Illustration 1 – ABC
A company manufactures two products, X and Y. The company uses absorption costing and fixed production costs and absorbed into production costs on a direct labour hour basis.
The budgeted information for the next financial year is as follows:
Product XProduct YTotal
Production and sales2,000 units5,000 units
Direct labour hours per unit32
Budgeted direct labour hours6,00010,00016,000
Fixed production costs$48,000
Absorption rate per direct labour hour
Fixed overheads absorbed$18,000$30,000
Using ABC
A review of the incidence of costs has established that the number of setups is the driver of the fixed production costs. Using ABC the fixed production costs would be allocated as follows:
No. of setups per 1,000 units81.6
Budgeted setups16824
Cost per setup$2,000
Fixed overheads allocated$32,000$16,000
This difference in costing could have significant implications for pricing, especially if a cost-based approach is used for profit calculation. These, and other implications are discussed in more detail below.
Activity-based costing could provide much more meaningful information about product costs and profits when:
§ indirect costs are high relative to direct costs
§ products or services are complex
§ products or services are tailored to customer specifications
§ some products are sold in large numbers and others in small numbers.
1.3 Identifying appropriate cost drivers under ABC
Under ABC costs are driven by activities and not production volume. Typical overheads which are NOT driven by production include the following:
§ Setup costs – driven by the number of manufacturing setups.
§ Order processing costs – driven by the number of orders.
§ Packing department costs – driven by the number of packing orders.
§ Engineering department costs – driven by the number of production orders.
§ Air conditioning maintenance – number of air conditioning units
1.4 calculating costs per driver and per unit using ABC
There are five basic steps in establishing and applying a system of ABC:
Step 1 Identify activities that consume resources and incur overhead costs.
Step 2 Allocate overhead costs to the activities that incur them. In this way, each identified activity becomes a cost pool for overhead costs. It is important that overhead costs should be directly allocated to a cost pool. There should not be any arbitrary apportionment of overhead costs.
Step 3 Determine the cost driver for each activity or cost pool.
Step 4 Collect data about actual activity for the cost driver in each cost pool.
Step 5 Calculate the overhead cost of products or services. This is done by calculating an overhead cost per unit of the cost driver (a cost per unit of activity). Overhead costs are then charged to products or services on the basis of activities used for each product or service.
1.5 Comparing costs per driver and per unit using traditional methods and ABC
Traditional absorption costing charges overhead costs to products (or services) in an arbitrary way.
The assumption that overhead expenditure is related to direct labour hours or machine hours in the production departments is no longer realistic for the vast majority of companies.
This will lead to very different values of overheads absorbed per unit.
1.6 Advantages and disadvantages of ABC
ABC has a number of advantages:
§ It provides much better insight into what drives overhead costs.
§ ABC recognises that overhead costs are not all related to production and sales volume.
§ In many businesses, overhead costs are a significant proportion of total costs, and management needs to understand the drivers of overhead costs in order to manage the business properly. Overhead costs can be controlled by managing cost drivers.
§ It can be applied to derive realistic costs in a complex business environment.
§ ABC can be applied to all overhead costs, not just production overheads.
§ ABC can be used just as easily in service costing as in product costing.
§ Criticisms of ABC:
§ It is impossible to allocate all overhead costs to specific activities.
ABC costs are based on assumptions and simplifications. The choice of both activities and costs drivers might be inappropriate.
§ ABC can be more complex to explain to the stakeholders of the costing exercise.
§ The benefits obtained from ABC might not justify the costs.
1.7 The implications of switching to ABC
The use of ABC has potentially significant commercial implications:
§ Pricing can be based on more realistic costs data.
- The traditional method of absorption of overheads into unit costs on a volume basis may be misleading, with the result that product costs can, potentially, be materially under/overstated.
- Thus, where cost plus pricing is in use, products that have been materially under-costed may be priced at levels that generate a loss whilst products that have been materially over-costed many be priced at levels that are uncompetitive.
§ Sales strategy can be more soundly based.
- More realistic product costs as a result of the use of ABC may enable sales staff to:
- target customers that appeared unprofitable using absorption costing but may be profitable under ABC
- stop targeting customers or market segments that are now shown to offer low or negative sales margins.
- Front line sales staff will be able to negotiate prices with greater confidence
- ABC can be used to review the profitability of products and services with a view to focussing the efforts of sales staff upon those products and services which offer the highest sales margins.
§ Performance management and decision making can be improved
- Research, production and sales effort can be directed towards those products and services which ABC has identified as offering the highest sales margins.
- ABC can influence decisions as to which:
- new products/services to develop
- existing products/services to curtail or drop
- products/services should be promoted
- overhead costs to target.
Test your understanding 1
Identify for a hospital x-ray department possible cost drivers for the following activities:
§ equipment preparation
§ patient preparation
§ patient aftercare
§ film processing
§ film reporting
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