behaviour. Consequently, ABC data should result in more accurate predictions of future long-term incremental spending when special studies are undertaken.

ABC should be evaluated on a cost versus benefits basis. ABC systems vary in their degree of sophistication; some systems use a small number of activity pools and cost drivers whereas others use many pools and cost drivers. Clearly, the greater the degree of sophistication the greater is the cost of operating the system. The benefits derived from implementing ABC are likely to be influenced by the level of competition, the number of products sold and the diversity of the product range. Companies operating in a more competitive envrionment have a greater need for more accurate cost information, since competitors are more likely to take advantage of any errors arising from the use of distorted cost information. Where a company markets a small number of products, special studies can be undertaken using the decision-relevant approach. Problems do not arise in determining which product or

284 -------------------------------• ACTIVITY-BASED COSTING

product combinations should be selected for undertaking special studies. Finally, increased product diversity arising from the manufacture and sale of low-volume and high-volume products favours more sophisticated cost systems, because, as diversity increases, so does the level of distortion reported by traditional cost systems. Thus the benefits arising from ABC will depend upon a firm's competitive environment, product range and extent of product diversity.

ABC has attracted a considrable amount of interest because it provides not only a basis for calculating more accurate product costs but also a mechanism for managing costs. An ABC system focuses management's attention on the underlying causes of costs. It assumes that resource-consuming activities cause costs and that products incur costs through the activities they require for design, engineering, manufac­turing, marketing, delivery, invoicing and servicing. By collecting and reporting on the significant activities in which a business engages, it is possible to understand and manage costs more effectively.

With an ABC system, costs are managed in the long-term by controlling the activities that drive them. In other words, the aim is to manage the activities rather than costs. By managing the forces that cause the activities (i.e. the cost drivers), costs will be managed in the long term. The application of activity-based systems may have the greatest potential for contributing to cost management, budgeting, control and performance evaluation. We shall discuss these aspects in Chapter 17.

The availability of cost driver rates can also have significant impact on the design of new products or can result in the redesign of existing products. Designers are made aware of the product characteristics that cause overhead costs through the cost driver rates that are applied in costing the product. For example, Cooper (1989) illustrates in a case study (The Tektronix Case) how one company used the number of part numbers as a cost driver to assign costs to products. Thus product designers were made aware that product costs could be reduced by designing products that contained common parts rather than those that were unique and costly to acquire.

In this chapter we have focused on the application in manufacturing organ­isations. However, ABC is particularly well suited to the service sector, since the majority of costs consist of overheads that are not volume-related or easily assigned to products. ABC, through the identification of activities and their cost drivers, provides the basis for understanding what causes overhead costs, and thus enables costs to be managed more effectively. With traditional systems, it is extremely difficult to trace costs in service organizations to different business segments. Activity-based systems assign costs to segments based on a segment's consumption or demand for each activity. Consequently, resource consumption by different segments (such as products or customers) is more accurately measured, and thus activity-based profitability analysis is likely to provide more meaningful information than an analysis based on traditional cost systems.

SELF-ASSESSMENT QUESTION You should attempt to answer this question yourself before looking up the suggested answer, which appears on pages 848-50. If any part of your answer is incorrect, check back carefully to make sure you understand where you went wrong.

The following information provides details of the costs, valume and cost drivers for a particular period in respect of ABC pic, a hypothetical company:

1. Production and sales (units) 2. Raw material usage (units) 3. Direct material cost 4. Direct labour hours 5. Machine hours 6. Direct labour cost 7. Number of production runs 8. Number of deliveries 9. Number of receipts (2 x 7) a

10. Number of production orders

SELF·ASSESSMENT QUESTION

Product X 30000

5 £25 11fJ 11h £8 3 9

15 15

Product Y 20000

5 £20

2 1

£12 7 3

35 10

Product Z 8000

11 £11

1 2

£6 20 20

220 25

Total

£1238000 88000 76000

30 32

270 50

285

11 . Overhead costs: Set-up Machines Receiving Packing Engineering

30000 760000 435000 250000 373000

£1848000 8 The company operates a just-in-time inventory policy, and receives each component onoe per production run.

In the past the company has allocated overheads to products on the basis of direct labour hours. However, the majority of overheads are related to machine hours rather than direct labour hours. The company has recently redesigned its cost system by recovering overheads using two volume-related bases: machine hours and a materials handling overhead rate for recovering overheads of the receiving department. Both the current and the previous cost system reported low profit margins for product X, which is the company's highest-selling product. The management accountant has recently attended a conference on activity-based costing, and the overhead costs for the last period have been analysed by the major activities in order to compute activity-based costs. From the above information you are required to:

(a) Compute the product costs using a traditional volume-related costing system based on the assump­tions that: (i) all overheads are recovered on the basis of direct labour hours (i.e. the company's past product

costing system) (ii) the overheads of the receiving department are recovered by a materials handling overhead rate

and the remaining overheads are recovered using a machine hour rate (i.e. the company's current costing system).

