Management Accounting
Module Code: AC392 (LJMU)/AC387 (HETAC)
a). Labour hours
i). Profit calculation based on the existing labour hour method
Total overhead cost = € 12,000,000
Total labour hours = 500,000 hours
Therefore, overhead per labour hour = € 12,000,000/500,000 = € 24
Table 1 – all figures (except units) are in €
| Sunshine | Roadster | Fireball | |
| Materials | 800,000 | 960,000 | 360,000 |
| Direct labour (€ 5 per hr) | 1,000,000 | 1,100,000 | 400,000 |
| Overheads (€ 24) | 4,800,000 | 5,280,000 | 1,920,000 |
| Total Costs | 6,600,000 | 7,340,000 | 2,680,000 |
| Cost per unit | 3,300 | 4,587.5 | 6,700 |
| Output of units | 2,000 | 1,600 | 400 |
| Selling price | 4,000 | 6,000 | 8,000 |
| Profit/unit | 700 | 1,412.5 | 1,300 |
| Total profit | 1,400,000 | 2,260,000 | 520,000 |
The profit across the three products is € 4,180,000
ii). Profit calculation based on the Activity Based Costing (ABC) method
Deliveries inwards = € 3,600,000/800 = € 4,500
Set-ups = € 6,000,000/100 = € 60,000
Deliveries to retailers = € 2,400,000/250 = € 9,600
Table 2 – all figures (except units) are in €
| Sunshine | Roadster | Fireball | |
| Materials | 800,000 | 960,000 | 360,000 |
| Direct labour (€ 5 per hr) | 1,000,000 | 1,100,000 | 400,000 |
| Overheads | |||
| Purchase orders at 4,500 | 1,800,000 | 1,350,000 | 450,000 |
| Set-ups at 60,000 | 2,100,000 | 2,400,000 | 1,500,000 |
| Delivers at 9,600 | 960,000 | 768,000 | 672,000 |
| Total: | 6,660,000 | 6,578,000 | 3,382,000 |
| Output units | 2,000 | 1,600 | 400 |
| Cost per unit | 3,330 | 4,111.25 | 8,455 |
| Selling price | 4,000 | 6,000 | 8,000 |
| Profit/unit | 670 | 1,888.75 | (455) |
| Total profit | 1,340,000 | 3,022,000 | (182,000) |
The profit across the three products is € 4,180,000
b).
i). For Abkaber plc the overall profitability given the potential usage of ABC does not change significantly. However, the ABC methodology does offer some benefits that Abkaber plc can try and integrate in its production environment. ABC can help the organisation to realise the importance of each activity and its related impact on the overhead costs. For a product with less number of output units the labour hours could be less but the amount of activity that is contributed by other costs drivers could be high. This would result in ABC suggesting a far higher overhead cost for the low output unit product. While using a direct labour method this particular aspect of cost might not come across clearly.
ABC is a good methodology as it tries to allocate cost to each activity that is part of the process of manufacturing a unit of all product types. In the service sector the cost will be allocated for each activity that contributes to the delivery of the service. This method does not try and rely just on the overheads cost. As a result overheads get summarised using a lot of input costs rather than just one as with labour hours. Essentially, if there is no input then there is no overhead cost for that specific input. This translates to the theory supporting ABC that the activities are the drivers of cost.
Abkaber plc should take care while allocating costs for each activity. The activity selected should be an input for the production. Costs for the same activity could vary under different circumstances and care should be taken to allocate costs accordingly. The cost driver should be allocated to the appropriate overhead cost that it is contributing to. The costs as a part of ABC have a characteristic where the costs increase with increased activity.
ii). The finance director feels that ABC will not tell us anything new about product viability. While the managing director feels that if we carry out an activity a lot of time the costs should fall. What the managing director is talking about is essentially one characteristic of activity based costing where there is a cause and effect relationship between the cost driver or the output and cost input.
When the direct labour approach is used to analyse Fireball profitability it has a profit of € 520,000. Whereas with the ABC approach the profitability is € (182,000). The change in fortunes for Fireball is a result of how costs are allocated in the profitability calculations. In the ABC method, low volumes of units get offset by the overhead costs relating to setup, maintenance, etc. While the traditional labour hours method allocates less cost to the Fireball product as low number of units are produced in comparison to the other products. ABC implementation has led to efficient use of overhead resources, and therefore, increased cost savings (Cooper & Kaplan, 1991). While selling or retaining Fireball Abkaber needs to understand the high overheads costs as pointed out by ABC and see if they can be rationalised to improve the profitability of the product.
