Below are sample questions, solutions, and lecture materials.
BUSI2157 Management Accounting
Overhead costs and
1
Learning outcomes
• Understand the limitations of traditional overhead allocation
• Appreciate the differences between traditional costing systems and
ABC
• Calculate product costs using ABC (& traditional costing system)
• Understand where ABC is used and some of the advantages and
problems associated with it
Cost classification (1)
Cost classification (2)
Statement of cost of a production item
Overview of costing systems
Two-stage Allocations – AC
Calculate AC unit cost
Step 1:
Allocate indirect costs to
cost centres.
Step 2:
Apportion service cost
centre to production
cost centres.
Step 3:
Absorb overhead
costs into products,
services or customers
(cost objects).
8
Calculate AC unit cost
? The POHR is used to apply overhead to units of output (products etc)
and is determined before the period begins.
POHR =
Ideally, the allocation base is a cost
driver that causes overhead.
Overhead applied = POHR × Actual activity
Traditional approach
• Volume related measures are used to arbitrarily
allocate costs to products.
However…
• Many activities do consume resources that are not
directly linked to physical volume.
• E.g. Support activities such as material handling and material
procurement.
• Traditional cost systems assume that products
consume all resources in proportion to their
production volume.
The problem of overhead
Two divisions each sell 10,000 units of an identical
product.
Division A sells its output to 1,000 different
customers and receives 5,000 orders a year.
Division B sells to 2 customers, has long term orders
with both and delivers its output in batches of 1000
units.
Which division has the higher costs?
Cooper and Kaplan:
1. Low volume products create more transactions
per unit than their high volume counterparts
2. Overheads are often driven by transaction
numbers
3. Error: under traditional costing methods high
volume products get a disproportionate amount
of overhead
Nowadays…
• Importance of accurate OH assignment methods has
increased due to:
Competitive environment
Changes in cost structure due to:
• Wide range of products
• Direct labour not as important as before
• Overheads are of considerable importance
• Non-factory emphasis – service organisations
• ABC attempts to reflect the complexity of today’s
products and services
Activity-based costing
• A system of cost allocation that aims to use mainly
cause-and-effect cost allocations by assigning costs to
activities.
• Focus on what causes overhead costs and how these
relate to products.
• Cash outflows provide resources (e.g. labour, machinery).
• Activities consume and cause these costs (e.g. set up, orders).
• Non production overhead as well as production
overhead can be influential in determining product
and customer profitability
• ABC assigns costs to a product or service based on its
consumption of an activity.
Two-stage Allocations – ABC
Key Steps in ABC
Major steps:
1. Identify major activities
2. Create a cost pool/centre for each activity
3. Determine the cost driver for each major activity
4. Calculate activity rates and assign costs of activities
to products according to the product’s
consumption of activities.
Step 1 Identifying activities
• Unit level (direct labour, material & energy costs)
• Batch level (setting up a machine; shipments)
• Product level (designing & advertising) or Customer level
(sales calls; account management)
• Organisation-sustaining (general admin. Eg. Head office;
computer network)
Step 2 Create a cost pool for each activity
• A cost pool groups together all costs associated
with an activity
• In the first stage allocation, overhead costs are assigned
to activity cost pools
• Not necessarily allocated on a departmental basis
Step 3 Determine the cost driver for each activity
• Drivers at this stage called activity drivers. They
should:
(a) provide a good explanation of costs of each activity
pool.
(b) be easily measurable
(c) the data should be easy to obtain and identifiable with
the product.
Step 3 Determine the cost driver for each activity
Activity (cost)
Purchasing
Materials handling
Set-ups
Quality inspection
Machine oil or machine
repairs
Supervisor’s salary
Cost Driver
Step 4 Calculate activity rates and assign the costs
• These are used for assigning overhead costs to cost
objects (products)
• Calculated by dividing the overhead cost by the total
activity for each activity cost pool
• This gives a charge out rate for each activity
Example – Ningbo company
Ningbo Company makes and sells four products. You are
required to calculate unit cost of each product. Relevant
information is given below:
Product
M
N
P
Q
Output in units
120
100
80
120
Costs per unit:
Direct material
Direct labour
£
40
28
£
50
21
£
30
14
£
60
21
Machine hours per unit
4
3
2
3
Total production OH
£
Machine dept costs (rent, rates,
depreciation and supervision)
Set up costs
Stores receiving
Inspection / quality control
Materials handling and dispatch
10,400
5,250
3,600
2,100
4,650
Traditional OH allocation
Machine hour basis:
Total machine hours
= 1,300
Total prodn OH
= £26,000
Rate per m/c h
=
M
N
Machine hours per unit
4
3
£
£
Direct materials
40
50
Direct labour
28
21
Production overhead
__
__
Total cost per unit
148
131
Output in units
120
100
Total cost
17,760 13,100
P
2
£
30
14
__
84
80
6,720
Q
3
£
60
21
__
141
120
16,920
Other information
The number of requisitions raised on the stores was 20
for each (type of) product, in total 80;
The total number of purchase orders executed was 42;
Each order is for a batch of 10 of a product;
Production runs are in batches of 20; in total: 420/20 =
21.
