Activity Based Costing – Essay 4

Topic Gateway Series Activity Based Costing Activity Based Costing Topic Gateway Series No. 1 1 Prepared by Stephanie Edwards and Technical Information Service Revised November 2008 Topic Gateway Series Activity Based Costing About Topic Gateways Topic Gateways are intended as a refresher or introduction to topics of interest to CIMA members. They include a basic definition, a brief overview and a fuller explanation of practical application. Finally they signpost some further resources for detailed understanding and research. Topic Gateways are available electronically to CIMA Members only in the CPD Centre on the CIMA website, along with a number of electronic resources. About the Technical Information Service CIMA supports its members and students with its Technical Information Service (TIS) for their work and CPD needs. Our information specialists and accounting specialists work closely together to identify or create authoritative resources to help members resolve their work related information needs. Additionally, our accounting specialists can help CIMA members and students with the interpretation of guidance on financial reporting, financial management and performance management, as defined in the CIMA Official Terminology 2005 edition. CIMA members and students should sign into My CIMA to access these services and resources. The Chartered Institute of Management Accountants 26 Chapter Street London SW1P 4NP United Kingdom T. +44 (0)20 8849 2259 F. +44 (0)20 8849 2468 E. [email  protected] com www. cimaglobal. com 2 Topic Gateway Series Activity Based Costing Activity based costing Definition and concept ‘An approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs. ’ CIMA Official Terminology, 2005 A development of the principles of activity based costing (ABC) is activity based management (ABM). Operational ABM is defined as: ‘Actions, based on activity driver analysis, that increase efficiency, lower costs and/or improve asset utilisation. CIMA Official Terminology, 2005 Strategic ABM is defined as: ‘Actions, based on activity based cost analysis, that aim to change the demand for activities so as to improve profitability. ’ CIMA Official Terminology, 2005 The main focus of this topic gateway is ABC. However, the development of ABC into ABM will be discussed further under Application. Context In the current syllabus, CIMA students will learn and may be examined on this topic in Paper P1, Management Accounting Performance Evaluation, Chapter 8, Developments in management accounting, and Paper P2, Management Accounting Decision Management, Chapter 10, Activity based approaches. Study systems for these papers are available from CIMA Publishing. Related concepts Activity based management; activity based budgeting; time driven activity based costing. Alternative approaches Traditional costing approaches. 3 Topic Gateway Series Activity Based Costing Overview The concept of ABC was first defined in the late 1980s by Robert Kaplan and William Burns. Initially ABC focused on manufacturing industry where technological developments and productivity improvements had reduced the proportion of direct labour and material costs, but increased the proportion of indirect or overhead costs. Comparison of traditional costing and ABC The traditional method of costing relied on the arbitrary addition of a proportion of overhead costs on to direct costs to attain a total product cost. The traditional approach to cost allocation relies on three basic steps. 1. Accumulate costs within a production or non-production department. 2. Allocate non-production costs to production departments. 3. Allocate the resulting production department costs to various products, services or customers. This type of costing system usually allocates costs based on a single volume measure, such as direct labour hours or machine hours. While using such a simplistic volume measure to allocate overheads as an overall cost driver, this approach seldom meets the cause-and-effect criteria desired in accurate cost allocation. This method of costing has become increasing inaccurate as the relative proportion of overhead costs has risen. This distortion of costs can result in inappropriate decision making. ABC is therefore an alternative approach to the traditional method or arbitrary allocation of overheads to product, services and customers. Stage 1. Activity cost pools Material Handling Stage 1. Activity cost pools Cost per material movement OVERHEAD COSTS Procurement Cost per purchase order Product lines Set-up Cost per set-up Figure 1. Framework of activity based costing 4 Topic Gateway Series Activity Based Costing Application In contrast to traditional cost accounting systems, ABC systems first accumulate overheads for each organisational activity. They then assign the costs of these activities to products, services or customers (referred to as cost objects) causing that activity. The initial activity analysis is clearly the most difficult aspect of ABC. Activity analysis is the process of identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service. ABC systems have the flexibility to provide special reports so that management can take decisions about the costs of designing, selling and delivering a product or service. The key aspect is that ABC focuses on accumulating costs via activities, whereas traditional cost allocation focuses on accumulating costs within functional areas. The main advantage of ABC is that it minimises or avoids distortions on product costs that might occur from arbitrary allocation of overhead costs. Steps in development of an ABC System ABC uses cost drivers to assign the costs of resources to activities and unit cost as a way of measuring an output. There are four steps to implementing ABC. 1. Identify activities The organisation needs to undertake an in-depth analysis of the operating processes of each responsibility centre. Each process might consist of one or more activities required to produce an output. 