Question 3: ABC and retail organisations
6.4 Activity-based management (ABM)
Although the terms are sometimes used interchangeably, ABM is a broader concept than ABC, being likely to incorporate ABC and activity-based budgeting (ABB).
Activity-based budgeting is where resources are allocated to individual activities depending on their inter- relationships. A detailed knowledge of this is not required in this unit.
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Definitions
Optimal ABM are actions, based on activity driver analysis, that increase efficiency, lower costs and/or improve asset utilisation.
Strategic ABM are actions, based on activity-based cost analysis, that claim to change the demand for activities so as to improve profitability.
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Key chapter points
• Traditional costing systems, which assume that all products consume all resources in proportion to their production volumes, tend to allocate too great a proportion of overheads to high volume products, which use fewer support services and too small a proportion of overheads to low volume products, which use more support services. Activity-based costing (ABC) attempts to overcome this problem and charge overheads on the basis of the use of support services.
• ABC involves the identification of the factors (cost drivers) which cause the costs of an
organisation's major activities. Support overheads are charged to products on the basis of their usage of an activity.
• When using ABC, for costs that vary with production levels in the short term, the cost driver will be volume related (labour or machine hours). Overheads that vary with some other activity, and not volume of production, should be traced to products using transaction-based cost drivers such as production runs or number of orders received.
• The main criticism of marginal costing decision making information is that marginal costing analyses cost behaviour patterns according to the volume of production. However, although certain costs may be fixed in relation to the volume of production, they may in fact be variable in relation to some other cost driver.
• ABC should only be introduced if the additional information it provides will result in action that will increase the organisation's overall profitability.
• ABC identifies four levels of activities: product level, batch level, product sustaining level and facility sustaining level.
• ABC has a range of uses and has many advantages over more traditional costing methods. However, the system does have its critics and it is not a panacea for all costing problems.
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Quick revision questions
1 Which one of the following statements is INCORRECT?
A Traditional costing systems tend to allocate too small a proportion of overheads to high volume products and too great a proportion of overheads to low volume products.
B In manufacturing, ABC is more appropriate than traditional absorption costing when the consumption of resources on overhead activities is not related to production volumes.
C ABC can be used for customer profitability analysis.
D A single cost driver may not explain the level of expenditure on an activity.
2 For which of the following costs might the number of machine hours worked be a cost driver?
A Set-up costs
B Short-run variable overhead costs C Materials handling and despatch costs D Product development costs
3 Which of the following is most likely to be the cost driver for production scheduling costs?
A Number of orders
B Number of production runs C Volume of output
D Volume of materials handled
4 In ABC, brand management might be an example of a:
A product level activity B batch level activity
C product-sustaining activity D facility-sustaining activity
5 In ABC, general factory administration costs might be an example of a:
A product level activity B batch level activity
C product-sustaining activity D facility-sustaining activity
6 Which one of the following statements is INCORRECT?
A In ABC, direct labour hours or direct machine hours may be used to trace costs to products.
B The cost driver for quality inspection is likely to be number of hours worked on the product.
C In ABC, activity costs are absorbed into product costs using an activity cost per unit of cost driver as the absorption rate.
D ABC may be used for cost and management accounting by service organisations.
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Answers to quick revision questions
1 A
Traditional costing systems tend to allocate too great a proportion of overheads to high volume products and too small a proportion of overheads to low volume products. Note that a weakness of the ABC method is that for some activities, there may be several cost drivers for cost.
2 B
Short-run variable costs (such as repairs costs) are generally driven by production activity (machine hours or direct labour hours).
3 B
Production scheduling costs are likely to be driven by the number of production runs. Set-up costs may be included in the general activity: ‘production scheduling’.
4 C
In ABC, activities are identified at different levels. At a product-sustaining level, activities are generally related to product or brand management,
5 D
General factory administration costs are incurred to keep the factory in operation, and so would be classified as a facility-sustaining activity
6 B
The cost driver for quality inspection is likely to be number of inspections carried out. In ABC, direct labour hours or direct machine hours may be used to trace some costs to products – typically short-run variable costs. ABC can be applied to any operations where resources are consumed by activities, including service organisations.
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Answers to chapter questions
1 D
A cost driver is best described as any factor which causes a change in the cost of an activity.
2 (a) D
Traditional absorption costing approach
Direct labour hours
Product L = 5 000 units × 1 hour 5 000
Product M = 7 000 units × 2 hours 14 000
19 000
Therefore Overhead absorption rate =
000 19
000
$285 = $15 per hour Overhead absorbed by one unit of product M would be as follows:
Product M 2 hours × $15 = $30 per unit (b) B
ABC approach
Machine hours
Product L = 5 000 units × 3 hours 15 000
Product M = 7 000 units × 1 hour 7 000
22 000
Using ABC the overhead costs are absorbed according to the cost drivers.
