Management Accounting 2

MANG2005
Lecture 2
Activity-Based Costing (ABC)

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 Learning Outcomes
By the end of this session you should be able to;

• Describe the technical shortcomings of

conventional absorption costing
• Describe the factors that have led to criticisms of
conventional methods.
• Describe the basic concepts and the key steps in
designing an ABC system
• Discuss features of ABC usage in practice

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 Main Readings
• Drury
● Relevant parts of Chapters 3 and the whole of
Chapter 11
• Relevant journal articles
● Banker et al. 2008, The role of manufacturing practices in
mediating the impact of activity-based costing on plant
performance, Accounting, Organizations, and Society, 33(1), pp.1-
19

● Kallunki and Silvola (2008), The effect of organizational life cycle

stage on the use of activity-based costing, Management
Accounting Research, Vol. 19(1), pp.62-79.

● Schoute (2011), The relationship between product diversity, usage

of advanced manufacturing technologies and activity-based
costing adoption, British Accounting Review, Vol. 43(2), pp.120-
134.
 INTRODUCTION
• Managers find costing information systems useful for
answering questions such as:
● What price should a product be sold at?运价
●
盈利
Does the market price allow us to make a profit?
●
产量
How many units must we sell to make a specified profit?

• Problem with simple costing systems:

● may not be able to answer these questions as accurate
as managers would hope.
● Inaccurate information to managers, then wrong
decisions may be made – e.g. Discontinuing a profitable
product and vice versa.
• Therefore, more advanced costing systems have been
designed, e.g. Activity-Based costing.

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Types of cost systems
Direct costing systems (Lecture 1):
1. Indirect costs are not assigned to cost objects so that
only contributions to indirect costs are reported.
2. Appropriate where the majority of costs are direct.
3. Require that indirect costs are incorporated at the
special study stage.

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Traditional costing systems (Lecture 1):
1.Use unsophisticated methods to allocate indirect costs to
cost objects (see lecture 1)

ABC systems (Lecture 2):

2.Use sophisticated methods to allocate indirect costs to
cost objects.
 A comparison of traditional and ABC systems

1.Traditional systems tend to allocate costs to departments

whereas ABC systems allocate costs to activities
• ABC systems tend to have more cost centres/cost pools

• traditional systems rely on a small number of volume-

based cost drivers (typically direct labour or machine hours)
whereas ABC systems use many cost drivers.

2. ABC systems seek to use器 only cause-and-effect cost

drivers whereas traditional systems often rely on arbitrary
allocation bases.

3. ABC systems tend to establish separate cost driver rates

for support departments whereas traditional systems merge
support and production centre costs.
A comparison of traditional and ABC systems

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In summary:
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•ABC ri
is similar to traditional full costing

•ABC
one
Differs from traditional costing
● In having more cost pools
● In assigning support costs directly to the cost
object
● In using far more cost drivers

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The two-stage allocation process
(traditional costing method)

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The two-stage allocation process
(ABC system)

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 DESIGNING ABC SYSTEM

‘The fundamental principle of ABC is that overhead costs

should be identified with cost objects as accurately as
possible. Costs are caused or ‘driven’ by the various
activities that take place within the business environment’

- Cost driver – various activities that take place in an

organisation to which costs are attached.

- Cost pools – the accumulation of costs associated with

particular activities in the organisation.

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 DESIGNING ABC SYSTEM
The implications of ABC

‘The goal of ABC is not to allocate common costs to

products. The goal is to measure and then price
out all the resources used for activities that support
the production and delivery of products and services
to customers’ (Kaplan & Atkinson)

Why?
‘…business is a series of linked activities and processes
that are undertaken to serve the customer and to
deliver product attributes. These processes and
activities are where costs are happening’
(T. Kennedy, May 2000)

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 DESIGNING ABC SYSTEM

Step 1: Identify activities in ‘overhead’ departments

● Level of detail/aggregation of tasks (cost-benefit
decision)
● Types of activity and amounts of activity data to be
collected.

