The ABC of overhead allocation
| by Dan King 03 Nov 2000 Diploma in Financial Management Relevant to All Papers |
|
During the 1980s criticisms of management accounting techniques were beginning to emerge. One of the main criticisms of management accounting was that the techniques used to allocate overheads to products/services were producing inaccurate information. Techniques that were suitable to the allocation of overheads in the 1920s were not suitable to the advanced manufacturing techniques being used in the 1980s and 1990s.
This article focuses on one of the techniques that emerged from the dissatisfaction with the traditional techniques - Activity Based Costing (ABC). It will first compare the two methods of overhead allocation and go on to illustrate the comparison using a detailed worked example.
Comparison of a Traditional and an Activity Based Costing
System
Most companies allocate overheads to products using a two stage
procedure. In the first stage overheads are assigned to cost centres,
while the second stage allocates the costs accumulated in the
cost centre to products.
Traditional cost systems focus on the product in the costing process. Costs are traced to the product because each product item is assumed to consume the resources. Therefore traditional allocation bases measure only attributes of the individual product item. For example these would be the number of direct labour hours or machine hours or value of materials consumed. However, in many modern-manufacturing operations, overheads are not homogeneous in terms of being primarily influenced by volume. Indeed it could be argued that the majority of overheads in a modern manufacturing operation are largely unaffected by changes in production volume. A study by Miller and Vollman (1985), categorises overheads into four groups which cover functions such as purchasing and materials movements, set up and scheduling, quality control and tracking and monitoring of production.
Therefore it can be concluded from this study that many of the more significant production overheads can be viewed as resulting from specific transactions or activities which are relatively independent of production volume. It is the volume of the above activities, and not the volume of production volume, which consumes resources and determines the level of overhead cost. The logical conclusion to the above is that if products are to be costed in a manner that reflects their actual consumption of resources then their share of overheads must be absorbed by them on the basis of the activities. However traditional cost systems focus on the product. Costs are traced to the product because each product item is assumed to consume the resources. Alternatively if products are to be costed in a manner, which reflects their actual consumption of resources, then their share of overheads must be absorbed by them on the basis of activities.
In Activity Based Costing, activities are the focus of the costing process. Costs are traced from activities to products based on the products demands for these activities during the production process. The allocation bases used in activity-based costing are thus measures of the activities performed. These might include such activities as set-up time or number of times handled.
 |
Not only is the nature of allocation base used by activity-based costing different but the number of allocation bases used to trace costs in the second stage is also different. Where a traditional system may use up to three second stage allocation bases (direct labour hours, machine hours and value materials used are the most common) an activity-based system makes use of many bases including such bases as set-ups, items ordered, number of times moved, amongst others.
Summary
As we can see from the above discussion activity based systems,
like traditional systems, are two stage systems. Firstly overheads
are charged to activity based cost pools. Secondly, a series of
cost driver based rates are devised to attach the pooled costs
to product lines. The design and operation of an activity-based
system is therefore dependent on three key factors: the choice
of the cost pools; the selection of the means of distributing
overhead cost to the cost pools; and the choice of cost driver
for each cost pool.
We will now examine a worked example to illustrate firstly how overheads are allocated using a traditional approach and then demonstrating the ABC approach to overhead allocation.
An Illustration of Traditional and Activity-based Costing
Systems
Figure 2 illustrates how an activity-based cost system can generate
unit cost information which is substantially different from, and
more accurate than that produced by a traditional costing system.
Figure 2 provides details of the costs, volumes and transaction cost drivers for a cost centre and the appropriate service departments, for a particular period in respect of a hypothetical company called Hopscotch Ltd. Hopscotch Ltd is a company with a single cost centre producing two products, Alpha and Beta.
