Fundamentals of Management Accounting for Decision Makers 6th edition_4 pot

Direct material cost £7 per unit £4 per unit £9 per unitDirect labour requirements: Cutting department: Unskilled operatives 6 hr/unit 1 hr/unit 3 hr/unit 4.6... Product cost centres Ser

If you would like to explore the topics covered in this chapter in more depth, we recommend the following books:

Atkinson, A., Kaplan R., Young, S M and Matsumura, E., Management Accounting, 5th edn,

Prentice Hall, 2007, chapter 3.

Drury, C., Management and Cost Accounting, 7th edn, Cengage Learning, 2007, chapters 3, 4

and 5.

Hilton, R., Managerial Accounting, 6th edn, McGraw-Hill Irwin, 2005, chapters 2 and 3.

Horngren, C., Foster, G., Datar, S., Rajan, M and Ittner, C., Cost Accounting: A Managerial Emphasis, 13th edn, Prentice Hall International, 2008, chapter 4.

Further reading

Full cost p 94 Full costing p 95 Cost unit p 95 Process costing p 96 Direct cost p 96 Indirect cost p 96 Overheads p 96 Common cost p 96 Job costing p 98 Absorption costing p 98 Cost behaviour p 99

Total cost p 100 Overhead absorption (recovery) rate p 101

Cost centre p 110 Product cost centre p 111 Service cost centre p 111 Cost allocation p 112 Cost apportionment p 112 Batch costing p 119 Cost-plus pricing p 121 Variable costing p 123Key terms

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Answers to these questions can be found in Appendix C at the back of the book.

What problem does the existence of work in progress cause in process costing?

What is the point of distinguishing direct cost from indirect cost? Why is this not necessary inprocess-costing environments?

Are direct cost and variable cost the same thing? Explain your answer

It is sometimes claimed that the full cost of pursuing some objective represents the long-runbreak-even selling price Why is this said, and what does it mean?

4.4 4.3 4.2 4.1

Exercises 4.4 to 4.8 are more advanced than 4.1 to 4.3 Answers to those exercises with coloured numbers can be found in Appendix D at the back of the book.

Bodgers Ltd, a business that provides a market research service, operates a job-costing tem Towards the end of each financial year, the overhead recovery rate (the rate at which indirect cost will be absorbed by jobs) is established for the forthcoming year

sys-(a) Why does the business bother to predetermine the recovery rate in the way outlined?

(b) What steps will be involved in predetermining the rate?

(c) What problems might arise with using a predetermined rate?

Athena Ltd is an engineering business doing work for its customers to their particular ments and specifications It determines the full cost of each job taking a ‘job-costing’ approach,accounting for overheads on a cost centre (departmental) basis It bases its prices to customers

require-on this full cost figure The business has two departments (both of which are cost centres): aMachining Department, where each job starts, and a Fitting Department, which completes all ofthe jobs Machining Department overheads are charged to jobs on a machine hour basis andthose of the Fitting Department on a direct labour hour basis The budgeted information for nextyear is as follows:

Heating and lighting £25,000 (allocated equally between the two departments)Machine power £10,000 (all allocated to the Machining Department)Direct labour £200,000 (£150,000 allocated to the Fitting Department and

£50,000 to the Machining Department; all direct workers are paid £10 an hour)

Indirect labour £50,000 (apportioned to the departments in proportion to

the direct labour cost)Direct materials £120,000 (all applied to jobs in the Machining Department)Depreciation £30,000 (all relates to the Machining Department)Machine time 20,000 hours (all worked in the Machining Department)

4.2 4.1

REVIEW QUESTIONS

EXERCISES

(a) Prepare a statement showing the budgeted overheads for next year, analysed between thetwo cost centres This should be in the form of three columns: one for the total figure foreach type of overhead and one column each for the two cost centres, where each type ofoverhead is analysed between the two cost centres Each column should also show thetotal of overheads for the year

(b) Derive the appropriate rate for charging the overheads of each cost centre to jobs (that is,

a separate rate for each cost centre)

