COST OF BOXES 25 ml 150ml
Direct Material 900,000 900,000
Direct Labour 300,000 200,000
Machine Department Costs 200,000 200,000
Set-up costs 200,000 200,000
Total Cost 16,00,000 15,00,000
This cost has been calculated on the basis of traditional costing system. The Direct Material cost and Direct Labour has been calculated on the basis of total production units. The overhead costs have been allocated to products on the basis of traditional costing system. The cost that has been calculated shows that traditional cost systems report less accurate costs because they use cost drivers where no cause-and-effect relationships exist to assign support costs to cost objects.
COST OF BOXES: 25 ml 150ml
Direct Material 900,000 900,000
Direct Labour 300,000 200,000
Machine Department Costs 20,000 40,000
Set-up costs 60,000 20,000
Total Cost 12,80,000 11,60,000
These costs of two different packages of boxes have been calculated on the basis of Activity based costing system, in which the overhead costs are allocated to products on the basis of cost drivers. The Direct Material and Direct Labour costs of the two packages of boxes have been calculated on the basis of number of production units. The overheads have been allocated to products on the basis of cost drivers. i.e., the machine department costs have been calculated on the basis of machine hours, whereas the setup cost has been calculated on the basis of number of production runs.
ACTIVITY BASED COSTING: HIERARCHICAL PROFITABILITY ANALYSIS
ABC is more accurate cost management system than Traditional Cost accounting. Traditional cost accounting cannot calculate the real cost of the product.
With the traditional costing system misleading information can be reported. A small loss can be reported for a product and if it were discontinued the costing system mistakenly gives the impression that overheads will decline in the longer term.
Furthermore, the message from the costing system is to concentrate on the more profitable specialty products. In reality this strategy would be disastrous because low volume products are made in small batches and require more people for scheduling production, performing set-ups, inspection of the batches and handling a large number of customer requests for small orders. The long-term effect would be escalating overhead costs.
In contrast, the ABC system allocates overheads on a cause-and-effect basis and more accurately measures the relatively high level of overhead resources consumed by a product. The message from the profitability analysis is the opposite from the traditional system; that is, the product concerned is profitable and the other product is unprofitable. If that product is discontinued, and assuming that the cost driver is the cause of all the overheads then a decision to discontinue than the product should result in the reduction in resource spending on overheads.
The boots plc’s case is very helpful in this regard. It is assumed that the organization has established only a single cost centre or cost pool, when in reality many will be established with a traditional system, and even more with an ABC system.
Some organizations market groupings of products within their product lines as separate brands. A typical example of the difference between product brands and product lines is Procter and Gamble who market some of their products within their detergent product line under the Tide label and others without this label.
Where products are marketed by brands, all expenditure relating to a brand, such as management and brand marketing is for the benefit of all products within the brand and not for any specific individual product. Therefore, such brand-sustaining expenses should be attributed to the brand and not to individual products within the brand.
The same reasoning can be applied to the next level in the hierarchy. For example, marketing, research and development and distribution expenses might be incurred for the benefit of the whole product line and not for any specific brands or products within the line. Therefore these product line-sustaining expenses should be attributed to the product line but no attempt should be made to allocate them to individual products or brands.
Finally, the profit for the organizational unit as a whole can be determined by deducting facility-sustaining expenses from the sum of the individual product line contributions.
The hierarchical profitability analysis was highlighted by Kaplan (1990) and Cooper and Kaplan (1991). They apply the ABC hierarchical activity classification to profitability analysis. In addition, they stress that the reported ABC product costs do not provide information that can be used directly for decision-making. Instead, they report attention-directing information by highlighting those potentially unprofitable products or services that require more detailed special studies. Cooper (1997) has stressed that a major role of ABC is to develop profitability maps (i.e. periodic profitability analysis by cost objects) that are used to focus managerial attention. He argues that because the cost of special studies are high the number performed has to be carefully controlled; hence the need for good attention-directing information.
He concludes that the primary value of ABC systems lies in the quality of the profitability analysis generated.
Their greater accuracy increases the probability that when the special study is undertaken, its findings will support the message sent by the cost system.
In other words, profitable products will be found to be profitable, and unprofitable products will be found to be unprofitable. Traditional cost systems often result in inaccurate profitability analysis resulting in special studies being at odds with the message sent by the cost system. In the extreme the cost system may be ignored.
Kaplan and Cooper (1998) extended cost hierarchies to develop activity-profitability maps by different cost objects.
This approach categorizes costs according to the causes of their variability at different hierarchical levels. Hierarchies identify the lowest level to which cost can meaningfully be assigned without relying on arbitrary allocations.
The aim of ABC hierarchical profitability analysis is to assign all organizational expenses to a particular hierarchical or organizational level where cause-and-effect cost assignments can be established so that arbitrary allocations are non-existent.
The hierarchical approach helps to identify the impact on resource consumption by adding or dropping items at each level of the hierarchy. For example, if a brand is dropped activities at the brand level and below which are uniquely associated with the brand will be affected, but higher level activities (i.e. at the product line level) will be unaffected. Similarly, if a product within a particular brand is dropped then all unit, batch and product-sustaining activities uniquely associated with that product will be affected but higher level brand and product-level activities will be unaffected (Drury Colin, fifth edition, accessed 21.11.2005)
Boots, Financial Results, Company Reports, accessed November 20, 2005 from:
Drury Colin (fifth edition), Management & Cost Accounting, accessed November 21, 2005):