$
Machine-hour driven costs 209 000 ÷ 22 000 m/c hours = $9.50 per m/c hour Set-up driven costs 25 000 ÷ 50 set-ups = $500 per set-up Order driven costs 51 000 ÷ 75 orders = $680 per order Overhead costs are therefore as follows:
Product M $ Machine-driven costs (7 000 hrs × $9.50) 66 500
Set-up costs (40 × $500) 20 000
Order handling costs (60 × $680) 40 800 127 300
Units produced 7 000
Overhead cost per unit of Product M $18.19
These figures suggest that product M absorbs an excessive amount of overhead using a direct labour hour basis. Overhead absorption should be based on the activities which drive the costs, in this case machine hours, the number of production run set-ups and the number of orders handled for each product. Most overhead costs are driven by machine activity, but Product M requires much less machine time than Product L.
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Activities Possible cost driver
Quoting prices (curtains, carpets etc) Number of requests for quotations Purchasing and receiving goods Number of orders
Returned goods Number of returns
Operating a department Number of departments/floor space
Check-out activity Number of customers/check-outs
Home deliveries Number of orders (or possibly the distance travelled to deliver)
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187
Chapter 7
Process and job costing
Topic list
1 The distinguishing features of process costing 2 The basics of process costing
3 Dealing with losses in process 4 Accounting for scrap
5 Valuing closing work in process 6 Valuing opening work in process 7 Joint products and by-products 8 Job costing
Learning objectives Reference
Process and job costing LO7
Explain the differences between job and process costing techniques LO7.1 Apply costing principles to job costing and process costing organisations LO7.2
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Introduction
This chapter looks at costing systems. Costing systems are used to cost goods or services. The method used depends on the way in which the goods or services are produced.
The chapter begins by considering process costing. Process costing is applied when output consists of a continuous stream of identical units. We will begin with the basics and look at how to account for the most simple of processes. We will then move on to how to account for any losses which might occur, as well as what to do with any scrapped units which are sold. Next we will consider how to deal with closing work in process before examining situations involving closing work in process and losses. We will then go on to have a look at situations involving opening work in process and how to deal with situations where we have both opening and closing work in process and losses. This is followed with an outline discussion of joint products and by-products.
This chapter will conclude by covering job costing.
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Before you begin
If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual.
1 When is process costing used? (Section 1)
2 Define process costing. (Section 1)
3 What is on the left hand side of the process account? (Section 2.1) 4 What is on the right hand side of the process account? (Section 2.1) 5 What are the four key steps involved in process costing? (Section 2.2) 6 Define normal loss, abnormal loss and abnormal gain. (Section 3.1)
7 How is normal loss valued? (Section 4)
8 How is work in process valued? (Section 6)
9 What is a joint product? Give examples. (Section 7.1)
10 What is a by-product ? Give examples. (Section 7.2)
11 Define job costing. (Section 8)
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1 The distinguishing features of process costing
Section overview
• Process costing is a costing method used when it is not possible to identify separate units of production, or jobs, usually because of the continuous nature of the production processes involved.
Process costing is used where there is a continuous flow of identical units and it is common to identify it with continuous production such as the following:
• Oil refining.
• The manufacture of soap.
• Paint manufacture.
• Food and drink manufacture.
Definition
Process costing is a form of costing applicable to continuous processes where process costs are attributed to the number of units produced. This may involve estimating the number of equivalent units in stock at the start and end of the period under consideration.
We will discuss 'equivalent units' later in this chapter.
The features of process costing which make it different from other methods of costing such as job or batch costing are as follows:
(a) The continuous nature of production in many processes means that there will usually be closing work in process which must be valued. In process costing it is not possible to build up cost records of the cost of each individual unit of output because production in progress is an indistinguishable homogeneous mass.
(b) There is often a loss in process due to spoilage, wastage, evaporation and so on.
(c) The output of one process becomes the input to the next until the finished product is made in the final process.
(d) Output from production may be a single product, but there may also be a by-product (or by- products) and/or joint products:
2 The basics of process costing
Section overview
• Costs incurred in processes are recorded in what are known as process accounts. A process account has two sides, and on each side there are two columns, one for quantities (of raw materials, work-in-process and finished goods) and one for costs.
• There is a four step approach for dealing with process costing questions.