(c) Athena Ltd has been asked by a customer to specify the price that it will charge for a ticular job that will, if the job goes ahead, be undertaken early next year The job is expected

par-to use direct materials costing Athena Ltd £1,200, par-to need 50 hours of machining time,

10 hours of Machine Department direct labour and 20 hours of Fitting Department directlabour Athena Ltd charges a profit loading of 20% to the full cost of jobs to determine theselling price

Show workings to derive the proposed selling price for this job

Pieman Products Ltd makes road trailers to the precise specifications of individual customers.The following are predicted to occur during the forthcoming year, which is about to start:

Heating, lighting and power £5,000

Other indirect cost (overhead) elements £1,000

All direct labour is paid at the same hourly rate

A customer has asked the business to build a trailer for transporting a racing motorcycle torace meetings It is estimated that this will require materials and components that will cost

£1,150 It will take 250 direct labour hours to do the job, of which 50 will involve the use ofmachinery

A first estimate of the direct cost for the particular job is:

improve-(c) Incorporate the effects of the information shown in the Appendix (below) into your estimates

of the direct material cost, explaining any changes you consider it necessary to make to theabove direct material cost of £4,000

Inks and other miscellaneous items 300

4,000Paper grade 1 is regularly used by the business Enough of this paper to complete the job is cur-rently held Because it is imported, it is estimated that if it is used for this job, a new purchaseorder will have to be placed shortly Sterling has depreciated against the foreign currency by

25 per cent since the last purchase

Paper grade 2 is purchased from the same source as grade 1 The business holds exactlyenough of it for the job, but this was bought in for a special order This order was cancelled,although the defaulting customer was required to pay £500 towards the cost of the paper Theaccountant has offset this against the original cost to arrive at the figure of £2,000 shown above.This paper is rarely used, and due to its special chemical coating will be unusable if it is not used

on the job in question

The card is another specialist item currently held by the business There is no use foreseen,and it would cost £750 to replace if required However, the inventories controller had planned

to spend £130 on overprinting to use the card as a substitute for other materials costing £640

Inks and other items are in regular use in the print shop

Bookdon plc manufactures three products, X, Y and Z, in two product cost centres: a machineshop and a fitting section; it also has two service cost centres: a canteen and a machine main-tenance section Shown below are next year’s planned production data and manufacturing costfor the business

Production 4,200 units 6,900 units 1,700 unitsDirect materials £11/unit £14/unit £17/unitDirect labour

Fitting section £12/unit £3/unit £21/unitMachine hours 6 hr/unit 3 hr/unit 4 hr/unit

4.5

Planned overheads are as follows:

Machine Fitting Canteen Machine Total

section

Allocated overheads £27,660 £19,470 £16,600 £26,650 £90,380

Depreciation and insurance

Additional data:

Machine Fitting Canteen Machine

(a) Calculate the following planned overhead absorption rates:

(i) A machine hour rate for the machine shop

(ii) A rate expressed as a percentage of direct wages for the fitting section

(b) Calculate the planned full cost per unit of product X

Shown below is an extract from next year’s plans for a business manufacturing three products,

A, B and C, in three product cost centres

Direct material cost £7 per unit £4 per unit £9 per unitDirect labour requirements:

Cutting department:

Unskilled operatives 6 hr/unit 1 hr/unit 3 hr/unit

4.6

Product cost centres Service cost centres Cutting Machining Pressing Engineering Personnel

Planned total overheads £154,482 £64,316 £58,452 £56,000 £34,000Service cost centre cost

incurred for the benefit

of other cost centres,

Derive the total planned cost of:

(a) One completed unit of product A

(b) One incomplete unit of product B, which has been processed by the cutting and machiningdepartments but which has not yet been passed into the pressing department

Consider this statement:

‘In a job costing system, it is necessary to divide up the business into departments Fixed costs(or overheads) will be collected for each department Where a particular fixed cost relates to thebusiness as a whole, it must be divided between the departments Usually this is done on thebasis of area of floor space occupied by each department relative to the entire business Whenthe total fixed cost for each department has been identified, this will be divided by the number

of hours that were worked in each department to deduce an overhead recovery rate Each jobthat was worked on in a department will have a share of fixed cost allotted to it according tohow long it was worked on The total cost for each job will therefore be the sum of the variablecost of the job and its share of the fixed cost It is essential that this approach is taken in order

to deduce a selling price for the business’s output.’

