Chapter 8

Activity Based Costing (ABC)

- method that can be used to measure the cost of
cost objects and the performance of activities
- most accurate form of costing products or
services
- costing based on activities rather than
department.
- basic coverage (ACC201 Detail)
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 Problems with traditional
product costing systems
• Features of traditional product costing
systems
– Direct costs are traced to products
– Allocation of manufacturing overhead costs
are to products
– Calculation of manufacturing overhead rate
– Non-manufacturing costs
– Mostly volume based cost drivers
(cont.)
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 Problems with traditional
product costing systems (cont.)
• Failure to adapt to the changing business
environment
– Manufacturing overhead is increasing as a
proportion of total manufacturing costs and
becoming more non-volume driven
– Non-manufacturing costs are increasing as a
proportion of total costs
• Causes of changes in cost structures
include growing automation (product
diversity)
(cont.)
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 Indicators of problems with a
product costing system
• Traditional product costing systems are
likely to result in inaccurate product
costs when:
─the proportion of direct labour costs decreases
─the proportion of related and unrelated
manufacturing overhead costs increases
─non-manufacturing costs that are product-
related become substantial
─product diversity increases (cont.)

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 Costing in service firms
• Service firms tend to use firm-wide,
volume-based overhead rates
• Customer demands are increasing
• Impact of increasing product diversity
and quality on the level of non-volume-
driven overhead costs
• Accuracy of service costs derived from
traditional product costing systems is
doubted
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 Activity-based costing
• A methodology that can be used to
measure both the cost of cost objects
and the performance of activities
• Can help solve problems such as
– Distorted product costs
– Poor cost control

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 Which costs should be
included in an ABC system?
• Depends on the purpose of the system,
which depends on the needs of management
• A decision to include activity-based
management (ABM) in an ABC system will
influence the range of costs included in the
system, as well as the type of cost drivers
identified. ABM-process of using information from ABC to analyze
activities, cost drivers, & performance so that CV and profits improve.

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 Hierarchy of activities for ABC
• Unit level activities
– Performed for each unit of product
• Batch level activities
– Performed for each batch of product
• Product level activities
– Performed for specific products or product
families
• Facility level activities
– Required to support the business as a whole

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 When to use ABC
• Overhead costs are a significant
proportion of total cost and a large part
of overhead is not directly related to
production volume
• The business has a diverse product
range, and individual products’ use of
resources differs from their use of volume-
based cost drivers
• Production activity involves diverse batch
sizes and product complexity (cont.)
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 When to use ABC (cont.)
• Proportion of product-related costs
incurred outside manufacturing is
increasing relative to manufacturing costs
• Likelihood of high costs associated with
making inappropriate decisions based on
inaccurate product costs
• The costs associated with the ABC
system is relatively low due to
sophisticated IT support

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 Impediments to introducing
ABC
• Lack of awareness of ABC
• Uncertainty about the potential benefits
to be gained from ABC
• Concern about the extensive resources
required to implement ABC
• Resistance to change from managers
and employees

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 Limitations of
activity-based costing
• Facility level costs
– Some systems arbitrarily assign facility level
costs to products
• Use of average costs in decision making
– Batch, product and facility level costs are divided
by the number of units produced leading to
product costs that are of limited use for decision
making
– Desirable to use cost per unit in the short term;
total product cost in the longer term (cont.)

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 Limitations of
activity-based costing (cont.)
• Complexity
– The cost of updating an ABC system can be
very high, but is needed to avoid producing
outdated, irrelevant information
– The level of complexity increases when the
system is used for both activity
management and product costing
– Activity-based management requires more
extensive and detailed analysis of cost and
activities
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Lecture Example

• THE END

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