| FIGURE 2 |
| Product Alpha | Product Beta | |
| Production and sales | 30,000 | 8,000 |
| Unit material cost (£) | 28 | 20 |
| Labour hours (unit) | 2 | 2 |
| Machine hours per unit | 1 | 3 |
| Labour cost (£) per unit | 14 | 7 |
| Number of set-ups | 4 | 20 |
| Number of receipts | 12 | 100 |
| Number of despatches | 36 | 80 |
The total overhead of £1.5m can be divided into cost pools as illustrated in figure 3
| FIGURE 3 |
| Overhead costs | £ |
| Machine | 900,000 |
| Set-up | 100,000 |
| Inspection | 300,000 |
| Packaging | 200,000 |
| 1,500,000 |
Traditional Overhead Absorption System
Let us assume for the sake of this illustration that Hopscotch
Ltd absorbs overheads using Direct Labour Hours (DLH). We can
see from the information above that one unit of Alpha uses the
same amount of DLH as one unit of Beta. If DLH are used as the
base for allocating overheads then the same amount of overhead
will be charged to one unit of Alpha as to one unit of Beta. The
calculations would be as follows:
Direct Labour Hour Rate
= £1,500,000 / 76,000
= £19.74 per DLH
Using this method the cost of a unit of Alpha and a unit of Beta are calculated in figure 4.
| FIGURE 4 |
| Costs | Apha (£) | Beta (£) |
| Materials | 28.00 | 20.00 |
| Labour | 14.00 | 7.00 |
| Overheads | 39.48 | 39.48 |
| 81.48 | 66.48 |
As this illustration shows an amount of £39.48 is charged to each unit of Alpha and to each unit of Beta. However as Alpha is a high volume product it could be argued that the resources consumed by a single unit of Alpha are less than the resources consumed by a single unit of Beta. In other words the traditional system, using direct labour hours as a base, is over costing each unit of Alpha and under costing each unit of Beta. To get a better idea of the resources consumed in the manufacture of individual units of Alpha and Beta, and a more accurate idea of the resources consumed the overheads will now be absorbed using an activity based costing system. Appropriate cost drivers will be selected and then these cost drivers will be used to allocate the costs from the cost pools to the individual products.
Activity Based Costing System
If we repeat the above exercise, but instead of using DLH as the
base for allocating overheads we divide the overhead into appropriate
cost pools and for each cost pool select an appropriate cost driver.
For the purpose of this illustration the appropriate cost pools
and cost drivers and cost driver rates are as illustrated in figure
5.
| FIGURE 5 |
| Overhead per Unit | Overhead per Unit | ||
| Overhead | Cost Driver | Alpha (£) | Beta (£) |
| Machine | Machine hours | 16.67 | 50.01 |
| Set-up | Number of set-ups | 0.56 | 10.42 |
| Inspection | Number of receipts | 1.07 | 33.48 |
| Packing | Number of despatched | 2.69 | 17.24 |
| Total | 20.99 | 111.15 |
This shows that the overhead that should be allocated to one unit of Alpha using an activity based costing system is £20.99 and that £111.15 should be allocated to a unit of Beta. The total costs for a unit of Alpha and a unit of Beta are shown in figure 6.
| FIGURE 6 |
| Costs | Alpha (£) | Beta (£) |
| Materials | 28.00 | 20.00 |
| Labour | 14.00 | 7.00 |
| Overheads | 20.99 | 111.15 |
| 62.99 | 138.15 |
A comparison of the traditional system with the activity based costing system indicates that the traditional system is over costing each unit of Alpha by £18.49 and under costing each unit of Beta by £71.67 as shown in the figure 7.
| FIGURE 7 |
| Alpha (£) | Beta (£) | |
| Traditional Costing | 81.48 | 66.48 |
| Activity Based Costing | 62.99 | 138.15 |
| Difference | 18.49 | -71.67 |
Summary
Activity based costing gives a better indication of the resources
consumed in the production of a product and therefore a better
indication of the costs incurred. The above exercise shows that
there are severe limitations in an traditional costing system
which can have consequences, not only for stock valuations, but
also for pricing and marketing decisions, product line decisions
and strategic decisions affecting the long term viability of the
firm.
In the selection of cost drivers it is often the case that there is a trade off between the cost of the activity based system and the accuracy required. In many cases it is possible to combine cost pools and therefore reduce the number of cost drivers without a significant loss in the accuracy of the information generated. In other cases good estimates, which may lack somewhat in precision, may be acceptable to the users of the information.
The Origins and Development of ABC
During the late 1980s, criticisms of management accounting
practices were widely publicised in the professional and academic
literature. In 1987 Johnson and Kaplan's book entitled Relevance
Lost: The Rise and Fall of Management Accounting, was published.
