Week 3

• •Under a machine hours basis all the overheads, regardless of whether they are machine related, are spread across production according to how many hours of machine time each product needs. The overhead allocation is VOLUME related.
• •A product with complex production processes may well use up a lot of the company’s overhead resource but if it doesn’t need much machine time, it won’t bear its fair share of overheads •So it will be under-costed, meaning that other products will be over-costed since they will absorb too much overhead!
• A price MAKER, who bases the selling price on costs plus a mark up

  An under-costed product will lead to a product that is too cheap but is attractive compared to its more expensive competition

  If the margin is actually lower than the company believes, and it is selling at high volumes, then the company is going to be less profitable than it should be and could even go out of business
• A price TAKER, who bases the selling price on what is being charged in the market place

  An under-costed product will look as if it is more profitable than it really is and other products will look less profitable.

  This will lead to poor decisions being made about the portfolio of products the company offers

  It can also lead to wrong decisions about divisions and team or management performance
• •Direct costs falling as a proportion of total cost. Labour is being replaced by technology
• •Increases in overhead costs: support for technology, product design, production planning, quality assurance, customer service. Poor overhead allocation matters more
• •Increases in the cost of technology: greater complexity and sophistication, shorter lives for production systems
• •Overheads were now much more significant than in the past and were often no longer related to direct labour or machine hours
• •Absorption costing can lead to very inaccurate results for non-traditional and new style businesses

  •The system offered little in the way of information for strategic management decision making
• Enter ABC

  •A theoretical approach that moves away from volume based allocation to a cause-and-effect based allocation There are some common principles but many variations It is not a perfect solution
• 1. Traditional costing allocate overheads to departments2) absorb overheads into cost objects (eg products) on the basis of an overhead absorption rate eg DLH
• 1. ABCallocate overhead costs to activity cost centres2) absorb overheads into cost objects (eg products) using activity cost drivers eg per inspection, per order
• Steps in Activity Based Costing

  1.Identify the activities within the organisation

  ●2.Determine the key cost drivers for each activity

  ●3.Pool costs together which have the same cost driver

  ●4.Measure the incidence of the cost driver for each pool

  ●5.Use the cost drivers as a basis for assigning overheads to each product.
• When is ABC useful?

  •Where competition is great and it is important to understand the relative profitability of each product/service•

  •When pricing depends on costs••Where indirect (overhead) cost is high compared to direct cost•

  •There is a wide range of products with different and more complex resource requirements•

  •In service organisations where the customers/clients take varying routes through the processes offered
• Advantages of ABC

  •More cost pools and cost drivers: increased accuracy

  •Observable link between products/services and activities

  •The cause and effect relationship between products, activities and costs is maintained

  •Can be used to conduct profitability analysis on products, services and customers

  •The opportunity to move into ABCM
• ABCM

  1.Understand how costs arise- what drives the costs in the cost pool?●2.Identify the cost of unused resources- is there spare capacity in this activity?

  ●3.Identify expensive activities and seek ways to reduce the cost of an ‘occurrence’- can we reduce the cost of this activity?

  ●4.Re-design/reengineer the process to reduce the consumption of activity resource- can we reduce the amount of activity this product needs?
• Disadvantages of ABC costing

  •Very complex approach- needs expertise in house even if consultants used•Time-consuming and therefore costly to implement•Needs to be maintained and kept up to date•May appear threatening so may be resisted•Results may affect decisions around portfolio, production, pricing, competitive strategy, organisational structure

  NEEDS a cost-benefit analysis, expertise, substantial funding and support from the whole organisation especially senior management