Financial Decision Making (FINM036) (University of Northampton-MBA) Lecturer: Arvind Harris Aharris@mauritius - Amity.edu

Financial Decision Making (FINM036)
(University of Northampton- MBA )

Lecturer: Arvind Harris
[email protected]
Topic : Activity-Based Costing (ABC)
1
Definition of ABC
ABC is a costing technique that traces overheads to cost pools and allocates these overheads
to cost objects based on the activities that drive the cost.
The rationale for ABC

The need for a new approach such as ABC stems from increasing criticisms of traditional or
conventional management accounting practices, especially in terms of cost allocation.
Johnson and Kaplan (1987) have provided a critique of traditional management accounting
systems. Thus the lack of ‘relevance’ in traditional management accounting systems has led
to the desire for more accurate costing systems. Under the traditional system, full costing was
employed on the basis that a decision to manufacture a product is a long-term decision.
Traditional cost allocation systems therefore produce product and process costs which can be
misleading as a basis for decision making, in particular due to inappropriate methods of
overhead allocation. ABC on the other hand has the potential to provide managers with
information useful for costing purposes because the costs are more accurate.
Principles of ABC
The main aim of ABC is to develop better bases on which to track overhead costs than the
traditional, by identifying the activities which give rise to those costs. The logical chain of
cause-and-effect on which ABC is based is that products (including services) cause cost
drivers, which require activities to be performed, which consume resources, which require
spending.
Stages of implementing ABC

There are five stages in implementing ABC:
 identify activities by asking employees what work they do
 identify costs of each activity
 identify a cost driver for each activity
 calculate an indirect cost rate/activity cost driver rate
 allocate costs to jobs
ABC and cost pools

Having identified the cost drivers at each level, they can be aggregated into cost pools which
collect together the costs of all resources which share a common cost driver. One
manufacturing business who introduced an ABC system identified eight separate cost pools,
defined below by their drivers:
2
1. materials (in £)
2. labour hours
3. machine hours
4. number of set-ups
5. number of orders
6. materials handling – the number of materials movements
7. parts administration – the number of parts carried
8. general and administration
The last pool was allocated simply in proportion to the costs already allocated to each
product from the first seven pools, and so was effectively the same as an across-the-board
apportionment of a traditional system. However, since the vast majority of costs were now
grouped in the first seven pools, the amount involved was not significant. The first three
pools were different types of measures of volume, i.e. these were all unit-level. These three
bases had been used previously under the company’s traditional system, and now still
accounted for a significant proportion of all overhead costs.
Major differences between ABC and traditional overhead costing

There are three major differences between ABC and traditional overhead costing.
1. In traditional systems, one or two cost pools are used, while in ABC many cost pools
are used as there are many activity areas.
2. In ABC systems, indirect cost application bases are more likely to be cost drivers.
3. In traditional systems, indirect cost application bases are often financial, such as direct
labour costs or direct material costs, while in ABC they are often non-financial, such
as number of parts, hours of test time, etc.
Benefits of ABC
There are three main benefits of ABC.
1. It increases the number of cost pools used to accumulate overhead costs. Rather than
accumulate all overhead costs in a single company-wide pool (or in departments),
costs are accumulated by activity.
2. It changes the bases used to assign overhead cost to products. Rather than assigning
costs on the basis of a measure of volume (such as direct labour-hours or machine-
hours), costs are assigned on the basis of the activities that generate the costs.
3. It changes the nature of many overhead costs. Costs that were formerly in direct
(depreciation, power, inspection) are traced to specific activities.
3
The process of calculating ABC cost
Activity-based costing is a two-stage costing method, since there are two levels of overhead
cost allocation involved.
1. In the first stage, costs are assigned to activity centres where they are accumulated
while waiting to be applied to products. These first stage costs are either traceable
directly to the activity centres or they are costs that arise from some resource that is
shared by two or more activity centres.
2. The second stage of the two-stage costing process involves assigning costs from the
activity centres to products. This is accomplished through the selection and use of
second stage cost drivers.
Interactive Question Task 5.1
A. Calculate the cost of each product under the conventional or traditional product
costing system.
B. Calculate the cost of each product using activity-based costing (ABC).
C. Explain how the use of the ABC system offer a better understanding of the costs
allocated to each product.
Question 1.
4
The wage costs which are incurred in converting materials into finished goods would be
known as:
a. Salaries
b. Indirect labour
c. Wages & salaries
d. Direct labour
Question 2.
Allocating indirect overheads to the direct cost of production is known as:
a. Activity based costing
b. Marginal costing
c. Contribution costing
d. Absorption costing
Question 3.
Which of the following is a reason why a firm would want to implement ABC?
a. The precision of ABC may be to small to justify its implementation
b. Costs of implementation are too high
c. It may help make decision making more accurate
d. The firm only produces a single product
Question 4.
When costing takes into account only the variable cost and not the full production cost we
will be using:
a. Activity based costing
b. Full costing
c. Absorption costing
d. Marginal costing
Question 5.
Marking up the cost of a product by an amount to represent profit is known as:
a. Full cost pricing
b. Predatory pricing
c. Price discrimination
d. Price skimming
Question 6.
5
An area of a business which collects costs is known as:
a. Cost unit
b. Branch
c. Profit centre
d. Cost centre
Question 7.
Repairs to factory machinery would be classed as:
a. Direct materials
b. Factory indirect expenses
c. Administration expenses
d. Direct expenses
Question 8.
Contribution can be defined as:
a. Sales revenue less fixed costs
b. Fixed costs less variable costs
c. Selling price less total costs
d. Selling price less variable costs
Question 10.
A collection of individual costs within a single heading is known as:
a. Cost total
b. Overhead centre
c. Cost centre
d. Cost pool

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Financial Decision Making (FINM036) (University of Northampton-MBA) Lecturer: Arvind Harris Aharris@mauritius - Amity.edu

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Financial Decision Making (FINM036)

(University of Northampton- MBA )

Topic : Activity-Based Costing (ABC)

The rationale for ABC

Stages of implementing ABC

ABC and cost pools

Major differences between ABC and traditional overhead costing

Interactive Question Task 5.1

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