The principle criticism of management accounting at that time
is summarised by Drury (1996) as follows:
- Conventional management accounting does not meet the needs of today's manufacturing and competitive environment.
- Traditional product costing systems provide misleading information for decision-making purposes.
- Management accounting practices follow, and have become subservient to, financial accounting requirements.
- Management accounting focuses almost entirely on internal activities, and relatively little attention is given to the external environment in which the business operates.
As a result of these and other criticisms of management accounting practice, the Chartered Institute of Management Accountants commissioned an investigation to review the current state of development of management accounting and the various claims being made about it. The findings of this investigation were published by Bromwich and Bhimani (1989) in a report titled Management Accounting: Evolution not Revolution. In the mid 1990s Bromwich and Bhimani (1994) updated their first report with a second report titled Management Accounting: Pathway to Progress. In this report they reviewed the literature and research in the intervening years and focused on the wider array of opportunities now facing the management accountant. The report concluded that in the UK no one school of opinion yet dominates views on the nature of reforms which might be appropriate for management accounting. The case for wholesale reform has not been accepted in practice. However, the report does recommend a number of approaches and practices which seem to provide practical promise in helping management accountants respond to the challenges of the 1990s. One of the contemporary issues discussed by Bromwich and Bhimani (1994) was Activity Based Costing.
It would seem to be apparent from the level of interest that practitioners have shown in ABC that many of them are dissatisfied with traditional costing systems. Articles on ABC only began to appear in 1988 but a survey by Innes and Mitchell (1995) reported that 20% of the responding organisations had implemented ABC. A further 27% of the respondents were considering adopting ABC.
Even though ABC systems seem to be superior to traditional costing systems in terms of accuracy of cost measurement they can be costly to implement and operate. However, ABC has attracted a considerable amount of interest because it provides not only a basis for calculating more accurate product costs, but also a mechanism for managing costs. Drury (1996) suggests that it is in the area of cost management and cost control where ABC is likely to have its greatest impact. A survey by Innes and Mitchell (1995) reported that the cost reduction and cost management implications outweigh the product costing applications amongst ABC users. Thus, many organisations apparently establish activity cost pools and cost drivers for cost management purposes but do not use the ABC system to assign costs to products.
| Bibliography Bromwich, M. and Bhimani, A., (1989). Management Accounting: Evolution not revolution, Chartered Institute of Management Accountants Bromwich, M. and Bhimani, A., (1994). Management Accounting: Pathway to Progress, Chartered Institute of Management Accountants Drury, C., (1996). Management and Cost Accounting, 4th edn., London: Thompson Innes, J. and Mitchell, F., (1995). A survey of activity-based costing in the UK’s largest companies, Management Accounting Research, 6(2) Johnson, H.T. and Kaplan, R.S., (1987). Relevance Lost: The Rise and Fall of Management Accounting, Harvard Business School Press Millar, J.G. and Vollman, T.E., ‘The Hidden Factory’, (1985). Harvard Business Review, September/October, pp. 142-150 |
During the 1980s criticisms of management accounting techniques were beginning to emerge. One of the main criticisms of management accounting was that the techniques used to allocate overheads to products/services were producing inaccurate information. Techniques that were suitable to the allocation of overheads in the 1920s were not suitable to the advanced manufacturing techniques being used in the 1980s and 1990s.
This article focuses on one of the techniques that emerged from the dissatisfaction with the traditional techniques - Activity Based Costing (ABC). It will first compare the two methods of overhead allocation and go on to illustrate the comparison using a detailed worked example.
Comparison of a Traditional and an Activity Based Costing
System
Most companies allocate overheads to products using a two stage
procedure. In the first stage overheads are assigned to cost centres,
while the second stage allocates the costs accumulated in the
cost centre to products.
Traditional cost systems focus on the product in the costing process. Costs are traced to the product because each product item is assumed to consume the resources. Therefore traditional allocation bases measure only attributes of the individual product item. For example these would be the number of direct labour hours or machine hours or value of materials consumed. However, in many modern-manufacturing operations, overheads are not homogeneous in terms of being primarily influenced by volume. Indeed it could be argued that the majority of overheads in a modern manufacturing operation are largely unaffected by changes in production volume. A study by Miller and Vollman (1985), categorises overheads into four groups which cover functions such as purchasing and materials movements, set up and scheduling, quality control and tracking and monitoring of production.
