Activity Based Costing and Activity
Based Management
P2 Chapter 1
A model to achieve and maintain cost competitiveness:
CGMA Cost transformational model:
6 suggested changes:
These changes are:
a) Engendering a cost-conscious culture: The organisation should aim to
be a cost leader so that its costs are lower than rivals and set a
competitive benchmark. Everyone in the organisation should be
motivated and enabled to reduce costs in whatever way possible.
Technology can play a key role in reducing costs.
b) Managing the risks that come from a cost-conscious culture: For
example, reducing cost may result in reducing quality and customer
satisfaction. The organisation should have a clear risk management
process in place to identify, assess and manage such risks.
c) Connecting products with profitability: It will be important that every
product or service makes a positive contribution to overall
organisational profits. This will involve understanding what drives costs
for each individual product and allocating shared costs to products as
accurately as possible.
d) Generating maximum value through new products: The potential
profitability of new products should be assessed before production
begins. Also, as part of product design, the product or service should be
made to be as flexible as possible so that it appeals or can adapt to as
many customer segments as possible.
e) Incorporating sustainability to optimise profits: Consider the
environmental impact of products – negative impacts (such as creating
unnecessary waste) can add costs as well as damaging reputation and
sales.
f) Understanding cost drivers: This involves investigating costs to
determine why they change and how different variables impact on the
cost. Plans should be put in place to reduce the drivers of costs as well as
the costs themselves.
The model suggests a number of tools and models which can be used in order
to achieve these changes. Activity based costing is one of those tools.
Activity-Based Costing: Basics revisited:
In traditional absorption costing, overheads are charged to products using a
predetermined overhead recovery rate. This overhead absorption rate (OAR) is
based upon the volume of activity. A full unit cost is computed in order to
satisfy financial accounting requirements.
Activity-Based Costing is 'an approach to the costing and monitoring of
activities which involves tracing resource consumption and costing final
outputs. Resources are assigned to activities, and activities to cost objects
based on consumption estimates. The latter utilise cost drivers to attach
activity costs to outputs.
Traditional systems accurately measure volume-related resources that are
consumed in proportion to the number of units produced of the individual
products. Such resources include direct labour, materials, energy and machine-
related costs.
However, many organisational resources exist for activities that are unrelated
to physical volume. Non-volume related activities consist of support activities
such as:
a) materials handling
b) material procurement
c) set-ups
d) production scheduling
e) first-item inspection activities
ABC Calculation:
Step 1: Group the production overheads into activities
Step 2: Identify cost drivers for each activity. I.e. what causes these
activity costs to be incurred?
Step 3: Calculate cost driver rate. (Same OAR calculation)
Step 4: Absorb activity costs into products. (Cost driver rate that we
found in step 3 should be applied to the individual products)
Step 5: Add all the costs that you found to give the full production
cost or profit or loss whatever has been asked in the question.
Illustration:
Conditions for ABC:
The purpose of moving from a traditional costing system to an activity-based
system should be based on the premise that the new information provided will
lead to action that will increase the overall profitability of the business.
This is most likely to occur when the analysis provided under the ABC system
differs significantly from that which was provided under the traditional system,
which is most likely to occur under the following conditions:
a) when production overheads are high relative to direct costs, particularly
direct labour
b) where there is great diversity in the product range
c) where there is considerable diversity of overhead resource input to
products
d) when consumption of overhead resources is not driven primarily by
volume
Information from an ABC analysis may indicate opportunities to increase
profitability in a variety of ways, many of which are long-term. For example, an
activity-based analysis may reveal that small-batch items are relatively
expensive to produce, and are therefore unprofitable at current prices.
A number of responses to this information could be adopted. The first
response might be to consider stopping production of such items, and
concentrate on the apparently more profitable high-volume lines.
Another approach would be to investigate how the production process could
be organised in such a way as to bring the cost of producing small-batch items
closer to that of producing high-volume goods.
Activity based cost hierarchy:
Unit-level activities: are performed each time a unit of product is produced.
They are consumed in direct proportion to the number of units produced.
Expenses in this category include:
a) direct labour
b) direct materials
c) energy costs
d) machine maintenance
Batch-related activities: are performed each time a batch is produced.
The cost of batch-related activities varies with the number of batches made,
but is common (or fixed) for all the units within the batch.