2. Assign resource costs to activities This involves tracing costs to cost objects to determine why the cost occurred. Costs can be categorised in three ways: i. Direct – costs that can be traced directly to one output. For example, the wood and paint that it takes to make a chair. Indirect – costs that cannot be allocated to an individual output, that is, they benefit two or more outputs, but not all outputs. For example, maintenance costs or storage costs. ii. 5 Topic Gateway Series Activity Based Costing iii. General/administration – costs that cannot be associated with any product or service. These costs are likely to remain unchanged, whatever output is produced. For example, salaries of administration staff, security costs or depreciation. 3. Identify outputs Identify all of the output for which an activity segment performs activities and consumes resources. Outputs might be products, services or customers. 4. Assign activity costs to outputs This is done using activity drivers. Activity drivers assign activity costs to outputs (cost objects) based on the consumption or demand for activities. ABC in practice ABC activities have been around for nearly 20 years and many companies in a variety of sectors have implemented activity based thinking. ABC and ABM have brought about radical changes in cost management systems. The principles and philosophies of activity based thinking apply equally to service companies, government agencies, process and manufacturing industries. Management practices and methods have changed over the last decade and will continue to change. Organisations have moved from managing vertically to managing horizontally. There has also been a move from a function orientation to a process orientation. However, management information systems to track and provide information about the horizontal aspects of business have lagged significantly behind managers’ needs. ABC and ABM fill this information gap by providing cost and operation information that mirrors a horizontal view. ABC focuses on accurate information about the true cost of products, services, processes, activities and customers. Using ABC, organisations gain a thorough understanding of their business processes and cost behaviour during ABC analysis. Management then applies this insight to improve decision making at operating and strategic levels. This is then known as ABM. Simply, ABM is ABC in action. 6 Topic Gateway Series Activity Based Costing Better management activity based costing survey: how ABC is used in the organisation This detailed study of how organisations are practically applying ABC can be found on the BetterManagement. com website (to access this study you must register, and then click on the link to activity based management in the top left hand corner of the home page). Available from: www. bettermanagement. om [Accessed 4 November 2008] The study was carried out in July 2005 to determine the state of ABC within over 500 organisations across numerous industries of different sizes and locations. It provides a useful and interesting insight into how ABC is used in organisations. Reported benefits †¢ †¢ ABC provides a more accurate method of costing of products and services. It allows for a better and more comprehensive understanding of overheads and what causes them to occur. It makes costly and non-value adding activities more visible, so allowing managers to focus on these areas to reduce or eliminate them. It supports other management techniques such as continuous improvement, scorecards and performance management. †¢ †¢ Reported drawbacks †¢ ABC can be difficult and time consuming to collect the data about activities and cost drivers. It can be costly to implement, run and manage an ABC system. Even in ABC some overhead costs are difficult to assign to products and customers. These costs still have to be arbitrarily applied to products and customers. †¢ †¢ Case studies Technical Matters: Activity-based costing. (PDF 99KB). This article, published in Financial Management (March 2005), provides a case study of implementation of an activity based costing system in the Crown Prosecution Service (CPS). Available from: www. cimaglobal. com/financialmanagement [Accessed 8 November 2007]. 