Chapter 1 - Activity-Based Costing and Activity-Based Management
Three main functions of planning, control and decision making. Must understand and calculate costs
to determine costs to manufacture a product or provide a service, calculate cost per unit to value
inventory in SOFP, can use costs to determine selling prices and are then aware of profits to
ascertain which products to supply and in what quantity, can also help benchmark for future
performance and any differences can be evaluated.
CGMA cost transformation model 6 key changes to achieve cost competitiveness:
1. Engendering a cost-conscious culture – aim to be a cost leader, where costs are lower than
rivals, and is embedded in culture of everyone in organisation to minimise costs, which
technology can massively assist with.
2. Managing risks that come with a cost-conscious culture – may result in reduction of quality
and customer satisfaction, which isn’t ideal so should be managed.
3. Connecting products with profitability – each product must make a positive contribution to
profits, so it is important to understand what drives costs and allocate shared costs
appropriately.
4. Generating maximum value through new products – potential profitability of products
should be considered before launching, and product design should also be made flexible to
align to different customer segments.
5. Incorporating sustainability to optimise profits – environmental impact of products can add
costs through unnecessary wastage and can damage reputation and sales.
6. Understanding cost drivers – investigating costs as to why they change and what variables
impact the costs, plans to reduce the cost drivers.
Activity-Based Costing
In tradition absorption costing, overheads are charged to products using pre-determined recovery
rate (OAR), which is based upon volume of activity. However, full products costs are not always
relevant so only relevant cash flows should be considered for decision making.
Therefore, only costs relative to the decision being made and those costs that will vary by this
decision occurring or not should factor into absorption costing. However, most businesses still use
full product costs, so ABC costing was developed.
“an approach to costing and monitoring activities by tracing resource consumption and costing
financial outputs. Resources are assigned to activities, activities to cost objects based on
consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.”
Overhead costs cost pools cost driver rates product lines.
Traditionally, volume-related resources would be measured in proportion to number of units
produced of product, these resources would be direct labour, materials, energy and machine related
costs. However, many resources exist for activities that are unrelated to physical volume support
activities like material handling, material procurement, set-ups, production scheduling, inspections
etc. Therefore, product-cost systems which assume products consume all activities in proportion to
their volumes can produce distorted results.
ABC procedure
,Cooper and Kaplan stated that support activities were cause of many overheads, so a three-step
philosophy was developed support activities cause cost, the products consume these activities,
cost should therefore be charged on the basis of consumption of activities.
Identify major activities (30 to 50, apply 80/20 rule where 20% of activities generate 80% of
overheads) estimate cost associated with performing each activity, which become cost pools
identify factors which influence the cost pools (cost drivers) calculate cost driver rate (COST POOL
/ LEVEL OF COST DRIVERS) charge overheads to products by applying cost driver rate to activity
usage of products.
Favourable conditions of ABC should be that new info will lead to increase in profitability, most
likely when production overheads are high relative to direct costs, where there is great diversity in
product range, where there is considerable diversity of overhead resource input to products, and
when consumption of overhead resources is not driven just by volume.
With ABC, business will account for costs by classifying source of either unit based, batch-based,
product-based, and facility-based. Unit level activities occur each time a product is produced (direct
labour, materials, energy costs, machine maintenance).
Batch-related costs arise when a batch is produced as opposed to the individual units within that
batch. Product-sustaining activities are performed for specific products and are independent of how
many units – product design costs, advertising, engineering etc. Facility sustaining activities may
generate costs based on the related building and facilities – building maintenance, plant security,
business rates etc.
Benefits provides more accurate product line costings especially where non-volume related
overheads are mass and a diverse product line. It’s flexible to analyse costs by cost objects other
than just products such as processes or other support activities. A reliable indication of long-run
variable product cost relevant to decision making. Meaningful financial and non-financial measures
relevant for cost management and performance assessment. Helps to identify and understand cost
behaviour and improves cost estimation. Also, provides a more logical, acceptable and
comprehensible basis for costing.
Limitations Little evidence that it improves profitability, ABC info is historical and internally
orientated lacking in relevance to future decisions, cost driver selection can be impractical, may be
too rigorous compared to conventional costing procedures.
ABC and decision making
ABC systems are primarily designed to provide cost info for products, but production of info isn’t all,
use of such info is equally as important achieve end result. ABC helps analyse and explain
profitability due to using historical info, but also should be used in decisions concerning product
pricing strategy, changes to the range and product mix via promotion and discontinuance of product
lines, as well as new product development according to Kaplan and Cooper – if ABC is used in these
ways, it will underpin senior management decisions and have a significant influence on longer term
prosperity.
Users of ABC believe value lies in its accuracy for product costing, increasing reliability of that info,
whilst others also feel ABC gives indication of long term variable costing of products. ABC is an
estimate of historical cost, but strategic decision making must take future perspective as well, so
future outlays should be considered rather than historical costs.
,Kaplan “conventional notions of fixed and variable costs are ignored because for the purpose of
product cost analysis, the time period is long enough to warrant treatment of virtually all costs as
variable”.
