Allocation of overhead is one of the problems that bedevils any form of costing. And the more sophisticated the business, the more difficult or arbitrary those allocations seem.
Businesses need to know the cost of their product so as to control those costs and get their pricing right. And adding up the raw material and cost of direct labour needed to manufacture a product may be relatively straightforward. And if the business had only one product, overhead could be dealt with easily too. But complications begin when there are more, sometimes many more than one product, mix and output varies. Knowing where to charge all those other costs that the business has to bear – items such as rent, rates, the cost of the accounts department and the quality control team – can be a real headache.
One of the simplest and longest established methods is ‘absorption costing’ – whereby each coast centre is apportioned overhead which are ‘absorbed’ by inclusion in the unit costs applicable to that cost centre. If budgets are met, the total overhead charge will be recovered – or absorbed.
This is all right if you know that your product range, mix and manufacturing techniques will remain more or less fixed. In sophisticated businesses with large, flexible and fast changing product ranges and techniques this may not be enough. Here ‘activity based costing’ commonly referred to as ABC, offers what many see as a better insight into overhead cost allocation.
As its name implies, it works on the basis that businesses undertake a number of activities which each add value to its products which should bear costs on a ‘pick and mix’ basis according to which activities they use. .
Financial Managers are required to show an understanding of the principles which underpin this approach to cost analysis, and to demonstrate their competence in applying this technique to a variety of differing business sectors.
A formal definition of ABC, as set out by the Chartered Institute of Management Accounts, is: ‘cost attribution to cost units on the basis of benefit received from indirect activities – for example: ordering, setting up and assuring quality.’
Other writers and researchers focusing on this technique have broadened the definition, Bromwich and Bhimani for example use the term ‘activity based accounting’ which they define as ‘examination of activities across the entire chain of value-adding organisational processes underlying causes or drivers of cost and profit’.
ABC was first used in the US as long ago as the 1950s, although some texts claim it is a relatively new technique. Early research on its use focuses on the attempts by a number of companies to allocate more accurately their selling and distribution costs.
With the introduction of zero-based budgeting in the 1970s and 1980s – leaning on the idea that budgets should not be constructed on the basis of what has gone before but starting with a clean sheet – we experienced a shift in the approach to coast analysis based upon activity. The concern now centred on an examination of the process of adding value.
Further work by writers as Copper and Kaplan shaped the framework for ABC and influenced its use by consultants and practitioners.
It is becoming more widely used in the UK, not least in the National Health Service, where recent research suggests managers are finding the approach more appropriate to their cost analysis needs.
As with many other management accounting techniques, ABC has its own terminology with words and phrases such as ‘activity’, ‘cost driver’, ‘cost pool’, and ‘cost driver rate’ given particular meanings.
In this context, an ‘activity’ is a value-adding process which consumes resources. Quality control is an example.
A ‘cost driver’ is an activity or factor which generates cost, for example the inspection process within quality control would be a ‘cost driver’.
Meanwhile a ‘cost pool’ is the collection of overhead s associated with quality control would together form a ‘cost pool’.
The ‘cost driver rate’ is the result of dividing the cost pool for the activity by the cost driver volume. In the case of quality control an appropriate cost drive volume might be the number of inspections conducted and the ‘cost driver rate’ the ‘cost poo’ divided by the number of inspections.
Application of ABC involves five steps:
- collection of overhead cost figures;
- allocation of those costs to activities to form cost pools;
- identification of cost drivers;
- determination of cost per unit of activity (cost driver rates) on the basis of cost drive volume rates;
- charging overheads to production based on demand placed on differing activities as measured by cost volume driver rates.
Hawsker Engineering has analysed its value added process and identified various activities, cost driver for those activities, and current volumes that apply across the whole firm.
The company has a broad range of products, one of which is its ‘Safeguard’ safety device fitted to crushing plant in the quarry industry. When preparing budgets for the coming period it wishes to use ABC techniques to apportion overheads to this and other products.
Taking into account its current finished product stock levels Hawsker budgets to produce 75 ‘Safeguard’ units. To achieve this level of output it will require the following activity cost driver inputs:
- 75 set ups and production runs;
- 25 purchase orders;
- 15 standard maintenance checks;
- 500 material movements;
- 75 inspections; and
- 50 sales customers.
This information allows the company, using the ABC technique, to estimate the overhead charge for the period.
This is done by multiplying the activity cost driver by the pool driver rates. Thus the overheads attributable to the ‘Safeguard’ machine guard will be:
Overhead cost per unit of output £38,250 ÷ 75 = £510
It is argued by a number of writers that compared to traditional methods ABC generates improved or more accurate product costs and provides information that enables companies to coventrate on the more profitable mix of products or customers (the aim of all costing techniques). But recent research suggest it may do more by improving the quality of cost information and providing managers with an understanding of the economics of production and the value added activities which consume resources.