Required:

Prepare a table of two columns In the first column you should show any phrases or sentences

in the above statement with which you do not agree, and in the second column you should showyour reason for disagreeing with each one

Many businesses charge overheads to jobs on a cost centre basis

4.8 4.7

Costing and pricing in a competitive environment

LEARNING OUTCOMES

We saw in Chapter 1 that major changes have occurred in the business world inrecent years, including deregulation, privatisation, the growing expectations ofshareholders and the impact of new technology These have led to a much morefast-changing and competitive environment that has radically altered the way that businesses need to be managed In this chapter, we consider some of themanagement accounting techniques that have been developed to help businessesmaintain their competitiveness in this new era

We begin by considering the impact of this new, highly competitive environment

on the full-costing approach that we considered in Chapter 4 We shall see thatactivity-based costing (ABC), which is a development of the traditional full-costingapproach, takes a much more enquiring, much less accepting attitude towardsindirect cost (overheads) Some other recent approaches to costing that can helplower costs and, therefore, increase the ability of a business to compete on price will also be examined

Managers must approach pricing decisions with care because of the significantimpact they can have on the profitability of a business We shall see how, in theoryand in practice, prices may be set in a competitive environment In setting prices,managers are likely to be guided by product-costing information We shall examine this point and, in so doing, pick up other points on relevant cost andcost–volume–profit relationships that were considered in Chapters 2 and 3

INTRODUCTION

5

When you have completed this chapter, you should be able to:

l Describe the nature of the modern product costing and pricing environment

l Discuss the principles and practicalities of activity-based costing

l Explain how new developments such as total life-cycle costing and targetcosting can be used to manage product costs

l Explain the theoretical underpinning of pricing decisions and discuss theissues involved in reaching a pricing decision in real-world situations

Costing and pricing products in the traditional way

The traditional, and still widely used, approach to job costing and product pricingdeveloped when the notion of trying to determine the cost of industrial productionfirst emerged This was around the time of the UK Industrial Revolution when indus-try displayed the following characteristics:

l Direct-labour-intensive and direct-labour-paced production Labour was at the heart of

production To the extent that machinery was used, it was to support the efforts

of direct labour, and the speed of production was dictated by direct labour

l A low level of indirect cost relative to direct cost Little was spent on power, personnel

services, machinery (leading to low depreciation charges) or other areas typical ofthe indirect cost (overheads) of modern businesses

l A relatively uncompetitive market Transport difficulties, limited industrial production

worldwide and a lack of knowledge by customers of competitors’ prices meant thatbusinesses could prosper without being too scientific in costing and pricing theiroutput Customers would have tended to accept what the supplier had to offer,rather than demanding precisely what they wanted

Since overheads at that time represented a pretty small element of total cost, it wasacceptable and practical to deal with them in a fairly arbitrary manner Not too mucheffort was devoted to trying to control overheads because the potential rewards of better control were relatively small, certainly when compared with the benefits fromfirmer control of direct labour and material costs It was also reasonable to charge overheads to individual jobs on a direct labour hour basis Most of the overheads wereincurred directly in support of direct labour: providing direct workers with a place to work,heating and lighting the workplace, employing people to supervise the direct workers,and so on Direct workers, perhaps aided by machinery, carried out all production

At that time, service industries were a relatively unimportant part of the economyand would have largely consisted of self-employed individuals These individualswould probably have been uninterested in trying to do more than work out a roughhourly or daily rate for their time and to try to base prices on this

Costing and pricing products in the new environment

As mentioned in Chapter 1, the world of industrial production has undergone mental change Most of it is now characterised by:

funda-l Capital-intensive and machine-paced production Machines are at the heart of much

production, including both the manufacture of goods and the rendering of services.Most labour supports the efforts of machines, for example, technically maintainingthem Also, machines often dictate the pace of production According to evidenceprovided in Real World 4.2 (page 97), direct labour accounts on average for just

