Chapter 2 PPS

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ACCA - F5 Performance Management 1

ACCA F5Performance Management

8th and 14th July

2011


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Activity Based

Costing(ABC)

Chapter 2

ACCA F5Performance Management


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Products consume activities,Activities consume resources

Manufacturing costs generally consist of:

Direct costs & Indirect costsTraditional: higher portion direct costs than indirect costs

Traditional absorption costing system acceptable sinceindirect cost portion is small accuracy

Recent year changes (advanced manufacturing technology ATM) indirect cost is getting higher accuracy?

ABC introduced for accuracy in costing and tool for PM

Performance ManagementABC: Introduction


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The emergence of ABC systems

Traditional systems were appropriate when:

1.Direct costs were the dominant costs2.Indirect costs were relatively small

3.Information costs were high

4.There was a lack of intense globalcompetition

5.A limited range of products was produced.



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Performance ManagementABC Concept


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Activity-Based CostingActivity-Based Costing

Involves the identification ofcost

drivers which cause the costs of acompanys activities, and

The allocation of indirect costs toindividual product or service onthe basis of the usage of costdrivers


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Activities

Aggregation oftasks that consume resources Resources are assigned to activities

Activities are assigned to cost objects Assignment to cost objects by cost drivers Support activities: production scheduling, set-

up machine, move materials, inspect items,process purchase orders, process customer

orders Production activities: machine products,

assemble products

Performance ManagementABC


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Cost drivers:

ABC systems seek to use only cause-and-effect cost drivers

Traditional systems often rely on arbitraryallocation bases (volume based). A cost driveris a factorwhich causes the cost

of an activity (a factor which causes a changein the cost of an activity)

Example: no of orders handled for despatchcosts, no of store requisitions for materials



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Examples of cost drivers:Activity Cost driver Material purchases no of POsMaterial handling no of movements

quality control no of inspectionsmaintenance no of break-downsline set-up no of set-upsPatient movement no of in-patientsbooking appointment no of patients

patient reception no of patientsx-ray equipment preparation time taken



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Types of costing systems

Costing system varies in terms of :Which cost are assigned to cost units

Accuracy depends on level ofsophistication

Classification:

Marginal costing systemTraditional absorption costing systemActivity-based costing system (ABC)

Performance ManagementABC v Traditional Systems


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Types of costing systems(cntd)

Traditional absorption costing systems:1. Assign indirect cost to cost unit

2. Use unsophisticated methods to assignindirect costs.

ABC systems:

1. Assign indirect cost to cost unit2. Use sophisticated methods to assign indirect

costs


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Both systems use the two-stage allocationprocess

Traditional systems:

Stage 1: allocates OHs to production & servicedepartments, then reallocates service department coststo production departments (cost pools)

Stage 2: allocates costs from cost centres/pools toproducts/costunits using small number of 2nd

stage cost drivers (volume based OAR)

C



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Traditional systems: cntd

Cost drivers usually known as allocation basis;OH allocation rates

Normally use direct labour hours or machine hours Normally allocate service /production costs to

production centresMerged with production centre costs cost poolsThen allocate to cost objects based on OAR

C



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Outli

1. Identify an organisations major activities that takeplace in an organization

2. Identify the factors which determine the size of the

costs of an activity. These are known as cost drivers

3. Collect the costs of each activity into what is knownas cost pools, equivalent tocost centres undertraditional costing methods

4. Charge costs to products on the basis of their usageof the activity. A products usage of an activity ismeasured by the number of the activitys cost driver

it generates

Performance ManagementABC: Steps


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Major difference:ABC relies on greater numberof cost centres & 2nd stage

drivers that cause activity resource consumptionABC assigns activity costs to cost units on basis ofcost

driver usage ABC measures resources consumed by cost units more

accuratelyTraditional system reports less accurate cost as cost drivers

used do not have cause-and-effect relationships existbetween support cost and cost objects

C



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Assigning the cost of activities to products:

Example 1:

Cost pool for sales order handling

Cost driver = no of orders processedTotal in cost pool = $300,000Total orders in the year = 1,000 orders

Cost per Driver = $300 per order

Product A with 200 orders for the yearOrder processing cost to charge to Product A = $60,000

($300 x 200)



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Assigning the cost of activities to products:

Example 2:

4 departments use purchasing function

Total purchasing dept costs = $10,000,000 per yearUsage of purchasing function:

Department No of orders Cost allocationA (10M/300x200K) 200,000 6,666,667B (10M/300x50K) 50,000 1,666,667C (10M/300x40K) 40,000 1,333,333D (10M.300x10K) 10,000 333,333

300,000 10,000,000



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Assigning the cost of activities to products:Example 3: Std cost of Product XFunction rate x usage$ allocated cost $Quality control 200 x 50 10,000Process set-up 300 x 50 15,000Purchasing 105 x 50 5,250

Customer orders 60 x 10 600Occupancy cost 2 x 50,000 100,000

(1M x 3min / 60 = 50,000) 130,850

Allocated cost per unit = 130,850 / 1,000,000 units = $0.14

Std unit cost for Product B:Material $0.50Labour 0.40Ohead 0.14

$1.04



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A

B

Product costs are more accurate

Allows company to assess product profitability realistically competitive market

Cost behaviour is better understoodFacilitates cost control enable ultimate cost reduction

Enhances better decisions

Recognises the current complexity in manufacturing withmultiple cost drivers (wider product range, shorterlife cycles, complex processes)

Performance ManagementABC: Advantages


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A

B

Cost of implementation may exceed itsbenefits

Not significant where indirect costs are low,small product range

Performance ManagementABC: Advantages


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A

BC

May cause distortion to pricing strategy over-priced orunder-priced profitability v competitive market

Product strategy encourages focus on products with

higher profit margin

Helps in identifying value added and non-value addeditems/activities with a view to elimination

Forces managers to evaluate drivers that effect costs andwhat these drivers contribute to the final product



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A

B

Decision making Accurate costenhances management

decisions such as make-or- buy,expansion or discontinuingbusiness line

Modern Business ApplicationsABC


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Chapter 2 PPS