The marketing director is suggesting that ABC will just average out the costs. This is not true as it will also shows the dependencies that certain products like Fireball have on overhead costs given the relatively low production volume. Labour hour costing can be used in the normal circumstances but for negotiating a contract and other strategic decision it would be ideal to introduce the concept of ABC. The methodology has a limitation wherein it will not be able to reflect accurately if costs for a particular activity are restricted to one product only.
c). ABC helps financial institutions and other service sector constituents to achieve higher profitability and operational controls. ABC helps in budgeting and understanding the existing drivers of costing in financial institutions (John Smullen, 1995). Examples of banks embracing ABC range from Abbey to Citigroup and other banks in the developing world such as Bank of China and ICICI Bank in India. The nature of the transactions in service sector and the products differ and hence there is a need to understand the contributors of cost drivers in this sector. The growth of ABC is being fuelled by various service sector organisations realising the applicability of the methodology outside the manufacturing framework. Japan’s travel industry seems to be one of the adopters of the approach. Travel industry is quite labor-intensive; the proportion of labour cost to total operating expenses is as high as 48% in 2006 (Monthly JTM Report: Aug 2008).
ABC can also help the firm dwell into a wide range of issues. It is possible for a firm to document the activity dictionary of various processes. The organisation can define how much it is spending on each activity. At times there could be huge variances in activity costs which might not be apparent. It can help understand the source that causes the activity. This source or the cost driver can then be quantified. If the customers are served across various channels then channel profitability can be worked. This is an important factor for service industry. The industry uses the traditional media but is also heavily reliant these days on digital media. The cost of serving through messaging, emails, online support, etc. can also be quantified using ABC. If the service sector organisation understands channel profitability then it can offer prices biased towards its preferred channel. The entire activity can lead to calculation of customer profitability. All required data regarding the cost element in the profitability equation can be generated through ABC. What is required is the revenue information that can be used to calculate profitability.
Let’s consider an example of a new credit card issued to a customer. There are certain costs associated with issuing a new card ranging from acquiring costs, processing and delivery of the card. A bank might have different divisions handling these processes. Each division would be in charge of some activity whose cost can be attributed to the entire activity of issuing a new credit card. When the bank issues the card it is experiencing a loss if it is issuing the card for free. This is done in the hope of gaining profitability as the customer starts using the card. However, to improve profitability or reduce loss at the time of card issuance the understanding of each activity as cost driver’s help banks optimise their costs. A lot of budgeting in banks happen based on the ABC framework where the costs for existing operations and products are allocated and costs related to the activities of new products are allocated to the yearly budgets.
The success in implementing an ABC based model in organisations can vary. What ABC enables is the understanding of how activities serve as cost drivers. It helps to understand the full cost of servicing be it in the social welfare or the financial sector. There are various activities such as business development, customer retention and complaint management which is usually not allocated a cost by organisations. These all activities end up using resources like employee time, communication resources, etc. All these activities have a certain cost associated with it which should be understood. Companies that offer help lines as a part of their insurance, technical support and other products/services need to incorporate cost of managing their customers in the overall business profitability.
As in the case of Abkaber plc, ABC helps in taking decision making. The decisions can be strategic in nature relating to the product profitability of operational in nature relating to monitoring the variance in activity cost over a period of time. The methodology is highly recommended usually in organisations that have a lot of process diversifications and different product categories. In such organisations the methodology can help understand how fixed and other costs can be allocated across various product categories.
References
Albright, T. L., R. W. Ingram and M. A. Lawley. 1992. The Beville Manufacturing case: Using factory-simulation software to teach the concepts of activity-based costing and nonfinancial performance measures. Journal of Accounting Education 10(2): 329-348
Abdallah, A. A. and W. Li. 2008. Why did ABC fail at the Bank of China? Management Accounting Quarterly (Spring): 7-14
Awasthi, V. N. 1994. ABC’s of Activity-Based Accounting. Industrial Management (July-August): 8-1
Cooper, R., & Kaplan, R. S. (1991, May-1991, June 30). Profit Priorities from Activity-Based Costing. Harvard Business Review
Financial Management Information and Analysis for Retail Banks
By John Smullen, Published by Woodhead Publishing, 1995
‘CIMA – From Activity Based Costing (ABC) to Activity Based Management (ABM)’ available from http://www.hawksmereltd.co.uk/croner/event.php?product=2417&type=public#46256
‘Japan’s Travel Industry Towards Productivity Improvement – Monthly JTM Report: Aug 2008’ available from http://www.tourism.jp/english/report/2008/08/11/20088-2e.php