For example, set-up resources are consumed when a machine is changed
from one product to another. As more batches are produced, more set-up
resources are consumed. It costs the same to set-up a machine for a run of 10
or 5,000 units.
Similarly, purchasing resources are consumed each time a purchasing order is
processed, but the resources consumed are independent of the number of
units included in the purchase order.
Product-sustaining activities: are performed to support different products in
the product line. They are performed to enable different products to be
produced and sold, but the resources consumed are independent of how many
units or batches are being produced.
Facility-sustaining activities: Some costs cannot be related to a particular
product line, instead they are related to maintaining building and facilities.
Examples would be maintenance of the building, plant security and business
rates.
Benefits:
1. Provides more accurate product-line costings particularly where non
volume-related overheads are significant and a diverse product line is
manufactured.
2. Is flexible enough to analyse costs by cost objects other than products
such as processes, areas of managerial responsibility and customers.
3. Provides a reliable indication of long-run variable product cost which is
particularly relevant to managerial decision making at a strategic level.
4. Provides meaningful financial (periodic cost driver rates) and non-
financial (periodic cost driver volumes) measures which are relevant for
cost management and performance assessment at an operational level.
5. Aids identification and understanding of cost behaviour and thus has the
potential to improve cost estimation.
6. Provides a more logical, acceptable and comprehensible basis for costing
work
Limitations:
1. Little evidence to date that ABC improves corporate profitability.
2. ABC information is historic and internally orientated and therefore lacks
direct relevance for future strategic decisions.
3. Practical problems such as cost driver selection.
4. Its novelty is questionable. It may be viewed as simply a rigorous
application of conventional costing procedures.
ABC and decision making:
Activity-Based Costing has a role in longer-term decision-making:
Advocates of the use of ABC for strategic decision making maintain that its
values lie in greater accuracy attaching to product costing, which in turn
increases the degree of reliability of cost information used for the above
purposes.
They further maintain that the use of ABC may give an indication for the
long-term variable cost of products, which arguably is the most relevant cost
information for use in decisions of the above type. Given the inherent
uncertainty involved in strategic decision making, management may use ABC
information in decision-modelling and sensitivity analysis to assist in the
making of such decisions.
Activity Based Management:
Activity-Based Management 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 simply using the information derived from an ABC analysis for cost
management. ABM seeks to classify each activity within a process as a value-
added or non-value-added activity:
Non-value-added activities are unnecessary and represent waste. The aim
should be to eliminate them.
ABM focuses on activities within a process, decision making and planning
relative to those activities and the need for continuous improvement of all
organisational activity. Management and staff must determine which activities
are critical to success and decide how these are to be clearly defined across all
function.
Clearly ABM and employee empowerment take a critical step forward beyond
ABC by recognising the contribution that people make as the key resource in
any organisation’s success.
a) It nurtures good communication and team work.
b) It develops quality decision making.
c) It leads to quality control and continuous improvement.
ABC information can be used in an ABM system to assist strategic
decisions, such as:
a) The value chain is simply a large activity map for the organisation and its
position in the industry chain.
b) Whether to continue with a particular activity.
c) The effect on cost structure of a change in strategy, e.g. from mass
production to smaller production runs.
d) How changes in activities and components affect the suppliers and the
value chain.
Problems with implementing ABC/ABM:
1. Where it was devised for a single project that was not taken up the
system got dropped as well. As communication between business units
in a large organisation is often not very good, the work was not
developed further by another unit.
2. Finance department opposed its implementation. Often finance staff
appear less than dynamic and unable to perceive the needs of the
production staff.
3. General ledger information too poor to provide reliable ABC
information. The resulting figures would have been no better than
traditional absorption methods
4. Of course, if organisations do not have reliable ABC information then
they also forgo the cost management advantages of an ABM system.
Since ABC provides the basic building blocks of activities, without ABC
there can be no ABM.
TIPS FOR ABM:
a) Get the support of senior management
b) Recognise that ABM requires a major investment in time and resource
c) Know what ABM can achieve and what information you want from the
system
d) Decide which model to use
e) Choose the model approach that emphasises the operational
understanding of all activities in the business
f) Involve people in the field
g) Transfer ownership of cost management from the accounts department
to the departments and processes where costs are incurred
h) Don't underestimate the need to manage the change process
i) Link ABM to corporate objectives in the form of increased product
profitability and added value for customer.