(b) Compute product costs using an activity-based costing system. (c) Briefty explain the differences between the product cost computations in (a) and (b).

SUMMARY

Articles on ABC were first published in 1988, and by 1991 only a few companies had implemented activity-based systems. ABC is therefore in its infancy and at this stage evaluation is inappropriate.

Traditional product costing systems report distorted product costs whenever an organization produces a diverse range of low-volume and high-volume products. Activity-based costing emphasizes the need to obtain a better understanding of the behaviour of overhead costs, and thus ascertains what causes overheads and how they relate to products. An activity-based costing system involves the following stages:

1. Identify the major activities which take place in an organisation.

2. Determine the cost driver for each major activity. 3. Create a cost centre/cost pool for each major

activity. 4. Trace the cost of activ~ies to products according to

a product's demand (using cost drivers as a measure of demand) for activities.

An illustration of the computation of activity-based product costs was presented in Exhibit 11 .1, and the resulting computations were compared with a traditional costing system. The illustration showed how traditional costing systems can overcost high­volume products and undercost low-volume products whenever the costs of some product-related activities are unrelated to

volume. ABC systems recognize that some activities are unrelated to volume by using cost drivers that are independent of production volume. Activities are divided into three major categories at the product level- unit level, batch-related and product-sustaining activities and product costs are accumulated by these three categories. Facility-sustaining expenses are performed to sustain a facility's general manufacturing process, and are common and joint to all products manufactured in the plant. These costs are not assigned to products.

An illustration of how the activity-based approach can be applied to profitability analysis has been presented, and it has also been shown how unit product costs can result in the reporting of misleading information. ABC systems are models of resource consumption, not spending. They attempt to measure the total organizational resources required to produce a product. It has also been stressed that ABC systems are designed to identify priorities for managerial attention, and not to provide decision-relevant costs.

ABC has attracted a considerable amount of interest because it provides not only a basis for calculating more accurate product costs but also a mechanism for managing overhead costs. By collecting and reporting on the significant activities in which a business engages. is possible to understand and manage costs more effectively. It is the area of cost management, rather than product costing, where activity-based systems may have their greatest potential.

286 ------------------------------ ACTIVITY-BASED COSTING

KEY TERMS AND CONCEPTS

• activity-based costing (p. 273) • batch-related activities (p. 280) • cost driver (p. 275) • facility-sustaining activities (p. 280) • product-sustaming activities (p. 280) • resource consumption model (p. 282) • traditional product costing systems (p. 273) • unit-level activities (p. 279) • volume diversity (p. 279)

RECOMMENDED READING

For a detailed description of activity-based costing systems, including case studies relating to three UK companies that have implemented ABC, you should refer to Innes and Mitchell (1990). Cooper (1990a,c,d; 1991) has also wntten a series of articles discussing some of the practical issues relating to the implementation and operation of ABC. For a discussion of the criticisms of activity-based costing see Piper and Walley (1990, 1991) and also Cooper's (1990e) reply to these criticisms. Finally you should refer to Kaplan (1990) for a discussion of activity-based profitability analysis and a comparison of resource consumption and spending models.

REFERENCES AND FURTHER READING

Cooper, R. (1989) The rise of activity-based costing- Part 4: What do activity-based costing systems look like?, journal of Cost Ma11agement (USA), Spring, 41-2'.

Cooper, R. (l990a) A structured approach to implementing ABC, Accountamy, June, 78-80. Cooper, R. (1990b) Cost classification in unit-based and activity-based manufacturing cost systems, journal of Cost Ma11ngemmt (USA), Fall, -l-13.

Cooper, R. (1990c) ABC: A need, not an option, Accotmtancy, September, 86-8. Cooper, R. (1990d) Five steps to ABC system design, Accountannt, November, 78-81. Cooper, R. (1990e) Explicating the logic of ABC, Ma11ageme11t Accoulltmg, November, 58-60. Cooper, R. (1991) ABC: The right approach for you? Accozmta11cy, january, 70-2. Cooper, R. and Kaplan, R.S. (1988) Measure costs right: make the right decisions, Harvard Busmess Revieu•, September 'October, 96-103.

Cooper, R. and Kaplan, R.S. (1991) Tlze Deszgn of Cost Management Systems: Text, Cases and Readings, Prentice­Hall, Ch. 5.

Drury, C., Braund, S., Osborne, P. and Tayles, M. (1992) A SunJey of Management Accounting Practices i11 UK Mamtfacturing Companies, ACCA Research Occasional Paper. Chartered Association of Certified Accountants.

Holzer, H.P. and Norreklit, H. (1991) Some thoughts on cost accounting developments in the UK, journal of Ma11agenu!llt Accozmti11g Research (llK), March, 3-13.

Innes, J. and Mitchell, F. (1990) Activity-Based Costing: A Revkw with Case Studies, Chartered Institute of Management Accountants.