14 per cent of manufacturers’ total cost

l A high level of indirect costs relative to direct costs Modern businesses tend to have very

high depreciation, servicing and power costs There are also high costs of personneland staff welfare, which were scarcely envisaged in the early days of industrial

Cost determination in the changed business environment

production At the same time, there are very low (sometimes no) direct labour costs.Although direct material cost often remains an important element of total cost,more efficient production methods lead to less waste and, therefore, to a lower totalmaterial cost, again tending to make indirect cost (overheads) more dominant.Again, according to Real World 4.2, overheads account for 25 per cent of manufac-turers’ total cost and 51 per cent of service sector total cost.

l A highly competitive international market Production, much of it highly sophisticated,

is carried out worldwide Transport, including fast airfreight, is relatively cheap Fax,the telephone and, particularly, the internet ensure that potential customers canquickly and cheaply find the prices of a range of suppliers Markets now tend to behighly price competitive Customers increasingly demand products custom made totheir own requirements This means that businesses need to know their productcosts with a greater degree of accuracy than historically has been the case Businessesalso need to take a considered and informed approach to pricing their output

In the UK, as in many developed countries, service industries now dominate theeconomy, employing the great majority of the workforce and producing most of thevalue of productive output Though there are many self-employed individuals sup-plying services, many service providers are vast businesses such as banks, insurancecompanies and cinema operators For most of these larger service providers, the activ-ities very closely resemble modern manufacturing activity They too are characterised

by high capital intensity, overheads dominating direct costs and a competitive national market

inter-Cost management systems

Changes in the competitive environment mean that businesses must now managecosts much more effectively than in the past This, in turn, places an obligation on thecost management systems employed to provide the information that will enable man-agers to do this Traditional cost management systems have often proved inadequatefor the task and, in recent years, new systems have gained in popularity We shall nowtake a look at some of these systems

In Chapter 4 we considered the traditional approach to job costing (deriving the fullcost of output where one unit of output differs from another) We may recall that thisapproach involves collecting, for each job, those costs that can be clearly linked to, andmeasured in respect of, the particular job (direct costs) All indirect costs (overheads)are allocated or apportioned to product cost centres and then charged to individualjobs according to some formula The evidence suggests that this formula is usuallybased on the number of direct labour hours worked on each particular job

In the past, this approach has worked reasonably well, largely because overheadrecovery rates (that is, rates at which overheads are absorbed by jobs) were typically of

a much lower value for each direct labour hour than the rate paid to direct workers aswages or salaries It is now, however, becoming increasingly common for overheadrecovery rates to be between five and ten times the hourly rate of pay, because over-heads are now much more significant When production is dominated by direct labour

Activity-based costing

paid, say, £8 an hour, it might be reasonable to have an overhead recovery rate of, say,

£1 an hour When, however, direct labour plays a relatively small part in production,

to have an overhead recovery rate of, say, £50 for each direct labour hour is likely tolead to very arbitrary product costing Even a small change in the amount of directlabour worked on a job could massively affect the total cost deduced – not because thedirect worker is very highly paid, but because of the effect of the direct labour hours

on the overhead cost loading A further problem is that overheads are still typicallycharged on a direct labour hour basis even though the overheads may not be closelyrelated to direct labour

Real World 5.1provides a rather disturbing view of costing and cost control in largebanks

An alternative approach to full costing

The changes in the competitive environment discussed above have led to much closerattention being paid to the issue of overheads, what causes them and how they arecharged to jobs Historically, businesses have been content to accept that overheadsexist and, therefore, for job (product) costing purposes they must be dealt with in aspractical a way as possible In recent years, however, there has been increasing recog-nition of the fact that overheads do not just happen; something must be causing them

To illustrate this point, let us consider Example 5.1

REAL WORLD 5.1

Bank accounts

In a study of the cost structures of 52 international banks, the German consultancy firm,Droege, found that indirect cost (overheads) could represent as much as 85 per cent oftotal cost However, whilst direct costs were generally under tight management control,overheads were not The overheads, which include such items as IT development, riskcontrol, auditing, marketing and public relations, were often not allocated between oper-ating divisions or were allocated in a rather arbitrary manner

Source: Based on information in A Skorecki, ‘Banks have not tackled indirect costs’, ft.com, 7 January 2004.

