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by Ronnie Patton 24 Oct 2005 Diploma in Financial Management Relevant to Module A

For many manufacturing organisations, the most difficult aspect of calculating the cost of a product is the calculation of the overhead cost. Apart from the fact that it can be difficult to forecast overhead costs with any degree of accuracy, there are several other reasons for this. One problem is that traditional approaches to cost accumulation focus attention on cost behaviour, with a simplistic differentiation between variable costs and fixed costs.

However, in many situations, costs which are traditionally classified as 'fixed' can be managed, even in the short term. In addition, a number of costs which are classified as variable may not actually respond directly to changes in the volume of production. While there may be some link between volume and total expenditure for such costs, this is not adequately explained by the change in volume, and consequently there is a need to identify specific influences for each cost.

The problem is exacerbated by the changes in manufacturing technology and processes that have arisen in recent years. The impact of Business Process Re-engineering (BPR), shorter production runs, increased flexibility, and increased investment in facilities have led to a significant increase in overhead expenditure.

When traditional approaches to cost calculation were developed, manufacturing was relatively stable and labour intensive. This meant that direct costs (direct material and direct labour) comprised the major proportion of total cost, and overheads were of less significance. It is also widely acknowledged that the complexity of modern production means that products which are produced in low volumes may actually be responsible for a greater share of costs than products which are produced in high volumes. Taking all these factors into account, traditional methods will be unsuitable for many organisations.

Cost behaviour
The classification of costs into two basic categories (fixed and variable) can be useful, but such usefulness is limited. Consider the cost of processing orders for raw materials. In most organisations this will be regarded as a fixed cost, and will be absorbed into product cost on the basis of the volume of production for each product. This means that products produced in greater volume will be allocated a greater share of the cost. However, even a cursory analysis of the cost will indicate that total expenditure will be a function of the number of orders placed. If the number of orders placed is not controlled, expenditure will increase in an uncontrolled manner. If an effort is made to identify the factors which lead to orders being placed, it will be possible to control the cost by managing such factors. Allocating costs to products on the basis of the factors which actually cause the cost will lead to more accurate calculation of costs.

Business process re-engineering
BPR seeks to remove the restrictions which arise due to existing practices. The aim is to radically change the way an organisation seeks to achieve its objectives. In most cases, such objectives can be stated in terms of meeting the needs of customers. In simple terms, this can be taken to mean that the organisation will need to be more flexible and more responsive. Although this will lead to increased overheads, the resulting improvement in customer satisfaction should ensure enhanced profitability. However if the impact on costs is not clearly understood, the benefits will be reduced, and may even be eliminated.

Cost structure
As noted above, the emphasis on flexibility will lead to an increase in overheads. This leads to a change in the cost structure as production becomes less labour intensive and investments in production facilities increases. This means that overheads now often represent the major part of total cost. When traditional approaches to cost calculation were developed, direct costs represented the major part of total cost. As a result of these changes, there is a need for much greater accuracy in the calculation of overhead costs.

If, for example, overheads represent 30% of total cost, an error of 10% in the calculation of overhead cost will result in a 3% error in the calculation of total cost. While significant, this margin of error may not be critical. However if, as a result of the initiatives referred to above, the proportion of overhead cost increases to 70%, a 10% error will lead to a 7% error in total cost. This is clearly of much greater significance.

Impact of production volumes
A further outcome of the need for flexibility is that production is no longer organised in long production runs. The need to respond quickly to customer demands and the shift to just-in-time practices mean that production runs are shorter, and changing from production of one product to another is a common feature.

The impact of such changes on costs needs to be considered. Consider a company which has estimated that it costs £1,500 to re-configure the production set-up each time the product being produced is changed. If a product is produced in batches of 100, the set-up cost per unit produced is £15. However, for a product which is produced in batches of 500 units, the set-up cost per unit produced falls to £3. Traditional costing methods would actually allocate a greater proportion of cost to the product with the greater volume of production, and a lesser proportion to the low volume product.

So what's the solution?
One solution, which has been adopted by many organisations, is Activity-Based Costing (ABC). This approach seeks to address the problems discussed above, and is based on a number of key observations.

Activities cause costs
The first is that costs are caused by activities. While in some cases, costs which are assigned to production on the basis of activity will be almost identical to the costs which would be assigned on the basis of volume, this is not always the case. A good example of this is the cost of set up as discussed above. The volume of each product produced will, in part, influence the level of cost which will be incurred. But volume is not always an accurate predictor of costs. As shown above, the number of times the machinery is set up is a much more reliable indicator of cost.

