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Lecture Notes 9

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Queensland University of Technology

AYB321 – STRATEGIC MANAGEMENT ACCOUNTING Lecture 9: Activity-Based Cost Systems and Activity-Based Management Why ABC?  Accuracy in overhead application has become much more important.  Direct labour replaced by indirect labour. There is no longer a need to focus on improving labour.  ABC presents a different approach to overhead allocation using Activity-Based Cost Drivers as opposed to Volume-Based Cost Drivers  Manufacturing Costs o Direct Labour (DL): traced directly to the product o Direct Materials (DM): traced directly to the product o Overheads (OH): allocated to the product  Not economy to link directly to the product  Gone from a small cost allocated on the basis of a large, representative cost to a large cost allocated on the basis of a small, unrepresentative cost: o Results in:  Inaccurate costing to products; and  (Potentially) poor decisions:  TSC vs ABC: o TCS: Overhead costs allocated to products using simple formulas (e.g. % of direct labour, DLH, MH). o The ABC approach measures the costs of objects by:  Analyzing the costs of activities; and  Where activity drives costs  Using causal cost drivers to assign activity costs to the products, services or customers that benefit from these activities. Benefits of ABC  Strategic benefits: improved information for pricing, make-versus-buy, product mix, outsourcing, and other strategic decisions.  Operational benefits: improved insight into the economics of production and the root causes or drivers of costs. Why are ABC Systems more Accurate?  TCS over-cost simple, high-volume products, and under-cost complex, low-volume products, because…  TCS use volume-based cost drivers (e.g., DLH). o ABC uses causal cost drivers  As a result, using TCS:  Cost of push mowers will be overstated  Cost of ride-on mowers will be understated  If the costs reported by the TCS in decision-making (e.g., pricing, product mix, make versus buy, outsourcing, and other strategic decisions), then expensive errors can be made. How do ABC systems work?  ABC involves the following steps: 1. Identify key activities; 2. Estimate the cost of each activity; 3. Determine what drives those costs (identify the “cost drivers”); 4. Calculate unit costs; 5. Allocate to products.  Traditional costing system assumes overhead cost is proportional to the physical volume of product produced.  Under ABC the cost allocated to the ride-on mower is much higher due to the complexity of the product: o many different raw materials and purchased parts; and o Production runs are relatively short.  That is: o PD#1 (push mowers): Long runs of standard products will make relatively few demands on the materials handling department. o PD#2 (ride-on mowers): many short runs of customised products, containing a large number of unique components, will make quite heavy demands on the materials handling department resources.  The direct labour resource driver fails to distinguish the large variation in demands for materials handling resources from the two quite different production departments. Selecting Activity Cost Drivers ABC Hierarchy of Activity Costs Product Level Unit Level Batch Level Facility Level  Unit-level costs are incurred each time a unit is produced. o Examples:  Direct materials  Depreciation on factory machinery  Some indirect materials (glue and  Energy costs for factory machinery nails)  Repairs and maintenance of factory  Direct labour machinery  Example Cost Drivers: o Machining – machine hours, labour hours or number of units produced o Maintenance of machines – machine hours  Batch level costs are incurred each time a batch of goods is produced. o Examples:  Salaries related to purchasing and  Quality control costs receiving  Depreciation of setup equipment  Salaries related to moving material  Salaries related to setup  Example Cost Drivers: o Purchasing – number of purchase orders or number of parts o Receiving – amount of material or number of receipts o Machine setups – number of setups o Customer orders – number of orders, customers  Product-level costs are incurred as needed to support the production of each different type of product. o Examples:  Salaries of engineers  Product development costs  Depreciation of engineering (testing) equipment  Quality control costs  Example Cost Drivers: o Product Testing – number of change orders, number of tests, hours of testing time o Supervision – number of supervision hours  Facility-level costs simply sustain a facility’s general manufacturing process. o Examples: o Depreciation or rent of a factory building o Insurance, taxes, etc. o Salary of a plant manager o Training  Example Cost Drivers: o Plant Occupancy – square footage, number of employees, labour hours, machine hours  Activity Cost Drivers provide the linkage between activities and cost objects, such as products, services and customers. Selecting Activity Cost Drivers  In selecting activity cost drivers there is a subjective trade-off between accuracy and the costs of measurement.  Three levels: o Transaction drivers  No. times an activity is performed.  E.g., no. of set-ups, no. of receipts.  Least expensive cost driver but could be the least accurate. o Duration drivers  Amount of time required to perform an activity.  Used when significant time variation.  E.g., Simple products may only require 10-15 minutes to set up, whereas complex high-precision products may require 6 hours.  Duration drivers are more accurate but more expensive. o Intensity drivers  Used when duration drivers may not be accurate.  E.g., A particularly complex product may require special set-up, quality control, special test
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