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

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About Shaun
I'm super cool and I do computer science (unrelated to the coolness)

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