Direct product profitability:
Direct Product Profitability is 'used primarily within the retail sector...DPP
involves the attribution of both the purchase price and other indirect costs (for
example distribution, warehousing and retailing) to each product line. Thus, a
net profit, as opposed to a gross profit, can be identified for each product. The
cost attribution process utilises a variety of measures (for example
warehousing space and transport time) to reflect the resource consumption of
individual products'
Direct product profit for
Product X
Selling Price $ $2.50
Less: Bought in price $1.80
Gross Margin $0.70
Less: Direct product
costs:
Warehouse cost $0.15
Transportation costs $0.18
Store costs $0.22 $(0.55)
Direct Product Profit $0.14
The benefits of DPP may be summarised as:
a) Better cost analysis
b) Better pricing decisions
c) Better management of store and warehouse space
d) The rationalisation of product ranges
e) Better merchandising decisions
DPP software systems can be purchased to model costs. They require a
number of key variables to analyse different situations.
The variables are:
a) Buying and selling prices
b) Rate of sale
c) Inventory
d) Product size
e) Pallet configuration
f) Ordering costs
g) Distribution routes
Customer profitability analysis:
Customer Profitability Analysis is 'the analysis of revenue streams and service
costs associated with specific customers or customer groups'.
Different customers or categories of customers will each use different amounts
of these activities and so customer profitability profiles can be built up, and
customers can be charged according to the cost to serve them.
Customer profitability curve:
When an organisation analyses the profitability of its customers it is not
unusual to find that a Pareto curve exists. That is 20 per cent of customers
provide 80 per cent of the profit.
Distribution channel profitability:
Distribution channels are in simple terms the means of transacting with
customers. The channel is the point of purchase which need not necessarily be
the point of communication, payment, delivery and after sales support.
Companies may transact with their customers through direct channels e.g.
sales teams, telephone, shops, Internet or through indirect channels e.g.
retailers, wholesalers, resellers, agents
The channel a company selects is therefore a critical driver to business
profitability. A company should not only aim to satisfy the needs of the
customer but must also ensure that the products and services that they are
providing are profitable. The method of channel distribution chosen can
account for a significant proportion of total cost and choosing the wrong
channel can result in significant losses for that particular product or service.
Key aspects that the company needs to consider in relation to their distribution
channels include; access to the customer base, brand awareness,
competitiveness, achieving sales and market targets, speed of payment,
customer retention rates and most importantly of all profitability.
Activity based budgeting:
ABB is 'a method of budgeting based on an activity framework and utilising
cost driver data in the budget-setting and variance feedback processes'
Whereas Zero-Based Budgeting (ZBB) is based on budgets (decision packages)
prepared by responsibility centre managers, ABB is based on budgeting for
activities.
The basic approach of ABB is to budget the costs for each cost pool or
activity.
There will also be some general overhead costs that are not activity-related,
such as factory rental costs and the salary cost of the factory manager.
General overhead costs are budgeted separately.
a) The cost driver for each activity is identified. A forecast is made of the
number of units of the cost driver that will occur in the budget period.
b) Given the estimate of the activity level for the cost driver, the activity
cost is estimated. Where appropriate, a cost per unit of activity is
calculated
Advantages:
1. It draws attention to the costs of 'overhead activities'. This can be
important where overhead costs are a large proportion of total
operating costs.
2. It provides a useful basis for monitoring and controlling overhead costs,
by drawing management attention to the actual costs of activities and
comparing actual costs with what the activities were expected to cost.
3. It also provides useful control information by emphasising that activity
costs might be controllable if the activity volume can be controlled.
4. ABB can provide useful information for a total quality management
(TQM) programme, by relating the cost of an activity to the level of
service provided (for example, stores requisitions processed) –Do the
user departments feel they are getting a cost-effective service.
Dis-advantages:
1. A considerable amount of time and effort might be needed to establish
an ABB system, for example to identify the key activities and their cost
drivers.
2. Activity-based budgeting might not be appropriate for the organisation
and its activities and cost structures.
3. Budget should be prepared on the basis of responsibility centres, with
identifiable budget holders made responsible for the performance of
their budget centre. A problem with ABB could be to identify clear
individual responsibilities for activities.