Step 2: Accumulate and assign costs to activity cost pools

● Using causal relationships where possible – ‘resource
cost drivers’.
● No reallocation of support costs
● Both direct and indirect costs are assigned to activity
cost pools.

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 DESIGNING ABC SYSTEM

Step 3: Selecting appropriate cost driver for assigning

the activity costs to the cost object.
• Select appropriate activity cost drivers or activity measures
● Significant determinants of the cost of activities
● Should be easily measurable and explains the behaviour of
costs
● Data should be easy to obtain and identifiable with the product
● Transaction (per activity) or duration drivers (or time it takes
for the activity).

Step 4: Assigning the activities costs to products (cost

object)
• Mechanism needed to monitor the use of one activity to the
product.
• Easier for transaction drivers vs. duration drivers.
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 ACTIVITIES Classification

• Activities are purpose-based (of support, or of

production):
● To set up machines, to schedule production, to purchase
materials … etc.
● Are made up of groups of related tasks / actions
● May cross departments / responsibility centres

• Four main categories/levels of activities:

● Unit-level
● Batch-level
● Product/customer-sustaining
● Business/Facility-sustaining

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 traditional costing
way similar to
Ants OR HIERARCHY OF ACTIVITIES
CLASSIFICATION
• Unit level – performed each time a unit is produced
● Resources are consumed in proportion to the number
of units produced or sold
● Related costs include direct labour & materials if
variable, energy / other expenses consumed in
proportion to machine time.

• Batch level
● Performed each time a batch of goods is produced
● Costs vary with the number of batches made
● Including setting-up, purchasing, moving materials
etc.
● Related costs may also vary between batches, but
cost to units within the batch is the same.

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CLASSIFICATION OR HIERARCHY OF ACTIVITIES
Product/service/customer sustaining
Performed to enable the production of individual products or
services or customer.
Examples include activities related to maintaining an accurate
bill of materials, preparing engineering change notices.
If cost object is a specific customer - market research and
support activities

Facility/Business sustaining - not included in product

costs
Performed to support the organization as a whole.
Examples include plant management, property costs
and salaries of general administrative staff.
Common to all products and services – not allocated to
products/services

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⼝译
Examples

• Process engineering
Product • Product specification
sustaining • Product design/enhancement

• Setups
• Materials movement
Batch
• Purchase orders
sustaining
• Inspection

• Direct labour
• Direct materials/components
Unit • Machine time
level • Energy consumption
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 SOME CLAIMS FOR ABC

• Improves the quality of information used for decision

making.
• Focuses attention on (necessary) activities.
• Reflects actual cost-generation – causal.
• Reduces arbitrary cost allocations.

• Hence, provides more accurate information

● for product costing
● for profit analysis
● For cost management

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 SOME CLAIMS FOR ABC - RESEARCH

• Innes et al (2000):
● found that companies who adopted ABC systems
reported reduced costs overall which improved pricing
decisions and better analysis of profitability and
budgeting.
• Cagwin and Bouwman (2002):
● found that with the use of ABC systems net financial
performance was improved.
• Kennedy and Affleck-Graves (2001):
● found that from a sample of UK businesses those that
adopted ABC techniques outperformed those that did
not in terms of profitability.
• Recent evidence….?

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 AS EASY AS ABC?
PROBLEMS WITH ABC……

• Implementation can be very costly as a great deal

of information must be collected.
• Staff may not want to change the way in which
the company operates.
• Problems may occur when selecting cost drivers:
● Too many activities,
●

•
1 Wrong cost drivers
Reported costs may not significantly differ from a
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less costly traditional system if indirect costs are a
low proportion of total costs.
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 Concluding remarks
• ABC can be considered as one of the major
developments in management accounting

• It has led to changes in other aspects of the

organization’s accounting system e.g. AB
management, AB budgeting.

• Service organizations can benefit more from ABC.

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 Summary
• Today
● Activity Based costing
● Attempt all review questions
● Attempt lecture example, and class
exercise 2
• Next week
● Process costing
● Readings – Drury Chapters 4 & 5,
including Appendix 5.1.