Cost behaviour is influenced by cost drivers
'Cost driver' is the term used for an activity which influences the amount of total expenditure on a particular cost. This is perhaps the most significant aspect of ABC. For some costs, volume will be the cost driver, but for many other costs, volume will be a very poor indicator. This means that effort must be made to identify the activities that cause cost. By grouping costs on the basis of cost drivers, we will be able to both manage costs better (by managing the activity) and to calculate the cost of production.

Costs should be grouped by cost pool
Each group of costs which are influenced by a particular cost driver is referred to as a 'cost pool'. It is fundamental to ABC that each cost pool has a specific identifiable cost driver. From this it follows that an organisation may have many cost pools. Indeed this can be one of the drawbacks of the approach in practice. The task of identifying cost pools and analysing costs on the basis of cost drivers will require more resources than is needed for traditional responsibility-based analysis.

Costs are assigned on the basis of the use of the cost driver (activity)
Once costs have been grouped into cost pools, it is possible to allocate costs to production on the basis of the product's use of the cost driver.

Application
The arguments above may seem logical, but it may be difficult to see what this means in practice. The simple worked example shown on page 17 may be helpful in getting to grips with the application of these ideas.

Benefits
The most obvious benefit of ABC is that more accurate cost information is obtained. This will enable managers to make better decisions. In the worked example, if a traditional machine hours basis had been used to allocate overheads, the cost per machine hour would be £49.19 (£542,532 ÷ 11,030). This would lead to an overhead cost per product of £122.98 for Bert, £68.87 for Rod and £157.41 for Del. Using ABC, overhead costs of £101.03, £171.68 and £123.14 respectively can be calculated.

This indicates that using traditional cost accumulation methods, the overhead cost of Bert and Del would be overstated and the overhead cost of Rod would be understated. This could have a significant adverse effect on the company's decision making. As the profitability of Rod would be overstated, the company's marketing effort is likely to be directed towards maximising the sale of this product, with a lesser emphasis on the other products. In addition, as the resulting selling price will be less than is required to fully recover overheads and yield a satisfactory profit, the market will perceive the product to be particularly attractive.

It follows logically that the situation is precisely reversed for the other two products. This will mean that the company will be selling a much greater volume of Rod at a price which is too low. Indeed the selling price may even be leading to a loss being sustained on such sales. Clearly this is totally unsatisfactory, and in extreme cases, could even lead to the collapse of the company.

More accurate cost information will allow managers to make better decisions, particularly in respect of pricing and marketing activities. This approach can be developed further to include profitability analysis based on particular products or customers.

Service organisations
So far in this article, ABC has been considered in terms of manufacturing. It is important to note that the approach can also be effectively applied to service organisations. Indeed, the fact that for most service organisations, indirect costs will represent the major proportion of total cost means that the technique is of particular relevance to service organisations. In addition, the provision of services tends to be characterised by the need for major investment in facilities in advance of supply.

Colin Drury (Management and Cost Accounting 2004, page 391) refers to a survey carried out in 2000 which indicated that 51% of service organisations had implemented ABC, compared with only 15% of manufacturers.

Disadvantages
The discussion above may suggest that ABC is universally beneficial. This is not the case. As with any technique, care must be taken in deciding whether or not to implement the initiative. There are two major issues to be considered:

Cost vs benefit
The need to analyse costs on a radically different basis will require resources, which will lead to additional costs. Clearly the benefits which will be obtained must exceed these costs.

In general terms, an organisation which has little competition, a stable and standardised product range and for which overheads represent a small proportion of total cost, will not benefit from the introduction of ABC.

Need for informed application
While ABC is likely to provide better information for decision makers, it must still be applied with care. The discussion above ('Impact of product volumes') refers to the set up cost per unit produced. However, it may be that costs should not be considered at the level of a unit of production. If production is normally organised in batches of 500, the set-up cost per unit will have been calculated to be £3.

However, if a customer requests a special order of 150 units, the cost will only be £450 (150 x £3) if the order can be met through 'normal' production. If the order requires a specific set-up, the full cost of £1,500 should be included in the order. Thus, the key rule of decision making - the decision should be made on the basis of relevant costs - must continue to be applied.

Conclusion
ABC can, in the appropriate circumstances, be a useful and effective method of calculating costs. However, it may not be suitable for all organisations, and the potential costs and benefits should be carefully considered before it is introduced.

Example
Foolish Horses Ltd manufactures three products, Bert, Rod and Del. The company has prepared an overhead cost budget for the following year as follows:

Cost drivers, related occurrences and production volumes have been estimated as follows:

What is the overhead cost for each product using ABC?

Step 1
Identify cost pools and cost drivers
The cost pools and cost drivers have already been identified and are provided in the question.
These are:

Step 2
Calculate the cost per unit of cost driver
Machine running

Ronnie Patton is examiner for Module A

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