Therefore it can be concluded from this study that many of the more significant production overheads can be viewed as resulting from specific transactions or activities which are relatively independent of production volume. It is the volume of the above activities, and not the volume of production volume, which consumes resources and determines the level of overhead cost. The logical conclusion to the above is that if products are to be costed in a manner that reflects their actual consumption of resources then their share of overheads must be absorbed by them on the basis of the activities. However traditional cost systems focus on the product. Costs are traced to the product because each product item is assumed to consume the resources. Alternatively if products are to be costed in a manner, which reflects their actual consumption of resources, then their share of overheads must be absorbed by them on the basis of activities.
In Activity Based Costing, activities are the focus of the costing process. Costs are traced from activities to products based on the products demands for these activities during the production process. The allocation bases used in activity-based costing are thus measures of the activities performed. These might include such activities as set-up time or number of times handled.
|
|
Not only is the nature of allocation base used by activity-based costing different but the number of allocation bases used to trace costs in the second stage is also different. Where a traditional system may use up to three second stage allocation bases (direct labour hours, machine hours and value materials used are the most common) an activity-based system makes use of many bases including such bases as set-ups, items ordered, number of times moved, amongst others.
Summary
As we can see from the above discussion activity based systems,
like traditional systems, are two stage systems. Firstly overheads
are charged to activity based cost pools. Secondly, a series of
cost driver based rates are devised to attach the pooled costs
to product lines. The design and operation of an activity-based
system is therefore dependent on three key factors: the choice
of the cost pools; the selection of the means of distributing
overhead cost to the cost pools; and the choice of cost driver
for each cost pool.
We will now examine a worked example to illustrate firstly how overheads are allocated using a traditional approach and then demonstrating the ABC approach to overhead allocation.
An Illustration of Traditional and Activity-based Costing
Systems
Figure 2 illustrates how an activity-based cost system can generate
unit cost information which is substantially different from, and
more accurate than that produced by a traditional costing system.
Figure 2 provides details of the costs, volumes and transaction cost drivers for a cost centre and the appropriate service departments, for a particular period in respect of a hypothetical company called Hopscotch Ltd. Hopscotch Ltd is a company with a single cost centre producing two products, Alpha and Beta.
| FIGURE 2 |
| Product Alpha | Product Beta | |
| Production and sales | 30,000 | 8,000 |
| Unit material cost (£) | 28 | 20 |
| Labour hours (unit) | 2 | 2 |
| Machine hours per unit | 1 | 3 |
| Labour cost (£) per unit | 14 | 7 |
| Number of set-ups | 4 | 20 |
| Number of receipts | 12 | 100 |
| Number of despatches | 36 | 80 |
The total overhead of £1.5m can be divided into cost pools as illustrated in figure 3
| FIGURE 3 |
| Overhead costs | £ |
| Machine | 900,000 |
| Set-up | 100,000 |
| Inspection | 300,000 |
| Packaging | 200,000 |
| 1,500,000 |
Traditional Overhead Absorption System
Let us assume for the sake of this illustration that Hopscotch
Ltd absorbs overheads using Direct Labour Hours (DLH). We can
see from the information above that one unit of Alpha uses the
same amount of DLH as one unit of Beta. If DLH are used as the
base for allocating overheads then the same amount of overhead
will be charged to one unit of Alpha as to one unit of Beta. The
calculations would be as follows:
Direct Labour Hour Rate
= £1,500,000 / 76,000
= £19.74 per DLH
Using this method the cost of a unit of Alpha and a unit of Beta are calculated in figure 4.
| FIGURE 4 |
| Costs | Apha (£) | Beta (£) |
| Materials | 28.00 | 20.00 |
| Labour | 14.00 | 7.00 |
| Overheads | 39.48 | 39.48 |
| 81.48 | 66.48 |
As this illustration shows an amount of £39.48 is charged to each unit of Alpha and to each unit of Beta. However as Alpha is a high volume product it could be argued that the resources consumed by a single unit of Alpha are less than the resources consumed by a single unit of Beta. In other words the traditional system, using direct labour hours as a base, is over costing each unit of Alpha and under costing each unit of Beta. To get a better idea of the resources consumed in the manufacture of individual units of Alpha and Beta, and a more accurate idea of the resources consumed the overheads will now be absorbed using an activity based costing system. Appropriate cost drivers will be selected and then these cost drivers will be used to allocate the costs from the cost pools to the individual products.
