M4_A1 ABC or Activity Based Costing

Activity-based costing

Activity-based costing (or ABC) is an attempt to identify a more accurate method of allocating overheads to products/services. In a later book by the authors of Relevance Lost, Kaplan and Cooper ( 1997 ) described how activity-based cost (ABC) systems:

emerged in the mid-1980s to meet the need for accurate information about the cost of resource demands by individual products, services, customers and channels. ABC systems enabled indirect and support expenses to be driven, first to activities and processes, and then to products, services, and customers. The systems gave managers a clearer picture of the economics of their operations (p. 3).

ABC uses cost pools to accumulate the cost of significant business activities and then assigns the costs from the cost pools to products based on cost drivers, which measure each product’s demand for activities.

Cost pools accumulate the cost of business processes, irrespective of the organizational structure of the business. The costs that correspond to the formal organization structure may still be accumulated for financial reporting purposes through a number of cost centres, but this will not be the method used for product costing. For example, the purchasing process can take place in many different departments, as we saw illustrated in Figure 9.1 in Chapter 9 . A stores-person or computer operator may identify the need to restock a product. This will often lead to a purchase requisition, which must be approved by a manager before being passed to the purchasing department. Purchasing staff will have negotiated with suppliers in relation to quality, price, and delivery and will generally have approved suppliers and terms. A purchase order will be raised. The supplier will deliver the goods against the purchase order and the goods will be received into the store. The paperwork (a delivery note from the supplier and a goods received note) will be passed to the accounting department to be matched to the supplier invoice and payment will be made to the supplier. This business process cuts across several departments.

ABC collects the costs for the purchasing process in a cost pool, irrespective of the cost centre or department which incurred the cost. The next step is to identify a cost driver.

The cost driver is the most significant cause of the activity for each cost pool. In the purchasing example, the causes of costs are often recognized as the number of suppliers and/or the number of purchase orders. Cost drivers enable the cost of activities to be assigned from cost pools to cost objects (products/services). Rates are calculated for each cost driver and overhead costs are applied to products/ services on the basis of the cost driver rates. There are no rules about what cost pools and cost drivers should be used, as this will be contingent on the circumstances of each business and the choices made by its accountants. Examples of cost pools and drivers are:

Cost pool	Cost driver
Purchasing	No. of purchase orders
Sales order entry	No. of sales orders
Material handling	No. of set-ups (i.e. batches)
Scheduling	No. of production orders
Machining	Machine hours (i.e. not labour hours)

For example, a rate will be calculated for each cost driver (e.g. purchase order, set-up) and assigned to each product based on how many purchase orders and set-ups the product has consumed. The more purchase orders and set-ups a product requires, the higher the overhead cost applied to it will be. ABC does not mean that direct labour hours or machine hours or the number of units produced are ignored. Where these are the significant cause of activities for particular cost pools, they are used as the cost drivers for those cost pools.

Using the same example as for absorption costing, assume for our two products that there are two cost pools: purchasing and scheduling. The driver for purchasing is the number of purchase orders and the driver for scheduling is the number of production orders. Costs are collected by an activity-based accounting system (which uses a coding structure to identify the cost pool as well as the cost centre) into cost pools and the measurement of cost drivers takes place, identifying how many activities are required for each product. The cost per unit of activity is the cost pool divided by the cost drivers, as shown in Table 13.4 .

Table 13.4 Overhead accumulated in cost pools and allocated by cost drivers.

Cost pool and driver	Total cost	Product A	Product B
Purchasing	£40,000
No. of purchase orders	4,000	3,000	1,000
	(£10 each)	£30,000	£10,000
Scheduling	£60,000
No. of production orders	100	75	25
	(£600 each)	£45,000	£15,000
Total overhead	£100,000	£75,000	£25,000