FT

Modern Producers Ltd has a storage area that is set aside for its inventories of finished goods The cost of running the stores includes a share of the factory rentand other establishment costs, such as heating and lighting It also includes thesalaries of staff employed to look after the inventories, and the cost of financingthe inventories held in the stores

The business has two product lines: A and B Product A tends to be made insmall batches and low levels of finished inventories are held The business pridesitself on its ability to supply Product B in relatively large quantities, instantly As

a consequence, most of the space in the finished goods store is filled with finishedProduct Bs, ready to be despatched immediately an order is received

Example 5.1

‘

What drives the costs?

Activity-based costing (ABC)aims to overcome the kind of problem just described bytracing the cost of all support activities directly to particular products or services For amanufacturing business, these support activities may include materials ordering, materialshandling, storage, inspection and so on The cost of the support activities makes up thetotal overheads cost The outcome of this tracing exercise is to provide a more realistic,and more finely measured, account of the overhead cost element for a particular product

2 The costs to be attributed to each support activity; and

3 The factors that cause a change in the costs of each support activity, that is, the cost drivers

Identifying the cost drivers is a vital element of a successful ABC system They have

a cause-and-effect relationship with activity costs and so are used as a basis for attaching activity costs to a particular product or service This point is discussed furtherbelow

3 The total cost in each pool to then be charged to output (Products A and B, in the

case of Example 5.1) using the relevant cost driver

Traditionally, the whole cost of operating the stores would have been treated

as a part of general overheads and included in the total of overheads charged tojobs, probably on a direct labour hour basis This means that, when assessing thecost of Products A and B, the cost of operating the stores has fallen on themaccording to the number of direct labour hours worked on manufacturing eachone; a factor that has nothing to do with storage In fact, most of the stores’ costshould be charged to Product B, since this product causes (and benefits from) thestores’ cost much more than Product A

Failure to account more precisely for the cost of running the stores is maskingthe fact that Product B is not as profitable as it seems to be It may even be lead-ing to losses as a result of the relatively high stores-operating cost that it causes.However, much of this cost is charged to Product A, without regard to the factthat Product A causes little of it

Example 5.1 continued

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‘

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The final step identified involves dividing the amount in each cost pool by the estimatedtotal usage of the cost driver to derive a cost per unit of the cost driver This unit costfigure is then multiplied by the number of units of the cost driver used by a particularproduct, or service, to determine the amount of overhead cost to be attached to it.

The following example should make this last step clear

The management accountant at Modern Producers Ltd (see Example 5.1) has estimated that the cost of running the finished goods stores for next year will be

£90,000 This will be the amount allocated to the ‘finished goods stores cost pool’

It is estimated that each Product A will spend an average of one week in thestores before being sold With Product B, the equivalent period is four weeks Bothproducts are of roughly similar size and have very similar storage needs It is felt,therefore, that period spent in the stores (‘product weeks’) is the cost driver

Next year, 50,000 Product As and 25,000 Product Bs are expected to pass throughthe stores The estimated total usage of the cost driver will be the total number of

‘product weeks’ that the products will be in store For next year, this will be:

Product A 50,000 × 1 week = 50,000Product B 25,000 × 4 weeks = 100,000

150,000

The cost per unit of cost driver is the total cost of the stores divided by the number

of ‘product weeks’, as calculated above This is:

£90,000/150,000 = £0.60

To determine the cost to be attached to a particular unit of product, the figure

of £0.60 must be multiplied by the number of ‘product weeks’ that a product stays

in the finished goods store Thus, each unit of Product A will be charged with

£0.60 (that is, £0.60 × 1), and each Product B with £2.40 (that is, £0.60 × 4)

Example 5.2

Can you think of any other benefits that an ABC approach to costing may provide?