Activity Based Costing System
If we repeat the above exercise, but instead of using DLH as the
base for allocating overheads we divide the overhead into appropriate
cost pools and for each cost pool select an appropriate cost driver.
For the purpose of this illustration the appropriate cost pools
and cost drivers and cost driver rates are as illustrated in figure
5.
| FIGURE 5 |
| Overhead per Unit | Overhead per Unit | ||
| Overhead | Cost Driver | Alpha (£) | Beta (£) |
| Machine | Machine hours | 16.67 | 50.01 |
| Set-up | Number of set-ups | 0.56 | 10.42 |
| Inspection | Number of receipts | 1.07 | 33.48 |
| Packing | Number of despatched | 2.69 | 17.24 |
| Total | 20.99 | 111.15 |
This shows that the overhead that should be allocated to one unit of Alpha using an activity based costing system is £20.99 and that £111.15 should be allocated to a unit of Beta. The total costs for a unit of Alpha and a unit of Beta are shown in figure 6.
| FIGURE 6 |
| Costs | Alpha (£) | Beta (£) |
| Materials | 28.00 | 20.00 |
| Labour | 14.00 | 7.00 |
| Overheads | 20.99 | 111.15 |
| 62.99 | 138.15 |
A comparison of the traditional system with the activity based costing system indicates that the traditional system is over costing each unit of Alpha by £18.49 and under costing each unit of Beta by £71.67 as shown in the figure 7.
| FIGURE 7 |
| Alpha (£) | Beta (£) | |
| Traditional Costing | 81.48 | 66.48 |
| Activity Based Costing | 62.99 | 138.15 |
| Difference | 18.49 | -71.67 |
Summary
Activity based costing gives a better indication of the resources
consumed in the production of a product and therefore a better
indication of the costs incurred. The above exercise shows that
there are severe limitations in an traditional costing system
which can have consequences, not only for stock valuations, but
also for pricing and marketing decisions, product line decisions
and strategic decisions affecting the long term viability of the
firm.
In the selection of cost drivers it is often the case that there is a trade off between the cost of the activity based system and the accuracy required. In many cases it is possible to combine cost pools and therefore reduce the number of cost drivers without a significant loss in the accuracy of the information generated. In other cases good estimates, which may lack somewhat in precision, may be acceptable to the users of the information.
The Origins and Development of ABC
During the late 1980s, criticisms of management accounting
practices were widely publicised in the professional and academic
literature. In 1987 Johnson and Kaplan's book entitled Relevance
Lost: The Rise and Fall of Management Accounting, was published.
The principle criticism of management accounting at that time
is summarised by Drury (1996) as follows:
- Conventional management accounting does not meet the needs of today's manufacturing and competitive environment.
- Traditional product costing systems provide misleading information for decision-making purposes.
- Management accounting practices follow, and have become subservient to, financial accounting requirements.
- Management accounting focuses almost entirely on internal activities, and relatively little attention is given to the external environment in which the business operates.
As a result of these and other criticisms of management accounting practice, the Chartered Institute of Management Accountants commissioned an investigation to review the current state of development of management accounting and the various claims being made about it. The findings of this investigation were published by Bromwich and Bhimani (1989) in a report titled Management Accounting: Evolution not Revolution. In the mid 1990s Bromwich and Bhimani (1994) updated their first report with a second report titled Management Accounting: Pathway to Progress. In this report they reviewed the literature and research in the intervening years and focused on the wider array of opportunities now facing the management accountant. The report concluded that in the UK no one school of opinion yet dominates views on the nature of reforms which might be appropriate for management accounting. The case for wholesale reform has not been accepted in practice. However, the report does recommend a number of approaches and practices which seem to provide practical promise in helping management accountants respond to the challenges of the 1990s. One of the contemporary issues discussed by Bromwich and Bhimani (1994) was Activity Based Costing.
It would seem to be apparent from the level of interest that practitioners have shown in ABC that many of them are dissatisfied with traditional costing systems. Articles on ABC only began to appear in 1988 but a survey by Innes and Mitchell (1995) reported that 20% of the responding organisations had implemented ABC. A further 27% of the respondents were considering adopting ABC.
