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AND COST
ACCOUNTING
SIXTH EDITION
COLIN DRURY
Chapter Ten:
Activity based costing
3. Require that indirect costs are incorporated at the special study stage.
• ABC systems:
• In the first stage 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)
• ABC systems seek to use only cause-and-effect cost drivers whereas traditional
systems often rely on arbitrary allocation bases.
• ABC systems tend to establish separate cost driver rates for support departments
whereas traditional systems merge support and production centre costs.
Example
Products HV (a high volume product)and LV (a low volume product)are two of
several products produced by a company. HV is made in large batches and LV is
made in small batches. HV consumes 30%of DLH ’s and LV consumes 5% but
each product consumes 15%of the batch-related indirect costs.The traditional
system uses DLH ’s as the cost driver and the ABC system uses the number of
batches processed. All overheads (total =£1m)are batch-related .
• Traditional system reports misleading information —In the longer term overheads
will not decline by £300 000 if HV is discontinued.
• ABC allocates on a cause-and-effect basis and shows high level of resources
consumed by LV —The 2 costing systems report different messages (Traditional
=Drop HV ABC =Drop LV).
•Traditional system motivates the wrong strategy.
• Costs assigned to activity cost pools will include direct and indirect costs.
• Activity cost drivers consist of three types (Transaction, duration and intensity
drivers).
• The cost driver must be measurable so that it can be identified with individual
products.
Classification of activities
• Unit-level activities:
• Batch-related activities:
• ABC systems measure the cost of using resources and not the cost of supplying
resources:
Cost of resources = Cost of resources + Cost of unused
Supplied used capacity
• Periodic financial statements measure the cost of resources supplied (i.e.15 000
orders at a cost of £300 000 in Example10.2).
• ABC systems measure the cost of resources used (i.e.13 000 orders at a cost of
£20 per order in Example 10.2).
• The difference between the cost of resources supplied and the cost of resources
used represents the cost of unused capacity (i.e.2 000 orders at £20 per order
=£40 000)
• With flexible resources supply can be continually adjusted to match exactly the
usage of resources.
• Cash flow consequences will only arise if action is taken to remove unused
capacity by reducing spending on the supply of resources.
• The periodic reporting of unused capacity signals the need for a change in the
spending on the supply of resources.
Example 10.2
• The correct denominator activity level to use is the level of capacity supplied
(practical capacity)and not the anticipated usage.
• Using anticipated usage in Example 10.2 would result in a cost driver rate of
£23.08 (£300 000/13 000)so that the cost of unused capacity will be hidden in the
cost driver rate rather than being separately reported.
• Using anticipated usage would result in high cost driver rates in periods of low
sales demand.
Criticisms of ABC
• ABC unit costs must be used with care —They can suggest an
inappropriate degree of variability.
• Reported costs may not significantly differ from a less costly traditional
system if indirect costs are a low proportion of total costs.