Implementing ABC – Get buy-in from rest of business as it will benefit financial function and
management, use ABC for pricing and product prioritisation decisions, and get management
accountants to implement ABC as best placed to do so. DON’T get caught up in too much attention
to detail and lose sight of strategic objectives, and DO NOT fall into thinking ABC costs are relevant
to all decisions, as not all of them will disappear if a product is discontinued.
Activity-Based Management
The need to calculate costs is to transform these costs, which ABM can achieve – it is a “system of
management which uses activity-based cost information for a variety of purposes including cost
reduction, cost modelling and customer profitability analysis”.
ABM is using ABC info for cost management, by classifying each activity as a value or non-value
added activity. Non-value added are unnecessary and wasteful, which should be eliminated. ABM
focuses on activities within a process, decision-making and planning related to those activities and
the need for continuous improvement. Must identify which activities are critical to success COST
POOLS COST DRIVERS KPI’s.
FIVE basic info outputs from ABM:
1. The cost of activities and business processes – provide relevant cost info, which are assigned
to activities.
2. Cost of non-value added activities
3. Activity based performance measures – total cost is not only measure required, should know
quality, cycle time, productivity and customer service activity levels to measure performance
as well.
4. Accurate product/service cost – each product/service consumes resources at different rates,
so costs of these must be accurately determined.
5. Cost drivers – what drives the cost levels of an activity? Whether to continue with that
activity? How cost structures measure to competition, and how changes in activities and
components affect the suppliers and value chain.
ABM and employee empowerment work in conjunction, nurtures good communication and
teamwork, develops quality decision making, leads to quality control and continuous improvement.
ABM won’t reduce costs but helps management to understand them better. Strategic activity
management is recognising that activities are grouped to form a total process or service, which
attempts to classify each activity as a value or non-value added activity, to eliminate non-value
added but also identify cost and value drivers to develop activities and linkages between them and
thus differentiate from its competitors. Also, firm can minimise those costs in medium term.
Value chain is a large activity map for organisation and its position in industry chain.
Problems with implementing ABC/ABM
If it is adopted for a single project and that project was not taken up, then the entire ABC system
gets dropped, as it was developed by another other business units/departments. If finance
department opposes, then this may make the idea redundant. General ledger info may be too poor
to provide reliable ABC info, therefore no better than traditional absorption costing.
, ABC based on resource consuming activities, not volume of products. Overhead costs allocated to
activities that consumed resources. Cost drivers should first be set for each activity centre, based on
that it had to measure resources used by a product for a particular set of activities, as well it there
being a link between cost changes and the activity centre (cause-effect relationship).
Overhead rate for each activity calculated by activity cost divided by cost driver. Product costs
achieved by multiplying number of cost driver for activity used by product by overhead rate for that
activity. This ABC system can then be applied to cost management – ABM. Companies can improve
operations by using ABC info in the form of ABM to re-design plant layouts, using common parts,
outsourcing, or strengthening supplier and customer relationships, developing alternative product
designs etc.
Tips for ABM Get senior management on board, prepare for major time and resource investment
required, know that information you want can be achieved through the system, decide which model
to use, choose model approach that emphasises operational understanding of all activities, involve
people in the field, cost management given to depts and processes where costs are incurred (not
accounts dept), manage the change process, link ABM to company goals for increased profitability
and added value for customers.
Direct Product Profitability (DPP)
Absorption costing uses labour hours which is rarely suitable for retail and service organisations, so
new methods had been devised like DPP to spread overheads in retail for grocery trade. It involves
attributions of both purchase price and other indirect costs (distribution, warehousing, retailing etc.)
to each product line, which identifies a net profit for each product rather than gross profit. The cost
attribution process utilises a variety of measures to reflect the resource consumption of individual
products (warehousing space, transport time etc).
DPP started in USA in 1960’s at GE and so on. Warehouse and store costs include labour, space,
insurance, while transport costs includes labour, fuel, vehicle maintenance, which are spread based
on volume or area occupied. However, some costs like insurance are better spread by value or risk,
and Handling costs are better by number of pallets than individual goods. Labour may also need to
be spread differently.
Benefits of DPP are better cost analysis, better pricing decisions, better management of store and
warehouse space, the rationalisation of product ranges, and better merchandising decisions. It is
now very similar to ABC.
Indirect costs used in DPP can be categorised into overhead cost (not directly linked to a particular
product), volume related cost (incurred by space used), product batch cost (costs for identical
products handled in a batch, rather than individual products), inventory financing costs (cost of tying
up money in inventory – cost of product x company’s cost of capital per day or week). Each of these
categories contain a number of activities like checking incoming goods, repacking or packing out for
storing, inspecting products, refilling store shelf.
DPP can be used to model costs, which require key variable to analyse different situations buying
and selling prices, rate of sale (as fast as possible), inventory holding size (should be as small as
possible), product size (space occupancy), pallet configuration (cheaper cost if more cases on pallet),
ordering costs, and distribution routes (direct to store or central warehouse).
Customer profitability analysis
