Ken Garrett demystifies
Activity-based costing and provides some tips leading up to the all-important
exams
Conventional costing distinguishes
between variable and fixed costs. Typically, it is assumed that variable costs
vary with the number of units of output (and that these costs are proportional
to the output level) whereas fixed costs do not vary with output. This is often
an over-simplification of how costs actually behave. For example, variable
costs per unit often increase at high levels of production where overtime
premiums might have to be paid or when material becomes scarce. Fixed costs are
usually fixed only over certain ranges of activity, often stepping up as
additional manufacturing resources are employed to allow high volumes to be
produced.
Variable costs per unit can at least
be measured, and the sum of the variable costs per unit is the marginal cost
per unit. These are the extra costs caused when one more unit is produced.
However, there has always been a problem dealing with fixed production costs
such as factory rent, heating, supervision and so on. Making a unit does not
cause more fixed costs, yet production cannot take place without these costs
being incurred. To say that the cost of producing a unit consists of marginal
costs only will understate the true cost of production and this can lead to
problems. For example, if the selling price is based on a mark‑up on cost, then
the company needs to make sure that all production costs are covered by the
selling price. Additionally, focusing exclusively on marginal costs may cause
companies to overlook important savings that might result from better
controlled fixed costs.
The conventional approach to dealing
with fixed overhead production costs is to assume that the various cost types
can be lumped together and a single overhead absorption rate derived. The
absorption rate is usually presented in terms of overhead cost per labour hour,
or cost per machine hour. This approach is likely to be an over-simplification,
but it has the merit of being relatively quick and easy.
EXAMPLE 1
See Table 1 below.
See Table 1 below.
The budgeted labour hours must be
112,000 hours. This is derived from the budgeted outputs of 20,000 ordinary
units which each take five hours (100,000 hours) to produce, and 2,000 deluxe
units which each take six hours (12,000 hours).
Therefore, the fixed overhead
absorption rate per labour hour is $224,000/112,000 = $2/hour.
The costing of the two products can
be continued by adding in fixed overhead costs to obtain the total absorption
cost for each of the products.
See Table 2 below.
For future reference, note that the
total costs accounted for (if production goes according to plan) will be =
20,000 x 85 + 2,000 x 102 = $1,904,000.
The conventional approach outlined
above is satisfactory if the following conditions apply:
- Fixed costs are relatively immaterial compared to material and labour costs. This is the case in manufacturing environments which do not rely on sophisticated and expensive facilities and machinery.
- Most fixed costs accrue with time.
- There are long production runs of identical products with little customisation.
Table 1, Example 1
Budget
|
|
Ordinary
units
|
|
|
Deluxe
units
|
|
Units produced
|
|
20,000
|
|
|
2,000
|
|
Costs per unit:
|
|
$
|
|
|
$
|
|
Material
|
|
10
|
|
|
12
|
|
Labour
|
5 hours
at $12/hour |
60
|
|
6 hours at $12/hour
|
72
|
|
Variable overhead
|
5 hours
at $1/hour |
5
|
|
6 hours at $1/hour
|
6
|
|
Marginal costs
|
|
75
|
|
|
90
|
|
Budgeted fixed production overheads
are $224,000
Table 2, Example 1
Budget
|
|
Ordinary
units
|
|
|
Deluxe
units
|
|
Units produced
|
|
20,000
|
|
|
2,000
|
|
Costs per unit:
|
|
$
|
|
|
$
|
|
Marginal costs
|
|
75
|
|
|
90
|
|
Fixed overheads
|
5 hours
at $2/hour |
10
|
|
6 hours
at $2/hour |
12
|
|
Total absorption
|
|
|
|
|
|
|
Cost/unit
|
|
85
|
|
|
102
|
|
However, much modern manufacturing
relies on highly automated, expensive manufacturing plants – so much so that
some companies do not separately identify the cost of labour because there is
so little used. Instead, factory labour is simply regarded as a fixed overhead
and added in to the fixed costs of running the factory, its machinery, and the
sophisticated information technology system which coordinates production.
Additionally, many companies rely on
customisation of products to differentiate themselves and to enable higher
margins to be made. Dell, for example, a PC manufacturer, has a website which
lets customers specify their own PC in terms of memory size, capacity,
processor speed etc. That information is then fed into their automated
production system and the specified computer is built, more or less
automatically.
Instead of offering customers the
ability to specify products, many companies offer an extensive range of
products, hoping that one member of the range will match the requirements of a
particular market segment. In Example 1, the company offers two products:
ordinary and deluxe. The company knows that demand for the deluxe range will be
low, but hopes that the price premium it can charge will still allow it to make
a good profit, even on a low volume item. However, the deluxe product could consume
resources which are not properly reflected by the time it takes to make those
units.
These developments in manufacturing
and marketing mean that the conventional way of treating fixed overheads might
not be good enough. Companies need to know the causes of overheads, and need to
realise that many of their ‘fixed costs’ might not be fixed at all. They need
to try to assign costs to products or services on the basis of the resources
they consume.
