4. Activity Based Costing

Need for Cost Accumulation System in generating Relevant Information for decision making
3 reasons why cost accumulation systems are important in gபைடு நூலகம்nerating relevant cost for decision making c. Product decisions are not independent : Indirect costs (e.g. support costs) are shared by all products & in the long term these costs will vary according to the demand by each product : Hence if focus is only on individual product (independent), decisions will be made in isolation of other products wrong decision may be made : E.g.: Viewed independently - For indirect costs (e.g. support costs) the decision to add / drop a single product may result in 0 relevant cost. If viewed at as a whole (all the products considered) - There may be significant change in the amount of indirect costs used (relevant costs) according to the demand by each product
Chapter 4: Activity Based Costing (ABC) 1) Need for cost accumulation system to generate relevant cost information for decision making 2) Difference bet. ABC & traditional costing systems 3) Volume based & Non-volume based cost drivers 4) Designing ABC systems 5) ABC cost hierarchy 6) ABC profitability analysis 7) ABC resource consumption model
Difference between Traditional Absorption & ABC systems Traditional Absorption Costing
-Use of 2-stage allocation process - 1st stage: allocates indirect costs (o/h) to production and service dept.s & then reallocates service dept. costs to production dept. - Production process activities & support activities : e.g. production scheduling; purchasing raw material; inspect quality; machine set-up; machining; assembly etc.
2) Types of Cost Systems
Costing systems are different in the way they assign costs to cost objects - 3 types of cost systems: (a)Direct costing systems – (Variable costing system) (b)Traditional absorption costing system - (Full costing) (c)Activity-based costing system (ABC) – (Cause-and-effect costing)
ABC
- Use of 2-stage allocation process - 1st stage: allocates o/h to each major activity (rather than dept.)
- Production process activities & support activities: e.g. production scheduling; purchasing raw material; inspect quality; machine set-up; machining; assembly etc. - More cost centres (activities)
Activity Based Costing (ABC) - ABC identifies and measures indirect relevant costs for decision making - Our focus will be on organisation’s existing products & services and future activities (to ensure only profitable products / services are launched) - Assumption here: product as cost object
3 reasons why cost accumulation systems are important in generating relevant cost for decision making a.Many indirect costs are relevant for decision making : Direct costs can be easily traced to products (cost object) and hence is easily classified as relevant : However, indirect costs (indirect labour; indirect materials; property taxes; lighting & heating; warehousing; production scheduling; customer order processing etc.) cannot be easily traced to products and hence may be classified as irrelevant. : Product introduction, discontinuation, redesign and mix decisions affect the amount of indirect costs (e.g. support functions) incurred. : Hence, to estimate the amount of indirect costs incurred due to such decisions, a cost accumulation system assigns indirect costs to products using cause-and-effect allocations (i.e. cost drivers)
Need for Cost Accumulation System in generating Relevant Information for decision making
3 reasons why cost accumulation systems are important in generating relevant cost for decision making b. It is an attention-directing information / reporting system that periodically identifies potential unprofitable products that require special studies : Periodic product profitability is required to identify which products / services are profitable / unprofitable : Hence cost accumulation systems assigns costs to products for periodic profitability analysis to identify those potentially unprofitable products / services that require special studies to ascertain whether or not they will be profitable in the future
(a) Direct costing system : only assign direct costs to cost objects : do not assign indirect costs to cost object (disadvantage) hence only report contribution (& not gross profit) of product to indirect costs :estimates of indirect costs that are relevant are incorporated only at special study stage : direct costing system can only be recommended when indirect costs are a small proportion of total costs. (b & c) Traditional absorption costing & ABC systems : assigns indirect costs to cost objects as well hence reports profitability of product
- Lesser cost centres (dept.s)
Difference between Traditional Absorption & ABC systems Traditional Absorption Costing
-2nd stage: allocates cost centre o/h to products (cost object) using o/h allocation base / rates -O/H allocation base / rates are volumebased (i.e. changes with volume produced) : units of output; DL hrs; machine hrs
-Although same techniques can be applied to other cost objects (i.e. customer; location; service)
1) Need for Cost Accumulation System in generating Relevant Information for decision making