Kaplan, R.S. (1990) Contribution margin analysis: no longer relevant, joumal of Managemmt Accounting Reseal'ch (LJSAJ, Fall, 2-15.

P~per, J.A. and Walley, P. (1990) Testing ABC logic, Manageme11t Accounti11g, September, 37, 42. Piper, j.A and Walley, P. (1991) ABC relevance not founcl, Mtmagement Accounting, March, 42-4, 54.

KEY EXAMINATION POINTS

ABC did not emerge until the late 1980s, and therefore very few questions have been set on this topic. As a resun. only a small number of questions are included in this chapter. It is likely that most questions will require you to compute product costs for a traditional system and an activity-based system

and expla1n the difference between the product costs. It is also likely that examiners will require you to outline the Circumstances where ABC systems are likely to prove most beneficial

KEY EXAMINATION POINTS ------------------------------- 287

QUESTIONS

·Indicates that a suggested solution is to be found in the Students' Manual.

11.1 *Advanced: Comparison of ABC with traditional product costing

(a) In the context of activity based costing (ABC), it was stated in Management Accounting - Evolution not Revolution by Bromwich and 8himam, that 'Cost drivers attempt to link costs to the scope of output rather than the scale of output thereby generating less arbitrary product costs for decision making.' You are required to explain the terms 'activity based costing' and 'cost drivers'. (13 marks)

(b) XVZ pic manufactures four products, nameiy A, 8, C and D, using the same plant and processes. The following information relates to a production period:

Material Direct Machine labour cost labour time cost

Product Volume per unit per unit per unit per unit A 500 £5 ~ hour ~ hour £3 B 5000 £5 ~ hour ~ hour £3 C 600 £16 2 hours 1 hour £12 D 7000 £17 1~ hours q hours £9

Total production overhead recorded by the cost accounting system is analysed under the following headings:

Factory overhead applicable to machtne·oriented activity is £37 424 Set·up costs are £4355

The cost of ordering materials is £1920 Handling materials - £7580 Administration for spare parts- £8600.

These overhead costs are absorbed by products on a machine hour rate of £4.80 per hour, giving an overhead cost per product of:

A= £1 .20 B = £1.20 c = £4.80 D = £7.20

However, investigation into the production overhead activities for the period reveals the following totals:

Number of Number of Number of Number of material times material spare

Product set-ups orders was handled parts A 1 1 2 2 B 6 4 10 5 c 2 1 3 1 D 8 4 12 4

You are required: (i) to compute an overhead cost per product using activity

based costing, tracing overheads to production units by means of cost drivers. (6 marks)

(ii) to comment briefly on the differences disclosed between overheads traced by the present system and those traced by activity based costing. (6 marks)

(Total25 ma1rks) CIMA Stage 4 Management Accounting - Control and Audit

November 1990

11.2 Advanced: Comparison of traditional product costing with ABC Duo pic produces two products A and B. Each has two components specified as sequentially numbered parts i.e. product A (parts 1 and 2) and product B (parts 3 and 4). Two production departments (machinery and fitting) are supported by five service activities (material procurement, material handling, maintenance, quality control and set up). Product A is a uniform product manufactured each year in 12 monthly high volume production runs. Product 8 is manufactured in low volume customised batches involving 25 separate production runs each month. Additional information is as follow:

Ptoduction

Details Components Annual volume produced Annual direct labour hours:

Machinery department Fitting department

Overhead Cost Analysis•

Product A

Parts 1, 2 300 000 units

500000 DLH 150000 DLH

Product 8

Parts 3, 4 300 000 units

600000 DLH 200000 DLH

£0005 Material handling 1 500 Material procurement 2 000 Set-up 1500 Maintenance 2 500 Quality control 3 000 Machtnery (machmery power, deprooation etc.)b 2500 Fitting (machine, depreciation, power etcl 2 000

15000

a It may be assumed that these represent fairly homogeneous activity based cost pools.

bIt is assumed these costs (depreciation, power etc.) are primarily production volume driven and that direct labour hours are an appropriate surrogate measure of this.

Cost Driver Analysis Annual Cost Driver

Volume per Component Cost Driver Part 1 Part 2 Part 3 Part 4 Material movements 180 160 1000 1200 Number of orders 200 300 2000 4000 Number of set-ups 12 12 300 300 Maintenance hours 7000 5000 10000 8000 Number of inspections 360 360 2400 1000 Machinery Direct labour

hours 150000 350000 200000 400000 Rtting Direct labour

hours 50000 100000 60000 140000

You are required to compute the unit costs for products A and 8 ustng (i) a traditional volume-based product costing system and (ii) an activity-based costing system. (Adapted from Innes, J and Mitchell, F., Activity Based Costing A Review wtth Case Studies, Chartered Institute of Management Accountants, 1990)

288 ------------------------------ ACTIVITY-BASED COSTING

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