ICB Management
Accounting and
Control Systems
(MACS)
Module 1 to 11
Prepared by: Adèle Hassall
, THEORY
SECTION
Prepared by: Adèle Hassall
, CHAPTER 1
ACTIVITY-BASED COSTING (ABC)
ABC
o is a cost model used to assign manufacturing overheads to different products produced by a
manufacturing entity based on the premise that products consume activities, and activities
consume resources, which incur costs. Costs of activities should be assigned to cost objects
on the basis of the activities they consume
o assists in reducing product cost distortion by creating a cost pool (costs accumulated by
activities) for activities that can be identified as cost drivers and assigning overheads to
products based on the actual number of separate activities they require for completion
o reduced cost distortion and more precise product cost estimation, can give a organisation a
better understanding of product cost and profitability by:
identifying inefficient and unnecessary costs and activities
identifying profitable products and activities to allocate more resources to them
facilitating improved product control and pricing
identifying and eliminating products that are unprofitable
Traditional costing systems and ABC
Total manufacturing costs (product costs) > Direct costs (direct materials and direct labour) and
indirect costs (overheads)
Differences:
Indirect costs – how overhead costs are allocated to each product
Direct costs – same for both traditional and ABC
Traditional systems ABC
Allocated overheads to both production and Allocate overheads to each major activity and
service dept and reallocates dept costs to not dept’s
production dept
Support centre costs are merged with Separate cost driver rates are calculated for
production centre costs and included with support centres. Costs are assigned to cost
production centre overhead rates objects without the reallocation to production
centres
Overheads are allocated using a small number Have a greater number and variety of cost
of cost drivers which vary directly with centres (uses unit based and non-unit based
production volumes (unit based drivers only). activity drivers)
Uses direct labour hours and machine hours as
volume basis
Uses term allocation bases or overhead User term costs drivers and cost driver rates
allocation rates
Less accurately approximates products costs More accurately approximates product costs as
and uses cost drivers with no cause-and-effect allocates overheads on a cause-and-effect
relationships to assign support costs to cost basis, based on the resources consumed by cost
objects objects
Prepared by: Adèle Hassall
, More suited to organisations with: More suited to organisations with:
• low competition levels • high competition levels
• indirect costs are a low proportion of • indirect costs are a high proportion of
total costs product costs
• standardised products range • diverse product range consuming
consuming resources in similar resources in different proportions
proportions
Calculating product overhead costs using ABC
5 Steps in allocating overhead costs using ABC
o identify the major activities
require judgement
o quantify and assign overhead costs to each activity cost centre
no arbitrary allocations should be used
o determine the cost driver and cost driver volume associated with each activity
cost driver = an activity that causes a cost to be incurred
activity cost drivers should:
• explain the overhead costs in each activity cost pool
• be easily measurable
• be related with the products
Examples of activities and potential related cost drivers:
Activity Cost driver …. Number of
Machining Machine hours
Assembly Direct labour hours
Purchasing components Purchase orders
Receiving components Material receipts
Production scheduling Production runs
Set-up machines Set-up hours
Quality inspection First item inspections
o determine the cost driver rate (activity cost / cost driver volume)
o assign the cost of activities to products according to the product’s demand for activities (i.e.
the cost driver rate x the volume for each product)
Using unit-based drivers to assign overheads
Unit-based drivers are directly related to the level of production and can cause distorted product
costs
Non-unit-based activity drivers measure the demand products place on activities that are not
related to the level of production (e.g. number of machine set-ups)
Prepared by: Adèle Hassall
Accounting and
Control Systems
(MACS)
Module 1 to 11
Prepared by: Adèle Hassall
, THEORY
SECTION
Prepared by: Adèle Hassall
, CHAPTER 1
ACTIVITY-BASED COSTING (ABC)
ABC
o is a cost model used to assign manufacturing overheads to different products produced by a
manufacturing entity based on the premise that products consume activities, and activities
consume resources, which incur costs. Costs of activities should be assigned to cost objects
on the basis of the activities they consume
o assists in reducing product cost distortion by creating a cost pool (costs accumulated by
activities) for activities that can be identified as cost drivers and assigning overheads to
products based on the actual number of separate activities they require for completion
o reduced cost distortion and more precise product cost estimation, can give a organisation a
better understanding of product cost and profitability by:
identifying inefficient and unnecessary costs and activities
identifying profitable products and activities to allocate more resources to them
facilitating improved product control and pricing
identifying and eliminating products that are unprofitable
Traditional costing systems and ABC
Total manufacturing costs (product costs) > Direct costs (direct materials and direct labour) and
indirect costs (overheads)
Differences:
Indirect costs – how overhead costs are allocated to each product
Direct costs – same for both traditional and ABC
Traditional systems ABC
Allocated overheads to both production and Allocate overheads to each major activity and
service dept and reallocates dept costs to not dept’s
production dept
Support centre costs are merged with Separate cost driver rates are calculated for
production centre costs and included with support centres. Costs are assigned to cost
production centre overhead rates objects without the reallocation to production
centres
Overheads are allocated using a small number Have a greater number and variety of cost
of cost drivers which vary directly with centres (uses unit based and non-unit based
production volumes (unit based drivers only). activity drivers)
Uses direct labour hours and machine hours as
volume basis
Uses term allocation bases or overhead User term costs drivers and cost driver rates
allocation rates
Less accurately approximates products costs More accurately approximates product costs as
and uses cost drivers with no cause-and-effect allocates overheads on a cause-and-effect
relationships to assign support costs to cost basis, based on the resources consumed by cost
objects objects
Prepared by: Adèle Hassall
, More suited to organisations with: More suited to organisations with:
• low competition levels • high competition levels
• indirect costs are a low proportion of • indirect costs are a high proportion of
total costs product costs
• standardised products range • diverse product range consuming
consuming resources in similar resources in different proportions
proportions
Calculating product overhead costs using ABC
5 Steps in allocating overhead costs using ABC
o identify the major activities
require judgement
o quantify and assign overhead costs to each activity cost centre
no arbitrary allocations should be used
o determine the cost driver and cost driver volume associated with each activity
cost driver = an activity that causes a cost to be incurred
activity cost drivers should:
• explain the overhead costs in each activity cost pool
• be easily measurable
• be related with the products
Examples of activities and potential related cost drivers:
Activity Cost driver …. Number of
Machining Machine hours
Assembly Direct labour hours
Purchasing components Purchase orders
Receiving components Material receipts
Production scheduling Production runs
Set-up machines Set-up hours
Quality inspection First item inspections
o determine the cost driver rate (activity cost / cost driver volume)
o assign the cost of activities to products according to the product’s demand for activities (i.e.
the cost driver rate x the volume for each product)
Using unit-based drivers to assign overheads
Unit-based drivers are directly related to the level of production and can cause distorted product
costs
Non-unit-based activity drivers measure the demand products place on activities that are not
related to the level of production (e.g. number of machine set-ups)
Prepared by: Adèle Hassall
