Management Accounting - ABC

ABC

(It's as easy as 123)

ABC stands for Activity Based Costing. It has a few benefits, such as:

• It provides more accurate costs for each unit of a product (or service)


• It gives a better understanding of the business to managers

It's fairly simple to the more traditional costing methods we've looked at already, but with a key difference: ABC looks at activities as a way of accumulating costs, instead of the old method of using cost centres. So with ABC the costs will be driven by:

• Each support activity involved in making the product or service


• The costs that are given to each support activity


• The 'cost drivers', things that cause these costs to change

And with ABC overheads are attributed like this:

• First come up with an overhead cost pool for each activity


• Then allocate the total cost of each support activity to the relevant cost pool


• Use the cost drivers to charge the total cost in each pool to output

I know this can sound a bit like it doesn't mean anything so we'll go through an example now.

Example

A company makes 2 products, one is called Hi and the other is called Lo. Coincidentally, Hi is a high volume product whereas Lo is a low volume product. Hi sells 10,000 units and Lo sells only 1000 units. Here are their overheads as analysed by activities:

• Volume related: £110,000


• Purchasing related: £120,000


• Set up related: £210,000


• TOTAL: £440,000

Here's some additional info:

First so we can compare, let's work out the cost per unit using traditional full costing.

• £440,000 overheads ÷ 22,000 machine hours = £20 per machine hour


• Total cost for Lo: (2000 hours × £20 per hour) = £40,000


• Total cost for Hi: (20,000 hours × £20 per hour) = £400,000


• Cost per unit for Lo: (£40,000 ÷ 1000 units) = £40 per unit


• Cost per unit for Hi: (£400,000 ÷ 10,000) = £40 per unit

Now we can do it using ABC.

Note: If you aren't clear on what the calculations in that table are to get those answers, leave a comment and I'll make it clearer. It should be straightforward though.

The last thing to do is work out the cost per unit.

• Lo: (£ 10,000 + 40,000 + 84,000) ÷ 1000 units = £134 per unit


• Hi: (£ 100,000 + 80,000 + 126,000) ÷ 10,000 units = £30.60 per unit

ABC criticisms

• It takes longer and is more complex


• It isn't suitable for all businesses


• It isn't very relevant for decision making (people say this about full costing too)

ABC advantages

• Can be more accurate than full costing


• It is a lot more relevant to a service based business


• Helps managers understand what drives costs in the business

..and that's all for ABC for now