What is an activity based costing (ABC)
Activity based costing is a method of costing which involves
identifying the costs of the main support activities and the factors that ‘drive’ the costs of each
activity. Support overheads are charged to products by absorbing cost on the basis of the
product’s usage of the factor driving the overheads.
major ideas behind activity based costing
(a) Activities cause costs. Activities include ordering, materials handling, machining, assembly,
production scheduling and despatching.
(b) Manufacturing products creates demand for the support activities.
(c) Costs are assigned to a product on the basis of the product’s consumption of these
activities.
What is a cost driver?
Cost driver is a factor that has most influence on the cost of an activity.
Why traditional absorption costing may be unsatisfactory?
(a) It under-allocates overhead costs to low-volume products (here, W and X) and over-
allocates overheads to higher-volume products (here Z in particular).
(b) It under-allocates overhead costs to smaller products (here W and Y, with just one hour of
work needed per unit) and over-allocates overheads to larger products (here X and particularly Z)
Absorbing costing formula
Overhead absorption rate (OAR) = budgeted production overheads / budgeted level of activity
The difference between unit costs under traditional absorption costing and ABC
The difference between unit costs under traditional absorption costing and ABC depends upon
the proportion of overheads in each category.
If most overheads are unit level or facility sustaining the costs will be similar.
If overheads are batch or product sustaining costs, the resulting unit costs will be very different.
When ABC should be used
(a) When production overheads are high relative to prime costs (eg service sector)
(b) When there is a whole diversity of product range
(c) When there are considerable differences in the use of resources by products
(d) Where consumption of resources is not driven by volume
ABC has both advantages and disadvantages and tends to be more widely used by larger
organisations and the service sector.
Benefits of ABC
(a) Cost control and reduction by the efficient management of cost drivers
(b) Better costing information used to assist pricing decisions
(c) Re-analysis of production and output/product mix decisions
(d) Profitability analysis (by customer, product line etc)
(e) A more realistic estimate of costs and profits which can be used in a performance appraisal
Criticisms of ABC
(a) It is time consuming and expensive.
(b) It will be of limited benefit if overhead costs are primarily volume related.
(c) The benefit is reduced if the company is producing only one product or a range of products
with similar costs.
(d) Complex situations may have multiple cost drivers.
(e) Some arbitrary apportionment may still exist.
What is cost plus pricing?
It is calculation of the manufacturing and selling product cost and then add mark up, to give the profit element.
Criticism of cost plus pricing
Do not consider any external factors
(eg demand for product, number of competitors).
What is a target costing?
Target costing involves setting target cost by subtracting a desired profit margin from a target selling.
What is target cost?
Target cost is the cost at which a product must be produced and sold in order to achieve the required amount of profit at the target selling price. When a product is first
planned, its estimated cost will often be higher than its target cost. The aim of target costing is then to find ways of closing this target cost gap, and producing and selling the product at the
target cost.
Target costing set up
- Set up selling price
- Set up margin
- Calculating target cost
Closing a target cost gap
Improving production technologies and processes
* Reducing the number of components
* Using cheaper staff (where this does not affect quality)
* Using standard components wherever possible
* Acquiring new, more efficient technology
* Training staff in more efficient techniques
* Cutting out non-value added activities
* Using different materials
Characteristics of services
- Intangibility
- Inseparability/ simultaneity
- Variability/
heterogeneity - Perishability
- No transfer of ownership
Cost gap
Target cost less estimated cost
Life cycle costing
is the accumulation of costs over a product’s entire life
Costs over the product life cycle
- Research and development costs
- The cost of purchasing any technical data required (eg purchasing the right from another
organisation to use a patent) - Training costs
- Production costs, when the product is eventually launched in the market
- Distribution costs
- Marketing and advertising
- Inventory costs
- Retirement and disposal costs
Product life cycle
- Development
- Introduction
- Growth
- Maturity
- Decline
Maximising return over the
product life cycle
- Design costs out of products
- Minimise the time to market
- Minimise breakeven time
- Extend the length of the life
cycle itself
Advantages of product life cycle
- Promotes maximisation of
return over the product life
cycle - Considers all costs leading to
cost reduction - Suitable for modern
environment with short life
cycles - Considers external factors
throughout product’s life
Theory of constraints
The theory of constraints (TOC) is a production system where the key
financial concept is the maximisation of throughput while keeping conversion and investment
costs to a minimum.
Throughput contribution (or throughput return or throughput)
sales revenue - direct material
cost