EXAMPLE 2
An analysis of the fixed overheads of $224,000 shows that they consist of:
An analysis of the fixed overheads of $224,000 shows that they consist of:
|
$
|
|
Batch set-up costs
|
90,000
|
|
Stores – material handling etc
|
92,000
|
|
Other (rent etc)
|
42,000
|
|
Total
|
224,000
|
|
Ordinary units are produced in long
production runs, with each batch consisting of 2,000 units.
Deluxe units are produced in short
production runs, with each batch consisting of 100 units.
Each ordinary unit consists of 20
components, each deluxe unit of 30 components.
What we want to do is to get a more
accurate estimate of what each unit costs to produce, and to do this we have to
examine what activities are necessary to produce each unit, because activities
usually have a cost attached. This is the basis of activity-based costing
(ABC). The old approach of simply pretending that fixed costs are incurred
because of the passage of time, and that they can therefore be accounted for on
the basis of labour (or machine) time spent on each unit, is no longer good
enough. Diverse, flexible manufacturing demands a more accurate approach to
costing.
The ABC process is as follows:
- Identify a distinct ‘fixed’ overhead cost.
- Identify the activity that causes that cost. In ABC terminology, that activity is the ‘cost driver’, but it might be better to think of it as the ‘cost causer’.
- Work out the cost incurred each time the activity occurs.
- Determine how many units are made for each incidence of the cost causer. This is likely to vary for each type of unit.
- Work out the cost that can be traced into each unit produced.
See Figure 1 below.
EXAMPLE 3
Applying these steps to the fixed
cost breakdown shown in Example 2 results in the following analysis:
Batch set-up costs
- Cost of set-ups = $90,000
- Cost driver (or cost causer) = each batch set‑up (presumably)
- The number of set-ups are:
For ordinary units 20,000/2,000 = 10
For deluxe units 2,000/100 = 20
Total set-up occasions 30
Cost per set-up 90,000/30 = $3,000 - Each set-up produces 2,000 ordinary units
Each set-up produces 100 deluxe units - Ordinary units: $3,000/2,000 = $1.50/unit
Deluxe units: $3,000/100 = $30/unit
Material handling costs
- Cost of material handling
- Cost driver will be number of components handled (presumably)
- The number of material handling events for the year =
20 x 20,000 + 30 x 2,000 = 460,000 (from the information given above)
Cost per material handling event = $92,000/460,000 = $0.20 - Each ordinary unit takes 20 items of material Each deluxe unit takes 30 items of material
- Each ordinary unit will cost $0.2 x 20 = $4/unit Each deluxe unit will cost $0.2 x 30 = $6/unit
Other fixed overheads will have to be absorbed on a labour hour rate because there is no information provided that would allow a better approach:
$42,000/112,000 = $0.375/labour hour
The ABC approach to costing
therefore results in the figures shown in Table 3 below. Check: total
costs accounted for if all goes according to budget = 20,000 x 82.375 + 128.25
x 2,000 = $1,904,000, as before.
Table 3, Example 3
Budget
|
|
Ordinary
units
|
|
|
Deluxe
units
|
|
Units produced
|
|
20,000
|
|
|
2,000
|
|
|
|
$
|
|
|
$
|
|
Marginal costs
(as before) |
|
75.00
|
|
|
90.00
|
|
Fixed overheads:
|
|
|
|
|
|
|
Set-up
|
|
1.50
|
|
|
30.00
|
|
Material handling
|
|
4.00
|
|
|
6.00
|
|
Other
|
5 hours
at 0.375 |
1.875
|
|
6 hours
at 0.375 |
2.25
|
|
Total absorption cost/unit
|
|
82.375
|
|
|
128.25
|
|
Comparing
the Approaches
|
|
Ordinary
units |
Deluxe
units |
|
Total absorption cost/unit –
conventional approach
|
|
85.000
|
102.000
|
|
Total absorption cost/unit – ABC
approach
|
|
82.375
|
128.25
|
|
You will see that the ABC approach
substantially increases the cost of making a deluxe unit. This is primarily
because the deluxe units are made in small batches. Each batch causes an expensive
set-up, but that cost is then spread over all the units produced in that batch
– whether few (deluxe) or many (ordinary). It can only be right that the effort
and cost incurred in producing small batches is reflected in the cost per unit
produced. There would, for example, be little point in producing deluxe units
at all if their higher selling price did not justify the higher costs incurred.
In addition to estimating more
accurately the true cost of production, ABC will also give a better indication
of where cost savings can be made. Remember, the title of Paper F5 is Performance
Management, implying that accountants should be proactive in improving
performance rather than passively measuring costs. For example, it’s clear that
a substantial part of the cost of producing deluxe units is set-up costs
(almost 25% of the deluxe units’ total costs).
Working on the principle that large
cost savings are likely to be found in large cost elements, management’s
attention will start to focus on how this cost could be reduced.
For example, is there any reason why
deluxe units have to be produced in batches of only 100? A batch size of 200
units would dramatically reduce those set-up costs.
The traditional approach to fixed
overhead absorption has the merit of being simple to calculate and apply.
However, simplicity does not justify the production and use of information that
might be wrong or misleading.
ABC undoubtedly requires an
organisation to spend time and effort investigating more fully what causes it
to incur costs, and then to use that detailed information for costing purposes.
But understanding the drivers of costs must be an essential part of good
performance management.
Ken Garrett is a freelance writer and lecturer
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