ABC activities, cost drivers and activity rates
Cost pool
Machine dept
Set up costs
Stores receiving
Quality control
Materials handling
Costs
10,400
5,250
3,600
2,100
4,650
E.g. Set-up costs/production runs
5,250/21 = £250
Driver
Machine hours 1,300
Prodn runs
21
Requisitions
80
Prodn runs
21
Purchase Orders
42
Rate
8
250
45
100
110.71
ABC allocation
Machine dept costs (8.00x)
Set up costs (250x)
Stores receiving (45x)
Inspection & quality control (100x)
Mats handling and despatch (110.7x)
M
£
N
£
P
£
Q
£
4×120
120/20
20
120/20
120/10
3×100
100/20
20
100/20
100/10
2×80
80/20
20
80/20
80/10
3×120
120/20
20
120/20
120/10
A note on calculation:
the figures come from the ABC cost drivers above (8, 250, 45, 100 & 110.71)
output in units (120,100,80,120),
machine hours (4,3,2,3),
divisor 20 comes from production run batches – i.e. prod. runs are in batches of 20
divisor 10 comes from each order is batch of 10.
ABC allocation
Direct materials
Direct labour
Production overhead:
Machine dept costs
Set up costs
Stores receiving
Inspection / quality control
Mats handling and despatch
Total cost
Output in units
Unit cost
M
£
4,800
3,360
N
£
5,000
2,100
P
£
2,400
1,120
Q
£
7,200
2,520
3,840
1,500
900
600
1,329
16,329
2,400
1,250
900
500
1107
13,257
1,280
1,000
900
400
885
7,985
2,880
1,500
900
600
1329
16,929
120
136.08
100
132.57
80
120
99.81 141.08
Comparison
Machine hour basis
ABC
Differences
M
£
N
£
148.00
136.08
11.92
131.00
132.57
(1.57)
P
£
Q
£
84.00 141.00
99.81 141.08
(15.81) (0.08)
Further questions can be asked based on the results, e.g.
profitability
Pricing strategy
management strategy – activities (value added or nonvalue added)
Merits of ABC
• Initial advantage of ABC is that it gives
more accurate unit cost.
• Identification of cost drivers may aid cost
control.
• Facilitates the use of ABM.
Some criticisms
• Costly complex system to design,
implement & maintain
• Measurability
• Marginal refinement of traditional
management accounting techniques
• Management fashion or ‘fad’
Readings for next lecture
• Drury, Chapter 11&22
• CASE STUDY – Cooper Kaplan Pen Co.
(e-copy of the case will be available on Moodle)
BUSI2157 Management Accounting
ABC and ABM
1
Learning outcomes
• Describe activity-based cost management;
• Distinguish between value added and non-value added
activities;
• Understand the role of management accountant in
ABC/ABM.
Rationale
• Customers are the driving force for any organization.
• Reflecting the recognition that interdependent processes
(cross departments) are the keys to creating value for
customers, organisations are shifting from managing
vertically to managing horizontally.
• Creating and improving processes to increase customer and
shareholder value is the primary goal of managers in these
organisations.
• Conventional management information analysis focuses on
costs analysis by departments, which lagged behind the
needs of its managers.
• ABC/ABM fills this information void by providing cost and
operating information that mirrors the horizontal view.
ABC
ABCM
ABM
• The premise behind activity based costing is that
products/services are a result of activities and activities use
resources and these resources cost money. i.e. activities
consume costs
• BUT… what’s the point of knowing our cost structure if we
don’t do anything with the information?
• there is an understanding that if we manage activities we
will manage costs in the long-term.
• “the real key to success is putting ABC information to work
to identify appropriate strategies, improve product design,
and remove waste from operations”
Turney,1992, p.20
• ABM is a management philosophy that has its roots in the
Consortium for Advanced Manufacturing-International
(CAM-I) but it goes beyond manufacturing (e.g. service
industry and government organisation)
• ABM focuses management attention on managing activities
with the aim of: improving the value received by a customer
and the profit achieved by providing this value.
• So the goal of ABM is to satisfy customer needs by making
fewer demands on resources
• ABM extends ABC by analyzing the management of
activities, instead of simply retracing the costs of activities.
(activities not departments)
• Helps to ‘guide efforts to adapt business strategies to meet
competitive pressures as well as improve business
operations’
(Turney, 1992)
ABM
• Management is forced to have a better understanding of
their business which should lead to better decisions and
planning
• The questions they should be addressing are:
– What activities do we undertake? – activity analysis, causeand-effect diagrams, Pareto analysis
– How much do they cost?
– How well are they performed – performance management
– Do they add value (to the customer)?
– How can we do it better? Benchmarking, JIT process
redesign, eliminative low value added activities
Fig. 2. Activity-based costing/management information system (adapted from Turney, 1992a).