7 Topic Gateway Series Activity Based Costing The Value Creation Group website provides a comprehensive range of examples of case studies within different sectors where ABC has been implemented, including financial services and social services. Available from: www. valuecreationgroup. com [Accessed 4 November 2008] References Barrett, R. Getting a better view of business with activity based costing. CIMA Insight, February 2005. Available from: www. cimaglobal. com/insight [Accessed 4 November 2008]. CIMA Technical Services. (2001). Activity-based management – an overview. (PDF 69KB). CIMA Technical Briefing. Available from: www. cimaglobal. com/technicalreports [Accessed 4 November 2008]. Friedman, A. L. and Lyne, S. R. (1995). Activity-based techniques: the real life consequences. London: CIMA Publishing. Further information Articles Full text from Business Source Corporate through My CIMA www. cimaglobal. om/mycima [Accessed 4 November 2008] Allott, A. Activity Based Management can work for your company. CIMA Insight, January 2004. Available from: www. cimaglobal. com/insight [Accessed 4 November 2008]. Barrett, R. How ABC can make shared services work. CIMA Insight, March 2005. Available from: www. cimaglobal. com/insight [Accessed 4 November 2008]. Barrett, R. Get a better view of business with activity-based costing. CIMA Insight, February 2005. Available from: www. cimaglobal. com/insight [Accessed 4 November 2008]. Cleland, K. As easy as CBA? Financial Management, September 2004, pp 28-32 Available from: www. imaglobal. com/financialmanagement 8 Topic Gateway Series Activity Based Costing [Accessed 4 November 2008]. Johnson, B. and Glad, E. Spring chicken or dead lunch? Chartered Accountants Journal, March 2006, Volume 85, Issue 2, pp 35-36 Kaplan, R. S. and Anderson, S. R. Time-driven activity-based costing. Harvard Business Review, November 2004, Volume 82, Issue 11, p. 131 Larson, P. and Kerr, S. Integration of process management tools to support TQM implementation: ISO 9000 and activity-based costing. Total Quality Management & Business Excellence, January-March 2007, Volume 18, Issue 1-2, pp 201-207 Leahy, T. Where are you on the ABC learning curve? Business Finance, December 2004, Volume 10, Issue 12, p. 47 Liu, L. Activity-based costing. Financial Management, March 2005, pp 25-29 Max, M. Leveraging process documentation for time-driven activity based costing. Journal of Performance Management, November 2007, Volume 20, Issue 3, pp 16-28 Meelah, R. and Ibraham, D. N. Factors influencing activity based costing (ABC) adoption in manufacturing industry. Investment Management & Financial Innovations, 2007, Volume 4, Issue 2, pp 113-124 Plowman, B. Activity based management driving profitability. Accountancy Ireland, April 2007, Volume 39, Issue 2, pp 23-25 Abstract only from Business Source Corporate through My CIMA www. cimaglobal. com/mycima [Accessed 4 November 2008] Sandison, D. , Hansen, S. C. and Torok, R. G. Activity-based planning and budgeting: a new approach. Journal of Cost Management, March/April 2003, pp 16-22 Liu, L. Activity-based costing. Financial Management, March 2005, p. 29 Available from: www. cimaglobal. com/financialmanagement [Accessed 4 November 2008]. The competitive advantage of management accounting. Journal of Management Accounting Research, 2006, Volume 18, pp 127-135 Books Friedman, A. and Lyne, S. Success and failure of activity-based techniques: a long-term perspective. London: CIMA Publishing. (CIMA Research Series) 9 Topic Gateway Series Activity Based Costing Hansen, D. and Mowen, M. (2006). Cost management: accounting and control. Mason, OH: London: Thomson/South-Western Kaplan, R. and Anderson, S. (2007). Time-driven activity-based costing: a simpler and more powerful path to higher profits. Boston, MA: Harvard Business School Turney, P. (2005). Common cents: how to succeed with activity-based costing and activity-based management. New York: London: McGraw-Hill CIMA Publications CIMA Technical Services. (2001). Activity-based management – an overview. (PDF 69KB). CIMA Technical Briefing. Available from: www. cimaglobal. com/technicalreports [Accessed 4 November 2008]. Websites University of Pittsburgh: Introduction to ABC An online presentation on ABC, by Narcyz Roztocki of Pittsburgh University. Includes links to further sources of information on ABC. Available from: http://digbig. com/4xtmc [Accessed 4 November 2008] The Activity Based Costing Portal Global community portal explaining all aspects of Activity Based Costing. Available from: www. offtech. com. au/abc/Home. asp [Accessed 23 March 2009] The Value Creation Group – Activity Based Costing Gateway site on Activity Based Costing. Available from: http://digbig. com/4xtmg [Accessed 4 November 2008] Where are you on the ABC learning curve? An article by Tad Leahy in Business Finance Magazine. Business Finance Magazine and ALG Software recently surveyed more than 250 finance executives from companies of all sizes and types about the scope and current status of their organisation’s ABC efforts. Available from: www. businessfinancemag. com [Accessed 4 November 2008] 10 Topic Gateway Series Activity Based Costing Bain and Company's 2005 Management Tools and Trends Survey. Shows that usage of ABM is slightly below the mean, but satisfaction with it is considerably below the mean. Available from: http://digbig. com/4xtmk [Accessed 4 November 2008] Copyright  ©CIMA 2006 First published in 2006 by: The Chartered Institute of Management Accountants 26 Chapter Street London SW1P 4NP United Kingdom Printed in Great Britain No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the authors or the publishers. All rights reserved. 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