A company manufactures two products, L and M, using the same equipment and similar processes.
An extract of the production data for these products in one period is shown below:
L M
Quantity produced (units) 5 000 7 000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set-ups in the period 10 40
Orders handled in the period 15 60
Production overhead costs $
Relating to machine activity 209 000
Relating to production run set-ups 25 000
Relating to handling of orders 51 000
285 000 (a) What is the amount of production overhead to be absorbed by one unit of product M using a
traditional absorption costing approach, with a direct labour hour rate to absorb overheads?
A $15.00 B $17.50 C $22.00 D $30.00
(b) What is the amount of production overhead to be absorbed by one unit of product M using an activity-based costing approach, with suitable cost drivers to trace overheads to products?
A $12.95 B $18.19 C $32.57 D $37.57
(The answers are at the end of the chapter)
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4 Marginal costing versus ABC
Section overview
• 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.
One view is that only marginal costing provides suitable information for decision making but this is not true.
Marginal costing provides a crude method of differentiating between different types of cost behaviour by splitting costs into their variable and fixed elements. However, such an analysis can be used only for short- term decisions and usually even these have longer-term implications which ought to be considered.
The problem with marginal costing is that it 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. A failure to allocate such costs to individual products could result in incorrect decisions concerning the future management of the products.
The advantage of ABC is that it spreads costs across products according to a number of different bases. For example, an ABC analysis may show that one particular activity which is carried out primarily for one or two products is expensive. A correct allocation of the costs of this activity may reveal that these particular products are not profitable. If these costs are fixed in relation to the volume of production then they would be treated as period costs in a marginal costing system and written off against the
marginal costing contribution for the period.
The marginal costing system would therefore make no attempt to allocate these 'fixed' costs to individual products and a false impression would be given of the long run average cost of the products.
Therefore, marginal costing may provide incorrect decision making information, particularly in a situation where 'fixed' costs are vary large compared with 'variable' costs.
5 Introducing an ABC system into an organisation
Section overview
• 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.
5.1 When should ABC be introduced?
ABC should only be introduced if the additional information it provides will result in action that will increase the organisation's overall profitability. This is most likely to occur in situations such as the following, when the ABC analysis differs significantly from the traditional absorption costing analysis:
• Production overheads are high in relation to direct costs, especially direct labour.
• Overhead resource consumption is not just driven by production volume.
• There is wide variety in the product range.
• The overhead resource input varies significantly across the product range.
5.2 Analysis of activities
ABC attempts to relate the incidence of costs to the level of activities undertaken. A hierarchy of four levels of activity has been suggested.
Management Accounting
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Definition
The hierarchy of activities is a classification of activities by level of organisation, for example, unit, batch, product-sustaining and facility-sustaining.
Type of activities Costs are dependent on …. Examples
Product level Volume of production Machine power
Batch level Number of batches Set-up costs
Product-sustaining Existence of a product group/line Product management Facility-sustaining Organisation simply being in business Rent and rates
Definitions
Product-sustaining activities are activities undertaken to develop or sustain a product or service.
Product sustaining costs are linked to the number of products or services, not to the number of units produced.
Facility-sustaining activities are activities undertaken to support the organisation as a whole, and which cannot be logically linked to individual units of output.
The difference between a unit product cost determined using traditional absorption costing and one determined using ABC will depend on the proportion of overhead cost which falls into each of the categories above.
(a) If most overheads are related to unit level and facility level activities, the unit product costs generated by each method will be similar.
(b) If the overheads tend to be associated with batch or product level activities the unit product cost generated by ABC will be significantly different from traditional absorption costing.
Consider the following example.
Worked Example: Batch level activity
XYZ produces a number of products including product D and product E and produces 500 units of each of products D and E every period at a rate of ten of each every hour. The overhead cost is $500,000 and a total of 40,000 direct labour hours are worked on all products. A traditional overhead absorption rate would be $12.50 per direct labour hour and the overhead cost per product would be $1.25.
Production of D requires five production runs per period, while production of E requires 20. An investigation has revealed that the overhead costs relate mainly to 'batch-level' activities associated with setting-up machinery and handling materials for production runs.
There are 1,000 production runs per period and so overheads could be attributed to XYZ's products at a rate of $500 per run.
• Overhead cost per D = ($500 × 5 runs)/500 = $5
• Overhead cost per E = ($500 × 20 runs)/500 = $20
These overhead costs are activity-based and recognise that overhead costs are incurred due to batch level activities. The fact that E has to be made in frequent small batches, perhaps because it is perishable, means that it uses more resources than D. This is recognised by the ABC overhead costs, not the traditional absorption costing overhead costs.
In the modern manufacturing environment, production often takes place in short, discontinuous production runs and a high proportion of product costs are incurred at the design stage. An increasing proportion of overhead costs are therefore incurred at batch or product level.
Such an analysis of costs gives management an indication of the decision level at which costs can be influenced. For example, a decision to reduce production costs will not simply depend on making a general reduction in output volumes: production may need to be organised to reduce batch volumes; a process may need to be modified or eliminated; product lines may need to be merged or cut out;
facility capacity may need to be altered.
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5.3 ABC in service and retail organisations
ABC was first introduced in manufacturing organisations but it can equally well be used in other types of organisation. For example, the management of the Post Office in the US recently introduced ABC. They analysed the activities associated with cash processing as follows:
Activities Examples Possible cost driver
Unit level Accept cash
Processing of cash by bank
Number of transactions Number of transactions Batch level Cash desk closed by clerk (close out) and
reviewed by supervisor Deposits
Review and transfer of funds
Number of 'close outs' Number of deposits Number of accounts Product level Maintenance charges for bank accounts
Reconciling bank accounts
Number of accounts Number of accounts
An important aspect of ABC in non-manufacturing operations is to identify the items for which the costing system is intended to provide cost information. In the case of cash processing above, ABC-related costs can be established for customer accounts and also for cash processing transactions. Costs can also be
established for ‘close outs’ and fund transfers.
Having identified the items for which unit costs are needed, at a unit, batch or product level, activity costs should be assigned to each cost item on the basis of their ‘use’ of each activity.