CIMA P2 Syllabus A. Managing The Costs Of Creating Value - Activity Based Costing (ABC) - Notes ^{2 / 11}

Absorption Costing vs. ABC

In absorption costing, we allocate overheads to production and service departments, using the overhead absorption rate based on volume of hours or units normally

However, in many modern operations, overheads are not primarily influenced by volume. 

So ABC absorbs overheads instead using cost drivers (an activity which generates costs) such as:

• Ordering costs – no. of orders

• Set-up costs – no. of set-ups

• Packing costs – no. of packing orders

Steps when applying ABC

1. Step 1: Identify activities (Cost pool) that incur overhead costs

2. Step 2: Determine the cost driver and Cost driver volume

3. Step 3: Calculate a cost per cost driver

4. Step 4: Calculate the overhead cost of products

Types of activities

1. Unit Level Activities

   are those where the consumption of resources is very strongly correlated with the number of units produced

   For e.g. Direct labour, direct materials, machine maintenance

2. Batch Level Activities

   consume resources in proportion to the number of batches produced

   For e.g. Purchase order processing costs, Material handling costs, Machine set up costs

3. Facility Level Activities

   relate to the business as a whole

   For e.g. Factory rent, Plant depreciation, Admin staff salaries, Production supervision costs, Property management

4. Product Level Activities

   relate to the existence of a product or product range

   For e.g. Product advertising costs, Product redesign costs

Illustration 1

A company uses an activity based costing system. 
The company produces different types of products.

Purchasing = $ 100,000
Number of Purchase orders of all products = 100 orders

Product A's details:
Annual production of Product A = 10,000 units
Number of Purchase orders of product A = 25 orders

Required:

Calculate The Purchase cost per unit of Product A

Solution

1. Step 1: Identify activities (Cost pools) that incur overhead costs

   Activity = Purchasing 
   Cost pool = $ 100,000

2. Step 2: Determine the cost driver and Cost driver volume

   Purchase orders = Cost driver

   Number of Purchase orders = 100 orders

3. Step 3: Calculate a cost per cost driver

   $100,000 /100 orders = $1,000 per purchase order

4. Step 4: Calculate absorbed overheads to the Product A

   Total purchasing cost for A = $1,000 per purchase order x 25 orders  = $25,000

   Purchasing cost per unit for A = $25,000 / 10,000 units = $2.5 per unit

Advantages of ABC

• More accurate cost information is obtained. 

  It identifies ways of reducing overhead costs in the longer-term. 

  This will enable managers to make better decisions, particularly in respect of pricing and marketing activities.

• It provides much better insights into what drives overhead costs. 

  ABC recognises that overhead costs are not all related to volume. It also identifies activities and costs that do not add value.

• ABC can be applied to all overhead costs, not just production overheads.

• Can also be applied to service companies

• Leads to more efficient management of resources

Disadvantages of ABC

ABC may not be universally beneficial. 

There are four major issues to be considered:

• Cost vs benefit

  The need to analyse costs on a radically different basis will require resources, which will lead to additional costs. 

  Clearly the benefits which will be obtained must exceed these costs. 

  In general terms, an organisation which has little competition, a stable and standardised product range and for which overheads represent a small proportion of total cost, will not benefit from the introduction of ABC.

• Need for informed application

  While ABC is likely to provide better information for decision makers, it must still be applied with care.  

  ABC is not fully understood by many managers and therefore is not fully accepted as a means of cost control.

• Difficulty in identifying cost drivers

  In a practical context, there are frequently difficulties in identifying the appropriate drivers. 

  ABC costs are based on assumptions and simplifications. 

  The choice of both activities and cost drivers might be inappropriate.

• Lack of appropriate accounting records

  ABC needs a new set of accounting records, this is often not immediately available and therefore resistance to change is common. 

  The setting up of new cost pools is needed which is time-consuming.

Worked out example

The following example looks at the different activities within a company, their cost and their cost driver.

The cost per driver is found by dividing the total cost of the activity by the quantity of the cost drivers. 

Overhead costs are then charged to products or services on the basis of activities used for each product or service.