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AYB321 Lecture Notes - Cost Driver, Deutsche Luft Hansa, Quality Control

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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:
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.
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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
Unit-level costs are incurred each time a unit is produced.
o Examples:
Direct materials
Some indirect materials (glue and
Direct labour
Depreciation on factory machinery
Energy costs for factory machinery
Repairs and maintenance of factory
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
Salaries related to moving material
Quality control costs
Depreciation of setup equipment
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
Depreciation of engineering
Product development costs
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 Salary of a plant manager
o Insurance, taxes, etc.
o Training
Unit Level Batch Level
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