By identifying the various support activities’ costs and analysing what causes them tochange, managers should gain a better understanding of the business This, in turn,should help them in controlling costs and improving efficiency It should also help them inforward planning They may, for example, be in a better position to assess the likely effect

of new products and processes on activities and costs

Activity 5.1

ABC versus the traditional approach

We can see that there is a basic philosophical difference between the traditional and

the ABC approaches The traditional approach views overheads as rendering a service to

cost units, the cost of which must be charged to those units ABC, on the other hand,

views overheads as being caused by activities, and so it is the cost units that cause these

activities that must be charged with the costs that they cause

With the traditional approach, overheads are apportioned to product cost centres.Each product cost centre would then derive an overhead recovery rate, typically over-heads per direct labour hour Overheads would then be applied to units of outputaccording to how many direct labour hours were worked on them

With ABC, the overheads are analysed into cost pools, with one cost pool for eachcost-driving activity The overheads are then charged to units of output, through activ-ity cost driver rates These rates are an attempt to represent the extent to which eachparticular cost unit is believed to cause the particular part of the overheads

Cost pools are much the same as cost centres, except that each cost pool is linked to

a particular activity (operating the stores in Examples 5.1 and 5.2), rather than being

more general, as is the case with cost centres in traditional job (or product) costing.The two different approaches are illustrated in Figure 5.1

ABC and service industries

Much of our discussion of ABC has concentrated on the manufacturing industry, haps because early users of ABC were manufacturing businesses In fact, ABC is pos-sibly even more relevant to service industries because, in the absence of a direct materialelement, a service business’s total cost is likely to be largely made up of overheads.There is certainly evidence that ABC has been adopted more readily by businesses thatsell services rather than products, as we shall see later

per-What is the difference in the way in which direct costs are accounted for when using ABC, relative to their treatment taking a traditional approach to full costing?

The answer is no difference at all ABC is concerned only with the way in which overheadsare charged to jobs to derive the full cost

Activity 5.2

Example 5.3 provides an example of activity-based costing and brings together thepoints that have been raised so far

Traditional versus activity-based costing

Source: Adapted from Innes, J and Mitchell, F., Activity Based Costing: A Review with Case Studies, CIMA Publishing, 1990.

Comma Ltd manufactures two types of Sprizzer – Standard and Deluxe Eachproduct requires the incorporation of a difficult-to-handle special part (one ofthem for a Standard and four for a Deluxe) Both of these products are made inbatches (large batches for Standards and small ones for Deluxes) Each new batchrequires that the production facilities are ‘set up’.

Details of the two products are:

Standard Deluxe

Annual production and sales – units 12,000 12,000

Number of separate material issues from stores per batch 1 1

In recent months, Comma Ltd has been trying to persuade customers who buythe Standard to purchase the Deluxe instead An analysis of overhead costs forComma Ltd has provided the following information

Special part handling cost 60,000 Number of special partsCustomer invoicing cost 29,000 Number of invoicesMaterial handling cost 63,000 Number of batches

Required:

(a) Calculate the profit per unit and the return on sales for Standard and DeluxeSprizzers using

(i) the traditional direct-labour-hour based absorption of overheads;

(ii) activity-based costing methods

(b) Comment on the managerial implications for Comma Ltd of the results in (a) above

Solution

Using the traditional full (absorption) costing approach that we considered inChapter 4, the overheads are added together and an overheads recovery ratededuced as follows:

Special part handling cost 60,000Customer invoicing cost 29,000Material handling cost 63,000

333,200

Example 5.3

Overhead recovery rate =

=

=

= £6.17 per hourThe total cost per unit of each type of Sprizzer is calculated by adding the directcost to the overheads cost per unit The overheads cost per unit is calculated bymultiplying the number of direct labour hours spent on the product (2 hours for

calculated above Hence:

Overheads (£6.17 per hour) 12.34 15.43

The return on sales is calculated as follows:

Return on sales [(profit /sales) × 100%] 22.55% 22.49%

Using the ABC costing approach, the activity cost driver rates will be calculated asfollows:

Overhead Driver Standard Deluxe Total Costs Driver

batchSpecial part Special parts 12,000 48,000 60,000 60,000 1

£333,200[(12,000 × 2) + (12,000 × 21/2)]