Even though ABC systems seem to be superior to traditional costing systems in terms of accuracy of cost measurement they can be costly to implement and operate. However, ABC has attracted a considerable amount of interest because it provides not only a basis for calculating more accurate product costs, but also a mechanism for managing costs. Drury (1996) suggests that it is in the area of cost management and cost control where ABC is likely to have its greatest impact. A survey by Innes and Mitchell (1995) reported that the cost reduction and cost management implications outweigh the product costing applications amongst ABC users. Thus, many organisations apparently establish activity cost pools and cost drivers for cost management purposes but do not use the ABC system to assign costs to products.
| Bibliography Bromwich, M. and Bhimani, A., (1989). Management Accounting: Evolution not revolution, Chartered Institute of Management Accountants Bromwich, M. and Bhimani, A., (1994). Management Accounting: Pathway to Progress, Chartered Institute of Management Accountants Drury, C., (1996). Management and Cost Accounting, 4th edn., London: Thompson Innes, J. and Mitchell, F., (1995). A survey of activity-based costing in the UK’s largest companies, Management Accounting Research, 6(2) Johnson, H.T. and Kaplan, R.S., (1987). Relevance Lost: The Rise and Fall of Management Accounting, Harvard Business School Press Millar, J.G. and Vollman, T.E., ‘The Hidden Factory’, (1985). Harvard Business Review, September/October, pp. 142-150 |
During the 1980s criticisms of management accounting techniques were beginning to emerge. One of the main criticisms of management accounting was that the techniques used to allocate overheads to products/services were producing inaccurate information. Techniques that were suitable to the allocation of overheads in the 1920s were not suitable to the advanced manufacturing techniques being used in the 1980s and 1990s.
This article focuses on one of the techniques that emerged from the dissatisfaction with the traditional techniques - Activity Based Costing (ABC). It will first compare the two methods of overhead allocation and go on to illustrate the comparison using a detailed worked example.
Comparison of a Traditional and an Activity Based Costing
System
Most companies allocate overheads to products using a two stage
procedure. In the first stage overheads are assigned to cost centres,
while the second stage allocates the costs accumulated in the
cost centre to products.
Traditional cost systems focus on the product in the costing process. Costs are traced to the product because each product item is assumed to consume the resources. Therefore traditional allocation bases measure only attributes of the individual product item. For example these would be the number of direct labour hours or machine hours or value of materials consumed. However, in many modern-manufacturing operations, overheads are not homogeneous in terms of being primarily influenced by volume. Indeed it could be argued that the majority of overheads in a modern manufacturing operation are largely unaffected by changes in production volume. A study by Miller and Vollman (1985), categorises overheads into four groups which cover functions such as purchasing and materials movements, set up and scheduling, quality control and tracking and monitoring of production.
Therefore it can be concluded from this study that many of the more significant production overheads can be viewed as resulting from specific transactions or activities which are relatively independent of production volume. It is the volume of the above activities, and not the volume of production volume, which consumes resources and determines the level of overhead cost. The logical conclusion to the above is that if products are to be costed in a manner that reflects their actual consumption of resources then their share of overheads must be absorbed by them on the basis of the activities. However traditional cost systems focus on the product. Costs are traced to the product because each product item is assumed to consume the resources. Alternatively if products are to be costed in a manner, which reflects their actual consumption of resources, then their share of overheads must be absorbed by them on the basis of activities.
In Activity Based Costing, activities are the focus of the costing process. Costs are traced from activities to products based on the products demands for these activities during the production process. The allocation bases used in activity-based costing are thus measures of the activities performed. These might include such activities as set-up time or number of times handled.
|
|
Not only is the nature of allocation base used by activity-based costing different but the number of allocation bases used to trace costs in the second stage is also different. Where a traditional system may use up to three second stage allocation bases (direct labour hours, machine hours and value materials used are the most common) an activity-based system makes use of many bases including such bases as set-ups, items ordered, number of times moved, amongst others.
Summary
As we can see from the above discussion activity based systems,
like traditional systems, are two stage systems. Firstly overheads
are charged to activity based cost pools. Secondly, a series of
cost driver based rates are devised to attach the pooled costs
to product lines. The design and operation of an activity-based
system is therefore dependent on three key factors: the choice
of the cost pools; the selection of the means of distributing
overhead cost to the cost pools; and the choice of cost driver
for each cost pool.