M Gupta, K Galloway, 2003
ABM
• Activity-Based Management encourage the
managers to:
– Evaluates the cost and value of activities to identify
opportunities for improvement
– High or low value to the customer?
– Enhance value-added activities
– Reduce non-value-added activities
Value-added vs. non-value-added
* Would the customer willingly pay for the cost of
the activity?
* Would the customer encourage doing more of the
activity?
* Does the activity help the organization reach its
goals?
Value-added vs. non-value-added activities
* Activity
– Material handling
– Set-up
– Assembly
– Testing and inspection
– Rework
– Packaging
– breaks and meetings
* Value-added?
– No
– No
– Yes
– No
– No
– Maybe
– No
Value-added vs. non-value-added activities
* Determination is often subjective
– Some are obvious
– Others may be necessary, but do not add
value to the customer
– Use rating scale to categorize
– Too much or too little detail can hurt
– Should use a team-based approach
– Must consider interactions
ABM
•An ABM system provides:
• Cost of activities and processes
• Cost of non-value added activities – identification
of waste
• Activity-based performance measures – in
addition to cost e.g., quality, cycle times,
productivity and customer services
• Accurate product/service cost
• Cost drivers
Also required:
• An understanding of how the organisation is
performing relative to others?
• need to benchmark so that there is an
understanding of how activities are performed in
other organisations.
• What are the best practices/ can others do it
better?
• Do we have a complex and ‘unique’ process?
Strategic alignment
• ABM provides a connection from ABC to the strategy/strategic
direction of the organisation
• ABM – decisions based on the information provided by ABC
information
– Product-Mix decisions – do we eliminate products?
– Used in Pricing – prices can be adjusted based on ‘better
quality’ costing information. 20% of products generate 300% of
profits whilst 80% of products generate 200% loss
– Capacity and investment Management- do we understand our
unused/non-production capacity?
– Cost reduction and process improvement – (helps us
understand Costs of Quality, efficiency, speed)
– Product and service design decisions that meet or exceed
customer expectations at a profit. Process nature helps us look
across marketing, finance and operations rather than having
individual perspectives.
Achievement of strategy
• ABC provides information for managers to manage (ABM) activities to
improve competitiveness and achieve strategic goals
• Successful firms use their resources on activities that lead to the
greatest strategic benefit
• ABM helps managers to understand the relationship between the
firm’s strategy and the activities and resources needed to implement
the strategy
– For those following a cost leadership strategy it identifies key
activities, cost drivers, and ways to improve processes to reduce cost
– For those pursuing a differentiation strategy it can help to:
identify value-enhancement opportunities
develop a customer strategy
support a technological leadership strategy
establish a pricing strategy
ABM
• Views the organization as a set of linked activities which add value to
the customer (you will be looking at the Value Chain in Advanced
Management Accounting)
• Management can pinpoint avenues for improving operations,
reducing costs, or increasing values to customers.
• ABM improves management’s focus on the firm’s critical success
factors and enhances its competitive advantage
• Management are forced to better understand their business which
should lead to better decisions and planning
– It is …’the entire set of actions that can be taken, on a better
informed basis, with activity-based cost information. With ABM the
organisation accomplishes its outcomes with fewer demands on
organisational resources; that is, the organisation can achieve the
same outcomes (e.g. revenues) at a lower cost.
Kaplan and Cooper, 1998, p.137
Differences between ABC and ABM
ABC
ABM
Focuses on understanding costs and
their drivers;
Seeks to change them;
Can provide information on process,
product and market performance;
Finds ways to improve them;
Is cost centered;
Lies at the heart of the management
process;
Is the result of a static analysis of the
organization;
Is embedded in the dynamics of change;
Is predominantly historical and focused
on controlling existing costs;
Is forward looking, seeking ways to avoid
unnecessary costs and put existing
resources to maximum use;
Reports on internal operational and
tactical results;
Is strategic, focused on understanding
the key elements of value from the
customer’s perspective;
Is source of explanatory data.
Provides actionable information.
(IMA, 1998)
The role of the Management Accountant in
ABC/M:
• Creation and maintenance of the ABC/ABM database;
• Assessing existing data sources and their applicability to the new structure;
• Developing data collection methods for new data sources;
• Designing and creating the ABC/ABM system database/module;
• Analyzing and designing report formats and structures; and after
implementation.
• Integrating ABC/ABM data with existing financial and non-financial systems;
• Assessing and monitoring data integrity within the ABM system;
• Participation on cross-functional teams at all levels of the organization and
education of line managers on the economics of business within process
settings
• Tracking the results, costs, and benefits provided by the ABC/ABM system
both during and after implementation
(Institute of Management Accountants, 2000)
Next lecture
• Drury, Ch. 9
Two-stage Allocations – AC
Requisitioner Buyer
Raise
requisitio
n
Supplier
Raise
order
Action
order
Receiving
Hold
copy
order
Match
goods to
order
Prepare
invoice
Receive
goods
Accounts
Process
invoice
Forward to
requisitioner
Authorise
payment
The purchasing process
Pay
supplier

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