Total overheadsNumber of labour hours

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Criticisms of ABC

Although many businesses now adopt a system of ABC, its critics point out that ABCcan be time-consuming and costly Set-up costs as well as costs of running and updat-ing the ABC system must be incurred These costs can be very high, particularly wherethe business’s operations are complex and involve a large number of activities and costdrivers Furthermore, ABC information produced under the scenario just describedmay be complex If managers find ABC reports difficult to understand, there is a riskthat the potential benefits of ABC will be lost

Not all businesses are likely to benefit from ABC Where a business sells products

or services that all have similar levels of output and involve similar activities and

The activity-based costs are derived as follows:

Overhead Total costs Total costs Unit costs Unit costs

The return on sales is calculated as follows:

Return on sales [(profit/sales) × 100%] 32.67% 14.94%

The figures show that under the traditional approach the returns on sales appearbroadly equal However, the ABC approach shows that the Standard product is farmore profitable Hence, the business should reconsider its policy of trying to per-suade customers to switch to the Deluxe product

Example 5.3 continued

processes, it is unlikely that the finer measurements provided by ABC will lead to ingly different results from those gained under the traditional approach As a result,opportunities for better pricing, planning and cost control may not be great and maynot justify the cost of switching to an ABC system.

strik-Measurement and tracing problems can arise with ABC, which may undermine anypotential benefits Not all costs can be easily identified with a particular activity andsome may have to be allocated to cost pools This can often be done on some sensiblebasis For example, factory rent may be allocated on the basis of square metres of spaceused In some cases, however, a lack of data concerning a particular cost may lead tofairly arbitrary cost allocations between activities There is also the problem that therelationship between activity costs and their cost drivers may be difficult to determine.Identifying a cause-and-effect relationship can be difficult where a large proportion ofactivity costs are fixed and so do not vary with changes in usage

ABC is also criticised for the same reason that full costing generally is criticised:because it does not provide very relevant information for decision making The pointwas made in Chapter 4 that full costing tends to use past costs and to ignore opportun-ity costs Since past costs are always irrelevant in decision making and opportunitycosts can be significant, full costing information is an expensive irrelevance In con-

trast, advocates of full costing claim that it is relevant, in that it provides a long-run

average cost, whereas ‘relevant costing’, which we considered in Chapter 2, relates only

to the specific circumstances of the short term The use of ABC, rather than the tional approach to job (or product) costing, does not affect the validity of this irrelev-ance argument

tradi-Real World 5.2shows how ABC came to be used at the Royal Mail

Real World 5.3 provides some indication of the extent to which ABC is used in practice

REAL WORLD 5.2

Delivering ABC

Early in the 2000s the publicly-owned Royal Mail adopted ABC and used it to find the cost

of making postal deliveries Royal Mail identified 340 activities that gave rise to costs, created a cost pool and identified a cost driver for each of these

Roger Tabour, Royal Mail’s Enterprise Systems Programme Director, explained, ‘A newregulatory and competitive environment, plus a down-turned economy, led management

to seek out more reliable sources of information on performance and profitability,’ and thisled to the introduction of ABC

The Royal Mail is a public sector organisation that is subject to supervision byPostcomm, the UK government appointed regulatory body The government requires theRoyal Mail to operate on a commercial basis and to make profits

Source: www.sas.com.

REAL WORLD 5.3

ABC in practice

A recent survey of 176 UK businesses operating in various industries, all with an annualturnover of more than £50 million, was conducted by Al-Omiri and Drury This indicatedthat 29 per cent of larger UK businesses use ABC

The adoption of ABC in the UK varies widely between industries, as is shown in Figure 5.2

Al-Omiri and Drury took their analysis a step further by looking at the factors that ently tend to lead a particular business to adopt ABC They found that businesses thatused ABC tended to be:

appar-l Large

l Sophisticated, in terms of using advanced management accounting techniques generally

l In an intensely competitive market for their products

l Operating in a service industry, particularly in the financial services

All of these findings are broadly in line with other recent research evidence involving nesses from around the world

busi-Source : Al-Omiri, M and Drury, C., ‘A survey of factors influencing the choice of product costing systems in UK organisations’, Management Accounting Research, December 2007.

ABC in practice

Figure 5.2