We will now examine a worked example to illustrate firstly how overheads are allocated using a traditional approach and then demonstrating the ABC approach to overhead allocation.
An Illustration of Traditional and Activity-based Costing
Systems
Figure 2 illustrates how an activity-based cost system can generate
unit cost information which is substantially different from, and
more accurate than that produced by a traditional costing system.
Figure 2 provides details of the costs, volumes and transaction cost drivers for a cost centre and the appropriate service departments, for a particular period in respect of a hypothetical company called Hopscotch Ltd. Hopscotch Ltd is a company with a single cost centre producing two products, Alpha and Beta.
| FIGURE 2 |
| Product Alpha | Product Beta | |
| Production and sales | 30,000 | 8,000 |
| Unit material cost (£) | 28 | 20 |
| Labour hours (unit) | 2 | 2 |
| Machine hours per unit | 1 | 3 |
| Labour cost (£) per unit | 14 | 7 |
| Number of set-ups | 4 | 20 |
| Number of receipts | 12 | 100 |
| Number of despatches | 36 | 80 |
The total overhead of £1.5m can be divided into cost pools as illustrated in figure 3
| FIGURE 3 |
| Overhead costs | £ |
| Machine | 900,000 |
| Set-up | 100,000 |
| Inspection | 300,000 |
| Packaging | 200,000 |
| 1,500,000 |
Traditional Overhead Absorption System
Let us assume for the sake of this illustration that Hopscotch
Ltd absorbs overheads using Direct Labour Hours (DLH). We can
see from the information above that one unit of Alpha uses the
same amount of DLH as one unit of Beta. If DLH are used as the
base for allocating overheads then the same amount of overhead
will be charged to one unit of Alpha as to one unit of Beta. The
calculations would be as follows:
Direct Labour Hour Rate
= £1,500,000 / 76,000
= £19.74 per DLH
Using this method the cost of a unit of Alpha and a unit of Beta are calculated in figure 4.
| FIGURE 4 |
| Costs | Apha (£) | Beta (£) |
| Materials | 28.00 | 20.00 |
| Labour | 14.00 | 7.00 |
| Overheads | 39.48 | 39.48 |
| 81.48 | 66.48 |
As this illustration shows an amount of £39.48 is charged to each unit of Alpha and to each unit of Beta. However as Alpha is a high volume product it could be argued that the resources consumed by a single unit of Alpha are less than the resources consumed by a single unit of Beta. In other words the traditional system, using direct labour hours as a base, is over costing each unit of Alpha and under costing each unit of Beta. To get a better idea of the resources consumed in the manufacture of individual units of Alpha and Beta, and a more accurate idea of the resources consumed the overheads will now be absorbed using an activity based costing system. Appropriate cost drivers will be selected and then these cost drivers will be used to allocate the costs from the cost pools to the individual products.
Activity Based Costing System
If we repeat the above exercise, but instead of using DLH as the
base for allocating overheads we divide the overhead into appropriate
cost pools and for each cost pool select an appropriate cost driver.
For the purpose of this illustration the appropriate cost pools
and cost drivers and cost driver rates are as illustrated in figure
5.
| FIGURE 5 |
| Overhead per Unit | Overhead per Unit | ||
| Overhead | Cost Driver | Alpha (£) | Beta (£) |
| Machine | Machine hours | 16.67 | 50.01 |
| Set-up | Number of set-ups | 0.56 | 10.42 |
| Inspection | Number of receipts | 1.07 | 33.48 |
| Packing | Number of despatched | 2.69 | 17.24 |
| Total | 20.99 | 111.15 |
This shows that the overhead that should be allocated to one unit of Alpha using an activity based costing system is £20.99 and that £111.15 should be allocated to a unit of Beta. The total costs for a unit of Alpha and a unit of Beta are shown in figure 6.
| FIGURE 6 |
| Costs | Alpha (£) | Beta (£) |
| Materials | 28.00 | 20.00 |
| Labour | 14.00 | 7.00 |
| Overheads | 20.99 | 111.15 |
| 62.99 | 138.15 |
A comparison of the traditional system with the activity based costing system indicates that the traditional system is over costing each unit of Alpha by £18.49 and under costing each unit of Beta by £71.67 as shown in the figure 7.
| FIGURE 7 |
| Alpha (£) | Beta (£) | |
| Traditional Costing | 81.48 | 66.48 |
| Activity Based Costing | 62.99 | 138.15 |
| Difference | 18.49 | -71.67 |
Summary
Activity based costing gives a better indication of the resources
consumed in the production of a product and therefore a better
indication of the costs incurred. The above exercise shows that
there are severe limitations in an traditional costing system
which can have consequences, not only for stock valuations, but
also for pricing and marketing decisions, product line decisions
and strategic decisions affecting the long term viability of the
firm.
In the selection of cost drivers it is often the case that there is a trade off between the cost of the activity based system and the accuracy required. In many cases it is possible to combine cost pools and therefore reduce the number of cost drivers without a significant loss in the accuracy of the information generated. In other cases good estimates, which may lack somewhat in precision, may be acceptable to the users of the information.
The Origins and Development of ABC
During the late 1980s, criticisms of management accounting
practices were widely publicised in the professional and academic
literature. In 1987 Johnson and Kaplan's book entitled Relevance
Lost: The Rise and Fall of Management Accounting, was published.
The principle criticism of management accounting at that time
is summarised by Drury (1996) as follows:
- Conventional management accounting does not meet the needs of today's manufacturing and competitive environment.
- Traditional product costing systems provide misleading information for decision-making purposes.
- Management accounting practices follow, and have become subservient to, financial accounting requirements.
- Management accounting focuses almost entirely on internal activities, and relatively little attention is given to the external environment in which the business operates.
As a result of these and other criticisms of management accounting practice, the Chartered Institute of Management Accountants commissioned an investigation to review the current state of development of management accounting and the various claims being made about it. The findings of this investigation were published by Bromwich and Bhimani (1989) in a report titled Management Accounting: Evolution not Revolution. In the mid 1990s Bromwich and Bhimani (1994) updated their first report with a second report titled Management Accounting: Pathway to Progress. In this report they reviewed the literature and research in the intervening years and focused on the wider array of opportunities now facing the management accountant. The report concluded that in the UK no one school of opinion yet dominates views on the nature of reforms which might be appropriate for management accounting. The case for wholesale reform has not been accepted in practice. However, the report does recommend a number of approaches and practices which seem to provide practical promise in helping management accountants respond to the challenges of the 1990s. One of the contemporary issues discussed by Bromwich and Bhimani (1994) was Activity Based Costing.
It would seem to be apparent from the level of interest that practitioners have shown in ABC that many of them are dissatisfied with traditional costing systems. Articles on ABC only began to appear in 1988 but a survey by Innes and Mitchell (1995) reported that 20% of the responding organisations had implemented ABC. A further 27% of the respondents were considering adopting ABC.
Even though ABC systems seem to be superior to traditional costing systems in terms of accuracy of cost measurement they can be costly to implement and operate. However, ABC has attracted a considerable amount of interest because it provides not only a basis for calculating more accurate product costs, but also a mechanism for managing costs. Drury (1996) suggests that it is in the area of cost management and cost control where ABC is likely to have its greatest impact. A survey by Innes and Mitchell (1995) reported that the cost reduction and cost management implications outweigh the product costing applications amongst ABC users. Thus, many organisations apparently establish activity cost pools and cost drivers for cost management purposes but do not use the ABC system to assign costs to products.
| Bibliography Bromwich, M. and Bhimani, A., (1989). Management Accounting: Evolution not revolution, Chartered Institute of Management Accountants Bromwich, M. and Bhimani, A., (1994). Management Accounting: Pathway to Progress, Chartered Institute of Management Accountants Drury, C., (1996). Management and Cost Accounting, 4th edn., London: Thompson Innes, J. and Mitchell, F., (1995). A survey of activity-based costing in the UK’s largest companies, Management Accounting Research, 6(2) Johnson, H.T. and Kaplan, R.S., (1987). Relevance Lost: The Rise and Fall of Management Accounting, Harvard Business School Press Millar, J.G. and Vollman, T.E., ‘The Hidden Factory’, (1985). Harvard Business Review, September/October, pp. 142-150 |